As mentioned in previous articles, one of the powerful advantages of multifamily real estate is the ability to obtain government (“agency”) backed non-recourse financing. When providing financing, the agencies (Fannie and Freddie) typically are looking at the property / income stream first and then sponsorship team (experience/balance sheet) second.
Even though the loans are non-recourse, there are provisions, typically referred to as ‘bad boy’ carve-outs, that if triggered, will spring recourse on the loan. These carve outs include gross negligence, material misrepresentation and fraud conducted by the general partners (GP) / sponsors. As such, the agencies require there be loan guarantors, commonly referred to as Key Principals (KP), to sign on the loan to guarantee loan repayment should the loan become recourse.
To qualify for an agency loan, the general partners and KPs, must have combined net worth of at least the loan amount and post-close liquidity of 10%. For example, a $10M deal that gets a $7.5M loan would require a combined net worth of $7.5M and liquidity of $750K.
The agencies require that the general partners sign on the loans as KPs. If the GPs themselves don’t meet the NW and liquidity requirements, then KPs can be added to sign on the loan and fill the gap. Therefore, KPs add a lot of value since they enable large dollar deals to get done. Before signing on a loan as a KP, it is very important to understand the benefits as well as the risks, which are covered below:
- Qualifying for Future Agency Loans – As a KP, you get the proverbial ‘agency’ country club card that makes it much easier to qualify for future loans especially if you aspire to one day become a GP or do your own individual deal.
- Building Resume / Experience – KPs typically get a closer view of the deal as compared to limited partners (LPs). KPs can learn from the GPs on how deals are structured, financed, operated, etc. and this will help them on future deals. Further, as a KP, you should have a good relationship with the GPs and as such, these can often lead to Co-GP opportunities down the road as you’ve already built trust and rapport, which are critical to successful partnerships.
- Potential Compensation – Depending on the deal, GP team, KPs balance sheet, etc. there are potential opportunities to get equity or fees for signing as a loan guarantor. This is especially true if a single KP has the net worth and liquidity to cover the loan alone as this adds significant value to the deal.
- Personal Liability – As mentioned, should the bad boy carve-outs be triggered, the loan will become recourse and will expose all KPs balance sheets for loan repayment, if required. This is a real risk that needs to be considered and mitigated (see below).
- Subpar Deal Performance – If the deal performs poorly (e.g. debt coverage ratio not met, physical repairs not completed, etc.) then it could go on the agencies ‘watch list’ and this will make it much more challenging for the KP to get loans in the future.
- Limited Control – KPs generally don’t have any control on the day-to-day operations of the deal as the GPs typically run and manage the deal. Hence, there is not much KPs can do to improve the deal if it goes sideways even though they’ve signed on the loan.
- Lack of Compensation – Interestingly, there is a lot of interest for people wanting to be KPs on agency loans due to the aforementioned benefits. As such, sponsors typically have more potential KPs than they need and therefore are often able to take on KPs without having to compensate them financially.
As evidenced above, there are certainly some significant risks that must be evaluated. To mitigate this risk, the KP needs to do significant diligence on the GPs and their track record as the GPs have full control over the day-to-day operations. Further, knowing the GPs well is key as you’ll have a relationship with them for many years to come. The KPs also need to do significant diligence on the deal underwriting and business plan to ensure that the deal is positioned for success and has conservative assumptions and multiple exit strategies. Lastly, the KP needs to decide whether the benefits outweigh the risks and whether they deserve financial compensation for signing on the loan. The fact is that a KP’s balance sheet and liquidity is at-risk and the KP should ensure the risk is extremely low. This varies deal to deal and by the specific KP’s goals and risk profile.
I’ve seen many people quickly indicate interest and sign-up for KP opportunities in the past. Some seem to be ready to almost blindly sign on the loans because they are “non-recourse” and they want the experience. Hopefully, it should now be very evident that there are many factors to consider before signing on the dotted line and I encourage potential KPs to weigh these factors carefully before making a commitment.