Developers and investors often seek nonrecourse debt to limit their personal liability. Investors working on existing commercial properties can often achieve this because the property and its existing cash flow provide sufficient collateral to the lender in case a recovery is necessary. Developers seeking construction loans find nonrecourse debt more difficult to locate, however, and available funding typically comes at lower leverage and higher rates.
From a lender’s perspective, this makes sense. Without a repayment guarantee, recovery from the collateral of an incomplete project could lead to a loss. Thus, true nonrecourse construction debt often prices at near equity yields, and only the most lucrative of projects can accept that pricing. To complicate matters, some lower-cost construction loans without personal repayment guarantees often contain completion guarantees, putting the guarantor at risk, and these are still typically referred to as “nonrecourse debt.”
Commercial mortgage brokers who negotiate on behalf of borrowers know that a personal guarantee puts real teeth into borrowing money; clients’ entire estates are put at risk with these recourse obligations. For brokers originating construction loans, understanding the finer points of these guarantees becomes especially important.
So, what is the difference between a repayment guarantee and a completion guarantee? A repayment guarantee provides for full repayment of the loan amount, or any deficiency in the lender’s recovery. This is one of the most robust, actionable and, in terms of case law, well-supported remedies to default that a lender can secure.
A completion guarantee, by contrast, promises on-time and lien-free completion, even if the borrower defaults. If demanded by the lender, the guarantee may also require deficiency deposits to keep the loan balance in the event of a cost overrun. Although on the surface these may look similar to a guarantor because there is recourse in both cases, they are different in terms of risk. The completion guarantee is a materially less burdensome guarantee to provide.
Completion guarantees expire when the building receives a certificate of occupancy, but repayment guarantees typically do not. So, once construction is complete, the guarantor no longer has any recourse. What happens if the market crashes and you can’t sell that asset? That isn’t a problem for the completion guarantor, but it is a considerable issue for the repayment guarantor.
With proper budgets, robust contingencies, payments, or guaranteed maximum price bids from a qualified general contractor and performance bonds to assure proper construction, the guarantor’s exposure to a completion guarantee can drop considerably. Furthermore, some general contractors will accept this guarantee as a part of their engagement.
Another reason that completion guarantees are much less onerous than repayment guarantees is because guarantor damages are fairly limited in the event of default. You should speak with your lawyer long before these items rest on the table for execution, but here is a layperson’s take on this subject:
- A guarantee of completion is a not a guarantee to substitute the guarantor’s funds for construction loan proceeds. Any loss a guarantor could incur would have to be calculated as if all loan proceeds were dispersed. The guarantor’s bargain, essentially, is that liability must be accepted for the excess costs to achieve completion with the full construction loan proceeds advanced.
- The amount of outstanding mortgage debt is the upper limit on the amount of damages that may be recovered under a completion guarantee — and any other guarantee, for that matter. The guarantee is security, and ancillary, to the mortgage debt. If as-is value exceeds the outstanding debt, the guarantor’s exposure is zero because the collateral is sufficient to provide the lender with a full recovery. If as-is value falls below the outstanding debt, the completion guarantor’s exposure is defined as the difference between the as-complete value and the as-is value, but only to the point that the undispersed loan proceeds plus the as-is value fall below the total loan amount. Said another way, the guarantor is required to support the improvement of the property only to the point where the as-is value of the asset equals the outstanding debt. This is a key point. If the cost to complete is greater than the as-is value, the gap between the current loan balance and the as-is value determines the maximum damages that the completion guarantor can incur, not the cost to complete.
- Court mandated specific performance of the guarantee is not likely. The courts show reluctance to intervene in commercial projects of this complexity where other remedies exist.
- Case law is very limited in addressing collection on completion guarantees. There may be as few as three cases nationally. This may indicate that lenders find the courts and guarantees of completion to be unreliable mechanisms for recovery. By contrast, the case law for repayment guarantees is robust, and these have proven to be a valid recovery mechanism.
In short, a guarantor of completion has nowhere near as much exposure as a repayment guarantor.
The collection of completion and repayment guarantees in single-action states like California is more difficult, however, because lenders can either go for judicial foreclosures or nonjudicial foreclosures, but never both. Acquiring a title in a nonjudicial foreclosure is fairly expedient and cost-effective, with the final event being a trustee sale on the courthouse steps. A judicial foreclosure, on the other hand, is costly and laborious, and can take years to resolve.
That said, a judicial foreclosure is the only foreclosure process that allows a lender to secure a judgment against a borrower for a deficiency in the loan repayment and recover the proceeds from the sale of the asset. But in a judicial foreclosure, the borrower has one year to redeem the foreclosure from the asset purchaser.
“ Many lenders choose nonjudicial over judicial foreclosures, but in doing so they effectively negate the impact of any guarantee. ”
This has a significant chilling impact on the asset sale as well as the sale price. Who would be willing to purchase an asset through foreclosure without a substantial discount when they know the developer — the person with the best knowledge of the deal — can reclaim the asset for the sale price within a year?
The bigger the discount, the more likely a sale, but also the more likely the developer could return to resuscitate the project. In practice, many lenders choose nonjudicial over judicial foreclosures, but in doing so they effectively negate the impact of any guarantee.
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Guarantees are substantial burdens that need to be fully understood legally and financially by all parties — brokers, lenders and investors — before they are accepted. Although the repayment guarantee is often preferred by lenders, the completion guarantee is vastly superior for borrowers.