Unless you run a large company with an established track record of repaying loans, a bank will likely ask for a personal guarantee before approving a commercial real estate loan. What is a personal guarantee? In this article we’ll thoroughly explain personal guarantees by covering the following:
- Definition of a personal guarantee
- When personal guarantees are used
- Personal guarantee types
- Alternatives to a personal guarantee
Personal Guarantee Definition
A personal guarantee is a promise to personally repay a loan should the underwritten sources of repayment fail.
When evaluating a real estate loan for repayment, a lender will analyze the viability of all potential sources of repayment. The sources of repayment typically look something like this:
- Primary Source of repayment: Cash flow generated from rental income or the sale of units/lots
- Secondary source of repayment: Liquidation of collateral
- Tertiary source of repayment: Personal guarantee
If the real estate project fails to produce enough income or sales to repay the loan as agreed, and the lender has to foreclose on the property, then the guarantor(s) will be required to pay the difference between the collateral proceeds and the outstanding loan balance.
Needless to say, this isn’t a situation that you want to find yourself in, which is why it’s important to understand the differences between personal guarantee types before agreeing to one. Let’s go through them:
Personal Guarantee Types
Understand this. Lenders are going to be looking for maximum possible protection when lending money. To that end, there are several types of personal guarantees that a lender may ask for:
Sole Unlimited Personal Guarantee
If a borrower is the only owner of a company and/or the only principal in the transaction, it’s likely that they’ll be asked for a sole guarantee. This means that they are individually responsible for repaying the loan or covering any gaps between collateral liquidation proceeds and the outstanding loan balance.
There’s an important twist to be aware of when agreeing to a sole guarantee structure. The lender may name only ONE guarantor, but if that guarantor is married and hold funds jointly with their spouse, the spouse is actually on the hook as well. They should be aware of the deal so they don’t get any rude surprises.
Joint Unlimited Personal Guarantee
When there is more than one principal in a transaction (like a partnership), a lender will likely ask for a joint guarantee.
Under a joint guarantee, all named guarantors are responsible as a group for repaying the loan. For example, let’s say that a loan with a $1MM outstanding balance goes into collections and the sale of the collateral produces $800M in proceeds. All named guarantors are jointly responsible as a group for repaying the $200M difference. In this structure, there are no percentages, so it’ll be up to the guarantors to figure out how to come up with the $200M amongst themselves. Two people could kick in $100M each or the same two people could divide it $150M and $50M.
As you can probably imagine, this can lead to some disagreements among guarantors about who is responsible for what.
Joint and Several Guarantee
The joint and several guarantee structure is the favored choice of lenders because it requires that all named guarantors are both jointly AND individually responsible for ensuring the loan gets repaid.
In other words, a lender could go after the group as a whole, but it could also go after each individual guarantor for the full amount. The lender could also choose not to pursue certain individuals, which might happen for example if one person is deemed judgment proof.
Going back to the above example, with a $1MM outstanding balance and collateral sale that produces $800M in proceeds, the guarantors are both collectively and individually responsible for the $200M difference. If partner A doesn’t have any funds to contribute, it is going to be up to partner B to cover all of the difference. It’s kind of like when you go out to lunch with your friend and they forget their wallet. If you want to get out of the restaurant in one piece, you have no choice but to pay for lunch.
Even more so than the joint guarantee, this has the potential to stir up disagreements, arguments, and animosity amongst partners. If you’re considering entering into a joint and several guarantee structure with someone, you better be sure they aren’t going to “forget their wallet” and stick you with the entire bill.
Limited Personal Guarantee
A limited personal guarantee is more palatable to you as the borrower, but less so for the lender. In a limited guarantee structure, there will be an upper limit on the amount the guarantor would be required to cover.
Continuing with the example above, let’s say there is a limited guarantee up to $150M. The loan has an outstanding balance of $1MM and collateral liquidation produces $800M in proceeds. With a $150M limited guarantee, the guarantor would be required to pay $150M and the lender would recognize the remaining $50M as a loss on the deal.
Declining Personal Guarantee
The declining personal guarantee structure is one that, as the name implies, declines over time based on certain milestones. The declining guarantee is commonly seen in loans where property sales are involved (like single family lots or condominiums). As units are sold and the loan is paid down, the guarantee declines as well.
For example, let’s say a developer has purchased a parcel of land and plans to subdivide it into lots to be sold to homebuilders. As the lots are completed and sold, the guarantee would step down as the loan’s principal balance is paid down.
Personal Guarantee Alternatives
A bank wants to be repaid, pure and simple. Requesting a personal guarantee is just an extra layer of protection to ensure that they are repaid.
Often, if a lender requests a personal guarantee, the borrower may not have much of a choice in the matter. But, there are 2 possible alternatives that they could try to negotiate to avoid agreeing to an unnecessarily punitive personal guarantee structure:
- Try another lender: If one lender asks for a guarantee, it’s likely that others will as well. However, the borrower could attempt to shop their deal around and make it clear up front that they’d like to negotiate a structure where a guarantee isn’t involved. Lenders have different appetites for risk and one just might accommodate the request.
- Pledge additional collateral: Instead of providing a guarantee, a borrower may offer additional collateral to the lender. The additional collateral could be in the form of cash, securities, or additional real estate. The collateral would only be liquidated in the event of a shortfall and only in an amount to cover it.
Bottom line, when entering into a borrowing transaction with a lender, it’s likely they’ll ask for some sort of personal guarantee. Understanding the nuances in personal guarantee structures is important when negotiating commercial loans.
Conclusion
In this article, we discussed personal guarantees, which are commonly required by commercial lenders. We defined the personal guarantee, discussed types of personal guarantees, and finally walked through a couple of alternatives to the personal guarantee.