More often than not, a portion of every commercial real estate transaction is financed by debt. Usually, that debt comes from a bank or non-bank lender that agrees to borrow a certain amount of money in exchange for certain concessions from a borrower. For example, they will almost always require a first mortgage on the property that guarantees the loan and may require the borrower to agree to certain covenants around Debt Service Coverage or Loan to Value.
Depending on the lender, they may also require the personal guarantee from the borrower(s)/sponsor(s) in the transaction.
What is a Personal Guarantee?
In a typical commercial real estate transaction, a lender looks for three sources of repayment. In most cases it looks something like this:
- Primary source of refund: Cash flow from real estate
- Secondary source of refund: Real estate sales
- Tertiary source of refund: Execution of personal guarantee
This structure means that the bank first evaluates the financial standing of the property to ensure that it produces enough cash to make the monthly loan payments. As long as this is the case, there are no problems. As a backup plan, they will also analyze the value of the property to ensure it can be sold for enough money to pay back the outstanding loan balance. As a last resort, if the sale price of the property is not enough to pay back the loan balance, the lender will turn to the transaction sponsor who will have to reach into their own pocket to make up the difference. To illustrate how this works, see the following example.
Suppose the borrower defaulted on a loan with an outstanding balance of $1,000,000. This means that the primary redemption source has failed. As such, the lender turns to the secondary source by foreclosure on the property and selling it for $900,000. These funds are applied to the loan balance, but $100,000 is still outstanding. When the bank executes the personal guarantee, it means that the sponsor(s) have to reach into their own pockets for the $100,000 needed to fully repay the loan.
Relying on funds from guarantors for repayment underscores the need for the lender to understand exactly what they look like. The main way this is accomplished is by requiring each of them to complete a personal financial statement.
Evaluating the Sponsor’s Financial Strength – The Personal Financial Statement
A personal financial statement is an individual balance sheet showing the income, assets and liabilities of each guarantor. Lenders use it to evaluate the financial situation of each “guarantor” / endorser and the collective strength of multiple guarantors. The specific template or form used to create a personal financial statement varies by lender, but they all contain the same general information, which is discussed in detail below.
The first section is quite simple and contains personal information about the individual or couple filling out the personal financial information. Usually it contains a combination of the following:
- Time duration at current address
- Rent or own main residence
- Driver’s license information
- Employment information such as employer, title and length of time in the current position.
The purpose of this information is to determine who the guarantor is, where they live and what they do for work. When preparing a credit report, this information may be referenced to ensure that the credit report has been requested from the correct person(s). An example of this section is shown in the screenshot below:
Assets and liabilities
This is the most important part of the personal financial statement. It is where the person(s) completing it lists their personal assets and debts. When the lender goes through this section of the PFS, they are looking for the following important information:
- Liquidity: This is perhaps the most important number on the Personal Account. Liquidity typically includes: cash, savings accounts, checking accounts, mutual funds, certificates of deposit, cash surrender value of life insurance policies, money market accounts, negotiable securities, and any other asset that can be quickly converted into cash.
As a general rule of thumb, lenders want to see liquidity equal to 10% of the loan amount, after the down payment has been made. For example, a $1,000,000 loan would require $100,000 in liquidity.
- Total assets: Non-cash assets include: primary and secondary homes, real estate partnerships, retirement accounts (401k, IRA, etc.), corporate ownership interests and personal property such as collectibles, notes receivable, jewelry, household goods, and automobiles.
The listed value of illiquid assets is usually taken with a grain of salt by the lender, as borrowers are notorious for exaggerating their value and are unlikely to hit full price in a liquidation scenario. For example, if a car is listed as worth $25,000 and the borrower was forced to sell it, he may only get $18,000 or $20,000.
- debt: Total liabilities can be divided into two groups, short term and long term. Current liabilities are debts due in less than 12 months and include things like credit card balances, unpaid taxes, and payday loans. Long-term debt is debt due over more than 12 months and includes account balances for things like: car loans, personal loans, business loans, and mortgages to be paid.
