A carry guarantee is expected to be called: the lease-up produces the shortfall, and the release test decides how long it runs.
A carry guarantee makes the sponsor pay whatever the property's net operating income fails to cover of interest and operating costs until the loan's release test is met, so the exposure is the cumulative shortfall during lease-up. On an illustrative $40.0M transitional loan at 7.5 per cent, a lease-up from 40 to 90 per cent occupancy over eight quarters costs the guarantor $0.85M; at half that speed it is $1.48M, and with rates a point higher as well, $2.27M, 5.7 per cent of the loan.
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 →
Lenders on vacant or transitional buildings rarely rely on the property alone to pay interest during lease-up. They take an interest reserve, a carry guarantee from the sponsor, or both. Unlike a bad boy guarantee, which only bites if the sponsor misbehaves, a carry guarantee is expected to be called: the business plan itself produces the shortfall. The question is how much, and what makes it larger.
| Term | Value |
|---|---|
| Loan, interest-only, floating rate | 40.0 |
| All-in interest rate | 7.5% |
| Interest per quarter | 0.75 |
| Rent at full occupancy, per quarter | 1.5 |
| Operating costs per quarter, recovered from tenants pro rata to occupancy | 0.4 |
| Occupancy at closing / at stabilisation | 40% / 90% |
| Loan term | 12 quarters |
| Guarantee released after two consecutive quarters at interest cover of | 1.20x |
The guarantee covers interest and operating shortfalls only, not principal. NOI is rent at the current occupancy less the operating costs the landlord cannot recover on vacant space.
NOI = 1.5 × occupancy − 0.4 × (1 − occupancy)
At 40 per cent occupancy NOI is 0.36 a quarter, 1.44 a year; at 90 per cent it is 1.31, 5.24 a year. Each point of occupancy adds about $19 thousand a quarter.
Break-even occupancy, where NOI = interest: (0.75 + 0.4) ÷ (1.5 + 0.4) = 60.5%
Release occupancy, where NOI = 1.20 × interest: (0.9 + 0.4) ÷ 1.9 = 68.4%
Shortfall in quarter q = max(0, interest − NOIq); exposure = Σ shortfalls until release.
Excel, one row per quarter: =MAX(0,$B$3-NOI), summed while the release test has not yet been met twice in a row.
| Quarter | Occupancy | NOI | Interest cover | Shortfall paid | Cumulative |
|---|---|---|---|---|---|
| 1 | 40.0% | 0.360 | 0.48x | 0.390 | 0.390 |
| 2 | 46.2% | 0.479 | 0.64x | 0.271 | 0.661 |
| 3 | 52.5% | 0.598 | 0.80x | 0.152 | 0.814 |
| 4 | 58.8% | 0.716 | 0.96x | 0.034 | 0.847 |
| 5 | 65.0% | 0.835 | 1.11x | 0.000 | 0.847 |
| 6 | 71.2% | 0.954 | 1.27x | 0.000 | 0.847 |
| 7 | 77.5% | 1.073 | 1.43x | released | 0.847 |
The sponsor pays $0.85M over four quarters. The guarantee stays alive for three more, until the second consecutive quarter above 1.20x: payments stop at break-even, but the obligation stops only at release.
| Scenario | Exposure | % of loan | Released |
|---|---|---|---|
| Base: 90% reached in 8 quarters | 0.85 | 2.1% | Quarter 7 |
| Slow: half the leasing pace | 1.48 | 3.7% | Quarter 12 |
| Slow, and the rate 8.5% instead of 7.5% | 2.27 | 5.7% | Not before maturity |
| Slow, and leasing stalls at 55% | 2.09 | 5.2% | Not before maturity |
Weighted 50, 25, 15 and 10 per cent, the expected call is $1.34M and the worst of the four is $2.27M. A cap at one year's interest, $3.0M, would not bind in any of them. What the cap protects against is a building that never leases; what the sponsor actually pays is decided by leasing speed and the rate.
Two features make the exposure worse than the averages suggest. First, the rate scenario and the slow scenario can arrive together, because the conditions that slow leasing can also keep rates high. Second, in the stall case the guarantee is never released, so at maturity the sponsor faces a refinancing on a building at 55 per cent occupancy with the guarantee still outstanding.
| Lease-up, quarters | Exposure | Released in quarter |
|---|---|---|
| 4 | 0.54 | 5 |
| 8 | 0.85 | 7 |
| 12 | 1.16 | 9 |
| 16 | 1.48 | 12 |
Every extra four quarters of leasing adds about $0.31M of carry. An interest reserve of $1.0M funded at closing would cover the base case entirely and leave the sponsor $0.48M to pay in the slow case and $1.09M in the stall case; sizing that reserve is worked in how to calculate an interest reserve on a bridge loan.
Sizing the guarantee to the base case and treating it as a formality. The guarantee is drafted against the lender's downside, and the release test, not break-even, sets how long it runs. Read the definition of operating shortfall (does it include capex and leasing costs?), the release test, any cap, and whether payments under it can be recovered from later cash flow. A guarantor that also gives net worth and liquidity covenants should test them against the stress case, not the base, and set the result beside its contingent recourse under a bad boy guarantee.
A carry guarantee is lease-up risk moved from the lender to the sponsor's balance sheet. Price it as the sum of quarterly shortfalls under a slow and a stalled lease-up, not only the business plan. The covenant and cure arithmetic around it is in the free workbook for How to Read a Real Estate Loan Agreement.
A sponsor guarantee that pays interest and operating costs the property's income does not cover, usually until the loan meets a release test such as interest cover of 1.20x for two consecutive quarters. On the illustrative $40.0M loan, the guarantor pays $0.85M in a base lease-up and remains liable until quarter 7, three quarters after the last payment.
A bad boy guarantee is triggered by specific acts of the borrower, such as fraud or a voluntary bankruptcy, and is not expected to be called. A carry guarantee is triggered by ordinary shortfalls during lease-up, so it is expected to be called. In the example the expected payment is $1.34M, 3.4 per cent of the loan.
Many lenders require both, with the guarantee covering what the reserve does not. A $1.0M reserve covers the illustrative base case in full, leaves $0.48M to the guarantor in a slow lease-up and $1.09M if leasing stalls at 55 per cent. The reserve costs interest from closing; the guarantee costs nothing until it is called.
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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