Leveraged Breakdowns

Underwriting a Construction Loan – Guarantor Analysis

This is the third post in our ongoing real estate private equity case study on how a construction loan is underwritten by potential lenders.  This installment will focus on guarantor analysis.  To read the previous posts in the series, click on the links below:  

Post #1Introduction & Setup 

Post #2Borrower Analysis

The intent of this article is to describe what a guarantor is, the types of guarantees that a lender may potentially ask for, and what sort of analysis they conduct to ensure the guarantor is capable of supporting the deal.  By the end of this post, readers will have a greater understanding of how guarantor analysis is conducted and should be able to incorporate this knowledge into their interactions with real estate lenders.  Or, this information could come in handy as part of a REPE Technical Interview.

Let’s start with a simple definition.  To jump directly to the summary section, click here.

What is a Guarantor?

We will go into more detail on repayment analysis in the next post, but a typical real estate private equity construction loan will have three sources of repayment:

  • Primary Source of Repayment:  Payoff from a permanent loan
  • Secondary Source of Repayment:  Income from rental or sale
  • Tertiary Source of Repayment:  Guarantor recourse

In a typical deal, this means that the lender is depending on the borrower to obtain a permanent loan, the proceeds of which will be used to pay off the construction loan.  If this is not possible, the backup plan is for the borrower to lease or sell the property and use the income to pay down the loan.  If this plan doesn’t work, the last resort is to ask the loan guarantor to go into their own pocket to pay off the outstanding balance.

With this scenario in mind, a loan guarantor can be defined as an individual, group of individuals, or entity that guarantees repayment of the loan balance, even if it means going into their own pocket.  A guarantee is not required on all loans, but is very common for lenders to require one in a real estate private equity loan transaction.

If the lender does require one, they could potentially ask for one of eight variations.

What Are The Types of Loan Guarantees?

It is important to remember that the guarantee requirement can vary by lender and deal.  While it is common in private equity deals, it is less common in loans that involve a government sponsored entity (like Fannie Mae).  If the lender does ask for a guarantee, it is typically something that is non-negotiable, loan approval is conditioned upon it.   Potential guarantee types include:

  • Individual Unlimited Guarantee:  One individual is responsible for the loan balance 
  • Joint Unlimited Guarantee:  Two or more individuals are responsible for the loan balance, collectively.  A corporate guarantee could also fall into this category.
  • Joint and Several Guarantee:  Two or more individuals are responsible for the loan balance, collectively and individually.
  • Limited Guarantee:  A guarantee type that sets a limit on the amount guaranteed by each individual or entity.  For example, a guarantor could be limited to 50% of the loan balance.
  • Declining Guarantee:  A guarantee that starts at 100%, but declines over time based on milestones.  For example, it could start at 100%, but decline to 50% once a property is leased and stabilized.
  • Springing Guarantee:  A guarantee that starts at 0%, but “springs” into place based on a milestone.  For example, if a borrower misses three consecutive loan payments, the guarantee could spring into place.
  • “Bad Boy” Guarantee:  A guarantee that also starts at 0%, but converts into a full guarantee based on nefarious activity like fraud or negligence, as defined in the loan agreement.

Obviously, a guarantee requirement raises the stakes for both the guarantors and/or their investors.  For this reason, it is critically important that all parties understand exactly how a loan guarantee is structured to accurately identify where potential liability lies.

What is a Lender Looking For In a Guarantor?

The key characteristic that a lender looks for in a guarantor is one who has the financial resources to step in and support the loan by either making the monthly payments or paying off the outstanding balance in full.  So, as the loan amount gets bigger, the guarantor’(s) resources must rise in tandem.

To illustrate this point, consider a common loan scenario.  Suppose that a lender is owed $5MM by a borrower who defaults on their loan.  As is their right, they foreclose on the property and sell it for $4MM (net of transaction costs).  These funds are used to pay down the loan balance, but there is still $1MM outstanding.  This is where the guarantor comes into play.  A lender wants a guarantor who has the financial resources to pay the remaining balance from their own pocket.