From an analysis standpoint, a lender typically compares the combined outstanding balance of short-term debt with the individual’s liquidity to ensure that there is enough cash on hand to cover them. For example, if a person has $25,000 in liquidity but $50,000 in short-term liabilities, this could potentially be problematic.
- Contingent liabilities: Contingencies are often overlooked, but they are critical. They represent other loans that the sponsors have guaranteed. They are important because if the borrower defaults on any of the other loans, his ability to support the loan in question could be compromised.
Typically, contingent liabilities are categorized based on the likelihood that the individual will have to support them. The categories are:
- feasible: A loan with a high probability of default, meaning the person may need to back it up. These include loans that are already past due or for which payments have been missed.
- Potentially realizable: A loan that may be in default or a loan that may need the support of a borrower. This category typically includes loans for land or development projects, as these typically represent the highest risk.
- Potentially not realizable: A lower-risk loan that the borrower may need to support at some point in the future. These could be loans for properties that currently have no cash flow or for which the covenants have not been fulfilled.
- unrealistic: A loan that will probably never need support from the person providing the PFS. These typically include cash flow property loans and loans with a long history of performing as agreed.
If the recoverable or potentially recoverable contingent liabilities significantly exceed an individual’s liquidity or total assets, this can be problematic for the lender as it means that the individual’s assets could be wiped out by another loan.
Below is an example of the Assets/Liability section:
Income / Expense
The next most important element of a person’s financial condition is how much money they earn and spend in a given month. This is shown on the PFS income statement portion.
Annual income comes from a variety of sources, including employment, alimony, interest, dividends, and K-1 distributions. Income in itself is not a critical measure, but net income is. A sponsor may have a high income, but if he also has high expenses, in the worst case scenario, his net income may not be enough to support the loan payments.
Expenses consist of daily living expenses for things like food, travel, child support and housing. They also include debt service for things like mortgage payments, student loans, payments on existing loans like mortgages, and car bills.
An example of the income/expenses section is shown in the screenshot below:
Finally, there may be an “other information” section with a series of questions about the borrower’s personal history. The point of the questions is to cover a few key items that would not be captured in the assets, liabilities, and income provided by the borrower. In the PFS template we use, these questions include:
- Have you ever declared bankruptcy?
- Has your assets been pledged elsewhere?
- Have you made a will?
- Is your tax return checked?
- Do you have any outstanding letters of credit?
- Do you have delinquent tax obligations?
If the answer to any of the above questions is yes, then chances are the lender will ask the guarantor for more information about the situation. For example, if the guarantor’s tax return is found to be audited by the IRS, he may have to pay a tax penalty that would have to be deducted from his available liquidity. A yes to any of the questions does not necessarily disqualify the borrower, but it does indicate that further investigation is needed.
Below is a screenshot of the “Other Information” section:
Summary and conclusions
As part of the commercial loan approval process, a financial institution or commercial real estate lender will require its borrower(s) to complete a personal financial statement.
A personal financial statement is a list of each guarantor’s income, assets and liabilities and they are used by the lender as a way to analyze the tertiary source or repayment in a loan transaction. The format of the PFS often differs from lender to lender, but they all contain the same general information and have the same general purpose, which is to summarize the financial position of the guarantor.
The Assets sections lists all the valuable things the guarantor owns and they are divided into short-term and long-term categories. Short-term assets include things like cash, money market accounts and negotiable securities. Long-term assets include things like cars, houses, and collectibles. They are listed at market value.
The Liabilities section is also divided into short-term and long-term categories. Current liabilities include things like credit card debt and payday loans. Long-term debt includes things like mortgages, car loans, and income tax payable.
Finally, income lists the borrower’s sources of income. Usually they include categories such as: wages, dividends, interest, benefits and gifts.
The higher the capital and liquidity of the guarantor(s), the more support they provide to the loan request and the more likely it is to be approved. If the guarantor(s) have negative equity, this will be deducted from the transaction and may be a reason to decline it.