What is Covenant Strength? Investing Explained
INVESTING EXPLAINED: What you need to know about Covenant Strength – a legal term relating to the reliability of the promise made when the lease on a property is signed
In this series, we bust the jargon and explain a popular investing term or theme. Here it’s Covenant Strength.
Covenant strength is a legal term relating to the reliability of the promise made when the lease on a property is signed.
It indicates the ability of the tenant to pay the rent – now and in the future – based on an assessment of that individual or company’s finances.
The term is being used more frequently in the assessment of Reits, real estate investment trusts which are companies that own and let out residential and commercial properties, aiming to deliver capital growth and a steady income to shareholders.
Is there a formula to determine it?
There seem to be no hard and fast rules – properties and tenants’ circumstances differ widely.
Formula for covenant strength?: There seem to be no hard and fast rules – properties and tenants’ circumstances differ widely
But much emphasis is placed on their credit ratings, as recorded by the likes of analytics group Dun & Bradstreet, and also on the nature of their business.
For example, a warehouse tenant that delivers essential goods and is rated as a low-moderate credit risk may be considered more robust than a fashion retailer whose fortunes are dependent on the vagaries of the economy and fickle consumer tastes. A FTSE 100 company would be viewed as a very strong tenant, boosting the value of the Reit’s properties.
Why am I reading about this now?
The collapse of the Home Reit, which specialised in social housing, has shone a spotlight on this crucial issue for investors.
This focus began late last year when the US consultancy Viceroy Research, run by UK short seller Fraser Perring, issued a report questioning whether Home’s tenants were sufficiently well-capitalised to pay their rent. These disclosures caused the Reit’s shares to tumble – benefiting Viceroy. The shares remain suspended.
What’s the latest?
Accountants Alvarez & Marsal were called in to investigate the Reit’s accounts, after rumours of a National Crime Agency probe. Alvarium, the trust’s managers, have quit, with a replacement expected to be announced this week.
When Home made its stock market debut in September 2020, shareholders were told that it would invest in ‘high-quality homeless accommodation’. But the properties require £20m of refurbishment work, and two tenants who represented 18 per cent of the rent roll have gone into liquidation.
Any legal issues?
Home Reit shareholders believed that they were making a secure investment that would help the homeless.
They want answers and redress, with covenant strength set to be the heart of compensation claims. Legal firm Harcus Parker is leading the action.
Are Reits best avoided?
Not necessarily, as they operate in a wide range of sectors. Some specialise in the super sheds catering for major bricks and mortar and online retailers. Others are in life science facilities, or data centres.
But their share prices are even more of a reflection of the stock market’s view of how economic conditions will affect tenants’ ability to pay – and whether they may need to lease less space in future. As a result, the shares of most Reits stand at a discount to their net asset value. The other social housing Reits are at the deepest discounts.