Saturday, October 5, 2013

"How to" avoid a guaranty of #CRE leases

I provide Location Advice to owners and occupants of industrial buildings in Southern California...AKA, I sell and lease commercial real estate for a living and have since 1984.

I was touring with a client the other day and he told me that he has not guaranteed a lease in fifteen years (he is only 33). Another large operator that we represent, has over 500 commercial leases,  and guarantees none of them...did I mention that the leasing entity has no assets?

Other occupants that we have represented are required to personally guarantee the lease without any discussion....without regard to creditworthiness, tenant improvements, term, or use.

So what is the difference in the above scenarios and what are some means for avoiding the personal guaranty?

Business defines a "personal" guaranty as:

"An agreement that makes one liable for one's own or a third party's debts or obligations. A personal guaranty signifies that the landlord can lay claim to the guarantor's assets in case of the tenant's default . It is the equivalent of a signed blank check without a date. The landlord is generally not required to seek repayment first from the tenant's assets before going after the guarantor's assets. The landlord's actions are usually based on whose assets are easier to take control of and sell. Once signed, a personal guaranty can only be cancelled by the landlord". Read more:

In effect, the guaranty is a security measure to insure the owner gets his rent. The ways to avoid a guaranty are seeded in understanding the owner's risk, clarifying the owner's reality, and proposing alternatives which provide security.

The owner's risk: An owner can spend up to 25% (or more) of the lease's future income originating the lease. I discuss that in this post. An owner wants to make certain the he receives his rent.. as the first several months of the lease's origination are net of revenue (the income reimburses the cost of origination). Only in the later months of the lease does the lease generate any cash flow. Understanding the actual origination costs of the lease are important. How much "free rent" did the tenant receive? How much was the brokerage fee? What, if any, special purpose improvements did the landlord fund? Was the space vacant for long period of time? The dollars associated with the lease terms generate a sum of money that could be construed as "risk". What will the owner lose if thebb tenant defaults (aside from the future rent payments)?

Clarifying the owner's reality: Assume that a 20,000 sf building is leased for five years at $.65 Industrial Gross with 3% annual increases. Generated is a potential income stream of $839,914. I will assume for this example that 3.5 months of "free rent" are outside the term ($45,500), that the owner spent $20,000 on improvements (north of paint and carpet), and paid a brokerage fee of  $41,950. The "concessions" and fees total just over $107,000 or 12.7% of the future rent. We have not considered the vacancy period preceding the occupancy. The owner wants a "guaranty" of the lease's revenue and has spent $107,000 in hopes of receiving $839,914.

Alternatives to a guaranty: My experience is that "reducing the owner's risk" is key to eliminating or modifying a guaranty. I have successfully negotiated the following "solutions".

  • Increase the security deposit: In lieu of a mechanism to insure rent receipt...which could include legal action that costs time and the owner double or triple the normal security deposit gives the owner cash in reserve to cure the non-payment of rent (and gives him money at execution to offset origination expenses). 
  • Shorten the term of lease: Shorter term, fewer concessions, less risk. I've used this approach with start ups who have little or no rent payment history.
  • Reduce the amount of Tenant Improvements: This reduces an out of pocket expense to originate the lease...thus reducing the owner's cash risk
  • Encourage the occupant to accomplish the Tenant Improvements: Similar to the point above. Occasionally corporate occupants have a "pool of money" for tenant improvements which is accounted for differently than lease payments.
  • Spread the leasing commission over the term of the lease: This does two things, the owner "pays as he goes" thus reducing the cash outlay at the lease execution AND if the tenant defaults, the fee payments stop. Some practitioners argue that they are not "guarantors of credit" but I've seen this work to avoid a guaranty.
  • Only guarantee a portion of the obligation including an "earn out bonus": The owner has shelled out over $100,000 to originate the lease in hopes of receiving $840,000. How about only guaranteeing the $100,000 and with one year of faithful and timely rent payments, the guaranty goes away?
  • Restructure the "free" rent to "abated" rent and spread out the concession: Abated rent is recoverable in the event of a default, free rent is not. Classify the free rent abated rent and spread the abatement over the term (1st, 13th, 25th months) of structure the abatement as 1/2 rent for a period of time. The initial cash flow drain is minimized.
Good luck with your deals! Hopefully this helps you close more lease transactions.