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.
In this article, we’ll discuss the difference between non-recourse loans and recourse loans.
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 commercial 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?
When it comes to non-recourse financing, 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 commercial 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.
Recourse Loans vs. Non-Recourse Loans – An Example
To illustrate the difference between a recourse and non-recourse loan, an example is helpful. Assume that a lender has made a loan for $5MM for the purchase of a retail shopping center. The loan is sponsored by two individuals, who are investment partners, with combined net worth of $2MM.
At first, everything with the property is going as planned. Tenants are paying their rent and this income is used to make the required loan payments. But, the shopping center’s largest tenant decided not to renew their lease and has left a major vacancy in the center. After several months of trying to lease the space to another tenant, they have exhausted their operational reserves and are no longer able to make the payments. After several months of missed payments, the borrower defaults on the loan and the lender moves to foreclose on the property.
Once the foreclosure process is complete and the lender has taken the property back, the loan has an outstanding balance of $4.5MM and the property is immediately put up for sale. After 2 months on the market, the property sells for $4.3MM and the proceeds are used to pay down the loan, leaving a remaining balance of $200M. Whether the loan is recourse or non-recourse debt dictates what happens with the remaining balance.
If the loan has recourse to the transaction sponsors, it means they provided their personal guarantee and the lender will ask them to pay the balance. If they have it, they must pay it. If they do not have the funds available, it is likely that the lender could pursue other legal means to recover the balance. This underscores why it is so important for the lender to underwrite both the property and the borrowers when reviewing a transaction.
If the loan is non-recourse, it means that the lender has no legal means to pursue the loan sponsors for the remaining loan balance and it is likely that they will have to absorb a loss on the deal. Clearly, a non-recourse commercial loan represents more risk for the lender and they are likely to price it accordingly with a higher interest rate.
Where to Obtain a Non-Recourse Loan
Given the lower level of personal liability that they entail, individual borrowers nearly always prefer a non-recourse loan. But, lenders aren’t always as happy to make them. For this reason, they can be a bit more elusive than borrowers would prefer.
Depending on the type of debt, loan amount, down payment, and market value of the collateral, there are two typical scenarios where a borrower may be able to obtain a non-recourse loan: (1) relationship; or (2) government. In the first instance, an exceptionally strong borrower can leverage their relationship and their financial strength to negotiate non-recourse loan terms with their lender. For example, in our case, we have been in business for a long time and have borrowed and repaid dozens of loans. We have a strong history of performing as agreed and we produce a significant amount of business for our lenders so we don’t hesitate to leverage our borrowing relationship to negotiate non-recourse terms.
In the other instance, there are specific loan programs designed to increase investment in certain property types where the loans are guaranteed by the United States government and are non-recourse to the individual borrowers. For example, the Federal National Mortgage Association (FNMA) or “Fannie Mae” is a major non-recourse lender in the multifamily space. These loans are guaranteed by the government because they are provided as an incentive to increase investment in multifamily housing across the United States.
While these are the two most common routes to a non-recourse loan, they aren’t the only ones. Under certain circumstances, they may be available from credit unions, community banks, insurance companies, or commercial mortgage backed securities (in the largest transactions).
Non-Recourse Loans Aren’t Always Non-Recourse
Taken at face value, a non-recourse commercial real estate loan appears to be a great deal for borrowers, and they can be. But, it is critically important to read the specific legal language in the Loan Agreement because, depending on the type of loan, many non-recourse loans include so-called “carve outs” that, upon certain triggers, can cause a guarantee provision to spring into place. Two of the most common triggers are for fraud/negligent behavior or broken covenants.
If, at any point during the term of the loan, the lender discovers that the borrower has materially misrepresented themselves or committed some act of fraud or negligence, they may have legal cause to convert the facility into a full recourse loan. This is commonly referred to as a bad boy carve out.
The other common carveout is when a borrower breaks a loan covenant. For example, a loan could begin as non-recourse, but it could also have a covenant that says the borrower must maintain $100,000 in liquidity at all times. If total liquidity falls below $100,000, a guarantee provision springs into place and the loan becomes full recourse and the borrower is responsible for loan repayment.
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 firstname.lastname@example.org for more information.