Note Terms & Clauses

[Aaron Mazzrillo]

On another post which we kind of derailed, we got into discussing creative financing techniques and clauses some of us use in notes secured by real estate. You can read more about it here:

Original "Motivation" Thread

I'd like to continue that discussion on clauses we sprinkle into notes such as 'substitution of collateral' and 'personal guarantees.'

[Aaron Mazzrillo]

I was asked why I don't allow personal guarantees into the notes I sign. The simple answer is that I don't want to create risk with my current financial position when taking on new business and part of that is avoiding putting any of my other lenders at risk of note being paid. Each deal has to stand on its own legs. If the beneficiary gets to dictate the terms, then she should be happy with the collateral. If the collateral ends up being insufficient, well, we all have to share in the risk of the investing game.

I consider myself a public person in that I am invited to speak at REI meetings, events, etc. I value my reputation as an educator in this business even though I take no compensation other than the sometimes free hotel room and even less often travel expenses. And it is that reputation that gets me deals most others would have no crack at. When I get a seller to take back a note secured by a rental property they own, I'm looking to create MORE value in their life. I don't want any deal to come back and bite me later. I discuss with them how they will no longer be a landlord and get to enjoy the thrill that accompanies that job, but instead, will become investors in real estate and essentially my business. If I sign personally on a note over here, then I could jeopardize my ability to pay on that note over there and I won't do that. Each deal has to stand alone. I won't put myself at risk and I won't put my other 'lenders' at risk because one greedy person wants to flog me to death beating every last penny out of me.

That all being said, if one doesn't hold himself or herself to a high standard and has no problem walking away from a deal or doesn't think he or she is stealing when late on a payment, maybe such clauses are not in the best interest of those who lend you money or secure their equity with a note they expect you to pay on.

[Bill Gulley]

Okay, but please understand 1. I'm not writing a book here and 2. What I'm about to say is my opinion based on several factors; a. experience in reviewing thousands of RE transaction with respect to lending issues. b. legal aspects from personal experience and formal training and c. subjective judgment in applying learned experiences. I'm not an attorney, I'm a finance guy, one who has given expert testimony in courts with such given without much, if any, objection or challenge to it. That translated, means I'll give you my opinion, I'm not about to argue with anyone, so let's move on politely and with due mutual respect.

As to the issues of non-recourse financing or not taking personal financial responsibility for debts created.

Let's start by giving some reasons why non-recourse debt is used and where and when it's appropriate.

Non-recourse debt (NRD) is customary in certain business loans where either a personal guarantee is illegal or it fails to comply with regulations or where the entity lending has 1. A borrower with a greater degree of having the ability to repay which poses a significantly lower risk of paying as agreed and 2. Where the amount of collateral is highly marketable, is clearly sufficient to cover the unpaid balance together with all expected costs involved in securing and disposing of the collateral and 3. falls within prudent lending practices in extending credit in similar financing transactions. All three of these aspects should be present in any NRD arrangement.

NRD is common when the underlying loan is guaranteed by another underwriter, endorser or guarantor or where any bond or surety is provided. An example is in Section 42 low-moderate income housing projects where the borrower developer is bonded and prevented from providing a personal guarantee by statute.

A lender may provide a commercial loan where the circumstances meet the two points mentioned above, where the borrower is an entity having sufficient capital and income fro operations where the ability to pay as agreed carries little lending risk. The other issue as to collateral, another example could be where "qualified bonds" (being government issued bonds "A" rated or better) can be pledged to reduce or even eliminate collateral risks. Such are considered to fall within the arena of prudent lending practices.

Now, let's shift gears to an individual level.

By statute and IRS code, a borrower may not receive a loan from a qualified tax deferred plan on a recourse basis, this is partly due to funds can becoming tainted and lose the deferred status. So, such is governed by government rules and regulations.

Now, consider any small investor. Do they meet the three aspects mentioned above, does the NRD carry little risk of paying as agreed, is it over collateralized and is such a financing arrangement usual and customary in similar transactions.