The more liquidity a guarantor has, the better.  But, real estate developers are notorious for carrying small amounts of liquidity and high amounts of leverage.

With this newfound guarantor knowledge, let’s see how the guarantor in our case study transaction stacks up.

Who Is the Guarantor?

In this transaction, the lender is requiring the full, unlimited guarantee of the United States subsidiary of the transaction sponsor, ABC Private Equity, Corp.  Let’s call them ABC US Private Equity.  The guarantee will remain in effect for the duration of the loan. 

This is a fairly simple guarantee structure for a complicated transaction.  There are risks and benefits for both the lender and the transaction sponsor.

Benefits and Risks for the Lender

For the lender, the simplicity of the structure makes it easier and more straightforward to track the guarantor’s financial condition.  We will get into loan covenants in a future post, but one of the covenants in this loan is that the guarantor will be required to provide the lender with audited financial statements annually.  The other benefit is that the guarantee comes from a company, not an individual.  The company has more financial resources than any individual.

But, the downside of the corporate guarantee is that:  (1) it is only the US subsidiary; and (2) the transaction sponsors have no personal liability, which means they may be less personally invested in the success of the project.  In an absolute worst case scenario, the sponsor could move all of their assets out of the US subsidiary, declare bankruptcy and leave the lender high and dry.  There are many reputational risks to such a move, but lenders often think in terms of worst case scenarios.  

Benefits and Risks for the Sponsor

For the sponsor, the major benefit is that nobody has to personally guarantee the debt.  This is left to the corporate entity, which means that there is much less personal financial risk for the principals in the transaction.

The downside is that there are many different projects in various stages of completion under the umbrella of the guarantor entity.  A major issue in any one of them could have ramifications for the entity as a whole.  So, there may be less personal risk, but the corporate risk is higher.

Guarantor Financial Summary 

As part of their loan application, the guarantor provided financial statements for two full years and an interim period.  Their financial condition is summarized in the table below (NOTE:  All numbers are in thousands):

Date Year 1Year 2Interim Period
Liquidity $3,000$6,000$9,000
Total Assets$25,000$78,000$48,000
Total Liabilities $14,000$64,000$29,000
Net Worth$11,000$14,000$19,000
Net Income($2,000)$3,500$4,100

This summary is a perfect example of a typical real estate firm’s financial condition.  This guarantor has $9MM in cash and liquid assets to cover $29MM in balance sheet liabilities plus the $110M loan they are asking for and whatever other debt they guarantee, which we will get into in a moment.

Needless to say, these numbers are underwhelming given the size of the loan request.  So, it is necessary to dig into the guarantor’s financial statements in a bit more detail.

Income Statement Analysis 

The guarantor’s income statement for the past two and a half years is summarized in the table below (all numbers in thousands):

Date Year 1Year 2Interim Period
Revenue$5,500$174,000$169,000
Cost of Sales$0$154,000$158,000
Gross Profit$5,500$20,000$11,000
Rental Income$400$700$300
Operating Expenses $10,400$14,000$5,100
Net Operating Profit($4,500)$6,700$6,200
Other Income (Expenses)$1,500($100)$600
Current Income Taxes$1,000$3,100$2,700
Net Profit($2,000)$3,500$4,100

To understand the guarantor’s income statement it is necessary to understand a little bit about their business.  They have three sources of revenue:

  1. Development, asset management, and consulting fees associated with development projects 
  2. Revenue from condominium conversion sales 
  3. Partnership income and real estate investment activities 

The key revenue stream here is #2, which explains the tremendous increase in revenue from year one to years two and three.  This is an uncertain revenue stream and can vary greatly based upon the completion dates of projects and the sales velocity of finished condominium units.  This sort of lumpiness can cause cash flow issues if not managed effectively.

