Nearly all commercial real estate deals are at leastpartially financed with a bank loan. Bank loans can come in different forms,including those with and without recourse. In an ideal world, and all elseconsidered equal, a borrower will typically want to obtain a non-recourse loanas a means of limiting their personal liability. In this article, we look atthe difference between recourse and non-recourse loans and why the latter isoverwhelmingly preferred by commercial real estate investors.
Recourse vs. Non-Recourse Loans
When obtaining a commercial real estate loan (for eithera purchase, new construction, or a refinance), borrowers usually have twooptions: recourse and non-recourse loans.
A recourse loan is one that is personally guaranteed bythe borrower(s). You sign something called a personal guarantee (often referredto as a “PG”). If you have partners in the deal, you’ll all sign the PG“jointly and severally”. The PG essentially says that whatever happens, you areon the hook personally. If something goes wrong and you default on the loan,the bank can come after you, your house, your car, your retirement accounts,any other investment properties, and similar types of collateral until the loanis repaid.
With non-recourse debt, the only recourse a lender has ifsomething goes awry is the property, its furniture, fixtures, and equipment(FFE), the leases, etc. Non-recourse loans are generally made to what is knownas a “special purpose entity” (SPE) – usually an LLC or Limited Partnership –that is structured for the sole purpose of that real estate deal. Only theassets held by the SPE are available as recourse to the lender. This shieldsthe borrower’s other assets in the event the business venture fails.
The Benefits of Non-Recourse Loans
With a few exceptions (which we’ll get into below), most borrowers willwant to obtain a non-recourse loan if possible. Non-recourse loans have severalbenefits compared to recourse loans, including:
1. Protection of personal assets. The first,and most obvious benefit of a non-recourse loan, is that the borrower’spersonal assets are not tied to the loan. This allows the borrower to take onsome degree of risk without worrying that their primary residence, retirementaccounts and other assets will be seized by the bank should the deal gosideways.
2. Underwriting is simpler. The process forobtaining a non-recourse loan is much simpler than obtaining a recourse loan.This is because a recourse loan requires the bank to underwrite not only thedeal and borrower in question, but also the borrower’s other assets being putup as collateral. For example, if the borrower is using another investmentproperty as collateral, the bank must underwrite that asset as well.
3. Less complicated for equity investors. Recourseloans can be incredibly complicated for equity partners in a joint-venture orGP/LP situation. In a deal that needs recourse, whomever is putting up therecourse will expect to be compensated for taking on that recourse. This cancomplicate an otherwise clean waterfall structure. Recourse loans are also aturnoff for equity investors because it complicates their own bookkeeping. Theymust now carry the recourse loan on their books as a liability, which issomething most equity investors do not want to do.
4. Easier to obtain future loans. Recourseloans are considered “contingent liabilities.” In other words, it is only aliability if something goes wrong. Whenever a borrower is looking to obtain a loan,the bank will inquire as to the borrower’s other contingent liabilities. A bankis more inclined to give a loan to someone who has few contingent liabilitieson their books. Another way of looking at it is if someone needs to geta recourse loan for one reason or another, they’ll have better luck getting oneif they don’t already have several outstanding contingent liabilities. The bankwill then need to quantify all of those liabilities. For the investor who onlydoes one or two projects at a time, this might be no big deal. This becomes abigger consideration for a developer doing many projects at once (andtherefore, has several loans on their books).
5. More leverage with the bank if things goawry. Here’s a little secret that not many people talk about: with anon-recourse loan, if something with the deal goes wrong, the borrower has theupper-hand when trying to renegotiate with the bank. The borrower can basicallytell the bank, “work with me here, or I’ll walk away…”. This makes the bankmuch more likely to negotiate with the borrower on new terms that help theborrower see the deal through to the other side.
Other Considerations for Non-Recourse Loans
As you can see, there are clear advantages to obtaining anon-recourse loan. So why doesn’t every borrower go this route when trying tofinance their commercial real estate deal? There are a few other factors totake into consideration when looking at recourse vs. non-recourse loans.
First, not everyone can get a non-recourse loan. Aborrower’s ability to obtain a non-recourse loan depends on a few factors,including:
· The risk profile of the deal. The riskierthe deal, the more likely the bank will want to have enhanced collateral.
· The reputation of the borrower. Thereputation of the sponsor is critically important. Typically, only experiencedsponsors can obtain non-recourse loans. They must have a proven-track recordand be considered highly reputable in their local marketplace or with thatasset class. Many borrowers will have to “earn” their way to being able to geta non-recourse loan by doing several recourse deals first before banks willtrust them enough to do a non-recourse deal.
· The amount of equity in the deal. Thereare some cases in which a bank will offer a non-recourse loan on a higher-riskdeal sponsored by a relatively unknown borrower. These cases typically requirethe borrower to put substantial equity into the deal, resulting in a lowerloan-to-value (LTV) ratio. This shows the bank that the borrower hassubstantial skin in the game and therefore, is less likely to walk away fromthe deal if they encounter challenges. Similarly, the lower LTV offers moreprotection for the bank if the borrower defaults and the lender needs torepossess the property. Non-recourse loans with a low LTV are sometimesconsidered a “prepaid guarantee”.
A second consideration is that both recourse loans andnon-recourse loans have what are known as “badboy carveouts”. This means that aloan can be non-recourse except in the case of a list of certainprohibited actions, such as voluntary bankruptcy or committing fraud.
Is a Non-Recourse Loan Right for You?
All else considered equal – such as the interest rate,LTV and other loan terms – most borrowers will want to opt for a non-recourseloan. The only time a borrower will want to take on a recourse loan is if thedeal and/or marketplace requires it.
That said, those who need to utilize a recourse loanshould know that recourse is entirely negotiable. Recourse loans are incrediblynuanced. For example, some deals can be done with just partial recourse thatburns off after achieving certain milestones. Other deals can be done so thatrecourse is capped at a certain amount.
When in doubt about which loan product is best for you,consult with a third-party advisor who can walk you through your options.