Firs of all, individual borrowers die, they can become incapacitated, they can be injured or become ill to the point they can no longer perform. If they are the key person in a business entity, that entity is no more able to continue than the individual running it. The individual small investor probably does not have life insurance and disability coverage to continue operations not are they bonded to ensure business continuation. So, in reality, a small investor will never be able to overcome the aspects of a lender acting prudently accepting that the ability to cover the debt will be ensured.

Next, is the collateral issue, is the individual borrower or small entity providing readily marketable assets as collateral sufficient to cover the debt together with all related costs to secure and dispose of same and pay the outstanding balance over the term. You might pass this test at 50% LTV, but by the nature of RE, it is not considered "marketable" from a liquidation stand point without slashing the price for an immediate sale. Why so extreme? Because the NRD nature requires the collateral to be more than sufficient for liquidation. RE foreclosures and collateral sales are not readily liquid and the fact that a recourse loans are made, address this issue of accepting a less liquid asset.

Now, if the individual borrower were to pledge the property as well as cash assets, say a bond or even stock or bank CDs, then the collateral aspect could swing the risk assessment toward a NRD.

Off to other areas.

Usual and customary carries legal weight in any transaction, from buying a car to having pizza delivered to residential and commercial real estate deals.

What would a reasonable person do in the same situation if they had equal or nearly equal knowledge as other parties?

In a transaction, at some point one party or the other is expected to have some slight advantage, transactions are rarely exactly equal. The question then becomes did one party have any distinct advantage, does one party have any clear advantage over another party.

The guru followers really need to understand these issues in contract law and what is looked to in assessing any dispute.

Is the transaction usual and customary for the type of transaction accomplished? Is the conduct of the parties prudent and rational under the circumstances? Does one party have a greater knowledge or expertise that constitutes an unfair advantage?

Lastly, to this post, as I shall return with more, any third party who is ever in a position to review or examine or judge any transaction doesn't give two hoots about the intentions of any party beyond what an agreement states and affords. To make any agreement that dictates any degree of performance or the ability to avoid any obligation, the contract dictates the intent before the claims or verbal recitals of that party as to their intent to take advantage o f such benefit. That falls on deaf ears. If some benefit to one party was not the intention, as an option to exercise then why is that benefit included?

As to reputation, most investors are still building their reputation in many ways, your personal reputation does matter as well as your business reputation. While we can preach about our business ethics, the proof is in the pudding over a long period of time. I'm not questioning anyone's reputation, but I can tell you from experience that your reputation stops at the courthouse doors in many respects as it can quickly become unraveled by the evidence provided in court. Saying I'm a great person and then entering an unfair, unusual, non-customary transaction that provides unusual benefits for the type of transaction at hand will likely be seen as predatory and there goes the claims as to any reputation.

Consider what I've said here in detail, in depth and with thought as to doing odd ball transactions in financing or in real estate. Just because some angle can be constructed and agreed to does not mean it will fly. It's not that we can't get creative, but the creativity needs to still comply with social and legal aspects, within the bounds of prudence and fairness.

I'll be back. :)

[Steven Hamilton II]

Originally posted by Bill Gulley:
By statute and IRS code, a borrower may not receive a loan from a qualified tax deferred plan on a recourse basis, this is partly due to funds can becoming tainted and lose the deferred status. So, such is governed by government rules and regulations.


@Bill Gulley ,

Exactly correct. The ENTIRE account would be distributed in full.

[Aaron Mazzrillo]

Originally posted by Bill Gulley:

As to reputation, most investors are still building their reputation in many ways, your personal reputation does matter as well as your business reputation. While we can preach about our business ethics, the proof is in the pudding over a long period of time. I'm not questioning anyone's reputation, but I can tell you from experience that your reputation stops at the courthouse doors in many respects as it can quickly become unraveled by the evidence provided in court. Saying I'm a great person and then entering an unfair, unusual, non-customary transaction that provides unusual benefits for the type of transaction at hand will likely be seen as predatory and there goes the claims as to any reputation.

Consider what I've said here in detail, in depth and with thought as to doing odd ball transactions in financing or in real estate. Just because some angle can be constructed and agreed to does not mean it will fly. It's not that we can't get creative, but the creativity needs to still comply with social and legal aspects, within the bounds of prudence and fairness.

