When utilizing a loan to acquire an investment property, there are two basic types available to the buyer: recourse and non-recourse. Regardless of the type of loan, the borrower may be asked to sign a guaranty, which can range in scope from full recourse against the borrower to limited recourse. Carveout guaranties are a form of limited guaranty.
With a traditional mortgage loan, the lender will have a lien on the property in question, and the borrower will be personally liable for the payment and performance of loan obligations. These are called recourse loans because the lender has recourse against the borrower personally, in addition to rights in the underlying property (collateral). Recourse loans protect the lender by providing that, in the event of a default, the lender may require the borrower to use unrelated personal funds to cure the default.
Some borrowers may, however, qualify for a non-recourse loan based on factors that include the underlying value of the real estate, the credit of the tenant(s), and the strength of the rent roll. The non-recourse lender may be able to foreclose and sell the property to satisfy outstanding mortgage indebtedness in the event of a default, but the lender generally cannot look to the borrower’s personal assets for any deficiency or loss.
One of the major advantages of obtaining a non-recourse loan, is that the borrower can reap the benefits of leverage without having to personally guarantee payment of the debt, in the event of loan default. This is particularly important if vacancies in the property occur, or if a tenant fails to pay rent on time. Both of these occurrences may severely impact net operating income and prevent the owner from making timely loan payments.
Having a non-recourse loan does not, however, mean that the borrower does not have to sign any type of guaranty. Lenders often require the borrower and/or its principals to sign a “carveout” or “bad boy” guaranty when they do not have personal recourse against the borrower’s assets.
[Editor’s Note: For more information on real estate buying and selling, check out our webinar, “Representing Buyers and Sellers of Commercial Real Property.”]
A carveout guaranty is a borrower’s promise to abstain from certain “bad acts” with respect to both the loan and the property. These promises generally fall into one of four categories:
The promises are made by the borrower him/herself, as well as its principals, if the borrower that is an entity rather than an individual. The triggers for liability under the carveout will be actions within the guarantor’s personal control. Carveout guaranties do not guarantee to the lender that tenants will continue to perform under their respective leases, that rental income from the property will remain at any particular level, or that loan payments will be made on time. Rather, carveouts provide that the guarantor will abstain from both misconduct and actions that may impede the lender’s ability to enforce the loan agreement.
[Editor’s Note: Tracy Treger explains “How to Leverage Real Estate Investments”]
A carveout guarantor will be required to make promises to the lender with respect to the insolvency of the borrower and its principals, or otherwise affecting the property, abstaining from fraud or other misconduct in connection with the loan and the property, additional borrowing in connection with the property, and the ownership of the borrower. Carveout guarantors should review these provisions carefully to ensure that potential liability is limited to actions within the guarantor’s reasonable control.
There are several insolvency-related representations commonly found in carveout guaranties. These include promises that the guarantor will not file for bankruptcy or receivership for itself, or put the underlying assets (or the entity that owns or controls the property,) into bankruptcy.
Relatedly, if an involuntary bankruptcy case is filed against the guarantor or the property, there are obligations under the carveout guaranty to contest the proceeding. Additionally, the guarantor must agree that it will not challenge or interfere with the lender’s exercise of its rights under the loan documents in the event of a bankruptcy or other insolvency proceeding affecting the property. This includes the bankruptcy of a tenant.
The nature of these obligations is primarily to protect the lender’s interest in its collateral. In the case of a property-level insolvency (where the cash flow from the property is insufficient to service the loan), the carveout guaranty helps ensure that the borrower is working together with the lender to preserve the lender’s interest in the collateral and the primacy of the mortgage lien when there are competing claims against the property.
On the borrower side, the bankruptcy prohibition provides some assurance that the party responsible for making the loan payments is not in financial distress. Importantly, the bankruptcy of a tenant that is unrelated to the borrower will not trigger guarantor liability under a carveout.
A carveout guarantor will represent to the lender that he, she, or it has not committed fraud with respect to the procurement of the loan, and will not commit acts of fraud with respect to the property or repayment of the loan. This generally includes making false representations, or material negligent representations, in connection with the transaction, such as providing fraudulent rent rolls. Some carveout guaranties also expressly include the misappropriation of funds from property operations. In essence, the guarantor promises not to lie, cheat, or steal in connection with the loan or the property.
