When it comes to guarantees in the world of real estate, even veterans of the industry may have a few questions about their exact role and how to make sure that you get one that protects both you and your assets properly.
To help with this issue, I am going to take a closer look at them to understand not only what they mean, but also reasons why we need them and some reasons why we may not.
The easiest way to break this down is to discuss the 3 basic types of guarantees that you will see in any given real estate deal. These include bad boy guarantees/non-recourse carveout guarantees, payment guarantees, and completion guarantees.
Bad Boy Guarantees
The bad boy guarantee was originally implemented to keep borrowing entities and their principals honest.
Many lenders who looked to collateral to recover a debt from a mortgage loan ended up being out of luck when they found that the collateral’s value had dropped below the debt or that borrowers had siphoned cash out of the property prior to default.
A bad boy guarantee held borrowers and their guarantors liable for losses suffered by the lender if these kinds of actions took place.
The overriding principle driving the bad boy guarantee is that people tend to put their own personal interests ahead of any corporate interests.
The bad boy mechanism is designed to ensure the sponsor acts in lender or investor best interests by ensuring that the sponsor preserves their own personal interests first through placing disincentives to do anything otherwise.
Consequently, if you see a bad boy guarantee, be sure to avoid having a corporate guarantor be the guarantor as this would defeat the original intent. In some cases, a single-purpose-entity (SPE) can be formed where the only asset is the property in question.
This can create the illusion of there being a guarantee, but actually none exists because the only collateral guaranteeing the investment is the asset itself.
In general, pretty much every loan you see will have a bad boy guarantee.
This is because lenders want to make sure that after they go through the trouble of crafting a loan document and structure, it is adhered to.
Bad boy guarantees alleviate this concern because they essentially say that as long as the borrower is adhering to the conditions of the loan agreement, they won’t be held personally liable.
Because bad boy guarantees are so common compared to some of the other options out there, here are a couple of examples of exactly what a bad act is in terms of breaching a guarantee - and how they can create difficult quandaries for sponsors.
One of the most common ones is declaring bankruptcy.
There have been some high-profile legal examples over the last few years where a sponsor found that declaring bankruptcy was deemed the most prudent option for protecting investor interests – perhaps by slowing down the foreclosure process through declaring bankruptcy, the borrower hoped to protect investor interests by riding out a downturn until values recovered.
The sponsor was, therefore, compelled to declare bankruptcy due to a fiduciary duty they had to their investors, but found that this triggered liability under the bad boy guarantee to the lender.
Another typical bad boy provision might be that the sponsor (the borrower) might be required to fund replacement or interest reserves.
If they fail to fulfill these requirements, the sponsor could be held personally liable under the bad boy provisions.
A payment guarantee is generally collateralized by the assets of the borrower.
These assets typically will have to be worth at least as much as the loan amount.
There are two ways to determine the value of the assets relative to the loan amount; one is through borrower statement in the loan application, and the other is audited statement – the latter being rarer and more onerous on the borrower to produce.
As these types of guarantees are not recorded, a borrower can, theoretically, pledge the same collateral on multiple loans making each worthless relative to others.
They can provide, therefore, less security than other types of guarantee.
A completion guarantee is more basic, ensuring that developers have to see a project through to its completion as a part of the conditions of the loan.
Often it will be the general contractor who will provide the completion guarantee, and not the sponsor directly.
One thing worth looking at here is what party serves as a counterparty to the completion guarantee.
For larger development deals, it’s not uncommon for the developer themselves to play a role.
In these cases, they will often be compensated with a fee for guaranteeing completion at the end of the project.
Questions to Ask When Looking At Guarantees
Anyone planning on buying an interest in a loan to a sponsor in a syndicated crowdfunding deal will want to drill down on the guarantees and to ask key questions, as follows:
- What type of guarantee is this?
- Who’s making the guarantee?
- Will this be an enforceable guarantee?
- How are the assets being verified?
Some third-party verification of assets is key here.
No one is ever going to confess to you that they breached a guarantee and voluntarily make you whole, and the fact is that it can be difficult to legally enforce a guarantee.
Indeed, especially for guarantees in real estate, there are a lot of state-level protections for sponsors and equity holders that are difficult to work with and can make it very difficult to recover on a guarantee.
Often, guarantees and the associated threat of litigation, are sufficient incentive to bring parties to the negotiating table to resolve differences.
As a final note, because so many provisions on a guarantee are negotiable, it’s essential for investors to look at the fine print.
Ensuring a deep understanding of the details of a deal’s guarantees is the type of thing that a bank would do if presented with these situations, and that smart investors should do as well.
About The Author
Adam Gower is a 30+ year veteran real estate investment and finance professional. He expands investor networks for real estate developers by implementing best-of-class digital marketing programs, and provides advanced training for investors looking at opportunities. Dr. Gower has written several books, the latest, Leaders of the Crowd, chronicles the legislative origins of crowdfunding and how real estate came to dominate the industry. For more information go to www.GowerCrowd.com
Podcast: The Real Estate Crowd Funding Show
Book: Leaders of the Crowd