You make a very good point on this Bill. The courts don't care who you think you are! When constructing an offer with SF, I actually do think, "How will this sound being explained to a judge?"

[Bill Gulley]

Substitution of collateral is another old approach used so that a new loan isn't required but is rare in institutional financing as it's easier to make a new loan.

Anyone who has been a funding brokerage, where you have partners or investors providing loans can use this to streamline operations. An investor drops 100K in a capital account and loans can be assigned as collateral or properties held. I know that brokers use this system telling their money guys that their funds are secured. Investors should really take a close look at these agreements and ensure that there is an acceptable loan to value that can be shown rather than taking the word of any broker that the collateral is sufficient.

It's also different in substituting collateral between partners or brokers with investors than a borrower on a note having any right to change collateral, especially in an equity funded installment contract.

Under the Uniform Commercial Code and in state law, installment contracts are defined basically as any financing arrangement to purchase an asset over time. The law states that any default in an installment contract voids that contract and that the security lien or agreement becomes effective for the property sold to be secured reverting back to the seller. It could be a TV, furniture, a vehicle or real property. A buyer/borrower can not sell that property without giving clear title.

Now, what actually occurs if collateral property is sold or any release of title is given that installment contract becomes void, ineffective as the property is no longer being sold. A seller can't accept another property securing their equity, they didn't own the other property. Doing so and releasing the property then constitutes another financing arrangement, debt forgiveness and a new obligation is created. Debt forgiveness may then become an issue for the buyer/borrower. There are also tax consequences as the sale terminates and property returned the property can be deemed as payment for the debt. In RE, that seller has to accept the property sold and it constitutes payment, taxes are due as if the agreement had been paid in cash and that seller then has a new basis in that property. So, attempting to switch properties around arising from installment sales opens all kinds of tax issues for both parties.

A promissory note and security agreement (as a mortgage or deed of trust) that is funded with an equity amount is an installment sale. The collateral interest assigned is different from an equity funded note than a note funded by cash.

Any borrower/buyer who devises agreements to substitute collateral in an installment sale and convinces a seller to accept such an agreement is really crossing several lines, they can be terminating the contract, they can be inflicting undisclosed tax liabilities on the seller and they can be a party to fraudulently convincing the seller to releasing collateral as well as taking an improper security interest i a financing agreement.

A substitution of collateral can be agreed to by a lender funding a loan with cash, they can release any collateral and accept other collateral interests.

When a substitution of collateral is made in connection with a cash funded transaction between private parties, (an investor's LLC is not a lender and is a private party) that will be viewed under a microscope to ensure that sufficient value of collateral is the same or better and that such value is not based on the borrower's opinion. This has been targeted as a red flag as to fraud issues due to brokers and dealers assigning insufficient collateral leading to investor's loosing money.

Again, review what was mentioned relating to contract law and predatory issues.

You might begin to understand now my issues with "finance gurus" or those with limited knowledge suggesting and even doing their own thing in financing.

Never use a note or security agreement or any financing contract that has not been reviewed by an attorney or at least someone with a formal education in financing.

Lastly, I have never met an attorney who would have an initial reaction to giving a 60 year old lady a 37 year fixed rate note as being a rational and informed decision by that lender in any installment sale. I'm sure that the initial reaction would be to suspect predatory dealing. By the time they get into that note seeing arrangements to substitute her collateral, all the attorneys I've met would be on the phone telling their 67 year old client to get to the office. Saying 67 year old implying the arrangement is found 7 years later.

While some things may sound great to investors as a really great negotiation or deal made, it's from a lack of understanding of the business, being unaware of the issues. Real estate is not really simple and financing is many more times as difficult than RE. There is plenty of room for creative thinking within the bounds of fair and equitable dealing, regardless of intentions. :)

[Bill Gulley]

Originally posted by Aaron Mazzrillo:

Originally posted by Bill Gulley:
As to reputation, most investors are still building their reputation in many ways, your personal reputation does matter as well as your business reputation. While we can preach about our business ethics, the proof is in the pudding over a long period of time. I'm not questioning anyone's reputation, but I can tell you from experience that your reputation stops at the courthouse doors in many respects as it can quickly become unraveled by the evidence provided in court. Saying I'm a great person and then entering an unfair, unusual, non-customary transaction that provides unusual benefits for the type of transaction at hand will likely be seen as predatory and there goes the claims as to any reputation.

