One of the major benefits of commercial property investment is that debt funding is widely available with generally favorable borrowing terms. However, “favorable” doesn’t mean easy. The primary concern for every lender, from a government agency to a community bank, is the risk associated with their loan being repaid.
One of the steps that lenders take to mitigate their repayment risk is to ask their loan sponsors to provide a personal guarantee of the loan’s balance.
What is a Personal Guarantee?
A personal guarantee is a pledge by the transaction sponsor(s) to personally ensure that the loan will be repaid. Practically, this means that they are pledging to reach into their own pocket for money to pay off the loan balance if necessary.
For most commercial real estate loans, the lender’s primary source of repayment is the cash flow produced by the property. The secondary source of repayment is the liquidation of the collateral. This means that, should the cash flow ever be insufficient to make the loan payments, the lender will foreclose on the property and sell it. If the sales proceeds are not enough to pay off the entire balance, the guarantor(s) are responsible for paying the remaining balance out of their personal assets.
But, not all personal guarantees are created equal. There are a number of different structures used by lenders, depending on the specific terms of the loan. For borrowers, it is critically important to understand the difference in order to assess their own personal liability in the situation.
What are the Different Guarantee Structures?
For the purposes of explaining how loan guarantee structures work, assume that a small business defaults and their lender forecloses on the collateral property. After it is sold, there is a $100,000 loan amount remaining. The specific structure of the guarantee is described in the loan agreement and has a material impact on who is responsible for the balance, as well as how it is divided up between partners.
On the whole, commercial real estate loan guarantee structures fall into one of the following 8 categories:
1. Sole Unlimited Guarantee
One individual guarantor who is responsible for the full amount of the loan balance on his or her own. This is most common when there is only one individual sponsor/business owner involved in the loan transaction. The sole guarantor would be responsible for the entire $100,000 balance on his or her own.
2. Joint Unlimited Guarantee
In cases with more than one guarantor, a joint unlimited guarantee means that the group is jointly responsible for the loan balance and they need to figure out how to divide it amongst themselves. Suppose there were two guarantors; they could pay 50/50, 60/40, or whatever configuration gets them to the full $100,000 balance.
3. Joint and Several Guarantee
If there is more than one guarantor, a joint and several guarantee means that the group is both jointly responsible and individually responsible. The key implication here is that if one guarantor is unable to pay their share, the other guarantor is still individually responsible for the entire balance. For example, if there are two guarantors and one of them does not have any money, the other would be individually responsible for the $100,000 balance. Most guarantee structures with multiple partners fall into this category.
4. Limited Guarantee
A limited personal guarantee places a limit on the dollar amount that the guarantor is responsible for. For example, assume that a guarantor agreed to a Limited Personal Guarantee of $50,000. This means they are only responsible for up to $50,000, the remainder would have to be a loss absorbed by the lender.
5. Declining Guarantee
A declining guarantee starts at 100% of the loan balance and falls over time based on certain hurdles. This is more common in development projects or properties with a major lease-up component. The guarantee may start at 100%, but come down as the property’s occupancy rises.
6. Bad Boy Carveout
In this type of guarantee, the loan may start as non-recourse instead of a recourse loan, but becomes full recourse if the lender can prove that the borrower or guarantor engaged in fraudulent or negligent behavior.
7. Springing Guarantee
A springing guarantee also starts as non-recourse, but a guarantee “springs” into place based on certain conditions. For example, if the borrower was 60 days late on a loan payment, a guarantee would spring into place.
From the above, it can be seen that the structure of the guarantee can have a material impact on the amount of personal liability that any one guarantor has to take on. For this reason, it is important that all parties read the loan documents carefully to ensure they have a complete picture of the transaction.
Alternatives to Providing a Personal Guarantee
If given the choice, nearly all borrowers would prefer to get a loan without providing a personal guarantee. But this isn’t always an option. In lieu of providing one, they typically have one of two options:
- Work With Another Financial Institution: The requirement for a guarantee varies by lender. One may require one while another may not. If a borrower feels strongly enough about not providing one, they can look harder for a non-recourse option.
- Pledge Additional Collateral: Personal guarantees are about risk. Another way to reduce risk for the lender is for the borrower to provide additional collateral. Sometimes borrowers have additional property, cash, account balances, or marketable securities that they could pledge in lieu of a guarantee.
- Look For a Government Agency: Certain government agencies, like the small business administration (SBA), FNMA, or the USDA, are tasked with providing or guaranteeing certain loans. Agency backed loan options are relatively limited but they are nearly always non-recourse.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
To learn more about our real estate investing opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