From a net income standpoint, the guarantor is only able to bring $3.5MM and $4.1MM to the bottom line in year two and the interim period, respectively.  This is a relatively paltry sum given the size of the loan request and does not make a significant addition to their cash position year over year.  Overall, this is a negative for the guarantor.

Now, let’s look at their balance sheet.

Balance Sheet Analysis

The guarantor’s balance sheet is summarized in the table below (all numbers in thousands):

Date Year 1Year 2Interim Period
Cash$2,600$6,000$9,000
Net Receivables$3,000$2,500$400
Due From Affiliates $5,000$6,800$3,700
Condo Units Held for Sale $0$36,000$3,200
Total Current Assets$10,000$53,000$20,000
Total Fixed Assets $8,700$10,000$10,000
Total Assets$24,700$78,000$48,000
Trade Payables $700$1,100$700
Loans From Related Co.$0$13,700$6,000
Due to Affiliates $2,800$11,300$10,400
Total Current Liabilities $5,800$37,000$22,000
Long Term Debt$7,000$25,000$7,000
Total Liabilities$12,800$62,000$29,000
Net Worth $11,900$16,000$19,000

Remember, the guarantor’s primary business in recent years has been the conversion of multifamily rental projects to condominiums.  This activity – and the variability that comes with it – explains the major variations in nearly all categories of the balance sheet.  There are a few items of note:

  • Cash:  The guarantor’s cash position has risen in each of the years shown as a result of successful (and profitable) condominium sales.  This is a positive.
  • Inventory:  The bulk of the remaining assets consist of condos held for sale.  Think of this as the guarantor’s inventory.  While it may look like there was a significant decrease from year 2 to the interim period, a closer look reveals that these units were “sold” to a related off balance sheet entity.  So, this should be taken with a grain of salt.
  • Debt:  The company has significant debts, most of which are due to affiliates.  These sorts of inter-company debts may not have strict repayment terms, but they are debt that needs to be repaid regardless.  Long term debt fell in conjunction with the sale of the units to the off balance sheet entity, which is a good thing.

This sort of balance sheet is fairly normal for a real estate developer.  Because all of the transactions are conducted through single purpose entities, it is common for there to be payables and receivables to affiliated entities.  When looking at a balance sheet, the primary concern is cash or anything that can be converted to cash quickly if the loan needs to be repaid.  From this standpoint, the guarantor is neutral.  They don’t bring particular strength or weakness to the deal.

Contingent Liabilities

When performing guarantor analysis, the key risk isn’t always found on the balance sheet.  Contingent liabilities are other debts for which the guarantor is responsible, but they may not appear on the balance sheet.  In other words, these are other loans that they have guaranteed, but may not necessarily be the direct borrower for.

When performing guarantor analysis, contingent liabilities are grouped into four categories:

  • Realizable:  There is a strong chance that the guarantor will have to support this loan.
  • Potentially Realizable:  There is a slight chance the guarantor will have to step in and support this loan.
  • Potentially Unrealizable:  It is unlikely the guarantor will have to step in and support this loan.
  • Unrealizable:  It is very unlikely that the guarantor will have to step in and support this loan.

The boundaries between these distinctions are somewhat subjective, but they generally correspond to the level of risk associated with the project.  For example, loans that are for pure land or development typically fall into the realizable or potentially realizable categories.  Loans that are for stabilized projects with positive cash flow would likely fall into the potentially unrealizable or unrealizable categories.  Let’s see how the guarantor stacks up on this front.  The following table summarizes their contingent liabilities:

Project Location Loan CommitmentGuarantee Amt.RPRPUU
Project #1Southeast$33,000$8,000$8,000
Project #2Southeast$23,000$12,000$12,000
Project #3Southeast$20,000$5,000$5,000
Project #4Southeast$29,000$2,000$2,000
Project #5Midwest$28,000$14,000$14,000
Project #6Midwest$7,000$7,000$7,000
TOTALS$140,000$48,000$23,000$25,000

