The Lease That Decides the Covenant
A distributor signs a 7-year lease on a distribution center: payments of $4.2m annually in advance, escalating 3% a year, incremental borrowing rate 6.5%. There is a 5-year renewal at then-market rent and a termination right after year 4 on payment of a $2.1m penalty. The bank's leverage covenant is total debt / EBITDA at or below 3.50x; unadjusted debt is $310m and EBITDA is $97m, so the company sits at 3.20x. The CFO wants the arrangement kept out of the 'net debt' the bank uses, argues the renewal is 'not reasonably certain', and has booked nothing but rent. The audit committee asks for your view two weeks before the covenant certificate is signed.
1. Determine the lease term and estimate the lease liability under each defensible term.
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- Term is a judgment, not a fact. Start from the non-cancellable 7 years and test the two options.
- Termination after year 4: the penalty is $2.1m against a PV of the years 5-7 rents of about $10.7m (3.68 + 3.56 + 3.44). A penalty worth roughly 20% of what it buys out is cheap, which points to a 4-year enforceable term - unless relocation costs, build-out or customer contracts make continued occupancy reasonably certain, which must be documented.
- Renewal: 5 years at then-market rent with no bargain element gives no economic incentive to renew, so it is correctly excluded. That is the one part of the CFO's position that holds.
- Liability at 6.5%, annuity due:
- 4-year term: 4.20 + 4.33/1.065 + 4.46/1.133 + 4.59/1.207 = $16.0m
- 7-year term: add 4.73/1.285 + 4.87/1.369 + 5.02/1.458 = $26.7m
- The lesson: one judgment about a termination penalty moves the liability by $10.7m, which is larger than most of the other accounting estimates in the file combined.
2. What does each term do to the covenant and to reported EBITDA?
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- Leverage at the 7-year term: (310 + 26.7) / 97 = 3.47x against a 3.50x limit. Headroom is 3.50 x 97 = 339.5 of debt capacity against 336.7 used - about $0.8m of EBITDA, or under 1%.
- Leverage at the 4-year term: (310 + 16.0) / 97 = 3.36x. Comfortable.
- The covenant answer hinges entirely on the term judgment, which is why the audit committee is asking. This is not a presentation preference; it is a $10.7m swing on a ratio with $2.8m of total cushion.
- The EBITDA side is subtler. Under a finance-lease style presentation, the ~$4.2m rent is replaced by depreciation and interest, so EBITDA rises by roughly the rent - about 4% - flattering the denominator of the very ratio the CFO wants to protect. A sophisticated bank will either freeze GAAP, exclude lease adjustments, or add the lease back into net debt.
- Before anything else: read the credit agreement's definition of Indebtedness and Net Debt. If it is frozen GAAP from the original closing date, the whole analysis may be moot for covenant purposes - but not for the statutory accounts.
3. What do you tell the CFO and the audit committee?
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- Correct the premise. Under ASC 842 / IFRS 16 there is no off-balance-sheet operating lease for a lessee. The question is not whether a liability exists, it is how large it is - $16.0m or $26.7m on the facts given. 'Booked nothing but rent' is not a tenable position and will not survive the audit.
- To the CFO: pick the term assumption you can defend in writing, disclose the sensitivity, and take it to the bank before the certificate is signed rather than after. Arriving at 3.47x against a 3.50x limit with no prior conversation is how a technical breach becomes a relationship problem.
- To the audit committee: the covenant is likely to be met under either term, but the 7-year case leaves under 1% of headroom. Note that the termination penalty is the pivotal input, that it should be reassessed each reporting date, and that the real estate intent behind the occupancy decision needs to be documented contemporaneously, not reconstructed after the fact.
- The general principle: classification labels do not create or destroy obligations. Argue about measurement and disclosure, which is where the defensible positions are, and never let a presentation preference carry a $10.7m balance sheet consequence into a signed certificate.