When obtaining a loan for your multifamily deal, the lender will require a guarantee from the individual or entity that is borrowing the funds. This individual or entity is referred to as the loan guarantor, who personally guarantees the loan if it is recourse. If it is nonrecourse, they still require someone to meet the liquidity, net worth, and experience requirements.
If you are first starting out, you will likely not meet the lender requirements to be the loan guarantor, either because you don’t have the liquidity, experience, or net worth. Therefore, you will need to find a high-net-worth individual to become the loan guarantor to qualify for the loan.
The purpose of this blog post is to explain how to compensate a loan guarantor who signs on your loan. But first, let’s look at the two different types of loans: recourse and nonrecourse.
There are two types of debts: recourse and nonrecourse. According to the IRS, a recourse debt holds the borrower personally liable, while all other debt is considered nonrecourse.
In general, recourse debt/loan allows lenders to collect what is owed for the debt even after they’ve taken collateral (i.e., the property). Lenders have the right to garnish wages or levy accounts to collect what is owed.
On the other hand, a nonrecourse debt/loan does not allow the lender to pursue anything other than the collateral. However, there are a few exceptions. If a "bad boy" carve-out is triggered, the nonrecourse loan is treated as a recourse loan and the lender can pursue what is owed even after they’ve taken the collateral. The two most common "bad boy" carve-outs are gross negligence (i.e., if the borrower forsakes the property) and fraud (i.e., the borrower does something illegal).
Ideally, the loan guarantor has real estate experience in the multifamily real estate niche. However, experience is not required because you or someone else who is on the general partnership side can fill that role.
The liquidity and net worth requirements will vary depending on the size of the deal, the lender, etc. However, for a general understanding to keep in mind when looking for a loan guarantor, according to Freddie Mac, the loan guarantor must meet the following requirements:
The compensation structure for a loan guarantor will depend on the type of loan they are signing. Since the recourse loan is riskier relative to the nonrecourse loan, you’ll have to compensate the loan guarantor more if you’re obtaining a recourse loan.
The two main ways to compensate a loan guarantor are 1) an annual fee and/or 2) a percentage of equity.
If you have a recourse loan, the fees and percentages could be twice (or greater) those of a nonrecourse loan because there’s much more risk involved.
All of these fees and percentages are rules of thumb. They can fluctuate up and down based on variables like your team, your relationship with the loan guarantor, the business plan, etc.
I believe that it is a very good deal for high-net-worth investors or individuals to do a loan guarantee, especially if it is a nonrecourse loan. They are essentially getting free equity and free cash because they aren’t investing any money into the deal. They are just providing their balance sheet with minimum risk.
At the same time, there is risk involved, like any investment opportunity. For example, if your business partner on the deal who is not the loan guarantor commits fraud without your knowledge, then the bank can call the note, which would make the payment due immediately. That could put you into foreclosure and then the loan guarantor could be at risk for the entire amount that is owed to the bank. That is a big problem.
When approaching potential loan guarantors, you have to look at it from both perspectives. Sure, that isn’t a likely scenario, but be aware of how they perceive this as well. It’s not a complete slam dunk for them.
When you are first starting out, you will need to find a high-net-worth individual to be the guarantor for your loan. In return for signing, you will offer the guarantor compensation via an annual fee based on the loan balance and/or a percentage of equity in the deal.
If the loan is nonrecourse, the annual fee offered is 0.25% and the equity offered can be 5%, 10%, or more, depending on the deal. If the loan is recourse, you will have to offer more compensation since the guarantor is exposed to more risk.
The benefits you want to get across when asking a high-net-worth individual to sign on the loan are the free equity and free cash in exchange for their balance sheet.
The loan guarantor can be an investor who is investing in the deal or anyone else, as long as they meet the liquidity, experience, and net worth requirement of the lender.
About the Author:
Joe Fairless is the co-founder of Ashcroft Capital, a fully integrated multifamily investment firm with more than $2.7 billion in assets under management, and the founder of Best Ever CRE. His podcast, the Best Real Estate Investing Advice Ever Show, is the world's longest-running daily real estate podcast with more than 500,000 monthly downloads.
Disclaimer:
The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.