As a commercial real estate investor seeking a loan, you have lots of choices of loan terms. That is a good problem to have but at first, it can be a bit overwhelming. Just find the right commercial real estate lender, and they will work with you to craft a loan that comfortably fits your individual situation.
One of the first and most important choices will be between a recourse and a non-recourse commercial real estate loan. The differences between the two are not especially complicated, but it helps to understand them when you are consulting with a lender.
Recourse versus non-recourse
The two loans tend to be for different stages in real estate development where the lender faces different levels of risk of default. Both types of loans require collateral, but then the differences kick in.
If the borrower defaults on a recourse loan, the lender not only can take the collateral (say, the property that is mortgaged) but, if that does not cover the debt, can go after the personal assets of the borrowers or guarantors of the loan. That could mean the lender’s right to seize bank accounts, certain other assets, and wages until the defaulted debt is covered. Sounds good for the lender, so why aren’t all commercial real estate loans recourse loans?
Because for some real estate loans, the collateral is adequate protection for the lender, and, to attract customers, the lender is willing to cut a different deal.
If the borrower defaults on the non-recourse loan, the lender may take the collateral to cover the debt. But if that collateral is insufficient to cover the debt, the lender cannot go after the personal assets of the borrowers or guarantors of the loan. If, for example, the default is on a mortgage, and if the property sold to cover the defaulted mortgage is insufficient to do so, the lender usually must take the loss.
There are exceptions to this, however, which are called “carve-outs” or, more colloquially, the “Bad Boy Guaranty.” In crafting the loan, the lender and borrower agree on certain types of instances where the borrower cannot hide behind the “non-recourse” clause. A classic case, which probably gave rise to “bad boy guarantees,” is the developer who sees a project is headed for default but drains off assets from the project before defaulting. The result is that the collateral (in this case, the mortgaged property) is reduced in value to the financial disadvantage of the lender. Today, the carve-out/bad boy guarantees also usually cover these other “bad” behaviors of the borrower:
Filing for bankruptcy
Fraud or misrepresentation
Failure to maintain the required insurance
Failure to pay property taxes
Any environmental indemnification
Committing a criminal act
These actions by the borrower (and others are being added) in effect nullify or cancel the nonrecourse protection of the borrower. That permits the lender to go after the personal assets of the borrow to cover the defaulted debt.
Which type of loan?
Of the two types of real estate loans, which the lender will be willing to offer typically depends upon the stage of development the loan will cover.
A non-recourse loan is usually for stable, income-producing property, where repayment of the loan will be from rental or lease income. The lender is willing to rely on this stable, productive property as collateral—without “recourse” to the personal assets of the borrower. Of course, no loan is entirely risk-free. If a sustained economic downturn occurs, vacancy rates rise, and rents must be lowered, the borrower may default. And the lender has no recourse—unless the bad boy guaranty kicks in.
A recourse loan typically is for a project under construction or for mini-perm—short-term financing needed by the developer to pay off construction projects or commercial properties before they become profitable. Mini-perm financing, which also may be for acquiring an investment property, typically is short-term (three to five years). To obtain these loans, the borrower may put up collateral and pledges personal assets to cover the debt in case of default.
Which type of loan will be most to your advantage? The answer is not as obvious as it may seem. The non-recourse loan certainly does limit your personal liability in the event of default. Fannie Mae and Freddie Mac loans for multifamily housing are non-recourse, part of the appeal of seeking agency financing. But a non-recourse loan may be harder to get because the lender faces more risk and sets the bar higher for underwriting the loan—and may be less flexible in structuring your loan. Also, non-recourse loans tend to be longer-term, which is not to your advantage in some investment scenarios.
Banks making commercial real-estate loans will usually offer you a recourse loan. If you have worked before with the bank, you may find that you can close more quickly on a recourse loan. And if you have a short-term need such as renovating and repositioning a property to resell it within a few years, you probably have to take a recourse loan because the short-term nature of your investment makes it higher risk (for example, if you run into an economic downturn). Some lenders nevertheless will make a short-term non-recourse bridge loan, so this is an issue to discuss with your lender.
You will want to read your loan documents carefully to understand the terms. You should involve your legal counsel, too, but your lender is your first resource for answers to your questions and an assessment of your investment strategy.
Talking to CommLoan about your needs
Your choice between a recourse and a non-recourse commercial real estate loan is one of the first to make before deciding upon a lender. At CommLoan, we discuss with you all the important considerations that go into making that choice. Because we have thousands of loan programs and hundreds of lenders on a single platform and our goal is to direct you to a lender that best fits your individual situation in all respects. You can be in contact with us for a quote at your convenience. The first step is to reach out.
And be sure to check back here regularly for information, insights, and updates on developments and opportunities in the commercial real estate space.