In most commercial real estate loan transactions, the lender will require at least two sources of repayment:
- Primary Source of Repayment: Rental Income
- Secondary Source of Repayment: Sale of property
As long as there is enough rental income to make the monthly loan payments, there are no issues. However, if the borrower falls behind, the lender has the right to foreclose on the property and take possession of it. When this happens, the property is sold and the proceeds are used to pay down the loan balance. However, there are times when the sale proceeds are not sufficient to reduce the loan balance to $0, which begs the question, who is responsible for the leftover amount? The answer lies in a provision of the Loan Agreement that states whether or not the lender has “recourse” to the borrower/guarantor.
What is a Recourse Loan?
In a recourse loan, the lender requires the borrower(s) to provide a personal guarantee, which states that they will pay the loan balance out of their own pocket if necessary. To illustrate how this works, an example is helpful.
Assume that a borrower and a lender agree on a loan of $1 million for the purchase of a small retail shopping center. For the first three years, the property’s rental income is sufficient to make the loan payments and there are no issues. In the fourth year, two of the property’s tenants decide not to renew their lease and the prevailing economic conditions at that time make it difficult to re-lease the space. After an extended period of vacancy, the borrower’s reserves are exhausted and they can no longer make the loan payments. At this point, the lender forecloses on the property and has to sell it into a down market for $750,000. After the sale proceeds are applied to the loan balance at that time, there is a remaining balance of $100,000.
In a loan with recourse, the individual(s) who guaranteed the loan will have to reach into their own pocket for the $100,000 needed to pay off the remaining balance. Obviously, this raises the risk profile of the transaction for the borrower/guarantor and, if given the choice, they would prefer a non-recourse loan.
What is a Non-Recourse Loan?
A non-recourse loan is just the opposite, there is no personal guarantee. In the example above, the $100,000 remaining balance would likely have to be absorbed by the lender, resulting in a loss. This raises the risk profile of the transaction for the lender, which means that they are likely to charge a higher interest rate or have more stringent approval requirements to compensate.
However, a non-recourse loan is not always non-recourse. In many cases, non-recourse loan agreements include a “carve out” for fraudulent or negligent behavior on the part of the borrower. This carveout is often called a “bad boy” provision and it means that a full guarantee “springs” into place if the lender discovers that the borrower has acted in bad faith. Such a discovery would allow the lender to pursue the borrower/guarantor for any leftover balances. But the burden of proof for this can be high and it is not uncommon for this situation to result in litigation.
Who Qualifies for Non-Recourse Financing?
The truth is that most commercial real estate loans require the personal guarantee of the borrower(s), especially those made by retail banks and community lenders. However, there are two situations where non-recourse loans could be obtained:
- Government Backed Debt: Certain loan programs, such as those administered by the Small Business Administration and FNMA, tend to come with no recourse. Instead, they come with a government guarantee, which means that the lender can turn to them to pay any remaining balances. These types of loans are widely available under generally favorable terms, particularly for certain commercial asset classes like multifamily.
- Exceptionally Strong Borrowers: Fundamentally, the requirement for a personal guarantee is a question of risk. If the lender is comfortable that they are dealing with an exceptionally strong borrower, they may drop the guarantee requirement. Elements of an exceptionally strong borrower include those with a significant amount of experience, substantial liquidity, or a proven track record of loan repayment performance. This bar is high and typically limited to transactions that involve large corporations or borrowers with a strong relationship to the lender.
Why Does it Matter?
Again, the question of recourse comes down to risk. For individuals making a direct real estate purchase, it is more than likely that a personal guarantee will be required and it increases the risk that they could be held legally responsible for the loan balance. When a transaction includes multiple borrowers/guarantors, this can be especially fraught because it can lead to finger pointing and questions about who is responsible for what part of the balance.
For individuals making an indirect commercial real estate investment with a private equity firm or deal syndicator, it is critical to understand whether not the debt has recourse to the general partnership. While it is unlikely that a bank would ever pursue limited partners for recourse, it is definitely possible they could pursue the general partnership if they provided a personal guarantee. Such a situation could threaten the stability of the transaction and put investment capital at risk.
Interested in Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in. We pursue non-recourse financing for all of our transactions because it is in the best interest of our investors and part of our strong risk management culture.
To learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.
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