The sponsor's personal financial statement says the guarantee is comfortably covered; the loan agreement's definitions say it is already in breach.
Guarantor covenants are tested on the loan agreement's own definitions of net worth and liquid assets, applied to the guarantor's financial statements, never on the totals the sponsor presents. On an illustrative 40,000,000 loan with a net worth test equal to the loan and a liquidity test of 10 per cent, a sponsor whose statement shows 66,000,000 of net worth and 7,500,000 of liquidity tests at 39,500,000 of net worth, a breach of 500,000, and 4,200,000 of liquidity, 200,000 of headroom.
Worked in full in How to Read a Real Estate Loan Agreement by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A non-recourse loan usually comes with a guaranty: the carve-outs, completion, sometimes a payment guarantee for part of the debt. The guaranty is only worth what stands behind it, so the lender adds two financial covenants on the guarantor. Typical wording requires the guarantor to maintain, at all times or at each test date, a Net Worth of not less than an amount and Liquid Assets of not less than another. Both capitalised terms are defined, and the definitions do the work.
Net Worth is commonly total assets less total liabilities, determined on a stated accounting basis, excluding the guarantor's interest in the mortgaged property. Liquid Assets is commonly unencumbered cash, cash equivalents and marketable securities freely available to the guarantor, which leaves out retirement accounts, pledged balances and undrawn credit facilities. The case below is fictional; the drafting pattern is the ordinary one.
| Item | Amount |
|---|---|
| Cash, of which 800,000 pledged against another loan | 2,600,000 |
| Marketable securities | 2,400,000 |
| Retirement accounts | 1,500,000 |
| Interest in the mortgaged property, sponsor's estimate | 14,000,000 |
| Other real estate interests, sponsor's estimate (book value 31,500,000) | 44,000,000 |
| Other assets | 4,500,000 |
| Total assets | 69,000,000 |
| Liabilities | 3,000,000 |
| Stated net worth | 66,000,000 |
| Undrawn personal credit line, shown under liquidity | 1,000,000 |
| Stated liquidity | 7,500,000 |
The loan is 40,000,000. The agreement requires Net Worth of at least 1.00x the loan, 40,000,000, and Liquid Assets of at least 10 per cent of it, 4,000,000, with the guarantor's financial statements prepared on a book value basis. On the sponsor's figures the guarantor covers the tests 1.65x and 1.88x.
Covenant Net Worth = stated net worth − interest in the mortgaged property − (estimated value − book value) of other assets
Covenant Liquid Assets = cash + cash equivalents + marketable securities − pledged or restricted balances (retirement accounts and undrawn lines never enter)
Excel, with named cells: =StatedNW-Property-(OtherRE_Estimate-OtherRE_Book) for net worth and =Cash+Securities-Pledged for liquidity, compared with =Loan*1 and =Loan*10%
| Step | Net worth | Liquidity |
|---|---|---|
| As stated | 66,000,000 | 7,500,000 |
| Exclude interest in the mortgaged property | -14,000,000 | |
| Other real estate at book, not estimate | -12,500,000 | |
| Remove retirement accounts | -1,500,000 | |
| Remove undrawn credit line | -1,000,000 | |
| Remove pledged cash | -800,000 | |
| Covenant figure | 39,500,000 | 4,200,000 |
| Requirement | 40,000,000 | 4,000,000 |
| Headroom | -500,000 | 200,000 |
The definitions take 26,500,000, or 40.2 per cent, off the stated net worth and 3,300,000, or 44.0 per cent, off the stated liquidity. Net worth fails by 500,000 on the day the statement is delivered. Liquidity passes, with 200,000 of headroom, 5.0 per cent of the requirement.
The exclusion of the mortgaged property is the adjustment sponsors forget most often, and it is the logical one: the lender already has the building. A guarantor whose wealth is the collateral adds nothing to the lender's position when the building fails, which is exactly when the guaranty is called. The same reasoning lies behind what a bad boy guarantee exposes the sponsor to: the guaranty matters in the state of the world where the property has lost value.
The liquidity test now rests on 2,400,000 of securities. A fall of 8.3 per cent in their value, 200,000, is enough to breach it.
| Fall in securities | Covenant liquidity | Headroom |
|---|---|---|
| 0% | 4,200,000 | 200,000 |
| 5% | 4,080,000 | 80,000 |
| 10% | 3,960,000 | -40,000 |
| 20% | 3,720,000 | -280,000 |
| Definition | Net worth | Headroom |
|---|---|---|
| As stated by the sponsor | 66,000,000 | 26,000,000 |
| Excluding the mortgaged property only | 52,000,000 | 12,000,000 |
| Excluding the property, assets at book value | 39,500,000 | -500,000 |
| Also deducting 25% of contingent guarantees | 32,000,000 | -8,000,000 |
The last row matters for active sponsors. This one has 30,000,000 of guarantees outstanding on other loans, which appear nowhere on the statement. Some agreements deduct contingent liabilities, in full or at a probability; at 25 per cent that is 7,500,000 more off net worth. Negotiating the definition is worth more than negotiating the multiple: at a requirement of 75 per cent of the loan, 30,000,000, the book value test passes with 9,500,000 to spare.
Treating the covenant as a balance sheet ratio the sponsor can manage by moving money around. Selling 500,000 of securities into cash changes net worth by nothing; it only shifts the asset from one line to another. A net worth shortfall needs new equity, liabilities repaid with outside money, a revaluation the definition allows, or an additional guarantor. Liquidity is the opposite: it can be cured by moving assets, but only into what the definition counts, and money moved out of a retirement account to pass the test usually costs tax.
Read the testing provisions as closely as the levels. A covenant tested "at all times" is breached the day the markets fall, not at the next annual certificate, and a breach of the guarantor covenants is often a cash trap trigger or an event of default under the loan, not just the guaranty.
Covenants, cash traps and recourse are read clause by clause in the book, and the free workbook for this case prices the covenant cures it discusses.
A common pattern is net worth at least equal to the loan amount and liquid assets of around 10 per cent of it, tested at closing and then annually on the guarantor's financial statements. On a 40,000,000 loan that is 40,000,000 of net worth and 4,000,000 of liquidity. The levels are negotiated, and the definitions behind them matter as much as the numbers.
Usually not. Most loan agreements define liquid assets as unencumbered cash, cash equivalents and marketable securities freely available to the guarantor, which excludes retirement accounts, pledged cash and undrawn credit lines. In the illustration those three items take 3,300,000 out of a stated 7,500,000, leaving 4,200,000 against a 4,000,000 requirement.
It is normally an event of default under the guaranty or a trigger for a cash trap or a replacement guarantor, depending on the drafting. Moving money between asset classes does not cure it: a net worth shortfall of 500,000 needs 500,000 of new equity, debt repaid from outside the balance sheet, or a substitute or additional guarantor.
This article is one calculation from How to Read a Real Estate Loan Agreement. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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