This information is obtained from the guarantor’s financial statement and there are several key takeaways:

  • The guarantor has 6 other projects in various stages of completion.  The total loan commitments for these projects is $140MM.  Of that, the guarantor has provided corporate guarantees of $48MM.
  • Of the $48MM in guarantees, $25MM is considered unrealizable.  These are not the ones to worry about.
  • Of the $48MM in guarantees, $23MM is considered potentially realizable.  These are the ones to worry about.  Remember, this potentially realizable designation means that it is possible that the guarantor will have to provide financial support for these facilities.  If they do, it takes away from their ability to support the requested loan.  
  • As of the interim financial statement, the guarantor has $9MM in liquidity on their balance sheet and $23MM in potentially realizable guarantees, not counting the subject request.  This ratio indicates significant potential risk regarding the guarantor’s ability to repay this facility.

Given the disparity between cash on hand and potentially realizable liabilities, this is a big negative for the guarantor’s ability to support the requested loan.

Personal Credit Analysis

In this particular case, the loan’s guarantee comes from a corporate entity so it is not necessary to pull individual credit reports on each of the individual guarantors.

If it is necessary, a lender would look for signs of individual financial distress like:  previous bankruptcies, significant number of late payments, liens, judgements, or a high ratio of outstanding credit to available credit.  If these conditions are present, they would be considered negatives.

With all of this information known, let’s recap our guarantor’s strengths and weaknesses.

Summary & Recap

Remember, a lender looks for at least two or three sources of repayment when evaluating the strength of a loan request. The exact sources vary by deal, but the typical sources of repayment for a construction loan are as follows:

  • Primary Source of Repayment:  Payoff from a permanent loan 
  • Secondary Source of Repayment:  Sale or rental of the project 
  • Tertiary Source of Repayment:  Guarantor recourse 

In other words, as a last resort, the lender will turn to the guarantor(s) to repay any outstanding loan balances.  As such, a guarantor’s financial resources need to be commensurate with the loan amount they are requesting.  

When analysing a guarantor, a lender looks at the following elements of the loan request:

  • Who is the guarantor:  Who is the person(s) or entity that will be providing the guarantee
  • Guarantee type:  What type of guarantee is being provided and how does it contribute to the risk profile of the transaction?
  • Income:  Does the guarantor have enough excess income to make the loan’s monthly payments?
  • Balance sheet:  Does the guarantor have enough cash on hand to pay off the loan balance if needed?
  • Personal credit:  Does the guarantor have a good personal credit score with no history of bankruptcy or legal judgements?

Let’s see how our guarantor stacks up against these factors:

  • Guarantor:  The guarantor is the US subsidiary of a major international firm.  Given that they are providing a guarantee at the corporate level, this is considered to be positive.
  • Guarantee Type:  The guarantor is required to provide an unlimited guarantee, meaning that they are responsible for the entire loan balance for the duration of the loan.  This is also a positive.
  • Income:  At present, the guarantor’s income stream is almost solely reliant upon the sales of condominium units, which makes it highly cyclical.  In addition, the small amount of net income relative to the loan amount is considered a negative.
  • Balance Sheet:  While the balance sheet itself is fairly unremarkable, the guarantor has $23MM in potentially realizable contingent liabilities (not counting the subject request) versus $9MM in liquidity.  This is negative.
  • Personal Credit:  The guarantor is a corporate entity.  As such, it is not necessary to pull individual credit.  This is neutral.

Conclusion

The guarantee comes from a corporate entity with a strong reputation for quality developments and on time execution.  However, their financial resources are not adequate to repay the loan in full if they were required to do so.  In addition, they have a significant amount of potentially realizable contingent liabilities relative to their cash on hand.  When all factors are considered, the guarantor does not add significant support to the deal outside of their legal responsibility to repay the loan should they be asked to.  This is a negative.

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