What is covenant strength and why does it matter?

By Cleo Folkes

As House of Fraser announced the closure of 31 stores earlier this month and Debenhams issued their third profit warnings in the year today, we hear that landlords worry about covenant strength. What is it exactly that they worry about?

In property you often hear the word covenant strength when people talk about a tenant or the quality of an investment property or real estate loan. When you Google the definition for covenant it will tell you it is “an agreement” or something you “agree by lease, deed, or other legal contract”. Thus, when people talk about covenant strength, they are talking about about how secure the income is coming from a lease with a tenant.

When a tenant wants to take space in a property the prospective landlord will check the financial strength and stability of that tenant. A landlord is weary of a tenant falling behind on rent payment or worse (not pay at all). Landlords will in the first instance run a credit report by an institution like Dun & Bradstreet. Those reports will provide a first impression.

However, this information is not enough since the financial information is often outdated, and some more independent digging needs to get done. Prospective landlords want to know what assets they have that they can lay their hands on in case the tenants default on rental payments, for example. Luckily landlords are one of the first in line to get paid from the line of creditors in case of bankruptcy.

So, if a prospective tenant hasn’t got an impeccable credit score, what happens? The landlord might see if the prospective tenant has a parent company with a better credit record who might be willing to guarantee the rental payments. Or a sizeable deposit might be demanded.

Still, someone looking to buy an asset with a tenant with a not-so-good name – i.e. poor covenant strength – would find that asset likely less desirable to purchase. They would probably not be willing to pay as much for it when let to a financially strong tenant. The acquisition price they are willing to pay per £1,000 of rental income is a bit less, so the Net Initial Yield would be higher. More risk means the demand for a higher return and yields go up. Valuers would also apply a higher yield. As in the end if a tenant were to go bust, the landlord will still have to go through the trouble to ensure they get paid, and they likely lose out a little on the income, but a lot on time and legal fees.

As such, commercial property is not only a function of location, but covenant strength. As you know now, covenant strength is not simply the ability to pay rent today, but also in the future, ideally until the end of the lease term.

We hope you found the explanation useful. The course ‘Introduction to Property’ explains a whole lot of property jargon from across the property industry, such as what does an asset manager do, terminology from the lettings as well as the investment side. We explain sometimes complex concepts in a simple way, and we use real-life examples to bring the material taught to life.

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