Consider what I've said here in detail, in depth and with thought as to doing odd ball transactions in financing or in real estate. Just because some angle can be constructed and agreed to does not mean it will fly. It's not that we can't get creative, but the creativity needs to still comply with social and legal aspects, within the bounds of prudence and fairness.

You make a very good point on this Bill. The courts don't care who you think you are! When constructing an offer with SF, I actually do think, "How will this sound being explained to a judge?"

Aaron, courts did care who I was, not so much about who I may have thought I was, I don't recall being asked that.

I'd say that's a problem in thinking too much, I'd also say what you have mentioned as your deal, won't sound good to a judge. I suggest you see your attorney and get that straightened out.

I've been point stuff out here for a few years now and sometimes what comes back from investors is that they had their deal approved or blessed by their attorney, so I'll head that off if that's the case, if some attorney approved that, find another attorney.

I'd say you're a creative guy, a real salesman, talented in the art of negotiation perhaps, but you should not be writing notes, it's not the wild west and things surface in time, so be careful out there. :)

[Aaron Mazzrillo]

@Bill Gulley - I didn't actually mean YOU when I put 'you' in my post. Just using it in the generic way, but I appreciate the follow up post. Just wanted to clarify.

[Will Barnard]

I got lost looking for the actual answer in that long response. @Bill Gulley can you answer me one question (no need to explain why) with either choice A, or choice B? Are you stating that an investor such as Aaron, or even myself SHOULD (choice A) or should NOT (Choice B) provide a personal guarantee on loans secured by RE in addition to the subject property as collateral?

[Bill Gulley]

@Will Barnard , NRD notes are those that prohibit the lender from having any other recourse in collecting amounts due other than accepting the collateral. If your company meets the requirements outlined above, along with it being usual and customary, NRD can be used. I'd say that unless it's required by regulation or law, small investors should not be using NRD instruments, it's certainly not customary practice.

I did not address personal guarantees, which is different from NRD. Again, with NRD the lender can only accept the collateral without any other recourse.

If I make any obligation with recourse only in the name of my LLC, without any personal guarantee, that is not NRD as the lender can look to my LLC for deficiencies beyond the collateral value.

Making an obligation without a personal guarantee is more customary in any business transactions than using NRD. I have used notes without personal guarantees in some instances, in both directions as a lender and as a borrower.

Honestly assess the situation in creating or entering a debt obligation as to fairness and ability to cover the debt. At times I had to consider this myself for a few days, it can be difficult to take yourself out of a transaction and view it as an independent third party. Before I ever put my name on any transaction I asked myself a simple (not really simple sometimes) question; How would a judge or jury view this transaction?

By not providing a personal guarantee you need to look to those same issues mentioned above as to NRD, does the business entity standing alone have the ability to pay and meet the obligation, is the question to ask. Is it prudent for the lender to extend credit without a guarantee?

There are only three ways a business can cover debt. 1. Through operations paying with earnings. 2. Paying debt with earnings a re-consolidating other assets or liquidating assets, or 3. borrow to replace or reduce debt.

THE SHELL GAME

The shell game is when someone basically borrows from Peter to pay Paul, it can be done to an extent but it really skirts on fraud, ponzi schemes and if Peter stops funding Paul is out in the cold.

If you have a company that has insufficient capital and you're simply moving money around and need to borrow to cover debt, you could be close to bankruptcy by definition with respect to your cash flow. In this case you had better provide a personal guarantee as that will at least help to show good faith dealings and keep you from being viewed as a predatory dealer or running an illegal operation.

LIQUIDATION

If your company has other marketable assets, cash on hand, accounts receivables, securities or marketable inventory, in other words current assets, these can be considered in covering debt. Real estate is not a current asset as it is not considered as "marketable" on a reliable basis. This stems from legal views as to the determination of assets.