Unsurprisingly, a breach of this type of provision will expose the borrower to claims for damages caused by the fraud or misrepresentation. Additionally, the guarantor’s misconduct may trigger personal liability for the entire outstanding mortgage indebtedness, as well as other amounts due and owing under the loan agreement.
A carveout guarantor will agree not to place a second/junior mortgage on the property without the lender’s prior written approval. Additionally, the guarantor cannot pledge its interest in the property to someone else as collateral for a loan, whether related to the property or for some unrelated purpose, unless the lender expressly consents. Carveout guarantors also agree that they will not allow liens, such as mechanics’ liens and liens for failure to pay taxes, to be placed on the property.
Additionally, the guarantor cannot pledge its interest in the property to someone else as collateral for a loan, whether related to the property or for some unrelated purpose, unless the lender expressly consents.
These provisions help preserve equity in the property for the lender, providing a cushion in case market conditions, or the net operating income of the property, decline. Additionally, lenders want to avoid future disputes about the relative priority of their mortgage lien and the secured claims of others. By requiring the borrower to obtain prior approval for any additional borrowing, the lender can assess its own risks to ensure that it is adequately protected.
If the borrower is an individual, carveout guaranties will typically afford some flexibility for intra-family and estate planning types of transfers. It would not be feasible, for example, to obtain advance approval for a successor if the guarantor dies unexpectedly. Additionally, lenders are often amenable to individual guarantors changing the manner in which title is held (i.e., holding title through a living trust), so long as the individual remains liable under the guaranty and retains control of the borrower. These types of transfers are therefore designated as “permitted transfers”, or are otherwise excepted from the list of “prohibited transfers”. For these transfers, the lender must be notified promptly afterward, rather than requiring advance approval.
Ideally, a guarantor will want to ensure that there are “cure” provisions in the case of a transfer that is not permitted or approved in advance by the lender.
When the guarantor is an entity, such as a partnership or limited liability company, the prohibition of transfers also includes the restructuring or change of control of that entity. The purpose of these provisions is to give the lender some assurance that the party who provides the guaranty at the inception of the loan will remain the responsible party for the carveout obligations throughout the loan term. Any “replacement” guarantor will meet the lender’s then-applicable underwriting standards.
As property transfers are not inherently “bad acts,” investors should read these provisions carefully and obtain any necessary clarifications before signing a carveout guaranty. For example, an entity guarantor may seek to permit transfers that do not involve the change of control of the borrower, such as the issuance of stock or membership interests to investors, employees, or family members. Ideally, a guarantor will want to ensure that there are “cure” provisions in the case of a transfer that is not permitted or approved in advance by the lender.
[Editor’s Note: Want more about real estate investments? Check out “Real Estate Partnerships: The Good, the Bad, and the Ugly”]
Carveout guaranties may contain additional provisions relating to the borrower’s performance under the loan agreement. These may include a personal guaranty:
Whether and to what extent a borrower is requested to, and should be willing to, provide these additional carveout guaranties is situation specific. Guarantors should ensure that the language of these provisions is negotiated and tailored to address acts that are within the guarantor’s control.
For example, if a tenant’s lease at the property restricts the borrower/landlord’s ability to enter the premises unless accompanied by a tenant representative, a guarantor will want to incorporate that limitation in its promise of access to the lender. In the case of financial reporting requirements, a prudent guarantor will insist on an opportunity to cure the default before the lender may exercise remedies under the guaranty.
The consequences of a breach often depend on the nature of the guaranty provision that is violated. For some provisions, such as a bankruptcy filing, a breach will give the lender a right to pursue the guarantor for the entire loan indebtedness. In other cases, such as failures to provide information, the lender will be entitled to damages caused by the breach.
The guarantor should always review the provisions of a proposed carveout carefully to ensure that he understands the circumstances that may trigger personal liability. As always, it is best to obtain the advice of a trusted legal or financial advisor before signing a carveout guaranty.
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Tracy is a Principal at Syndicated Equities where she helps high net worth individuals and family offices to profitably invest in real estate. She also assists investors in identifying appropriate replacement property to complete tax-deferred exchanges under Section 1031 of the Internal Revenue Code. Drawing upon her 20 years of legal experience in the areas…
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