One of the major benefits of a commercial real estate investment is that debt is widely available for most property types at terms that are generally favorable for the borrower. In addition, there are a number of different lending programs whose terms – like the interest rate, amortization period, or term – can be adjusted to meet the specific needs of a borrower and their investment.
When reviewing available loan programs, there is one term in particular that investors tend to be acutely aware of and that is whether the lender is offering a recourse or non-recourse loan.
Loan Guarantee Requirements Explained
When a lender is reviewing an application for credit, their primary concern is how they will be repaid. For each commercial real estate loan, the typical lender will analyze three potential sources of repayment as follows:
- Primary Source of Repayment: Cash flow generated by the property’s rental income
- Secondary Source of Repayment: Sale of the property
- Tertiary Source of Repayment: Guarantor recourse
What this means is that, if everything goes according to plan, the rental income produced by the collateral property is enough to make the loan payments. However, there are times where the property may experience declines in rental rates or periods of prolonged vacancy that cause the rental income to drop below the level needed to make the loan payments. If this continues to be the case for a prolonged period of time, the lender may seek to foreclose on the property, which the legal means by which they take possession of it from the borrower.
Lenders are not in the real estate business. So, when they take possession of a property, they do not want to keep it, they want to sell it and they will hire someone to assist them in the transaction. In an ideal scenario, they are able to sell it for a price that is sufficient to repay the entirety of the loan balance. But, this is not always the case.
If the lender is not able to sell the property for enough to repay the loan balance, the next step is highly dependent on whether or not they required the borrower to personally guarantee the loan. If they did, the loan is considered to have “recourse” and the individual loan sponsors are required to pay the remaining loan balance out of their own pocket. If the lending facility is “non-recourse,” the borrower does not have to pay the outstanding balance and the lender is likely to take a loss on the transaction.
Recourse vs. Non-Recourse – 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 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 – including middle-market service-oriented retail shopping centers – 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.
When financing all of our transactions, we first seek to obtain non-recourse financing. If it isn’t available, we will consider alternatives as a last resort.
To learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
