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What is a loan guarantee, and how do Bad Boy carve-outs play into the efficacy of guarantees? Wharton Emeritus Professor Dr. Peter Linneman explains.
BRUCE KIRSCH: When we talk about loans, whether they’re construction loans or acquisition loans, we’ll often discuss whether the borrower has personally guaranteed the loan, either partially or in full, and what this means is they place their personal assets at risk as a backup collateral. What does it mean to only partially guarantee a loan, and whether it’s partially or in full, does a personal guarantee for an amount that’s greater than the borrower’s net worth have any significance to the lender for amounts beyond their net worth?
PETER LINNEMAN: Well, good question. Let’s say, what is a partial recourse to the borrower? A partial recourse is a situation, where I may have a $50 million loan, and the property is collateral. In addition, as the borrower I’m responsible for up to $2 million of that $50 billion loan personally against my personal assets, my personal income, et cetera.
So it’s not a full guarantee of the loan, but it is guaranteeing that, if a $50 million loan comes due and the property doesn’t generate the full $50 million, the first $2 million shortfall I make up. Now, if the shortfall is $5 million, I would make up $2 million of it personally, and then the lender suffers the remaining loss. So that’s a partial recourse.
There also recourses that exist conditionally. The most common are construction guarantees, where I provide full recourse personally for the debt beyond the property up until a certificate of occupancy or some degree of leasing or completion of construction occurs. You almost always have in loan documents, so-called bad boy carve outs, that say, if I defraud you, if I violate laws, if I do bad things, hence, the bad boy carve-out.
For those things, there’s personal recourse. For everything else, if the market goes bad and I just can’t pay you, the building is not generating enough income and I can’t pay you, as long as I didn’t do any bad behavior, there’s no personal recourse under a bad boy. It’s only if there’s some type of bad behavior as defined by the document. So you can have partial.
Why does the lender want it? The lender wants it, because if the asset isn’t enough to cover their loan, they want to have personal assets. Borrowers clearly don’t want personal recourse, saying, look, you’ve got a hard asset here. You’ve had the chance to underwrite it. You’re giving us a loan that has sufficient interest coverage and a loan that has sufficient loan-to-value coverage that you shouldn’t get personal recourse.
Do lenders value it? It’s funny. Lenders absolutely value the idea of it, but one of the things lenders find out is in a bad market, somebody who looks like they have a lot of wealth may not. Namely, imagine somebody who on five properties has $10 million equity value in excess of a 90% loan. So there’s a person who looks like they have a lot of wealth, but a 10% drop in property market values in general wipes it all out, and therefore the personal guarantee is not worth anything.
Lenders like it because it puts a burden. People undoubtedly think more about a personal guarantee than a property only guarantees, and lenders like it, even if it is more than what you think their personal wealth is, because who knows what happens between now and then, and it definitely makes you think.
BRUCE KIRSCH: On that note, isn’t this potential liability on a personal level, one of the reasons why a lot of real estate investors and developers will put their assets in their spouses name?
PETER LINNEMAN: Sure. There’s a whole bunch of mechanical ways to shelter in that regard under US law and depends on the country you’re in the state of the United States you’re in, but yes, it is absolutely. And in fact, there have been examples, where in some cases, I may only have net wealth of $1 million, and I’ve got personal guarantees, but my father or my aunt or someone might have substantial personal wealth, and if they die, that asset value that comes in through my inheritance is part of my guarantee if and as I inherit it.
And there have been some tricky times where people in bad markets have been negotiating to get rid of their loan saying, well, I have no wealth, and then a parent dies and suddenly, they could be quite wealthy and the negotiations get very tricky.
BRUCE KIRSCH: In one sense, a good problem to have.
PETER LINNEMAN: You can imagine for somebody has– you could have a $100 million inheritance coming in, and you say, boy, I’m going to be rich, rich, rich forever, and you’ve got $80 or $90 million of personal guarantees sticking out on a real estate development that you were minutes away from having settled and being free of. And you go, holy cow, my entire inheritance is now going to just go to pay off this lender that was hours away from settling that they have no claim, and you can get quite crazy