(Real estate to a real estate investor who buys and sells falls into income from operations more than as to asset liquidation)

INCOME

A personal guarantee may not be necessary when there is sufficient income from operations. Generally you're looking at least 2 times or more of the required obligation from available funds. This is just generally accepted practice, there is no law stating the debt coverage, but what will be considered as prudent will be what is generally accepted. Available funds means income after all other debts and expenses are paid together with amounts allocated to any contingent liability, a debt that could become due, but is not actually obligated currently. At this point, you can begin to justify not providing a personal guarantee.

Other circumstances may exist where a lender is compelled to accept an obligation that is not personally guaranteed.

Partnership arrangements where capital is provided and the degree of risk is assumed by partners in order to profit. This is addressed in operating or charter agreements between the parties. There will be a measure or risk and reward as to what is generally acceptable.

Cross collateralization of an obligation can offset expectations of a personal guarantee. 100% coverage is prudent. An example could be borrowing $50,000 on a $100,000 property and giving a lien on a $50,000 property, or even a second on anther $100,000 property with a $50,000 underlying mortgage could meet reasonable risk assumptions.

Property marketability may be an issue that many investors will be faced with. This can be a two edge sword of sorts. If a seller is stuck, a real dump of a property that can't be sold under normal market conditions the transaction could dictate that the seller forego any personal guarantee as a seller concession. Even so, it doesn't relieve the borrower from meeting the obligation or the ability to pay in combination with the factors mentioned above.

The term of the transaction can be a factor as well, a seller financed note that is of a short duration, less than a year for example, should be under less risk considerations if there is no other risk activity, like construction. If you are basically taking title to resell quickly, without extensive work, that may be seen as a lesser risk for the seller as you are basically acting as a pass through or conduit as you may add value in the scope of that transaction benefiting the seller. A good example of this might be a seller leaving the area, selling at a stated value with the agreement of receiving their money in a few months.

As to brokers or those using other people's money, this can fall in the partnership arrangement above. Personal guarantees may be limited.

Limited guarantees are those with a cutoff amount, in other words a personal guarantee may be limited up to a certain amount. This is really the best way to transfer risk for brokerage operations or larger transaction. The issue with using other peoples money may be better understood if an operator were to borrow most or all of a property's value and assign a note or property as collateral. These matters can be very involved, but having investors assuming an interest at some loan to value has issues.

First, LTVs can fluctuate especially in a construction or rehab property. A purchase amount that carries an investor's involvement at say 80%, can quickly become under secured when work begins. Walls might be torn out, flooring removed, the aspects of condition are endless. If you get into some issue where work ceases or it can't be completed on time you have really not kept that investor at an agreed level of protection. In such a case, providing a personal guarantee as to any gap should be provided. Frankly, you'll likely be held to it anyway.

Secondly, as a broker or investor using other's money, you place yourself in a position to perform as you turned your investor into a lender. If you are charged with the management of a project or transaction you have likely already agreed to personal liability, by reasonable implication, even if you are operating in a business entity as the manager. Cutting deals thinking you are not taking personal responsibility is not reality.

There can be circumstances where both the lender or seller may agree to act without a personal guarantee. Lets say a seller has 20 acres worth $800,000 and the seller wants the property to be developed for specific purposes, say with a dedicated park area or to serve some specific goal. Such limitations or restrictions of property use can reasonably place that seller in a position to assume more risk in the transaction. The higher value at risk would usually be difficult for a small or even mid-size investor to cover. Such circumstances in high value properties can be justified in doing without personal liability to cover the debt.

No investor buying some median priced home in a straight up, customary transaction should be doing such without a personal guarantee unless there is a valid reason mentioned above. Saying I don't want the liability is not a valid reason, if you can't stand the heat get out of the kitchen. Doing loans without a personal guarantee with lame justifications simply won't cut good faith dealing aspects with less sophisticated parties. I have to stress again that those investors who draft agreements, devise financing obligations, present the deal themselves, throwing in some salesmanship or providing implications of expertise, assume the position of the expert in the room when dealing with the general public.

