What is Covenant Strength? Investing Explained

In this series, we break down the jargon and explain a popular investment term or theme. Here is the Covenant Power.

What is this?

Covenant strength is a legal term pertaining to the reliability of the promise made when the lease for a property is signed.

It indicates the tenant’s ability to pay the rent – now and in the future – based on an assessment of that person’s or company’s finances.

The term is more commonly used when reviewing Reits, real estate investment trusts, which are companies that own and rent out residential and commercial properties, with the goal of providing capital appreciation and steady income to shareholders.

Is there a formula to determine this?

There don’t seem to be any hard and fast rules – tenants’ characteristics and circumstances vary widely.

But a lot of emphasis is placed on their creditworthiness, as recorded by analysis group Dun & Bradstreet, as well as the nature of their business.

For example, a warehouse tenant who supplies essential goods and is rated as having low to medium credit risk may be considered more robust than a fashion retailer whose fortunes depend on the vagaries of the economy and fickle consumer tastes. A FTSE 100 company would be seen as a very strong tenant, increasing the value of the Reit’s properties.

Why am I reading about this now?

The collapse of the Home Reit, which specializes in social housing, has thrown a spotlight on this crucial issue for investors.

This focus began late last year when US consultancy Viceroy Research, led by British short seller Fraser Perring, released a report questioning whether Home tenants had sufficient capital to pay their rent. These revelations caused the Reit’s stock to plummet, benefiting Viceroy. The shares remain suspended.

What is the most recent?

Accountants Alvarez & Marsal were brought in to investigate the accounts of the Reit, following rumors of a National Crime Agency investigation. Alvarium, the trust’s trustees, have resigned and a replacement is expected to be announced this week.

When Home made its stock market debut in September 2020, shareholders were told it would invest in “high-quality homeless shelters.” But the properties require £20 million in renovation work, and two tenants representing 18 per cent of the rent list have gone bankrupt.

Legal problems?

Home Reit shareholders believed they were making a safe investment that would help the homeless.

They want answers and redress, where the strength of a covenant will be at the heart of compensation claims. Law firm Harcus Parker is leading the action.

Are Reits Best Avoided?

Not necessarily, as they operate in a wide variety of industries. Some specialize in the super warehouses for major physical and online retailers. Others are in life science facilities or data centers.

But their stock prices are even more reflective of the stock market’s view of how economic conditions will affect tenants’ ability to pay — and whether they might need to rent less space in the future. This leaves most Reits’ shares at a discount to their net asset value. The other Reits social homes are at the biggest discounts.