When evaluating a loan request, a lender’s primary concern is evaluating the risk of loss associated with the transaction. Specifically, they want to know how they are going to be repaid and if the source(s) of repayment are reliable. In a commercial real estate context, a lender will typically evaluate up to three sources of repayment.
Primary Source of Repayment
In nearly all cases, a commercial real estate loan’s primary source of repayment is the property’s cash flow. This means that the lender will spend a significant amount of time reviewing the property’s rent roll, operating expenses, and pro forma forecasts to get comfortable with the reliability of this income stream as a primary source of repayment.
Secondary Source of Repayment
Again, in nearly all cases a CRE loan’s secondary source of repayment is going to be liquidation of the loan collateral. This means that if the borrower defaults, the lender will take legal action to foreclose on the property and take it into their own possession. Once the foreclosure process is complete and the lender owns the property, they will sell it and use the proceeds to repay the loan balance.
To evaluate the strength of the collateral as a repayment source, a lender will commission an appraisal to get an independent opinion of the property’s market value. And they will also limit the amount of the loan to a percentage of the appraised value, usually about 75%. This provides some room for decreases in value before repayment, via sale of the property, is jeopardized.
In situations in which the sales proceeds are insufficient to retire the loan balance, the difference between a recourse and non-recourse loan becomes clear.
Tertiary Source of Repayment
If the loan has “recourse” to a “guarantor,” the tertiary source of repayment is guarantor funds. This means that the individual guarantor(s) are required to step in and use their own personal funds to repay any remaining balance after the property is sold. To evaluate the strength of a guarantor, the lender asks each one to complete a “personal financial statement” that outlines their personal assets—such as cash, stock, and houses—along with their personal liabilities, like credit card, auto loan and home loan balances.
If the loan is “non-recourse,” there may be no viable tertiary source of repayment and the lender may have to absorb a loss in the deal.
To illustrate how this works, an example is helpful.
Recourse vs. Non-Recourse – An Example
Suppose that two investment partners have obtained a multifamily CRE loan for $1,000,000. At the time of origination, the property appraised for $1,350,000, which resulted in a loan to value ratio (LTV) of 74.07%.
For the first two years of the loan, everything goes smoothly. Tenants are paying their rent, and this money is used to pay for the property’s operating expenses and to make the required loan payments. However, in the third year, an economic recession hits. Many of the residents in the property lose their jobs and are unable to pay their rent. As a result, the borrower misses several payments and defaults on the loan.
At the time of default, there is an outstanding loan balance of $800,000. The lender forecloses on the property and takes possession of it. Due to the recession and a dramatic decrease in the property’s net operating income, the property’s value has decreased significantly. Having to liquidate the property in a weak market, the lender is only able to get $750,000 for it. The money is used to pay down the loan, leaving a remaining balance of $50,000.
In a non-recourse loan, the lender or financial institution is likely going to have to absorb a $50,000 loss on the deal because they have exhausted all of their possibilities for repayment.
In a recourse loan, the lender has the legal right, per the loan agreement, to approach the loan guarantor(s) and ask them to pay the remaining balance. In this case, there are two partners and they would have to figure out who is responsible for what portion between themselves.
Benefits & Risks
For an individual borrower, a recourse loan increases their personal liability in the transaction. But, recourse loans also tend to come with lower interest rates because they represent less risk for the lender. From the borrower’s perspective, a non-recourse loan is almost always the preferred option. However, these come with higher interest rates.
From the lender’s perspective, a loan with recourse represents less risk because they have a third source of repayment to pursue in the case of default. But, they occasionally risk losing a deal if the borrower is insistent that they will not provide a guarantee.
The truth is that, in many cases, the borrower may not have a choice to provide a guarantee—it may be a condition of loan approval. Still, the borrower does have a choice about which lender(s) they want to work with because some provide non-recourse loans and some do not.
Who Makes Recourse vs. Non-Recourse Loans
Generally, the bigger the relationship that a borrower has with a lender, the more negotiating power they have to get a non-recourse loan. But, this is the exception, not the norm.
In commercial real estate, non-recourse loans can typically be obtained from conduit lenders, life insurance companies, and government backed agencies like FNMA, FHLMC, and the FHA. Otherwise, any loan obtained from a retail bank, credit union, or specialized lender is more likely than not to require a personal guarantee.
It is worth noting that all loan transactions are unique and the guarantee requirement is influenced by many factors, including: property type, borrower credit score, bank account balances, type of debt, and property location. The loan documents will define the exact guarantee requirements in detail.
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