So, Will, my opinion is to provide personal guarantees, at least to some degree as the bottom line. I'd have to say, IMO, that those who dance around trying to be involved in doing business without being responsible probably are either acting in something they don't have a grasp of, scared to take the reigns and drive the wagon or they are probably acting in a more predatory area, intentionally or unintentionally. Predatory is simply taking undue advantage at some point. How that may be viewed is, again, not in the eyes of the investor but in the eyes of competent authority.

[Will Barnard]

Originally posted by Will Barnard:
I got lost looking for the actual answer in that long response. @Bill Gulley can you answer me one question (no need to explain why) with either choice A, or choice B? Are you stating that an investor such as Aaron, or even myself SHOULD (choice A) or should NOT (Choice B) provide a personal guarantee on loans secured by RE in addition to the subject property as collateral?

Perhaps I need to repeat my question, 24 paragraph answer and nowhere did it say that you recommend either option A or option B. So I will ask one more time, with just a simple a or b answer, which is it?

[Bill Gulley]

Subject to what I said..... A

It's mentioned a couple times, there was a conclusion, you just need to read it, sorry it's so long but it's not really a yes-no question. :)

[Will Barnard]

I invest plenty of time on this site, I can't read 24 paragraphs just to find a simple a or b answer. Thanks for dong so in your next one.

[Bill Gulley]

I understand Will, you're a busy guy. It hurt me more to type it and present the applicable areas than it should for anyone reading it, I'm sure.

There is almost 30 years of insight into these financing issues, hopefully it will benefit others in seeing a bigger picture. :)

[Will Barnard]

Of course every situation is different and has its own variables, as such, I would point out that I often provide investors with personal guarantees, not for any of the compliance issues you have stated, but for other reasons and that I am in a different business situation when doing so than someone like Aaron. I have the fix and flip scenario where I have a bit more control over the asset and the market (I am not exposed to long hold periods which open up market volatility and other risk factors) and Aaron has more of the buy and hold, often with seller financing. Two different scenarios from two different investors.

Regulatory issues aside, I fully understand how and why Aaron operates in the manner he does in accordance with his strategy and his disclosures to the seller.

[Bill Gulley]

As I said, I'm not going into pointing out more than has been mentioned, actually, your reasons are cover up there Will, there are no real unique business models in RE that go beyond customary financing methods as they are all covered, then it becomes a preference. Going "outside the box" too far is covered up there as well.

I didn't say anything about "disclosures" but I see them being a really bid deal to investors who, in my opinion, put way too much stock in thinking a disclosure keeps you out of trouble, it doesn't. What a disclosure could be showing is the ability of some smooth operator having the skills to give some caution or clarification and still convince someone that what they are about to do is the best solution for them......salesmanship.

While disclosing to someone that they are about to be had may lighten the blow, but it still doesn't wash away the responsibility for your actions when you are the one devising the deal.

It's not so much compliance issues as it is in prudent operations and fairness in dealing with the public, John Doe Public is usually at a distinct disadvantage in RE and financing.

I understand what Aaron presented too, disclosures don't wash away the obvious. He did mention that the lender made a comment as to her trusting him, so I suggest she did the deal based on trust rather than seeking competent advice. I just don't see such triumphs being celebrated as they aren't really triumphs in good business practices. Over 37 years, fixed rate, substituting collateral, I'm pretty sure that will blow up someday to some extent and we will never hear about it. Just speaking from experience.

I'm not going to bang away at Aaron, he was being creative and trying to work things at his advantage, which he did, too much so, but I doubt there was any ill intent or intentional wrong doing. That's how things usually begin, with good intentions, and over selling some arrangement, it's just that the weather can change and it can be very stormy later on.

[Benjamin Cowles]

geez Bill, I appreciate your contribution to the many threads in this forum but for GS please shorten it down by half at least, if possible. I'm a long-winded person myself so I know what it's like, and I believe the quicker you can get the point the better you can think and therefore sleep at night. Anyway, just had to throw that out there. Again, I do appreciate all the info you share -just not ALL the words in between.