Commercial real estate (CRE) bankers have much on their minds early in 2025, but growing their portfolios in a risk responsible way remains a top concern and priority. With the CRE lending landscape’s rapid shifts and evolution, many bankers are re-examining their strategies to adapt to meet the demands of the current lending environment.
This should also mean turning a critical eye on many of the long-held beliefs — and myths — about risk mitigation in CRE lending.
As industry experts have continued to stress, CRE bankers should be approaching their borrower relationships with extra care. But the truth is they could be sabotaging those very relationships right from the start by relying on common yet outdated industry standards — personal guarantees (PG).
Realities of CRE deal structures and shortcomings of personal guarantees
One of the most ingrained and enduring myths for banks underwriting CRE loans is belief in the efficacy of the PG. While traditional wisdom has long favored these as an effective risk mitigation tool for ensuring loan repayments, unfortunately this may not be as true as once thought.
This approach is based on two simple yet conflicting misconceptions: that these pacts keep borrowers honest and provide lenders with a direct target if a default occurs. Most CRE lenders have longed relied on the punitive behavioral incentives through PGs, believing they help to curb risk. However, evidence suggests these may be much less effective than assumed, even counterproductive, and could exacerbate risk rather than lower it.
With most CRE deals, a sponsor or developer acts as the general partner (GP) with a passive investor involved as a limited partner (LP). Together, they form a single asset entity as the borrower, with the GP typically providing 5%-10% of the equity and the LP supplying the remaining bulk. But as it is the GP who usually arranges the loan, they are also the only one to provide the personal guarantee (PG). This means that if there is a default, the bank will be pursuing the GP, who often has limited financial capability and illiquid assets, making repayment difficult and ineffective (not to mention pressuring the smaller money partner makes little sense).
The reality is that PGs offer little protection for CRE bankers for recouping losses, presenting many significant challenges and could have the opposite of the intended effect. The extreme illiquidity of most sponsors means they lack the necessary assets to fulfill the loan obligations even if pursued legally. And the legal disputes themselves not only waste time and resources for both sides, but they also create an adversarial environment, threatening personal ruin, damaging trust and future business relationships. What’s more, resolution through the courts can take up to two-three years, requiring major legal and upkeep costs. And even if the lender ultimately wins, repayment is still not guaranteed as 80% of bankers admit they rarely if ever collect on PGs in full.
There are also a host of negative behavioral realities that can impact PG effectiveness, too, including:
Misaligned Incentives. Without significant equity at stake, borrowers may be less inclined to work in the lender’s interest. Many borrowers may even go as far as to employ “strategic defaults” to leverage against the lender.
Legal obfuscation: Wealthy sponsors often have sophisticated legal teams to frustrate and complicate the collection process, making collection difficult even if the lender ultimately wins a deficiency judgment.
The “Penguin Effect.”: The CRE lending industry’s tendency to wait for others to act first can hinder innovation and progress in underwriting practices, delaying or stymieing new effective measures. Likewise, this holds true for bad decisions, too.
Behavioral Economics: Recent studies suggest there is often a disconnect between lender assumptions and borrower intentions when it comes to non-recourse loans in distress scenarios. Unsurprisingly, removing the threat of personal ruin and harassment will likely result in a more cooperative resolution to problems, often adding further equity and/or resources.
Rethinking risk mitigation and true risk transfer
While many across the industry are aware of the significant limitations of PGs as risk mitigation tools, they have also been one of the only options available for CRE bankers. Other currently available conventional risk mitigation tools also tend to fall short, offering limited mitigation at best. These include:
Participations or Syndications: While once a decent option, they are now much less viable in the post-Global Financial Crisis landscape, as banks are much more hesitant to work with entities they do not fully know or trust.
Entity Guarantees: As these typically rely on one pool of funds to support multiple loans, once this is drained (often by just one loan), the other loans then lack coverage.
Co-Guarantors: These face the same collection problems as PGs and often have even bigger legal teams to frustrate and complicate the process.
Rather than more tools that offer limited risk mitigation, what is needed is a reliable risk transfer mechanism, something the industry has lacked. While options like Credit Linked Notes (CLNs) can offer some capital relief, they are costly, limited in scope and not widely available for CRE loans.
Outright selling the note seems to be the easiest and currently preferred method used by many lenders today due to increased capital rules, but this is far from ideal, as it is often done at a steep discount, and thus a big loss for the bank. Additionally, issues from discounted payoffs and loan sales can end up severely impacting a lender’s bottom line, resulting in either an outright inability to collect repayment or only receiving a fraction of a loan’s value – and further complicating a lenders balance sheet (often requiring capital calls).
CRE bankers need a more modern approach for how they can assess, manage and mitigate loan risk related to credit, which until recently has been lacking. However, one effective option that is now available is to adopt a commercial property loan insurance (CPLI) approach, an insurance strategy used in other bank portfolios and now recently made available for CRE lending.
While banks are very good at accumulating and distributing capital, it is the insurance industry that excels at assessing, pricing and managing risk. Similar in concept to private mortgage insurance (PMI) in residential mortgage lending and SBA, CPLI can be employed to ensure the riskiest portion of a CRE loan, either alone or in combination with other strategies. It is significantly less expensive and arguably more effective than PGs, offering efficient scalability for both borrower and lender.
The CRE lending landscape is continuing to evolve rapidly. To keep up, industry leaders must continue to challenge many of the embedded yet outdated practices stymieing the lending process and embrace new innovative solutions that offer advantages for both the banker and borrower alike.
Threatening borrowers with behavioral “sticks” like personal ruin is ineffective, adversarial and costly. As bankers continue to see their market share compete with new nonbank alternatives like debt funds, they need new tools and approaches to help them adapt and compete.
By embracing practical, cooperative solutions and leveraging new risk transfer tools, CRE bankers can enhance their risk management, regain market share and drive profitable growth for their CRE portfolios in the new year and well beyond.
David Eichenblatt is President and Founder of LGIS Group.
