Personal Guarantees and Private Money - Yes or No?

Should you ever personally guarantee principal or returns to a private investor? This question vexes many real estate investors from the green newbies to the most experienced and savvy.

I'll admit: I wrestled with this one a bit myself when I began bringing private money as my exclusive financing source.

When you work with private investors, you have to be flexible while also sticking to your business model and deal parameters. There is some wiggle room, but not much once you begin down a particular path. For instance, if you are flipping single family houses, there are a few deal structures that work better than others and you have a ceiling on what the private investor can make based on the profit margins.adam-davis-private-money-guaranteed

Where Guarantees Come Into Play

Since there are two types of private money investment: private money loan or private equity investment, the subject of personal guarantees is relevant only as it applies to loans. By it's very nature, an equity investment is an "at risk" investment and most people know that when you buy 1,000 shares of GE nobody is guaranteeing your principal or return.

Fear not, however! There are many ways that you can structure real estate investment deals with equity investors so the investors principal is protected (in many cases better than a loan!).

Personal Guarantees apply to private  loans - where a private investor loans you money at a specific interest rate for a set period of time. Usually, a private money loan is going to be secured by a mortgage or trust deed, so the private lender can foreclose and sell the property to recoup their investment if you don't pay them back.

Most banks and mortgage companies require you to sign a personal guarantee when you borrow money from them. The reason for this is the lender wants to put you on the hook for any money you don't repay that cannot be recouped if the property is sold at foreclosure. Here's how it works in the eyes of the bank or mortgage company:

You borrow: $200,000

Bank forecloses and nets out: $175,000

You are personally liable for: $25,000

The personal guarantee you sign with the lender means that you must pay back that $25,000 or they can come after your personal assets. While this seems scary to many real estate investors, there isn't much you can do about it if you are the one borrowing the money -it's either sign the personal guarantee or walk away from the deal.

When the investment project gets bigger, such as with commercial deals, the bank or lender may write a non-recourse loan. The  non-recourse loan means you are not personally guaranteeing anything on the note - the only collateral or recourse the lender has is the property itself. Non-recourse loans are more common on larger commercial and multi-family deals - you won't see them with residential loans.

This brings us back to the burning question: should private money loans be non-recourse? Should you personally guarantee a private lender?

My answer can only be based on my experience: it depends on the deal, the lender, the situation.

When I first started with private money loans, I would sign a personal guarantee for the principal amount. I set up the deals the same way that I would if I was a bank. The lender got a note, mortgage and personal guarantee.

Did this make me nervous? Not a bit. If the deal was as good as I was telling my private lender it was, then I should have no problem treating them the same a bank.

For some deals you are going to be personally guaranteeing your private money loans. Others you won't. If your lender is OK with no personal guarantee (some lenders will invest money with you without a mortgage as well), then you can move on without worry.

As I grew in my business on the residential investment side, I was able to get better and better deals and demonstrate to my private money lenders that there was sufficient equity in the deal so that personal guarantees were not necessary. Some of them still asked for one and I would sign with no problem. If the deal isn't good enough for you to sign that guarantee to the private lender, you should re-think it.adam-davis-private-money-handshake

That being said, some situations do not lend themselves well to personal guarantees. If the private investor wants to share in the profits and up-side of the deal, then you shouldn't be signing a guarantee. In this case, the investor is essentially moving from "lender" status into "partner" status. Partners share in the risks and rewards of an investment deal. It isn't fair for you to give up part of your lucrative profits on a real estate investment and, then, if things don't go right you have to be personally liable for the loan.

Moving Away from Guarantees

With the way I set up my deals now, I don't personally guarantee any principal or return on investment. While this may sound blasphemous, consider that I've gotten more private money with equity deal structures that with loans. There are ways to protect investors so they feel good about the deal and so you're not on the hook personally. Using these strategies has enabled me to be more flexible in my business and take advantage of greater opportunities. I'll go into the specifics in a later post, but you should keep in mind the following:

if you're telling the private lender that they are going to "be the bank", then you shouldn't treat them any differently than you would a bank.

Operating like this will bring you a lot more private money for your deals - it's "win-win" all the way around.