To Guaranty or Not to Guaranty?

Real estate professionals often ask themselves this question when negotiating terms of a loan. The pros know the script well:

The customer, Slim Pickens, says to the banker, Sticky Fingers, with an edge:  “Sticky, if you did your underwriting properly, you would know that you don’t need my guaranty.  The tenants are sound, and there is more than ample equity in the property.  Why do we always need to play this game? Besides it makes my personal financial statement less desirable to my other lenders.”

Sticky Fingers replies defensively:  “Slim, we did the underwriting just right; that’s not the issue.  You know our bank’s policy on personal guarantees, and this is a seven year loan. Anything can happen to those tenants during that period.  We need to make sure you stay incentivized when things go bad.  The guaranty will do that.  Just think of it as an umbrella in the sunshine.”

And so it goes.  Each side espouses the merits and demerits of the personal guaranty.

What can the customer or banker do when the guaranty becomes a perceived red line?  Is there some middle ground?  There is if both sides are willing to compromise.  Here are some approaches to consider:

1. If there is more than enough equity in the property, at least a 50% or 60% loan to value, the bank probably does not need a full payment guaranty.  One solution for the bank may be a so-called springing guaranty, one that “springs” into life when an appraisal of the property reveals a loan to value that exceeds 65%, 70%, 75%, etc….. , a percentage to be negotiated.  Or, a limited guaranty could be required at closing for a percentage of the principal of the loan.
2. If the equity is enough to satisfy the bank for a loan but not enough to waive a guaranty, close the loan with a guaranty and agree to test debt service coverage or the loan to value ratio on each anniversary date.  If the either of those financial covenants reach a pre-negotiated threshold, the guaranty is terminated.
3. Another possibility is what’s commonly referred to as a secondary guaranty.  Most payment guarantees are primary.  The lender need not wait to foreclose its mortgage before enforcing its rights under the guaranty.  It can do so as soon as the loan is called after default.  A secondary guaranty requires the lender to exhaust its remedies against the real estate first before chasing a guarantor.  Only if a deficiency results from a foreclosure, can the lender enforce the guaranty.  Lenders do not favor secondary guarantees because by the time the foreclosure is completed (sometimes after a brawl in a bankruptcy court), the guarantor’s net worth may be depleted.
4. Customer can also provide additional collateral.  The bank will prefer liquid collateral such as cash deposits or marketable securities.  The customer will prefer illiquid collateral such as a mortgage on his other properties.  If a mortgage is offered, the bank will want it to be in first position.  But the customer may not have unencumbered property so a second and even a third mortgage may be all he can offer.   The bank may be persuaded if the customer can demonstrate enough equity behind a first mortgage.

With a good and long lasting relationship between customer and banker, the question to guaranty or not to guaranty need not be perplexing.  Reasonable people will generally find reasonable solutions to their differences.