Recourse loans and non-recourse loans are both fairly common in the commercial real estate world. If you’re in the business, you need to have a good idea of what each one is and how it works. Here’s a quick rundown of these two types of commercial real estate loans.
What Are Recourse Loans?
Recourse means “the legal right to demand compensation or payment.”
With a recourse loan, if the borrower defaults on the loan, the borrower or guarantors are personally liable. This means they are responsible for repaying the outstanding balance and handing over any collateral in a default situation. Additionally, the lender can seek financial damages as well if the situation calls for it. So, for example, if the borrower needs to liquidate the collateral but the resulting money doesn’t cover the amount owed on the loan, the borrower and guarantors are still on the hook for the difference. The lender can pursue them personally to cover the total amount owed. This is where the assets on the personal income statement come into play.
In the world of recourse loans, there’s greater flexibility in the process, pricing, and overall structure of the loan.
What Are Non-Recourse Loans?
As you may have guessed, a non-recourse loan is just the opposite of a recourse loan. It’s often seen as an alternative financing option. With non-recourse loans, the borrower or guarantors aren’t personally liable for repaying the outstanding balance and collateral on the loan if they default. The lender can seize the assets that were labeled as collateral in the transaction. However, the lender cannot go after the borrower or guarantor personally. Generally, only people or businesses who have excellent credit are candidates for non-recourse loans. And, these are longer-term loans, with larger capital expenditures, and slightly higher interest rates. The longer-term loan allows a property owner to maximize their cash flow while reducing their risk profile.
With non-recourse loans, the lender has the potential to lose money. However, even when a non-recourse loan is used, there are situations where the borrower/guarantor can be held personally liable — we’ll get to those later. In any event, if a default occurs, it will still impact the borrower’s credit score.
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When Are Recourse or Non-Recourse Loans Used?
Recourse financing is preferred by most lenders, and recourse loans are usually used for any transaction that might potentially be risky. Since the lender is legally able to seize property beyond the initial underlying asset, it can reduce the perceived risk.
Non-recourse loans come in two forms. The first and less common is balance sheet lending where the loan stays in-house. These loans are usually used for smaller amounts. The second and more commonly accepted non-recourse loan is a long-term permanent commercial real estate loans that are placed on a stabilized and performing asset. Not every borrower is able to get a non-recourse loan. This is a place where experience and a good track record counts. Once an asset is stabilized, a non-recourse loan is an excellent option.
What Are Carve-Out Provisions/Bad Boy Guarantees?
Not every borrower is trustworthy. That’s why there are provisions to protect the lender in the case of fraud. A carve-out provision, or “bad boy guaranty/guarantee,” makes an exception to non-recourse loans.
So, if a borrower files for bankruptcy, doesn’t maintain the required insurance, doesn’t pay their property taxes, gets accused of fraud, or commits another crime, then the lender may be able to pursue personal recourse. In some cases, there doesn’t even have to be a major event — there are minor provisions that may be acceptable.
What’s the Current Status of Recourse and Non-Recourse Financing?
Recourse loans are the more traditional option, and it is likely that they will always be more prevalent. They certainly aren’t going anywhere anytime soon.
However, commercial real estate owners are becoming aware that they can reap the benefits of non-recourse loans. Since non-recourse loans are less risky for borrowers, they are in high demand among those who know about them. And, lenders are sometimes willing to extend non-recourse because it gets them a higher yield on their money.
Lately, these loans have been popular with fix-and-flip real estate investors. Recent high-profile non-recourse loans include these $100 million loans by Ready Capital and this $75 million non-recourse loan on a Texas retail property.
Depending on your commercial real estate situation, you might consider pursuing a non-recourse loan the next time you’re in the position of financing a property.
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Originally published at STRATAFOLIO.