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Key takeaways
- A real estate guarantee is an agreement between developers, financiers, and a third party. The third party, a guarantor, agrees to pay if the developer defaults on payment or the property isn’t profitable.
- Three common types of guarantees are completion guarantees in real estate, bad boy guarantees, and declining guarantees.
- If you want to avoid signing a real estate guarantee, you could sign a new loan agreement with different institutions or you could use a governmental loan.
For many property developers, securing multifamily financing to actually start development is one of the biggest hurdles. To attract financiers, developers might offer a real estate guarantee. This ensures that a moneylender will eventually get their money back.
In this post, we explain what a real estate guarantee is and some common types of guarantees. Then, we go over the alternatives to signing a real estate guarantee.
This post covers:
- What is a real estate guarantee?
- What are three common types of real estate guarantees?
- Two alternatives to real estate guarantees
What is a real estate guarantee?
A real estate guarantee is an agreement where a third party agrees to pay back a loan in the event that the recipient of the loan cannot. This third party is called a guarantor.
In real estate financing, a real estate guarantee is a way for a borrower to secure a loan. They can start developing a property by assuming some personal risk.
The developer making the purchase is betting that their new property will eventually become profitable. A developer might want to finance a commercial, multifamily, or mixed-use property that begins to generate cash. Then, when the property starts making money, the borrower can start paying back the loan.
But moneylenders might want to hedge their bets and ensure that their loan is paid back either way.
To secure their initial investment, borrowers might agree to a guarantee agreement for a loan stating that they’ll repay loans out of their personal funds if the property isn’t profitable. But real estate guarantees come in all forms and come with many different conditions.
Who is involved with a real estate guarantee?
These days, it’s quite rare for a developer to pay for a new property entirely themselves.
Instead, to raise all the money needed to purchase a property, developers might team up with:
- Other developers
- Corporations
- Funds
- Financial institutions
Moneylending parties might not feel comfortable allowing somebody else to borrow millions, or even hundreds of millions of dollars, without a few stipulations. That’s why multiple parties become involved in financing the purchase of real estate.
Learn about the real estate cycle with ButterflyMX:
What are three common types of real estate guarantees?
Depending on how many parties are involved in the initial borrowing, you can have a few different types of real estate guarantees.
Three common types of guarantees in real estate include:
1. Declining guarantees
A declining guarantee reduces the amount a developer must pay for every construction or occupancy milestone the property hits.
For example, when the investment is made, a developer may be responsible for paying back 100% of the real estate loan. But after the developer has finished constructing the building, investors might signal their satisfaction with the developers’ progress by reducing that percentage.
And as the building obtains tenants and makes money, that percentage might continue to shrink.
2. Bad boy guarantees
Bad boy guarantees are also known as recourse carve-out guarantees — but that’s not nearly as catchy.
A bad boy guarantee ensures that a developer keeps working on the property in good faith.
Construction delays and other holdups are bound to happen. But bad boy guarantees are there to guard against overtly negative acts. Bad boy acts include things like fraud, construction or regulatory violations, or bankruptcy.
3. Completion guarantees
A construction completion guarantee puts the developer on the hook if the cost of construction is greater than the amount that the developer and lenders originally agreed upon.
You can change the terms of a completion guarantee to best suit your purposes. Usually, completion guarantees only make a developer responsible for cost overruns. But you can also be held responsible for the entire loan in case of an overrun, or you can set the completion guarantee to kick in if a certain amount of overrun is reached.
Two alternatives to real estate guarantees
If you’d prefer not to sign a real estate guarantee, you might consider:
1. Finding other moneylending parties
As a developer, you can choose between a wide range of banks, trusts, and funds for a loan. If you ask around, you might be able to receive a loan that doesn’t require a guarantee.
However, a loan without a guarantee might come with more stringent terms. You might not receive as much money as you’d like, or you might need to deal with a higher interest rate.
2. Using a governmental loan
Depending on the type of property you’re interested in developing, you may take advantage of government-provided loans. Some agencies you can look into include the federal Small Business Administration. Your local city or state might also offer loans.
However, using government funds might come with its own hurdles. You might have to deal with longer wait times as you deal with bureaucratic red tape. Or, you might only be able to use that money for specific purposes. For example, the city-run Energy Efficiency Corporation based in New York only lends out money for energy-efficient upgrades.
