Banks and other traditional lenders remain the most logical financing choice for established investors in commercial real estate, but an antiquated practice has been holding the industry back. Many lenders still require investors to put up a personal guarantee as a safety net.
Requiring a personal guarantee can kill a deal or cause a client to accept an inferior commercial mortgage and terms from a nontraditional lender. It also is an ineffective way for a lender to hedge against risk. There’s a better way of doing business.
Risk is always a major concern in commercial real estate lending. With an eye toward lessening their exposure to losses, lenders have traditionally required a personal guarantee from individual borrowers.
This basically places the borrower’s personal balance sheet on the line in case of default. Most commercial mortgage lenders see this guarantee as a way of holding a borrower’s feet to the fire should something go wrong. In reality, however, personal guarantees offer little protection for lenders in recouping losses. Even with a guarantee, borrowers often still negotiate a discounted payoff that increases the cost to the lender by dragging out the collection process while simultaneously reducing what they can actually collect.
For commercial mortgage brokers working to serve their clients, this process is problematic for several reasons. Lenders fund fewer deals and at lower amounts. Additionally, the default and collection process can damage the relationship with the borrower. When a commercial mortgage lender threatens its borrowers and sponsors with personal ruin, it motivates borrowers to protect their own interests rather than focusing on solving the problems with their project.
Innovations in investment-grade insurance products are benefiting mortgage brokers by offering lenders access to liquidity and, most importantly, risk coverage for their commercial real estate projects.
If personal guarantees are ineffective, why do traditional lenders continue to rely on them? The primary reason is that it has been the only available tool. More recently, however, some lenders are looking to the insurance industry as an alternative solution.
Loan-insurance basics
Innovations in investment-grade insurance products are benefiting mortgage brokers by offering lenders access to liquidity and, most importantly, risk coverage for their commercial real estate projects. Commercial property loan insurance (CPLI) is increasingly being used by borrowers and lenders. It represents a structural change in how commercial real estate lending is managed for all parties.
Similar in concept to private mortgage insurance (PMI) for residential mortgages, CPLI is an institutional grade-rated loan-guarantee product. It provides credit and capital relief to lenders, which better positions them to do more lending and earn higher profits across their commercial real estate portfolios. Most importantly, it removes the need for a personal guarantee. Customer relationships tend to benefit due to improved loan terms. And, for brokers, it increases the capacity to close deals.
A CPLI solution covers the riskiest 10% to 40% of a qualified mortgage amount, significantly reducing the lender’s exposure to foreclosure losses. This gives chief credit and risk officers the ability to underwrite and approve more commercial real estate loans, allowing their companies to stay competitive and protect their best interests, while at the same time benefiting the borrower by allowing more favorable rates and larger amounts of leverage.
The size of commercial real estate loans can vary greatly depending on the scope of the project, the needs of the borrower and the capital reserves of the lender. As brokers know, borrowers who seek loans from banks and other traditional lenders are typically investors with years of experience. Yet a personal guarantee is demanded by most traditional lenders.
Compounded savings
Generally speaking, a personal guarantee holds back the most seasoned borrower and requires them to keep more of their money on their balance sheets to cover the guarantee. Commercial mortgage insurance, by contrast, covers a significant portion of the risk through the policy, rather than placing the risk directly on the borrower. This frees up more of the borrower’s funds, money which can then be leveraged for more deals with their lender and broker network.
If today’s traditional lenders could recognize the limits that outdated methods are putting on the industry, they could boost business for all involved by utilizing commercial mortgage insurance.
If we consider a commercial real estate deal of $10 million, we can see how mortgage insurance not only protects borrowers, but how it can provide significant savings over the life of the loan. In this example, assume investor equity of $3 million and an outstanding loan balance of $7 million. Should a loan with a personal guarantee fail, the borrower and lender would be exposed to this full amount of debt. Mortgage insurance, however, significantly reduces the risk for both borrower and lender. Implementing coverage at 40% decreases the initial exposure from $7 million to about $4.3 million.
The lender is better protected by insurance than by a personal guarantee and it also can gain capital relief on its overall lending portfolio. These benefits can then be passed to borrowers in the form of lower interest rates. In the aforementioned $10 million deal, a borrower would pay a one-time, upfront premium at closing that would be rolled into the loan amount. The lender might realistically be able to lower the interest rate from 5% to 4.5%, saving the borrower several thousand dollars in costs for a single deal. When considering multiple deals, the possible compounded savings become quite compelling.
Improved relationships
To put it bluntly, if today’s traditional lenders could recognize the limits that outdated methods are putting on the industry, they could boost business for all involved by utilizing commercial mortgage insurance. An insurance strategy could not only help increase their loan volume by allowing more experienced borrowers to qualify, but it positions mortgage brokers to better serve their clients.
Removing the personal-guarantee covenants opens possibilities for new structural advantages when arranging for short-term loans of less than 36 months — and it could ultimately increase revenue. What’s more, commercial mortgage insurance can clear a path for a client to stay with a lender when it is time to secure permanent financing.
This allows brokers to build closer, stronger relationships with their more experienced investor clients, increasing the chances for additional business down the road. Commercial mortgage insurance removes the contentious personal-guarantee covenant. In doing so, it removes the potentially bitter end to the lender-borrower relationship should a default or foreclosure occur.
According to a Harris Poll of 350 U.S. commercial real developers conducted this past June, 79% of the respondents are more likely to work with a lender that offers a nonrecourse repayment option, such as commercial mortgage insurance, over one that does not. The poll also revealed that more than half of those surveyed indicated interest in investing additional funds into a project to help solve a development issue if there were no personal-guarantee repayment requirements.
Alternative lenders and nonbanks that offer similar, albeit more costly, options are beginning to pose a serious challenge to traditional commercial mortgage lenders that do not adopt this kind of strategy. This, in turn, impacts the mortgage brokers who support them. Borrowers are not only demonstrating that they are open to work with lenders that offer nonrecourse repayment options, they are actively seeking them out in today’s competitive marketplace.
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Implementing an insurance strategy offers traditional commercial real estate lenders the opportunity to work more effectively with their broker partners. This can help them grow their borrower relationships — and investment portfolios — by remediating an ineffectual system that is holding the industry back.
