Even veterans in the real estate industry might have questions about Guarantee Real Estate and how to ensure that they are right for you.
I will be taking a closer look at these items to help you understand why they are important and why you may not.
This is the easiest way to understand it. Let’s talk about the three main types of guarantees you will find in every real estate deal. These include bad boy guarantees/non-recourse carveout guarantees, payment guarantees, and completion guarantees.
Bad Boy Guarantee Real Estate
Original intent of the bad boy guarantee was to protect principals and borrowing entities.
Lenders who tried to recover mortgage loans debts from collateral ended up losing a lot of money when they discovered that collateral’s value was lower than the debt, or that the borrowers had taken cash out of the property before default.
Bad boy guarantees made borrowers and guarantors responsible for any losses incurred by the lender in these types of cases.
The bad boy guarantee stems from the fact that people will put their personal interests above any corporate interests.
Bad boy mechanisms are designed to protect the interests of the lender or investor by ensuring the sponsor does not act in their best interest. This is done by placing disincentives on the sponsor to avoid doing anything else.
If you are given a bad-boy Guarantee Real Estate, avoid having a corporate garantor act as the guarantor. This would be contrary to the original intent. In some cases, a single-purpose-entity (SPE) can be formed where the only asset is the property in question.
This illusion can give the appearance of a guarantee. However, the only collateral that guarantees the investment is the asset.
Most loans will come with a bad boy guarantee
Lenders want to ensure that the loan documents and structures they create are followed.
Bad boy guarantees are a way to alleviate this concern. They basically say that the borrower will not be held responsible if they adhere to the terms of the loan agreement.
Bad boy guarantees are more common than some of the other options. Here are a few examples of what a bad act looks like in terms of breaking a guarantee and how it can cause problems for sponsors.
Declaring bankruptcy is one of the most popular
In recent years, there have been many high-profile legal cases where sponsors found declaring bankruptcy to be the best option to protect investor interest. Perhaps by slowing down foreclosure through declaring bankruptcy the borrower wanted investor protection by riding out any downturns until values recover.
The sponsor was therefore forced to declare bankruptcy because of a fiduciary obligation they had to investors. However, the lender found that the bad boy guarantee triggered liability.
A bad boy provision could also include the requirement that the borrower (the sponsor) funds replacement or interest reserves.
Sponsors could be held responsible if they fail to meet these requirements.
Types of Personal Guarantee
This is important. Lenders will want to ensure that they are protected when they lend money. A lender might ask for personal guarantees to help them achieve this goal.
Unconditional Personal Guarantee
A sole guarantee will be required if the borrower is the sole owner of the company or the principal in the transaction. They are responsible for repaying the loan and covering the gap between the collateral liquidation proceeds or the remaining loan balance.
When you agree to a sole-guarantor structure, there is an important aspect to consider. Although the lender may only name one guarantor, if the guarantor and spouse are married, they will be jointly responsible for the spouse’s funds. To avoid any unpleasant surprises, they should be informed about the agreement.
Joint Unlimited Personal Guarantee
Lenders will often request a joint guarantee if there are more than one principal involved in a transaction (like a partnership).
All named guarantors have a collective responsibility for the repayment of the loan under a joint guarantee. Let’s take, for example, a loan of $1MM with an outstanding balance and proceeds of $800M from the sale. As a group, all named guarantors share responsibility for the $200M difference. There are no percentages in this structure so it will be up to the guarantors how they can come up with $200M. One person could contribute $100M, or two people could split it between them.
This can cause disagreements between guarantors as to who is responsible for what, as you can probably see.
Joint and Multiple Guarantee
Lenders prefer the joint and multiple guarantee structure because it requires that each named guarantor is both jointly AND individually responsible to ensure the loan is repaid.
The lender can pursue the entire group, but also each individual guarantor to recover the full amount. A lender might choose to not pursue certain individuals. This could happen, for example, if one individual is judge proof.
Referring to the previous example, there is a $1MM outstanding balance. Collateral sales generate $800M. Guarantors are jointly and individually responsible for the $200M difference. Partner A may not have the funds to contribute and partner B will pay all the difference. It’s like going out with a friend to lunch and forgetting their wallet. You can’t afford to leave the restaurant without paying for lunch if you want to be able to get home in one piece.
This is even more dangerous than the joint guarantee because it can cause disagreements, arguments and animosity between partners. You should make sure that you are not being pushed around by someone who is looking to enter into a joint guarantee with you.
Limited Guarantee Real Estate for Personal
A personal guarantee with a limited amount is more acceptable to the borrower than it is for the lender. A limited guarantee structure will have a maximum amount that the guarantor must cover.
Let’s continue with the previous example and say that there is a $150M limit on the guarantee. The loan is $1MM in arrears and collateral liquidation generates $800M in proceeds. The lender would accept $50M of the remaining balance as a loss and would give $150M to the guarantor.
Declining personal Guarantee Real Estate
As the name suggests, the declining personal guarantee structure decreases over time depending on certain milestones. This is most common in loans involving property sales (such as single-family lots or condominiums). The guarantee decreases with each sale of units and as the loan balance is paid down.
Let’s take, for example, a developer who has bought a parcel of land. He plans to divide it into lots that can be sold to homebuilders. The guarantee would decrease as the loan’s principal balance is repaid.
