In 2021, commercial real estate loans valued over $2,000 billion. Businesses across the country turn to these loans to help them secure the property they need to build their organization and begin to generate revenue and profit.
For a while, non-recourse commercial real estate loans were being called “a vanishing species.” Now, larger commercial banks and life insurance companies, among others, are making more of them. These loans have terms that have been changing with time, so the borrower should be aware of risks new and old.
Recourse and non-recourse loans
The relevant distinction, of course, is between recourse and non-recourse loans.
Recourse loans, often made for construction or short-term financing like mini-perm, require the borrower to put up collateral. In addition, however, the borrower or guarantor of the loan is personally liable for repayment. Thus, for example, if a developer defaults on payment of the recourse loan, and the value of the collateral does not cover the debt, the lender has “recourse” to seizing or attaching the borrower’s personal assets, including wages.
Non-recourse loans are usually made for later stages in real estate development. For example, a commercial property that is financially stable, with regular income, might get a non-recourse loan for renovations, including in preparation for a new tenant. Or the developer has completed a new building and needs a bridge-loan between the end of the construction and the fully expected lease or rental income. Because the collateral here is viewed as carrying less risk, a non-recourse loan is more likely to be offered. Default is not expected, but, if it occurs, the lender must rely on the value of the collateral to cover the debt still owed.
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Be careful of the recourse/non-recourse distinction
But recourse versus non-recourse is not a not “bright line” difference–not cut-and-dried. The reason is that non-recourse loans often have a carve-out or, less formally, a “Bad Boy Guaranty”. These are loan terms that “carve-out” of the non-recourse protection of the borrower certain events where the non-recourse shield does not apply.
Such events used to include wrongful action on the part of the borrower—the initial case probably being the borrower who saw a default coming but siphoned off part of the value of the collateral before defaulting. That was to the clear disadvantage of the lender, who relied on the value of collateral in case of default on the loan. Other instances of bad-boy behavior were added such as fraud, misrepresentation of the collateral property, canceling insurance on the property, and criminal acts. These events, in effect, turned the non-recourse loan into a recourse loan and the lender could go after personal assets of the borrower to cover the defaulted debt. Here is a summary of these non-recourse carve-out events today:
Fraud or misrepresentation,
Gross negligence or willful misconduct,
Any environmental indemnification,
Misappropriation, misapplication or conversion of insurance proceeds, condemnation proceeds, rents, or security deposits,
Failure to maintain required insurance,
Failure to pay real estate taxes
Waste at the property and
A borrower’s commission of a criminal act.
What is important to realize is that over the years other actions by the borrower, not necessarily viewed as wrongful, have been added to the non-recourse loan terms as additional reasons for invalidating the non-recourse feature. In fact, enough new, various, and technical bad-boy carve-outs have been added to some non-recourse loans that the distinction between recourse and non-recourse has become complex and clouded.
Some new non-recourse loan carve-outs
These new non-recourse carve-outs fall into two categories. The division is because the first type can result in the stripping of all non-recourse protection from the borrower and guarantor, so they are fully liable. This is when the borrower files for bankruptcy or enters into an agreement for involuntary bankruptcy or for going into receivership.
The other category includes events that less definitely trigger full personal liability:
Not permitting the lender to inspect the mortgaged property.
Not providing the agreed financial information to the lender.
Letting the property be encumbered by a voluntary lien.
Transferring the property or ownership interest in ways not allowed in the loan document.
In working with a lender to carve out terms of a non-recourse loan, you will be negotiating the terms and provisions of the loan. Following is a shortlist of what terms you should try to obtain for the borrower or guarantor:
As discussed, bankruptcy is a non-recourse loan carve-out that triggers full personal liability. For all other events, you should request that liability be limited to the actual loss suffered by the lender.
Since non-recourse loans are intended to be repaid from income on the property, you should ask that if the property has cash flow that cannot support payment of taxes, or required maintenance, recourse liability not be triggered.
You should require reasonable notice and an opportunity to cure before failure to allow inspections or provide required financial information results in recourse liability.
Insolvency or late payment of debts should not automatically trigger recourse liability.
Do your best to limit the scope of recourse liability for improper transfers of the property.
Any distributions paid to the owners prior to a default event should be subject to “claw-back.”
The trend in non-recourse loans is fairly clear. Lenders may be willing to make them, but they want to trim back their risk with more and more complicated carve-outs. That makes it incumbent upon you, the borrower or guarantor, to understand everything in the loan document and what it implies for your specific project and circumstances.
Moving forward with a carve-out guarantee
Carve-out guarantees can be understood since those who administer loans want to protect their investment. Investors interested in signing commercial loans should carefully look over the terms of their carve-out guarantee to make sure they thoroughly understand when action can be taken against a borrower and what ‘bad acts’ will entitle the lender to personal assets to recuperate the loan. Working with a legal professional can also help an investor ensure that they fully understand all the implications of their contract. With a beneficial contract, however, investors can begin to build their own assets with confidence.
When investing in commercial real estate properties, it is vital to have partners that you can trust when it comes to securing the right financing options available to you. At CommLoan, that is exactly what our platform strives to achieve. With hundreds of lenders on board and thousands of loan programs, leverage CommLoan to help you find the best deal.