How One Covenant Violation Could Trigger a Financial Domino Effect — and How to Stop It Before It Starts

Imagine this: You've built your medical practice for years and own the real estate through a separate entity. You’ve never missed a loan payment. But one morning, you receive a notice from your lender: your loan is in default. Not because of missed payments — but because a debt service coverage ratio (DSCR) fell below the required covenant of 1.20x.

The bank now has the right to increase your interest rate, demand a principal paydown, or even accelerate the entire loan. You scramble to understand how you tripped the covenant — only to learn that the bank calculated coverage not just from the rent paid by your real estate entity but also based on your operating practice’s financials. This wasn’t just a tripwire. It was a “killer clause".

What Are “Killer Clauses”?

In real estate loan agreements, particularly those for physician-owned practices, financial covenants such as DSCR and Fixed Charge Coverage Ratios (FCCR) measure a borrower’s ability to meet its debt obligations. However, these covenants can become dangerous when misunderstood, misapplied, or structured over-aggressively.

A big culprit that frequently causes confusion and frustration is the term “Global” Pre-Distribution DSCR. This calculation includes your operating practice.

Borrower-Only vs. Global DSCR: A Crucial Distinction

For borrowers, clearly understanding and negotiating which DSCR will be used can have significant implications on loan approval, terms, and required guarantees.

Borrower-Only DSCR

• Definition: Measures net operating income (NOI) from the real estate entity (e.g., medical office building) divided by its debt service.
• Purpose: Ensures the rent received from the operating entity covers the loan payments without relying on outside sources.

Global DSCR

• Definition: Combines the financials of both the real estate entity and the operating practice (your medical group) to determine debt coverage.
• Purpose: Allows lenders to evaluate the combined risk of the two related entities.

Fixed Charge Coverage Ratio (FCCR): Another Hidden Trap

While DSCR focuses on real estate cash flow, FCCR captures a broader range of obligations, including  rent, debt service, capital leases, and dividends/distributions.

If a lender applies FCCR globally (i.e., across the practice and real estate), even a one-time equipment lease or partner buyout could trip the covenant.

The Consequences of Tripping These Covenants

Violating DSCR or FCCR doesn’t just lead to a stern warning. It can trigger:

• Interest rate increases (default rates 2–5% higher
• Principal paydown requirements (e.g., $500,000 due in 30 days)
• Loan acceleration (entire loan balance called immediately)
• Restriction on distributions to physician-owners
• Damage to future financing due to reporting of a technical default

For most physician-owners, this is a completely avoidable crisis — if they catch it early.

How to Prevent a Killer Clause from Striking

1. Identify the Covenant Language Before You Sign

Ask your lender to clarify:

• Is the DSCR based only on the real estate entity or global?
• Is there a FCCR? If so, which entities does it include?
• What happens if the covenant is violated? Is there a grace or cure period?

2. Test the Covenant Yourself — Every Year

Before agreeing to terms or committing to financial projections, you must:

• Use prior year financials (tax return or CPA-prepared statements) to calculate:
  • Borrower-only DSCR
  • Global DSCR
  • FCCR (if required)
• Model forward-looking projections based on:
• Rent schedule
• Operating practice P&L
• Capital expenses or planned distributions

You’re not just running math — you’re simulating whether your loan is safe.

3. Negotiate or Recast Risky Covenants

If your projections suggest a future covenant breach:

• Ask for a waiver or restructure before the issue arises.
• Push for more flexible thresholds (e.g., 1.10x vs. 1.25x).
• Include carve-outs for non-cash or one-time items (e.g., bonuses, equipment purchases).
• Try to separate entities in financial calculations.

4. Build a Covenant Compliance Checklist

Create an internal process to:

• Review covenants quarterly
• Update projections annually
• Flag any major practice changes (e.g., new leases, capital expenditures)
• Communicate with the lender proactively if needed

Final Thought: A Covenant Doesn’t Have to Be a Killer

When structured clearly and monitored proactively, loan covenants protect both you and the bank. But when vague or misunderstood, they can become lethal.

For physician-owned real estate entities, especially where the practice and real estate are tied together, understanding how your lender defines “coverage” is just as important as understanding your interest rate.

Before you sign — and every year after — test the numbers. Know the risk. Don’t let a technicality endanger your practice or your property.

Questions? Get in touch with us at solutions@cmacpartners.com or schedule a meeting with our team.