Why Do Hard-Money Lenders Require a Personal Guarantee?
The conversation took a strangely educational turn. Up until that moment, it had been networking, catching up, and eating tasty middle-eastern food. Shawarma for me. But now, the question, like a mashed brake pedal, brought the conversation to a screeching stop.
Last week, I attended my first meet-up in more than 15 months. Thanks COVID. It was Reed Starkey’s Multifamily Meet-up and the conversation was halted when someone asked me why lenders want a personal guarantee if the hard-money loan is asset-backed. I thought he was trying to make a joke, because the answer was obvious to me. So I simply replied, “it may be asset-backed, but there still needs to be something behind it.” People listening thought I was being a wise guy, it seemed.
Maybe the gentleman who asked the question was trying to be funny. But the question is worth answering. So, why do asset-backed loans from hard-money lenders typically require a personal guarantee? And what is a personal guarantee?
A personal guarantee is a legal document that at its most basic guarantees that you, personally, will repay a loan if the actual borrower (presumably your entity) defaults. Requiring a personal guarantee discourages fraud for anyone trying to use his or her business to borrow money and then simply walk away. A personal guarantee also underscores the personal responsibility, accountability, and trust required to make these deals. It shows the lender that you’re confident in the deal and are willing to risk your personal assets for your business.
There are borrowers who are completely law-abiding, however, who still make bad choices. We lent to one such borrower on not one, but two properties. Simultaneously. They took possession and started demo. The investor’s husband was a general contractor. “He can handle it all.”
Snow started falling, winter came, work slowed. After a couple of months, the properties were down to the studs. Then the payments stopped.
And never started again. We spoke a few times. False promises were made with the best of intentions, no doubt. And a couple of months after that we started the foreclosure process. Eight months later, we took possession and the studs were still bare. There were scribbles of plans scattered around the houses. Evidence of a squirrel that made it down the chimney in one of them. And we were owed more than double what the houses were now worth.
It’s unclear if this investor set out to commit fraud. We later discovered that her LLC purchased a total of five houses almost at the same time, all of which needed extensive rehab. Let’s agree that they were optimistic. And all purchased with lenders’ money. At some closings they even walked away with cash, too. Now the borrower’s LLC was out of money and had no assets left to seize.
This. This is why personal guarantees are required. Yes, even though the loan is asset-backed. Without a personal guarantee, hard-money lenders could be left high and dry. Let’s be honest, even with a guarantee we could be out of luck if the guarantor has no personal assets. But by requiring the personal guarantee, at least we have the potential to recoup our funds.
