Carve-Out Guarantees in Commercial Real Estate Finance

Carve-Out Guarantees In Commercial Mortgages

A carve-out guarantee, also referred to as a carve-out guaranty, gives a commercial lender the authority go after a borrower’s personal assets if the lender forecloses on the property. Carve-out guarantees are standard on almost all types of non-recourse commercial loans; if they are violated, they essential make the non-recourse loan into a full recourse financial instrument. Depending on the wording of the carve-out guaranty, the lender has the ability to either seek damages or the entire loan amount if there are any violations of the note or commercial mortgage loan agreement.

''Bad-Boy'' Carve-Outs

Also called a “bad boy” carve-out, a carve-out guaranty often applies when the borrower or guarantor of the loan engages in serious violations—like misrepresentations of the property, fraud, theft, or voluntary destruction of real estate—that impact the value of the property or loan. This guarantee therefore gives the lender immediate financial recourse against such acts.

The carve-out guarantee also allows a lender to require payment for a real estate loan if the borrower files for voluntary bankruptcy or conspires with another party to have involuntary bankruptcy filed. The lender can also seek loan repayment or damages if the borrower transfers any part of the commercial real estate that affects its value. Other common “bad boy” acts that could trigger a loan’s recourse provisions include failure to pay required property insurance premiums, failure to pay property taxes, wasting funds, environmental indemnifications, and borrower negligence.

Cave-Out Guaranty Provisions for Borrower Protection 

In many situations today, carve out guarantees are so complex and numerous that a non-recourse loan begins to significantly resemble full recourse financing. That's why borrowers should be careful to make sure that the terms of their non-recourse loan are reasonable and that recourse will not likely be triggered by poor market conditions or small oversights.

In particular, we recommend that a non-recourse loan agreement have the following provisions in regards to carve-outs: 

  • The lender must provide reasonable advance notice a "cure period" for certain carve-outs, such as failure to pay taxes. 

  • If recourse is triggered, the lender must not attempt to seek damages beyond the loan amount they were originally owed (exceptions may include certain legal and administrative costs)

  • The insolvency of the borrowing entity will not trigger the loan’s recourse provisions.

  • Any cash distributions to property owners made before loan default will not be recaptured by the lender.

Carve Out Guarantees and Mezzanine Loans 

Carve-outs can be especially tricky if a borrower has decided to take out mezzanine debt on top of a senior loan. In most cases, mezzanine loan borrowers are required to pledge a controlling equity interest in the borrowing entity as collateral for their loan. If a borrower defaults their mezzanine loan, the mezzanine lender could then take control over the property; and, in theory, could commit various acts that would violate a loan's carve-out provisions, such as declaring bankruptcy or failing to pay property taxes.

In this situation, the original loan borrower could be held liable, even if they no longer have any control over the operation and finances of the property itself. For this reason, it's essential that borrowers who are considering taking on mezzanine debt make sure they are legally protected. However, this protection does not only benefit borrowers, it protects the senior lender as well. For example, if a borrowing entity controlled by a mezzanine lender declared bankruptcy, it could prevent the lender from actually foreclosing upon the property. To prevent these types of unfortunate legal scenarios, senior lenders sometimes require a mezzanine lender to indemnify the borrower against all outs in the case that the mezzanine lender takes control of the borrowing entity.

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