Nearly all commercial real estate deals are at least partially financed with a bank loan. Bank loans can come in different forms, including those with and without recourse. In an ideal world, and all else considered equal, a borrower will typically want to obtain a non-recourse loan as a means of limiting their personal liability. In this article, we look at the difference between recourse and non-recourse loans and why the latter is overwhelmingly preferred by commercial real estate investors.
Recourse vs. Non-Recourse Loans
When obtaining a commercial real estate loan (for either a purchase, new construction, or a refinance), borrowers usually have two options: recourse and non-recourse loans.
A recourse loan is one that is personally guaranteed by the borrower(s). You sign something called a personal guarantee (often referred to 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 are on 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 loan is repaid.
With non-recourse debt, the only recourse a lender has if something goes awry is the property, its furniture, fixtures, and equipment (FFE), the leases, etc. Non-recourse loans are generally made to what is known as a “special purpose entity” (SPE) – usually an LLC or Limited Partnership – that is structured for the sole purpose of that real estate deal. Only the assets held by the SPE are available as recourse to the lender. This shields the 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 will want to obtain a non-recourse loan if possible. Non-recourse loans have several benefits compared to recourse loans, including:
Protection of personal assets.
The first, and most obvious benefit of a non-recourse loan, is that the borrower’s personal assets are not tied to the loan. This allows the borrower to take on some degree of risk without worrying that their primary residence, retirement accounts and other assets will be seized by the bank should the deal go sideways.
Underwriting is simpler.
The process for obtaining 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 the deal and borrower in question, but also the borrower’s other assets being put up as collateral. For example, if the borrower is using another investment property as collateral, the bank must underwrite that asset as well.
Less complicated for equity investors.
Recourse loans can be incredibly complicated for equity partners in a joint-venture or GP/LP situation. In a deal that needs recourse, whomever is putting up the recourse will expect to be compensated for taking on that recourse. This can complicate an otherwise clean waterfall structure. Recourse loans are also a turnoff for equity investors because it complicates their own bookkeeping. They must now carry the recourse loan on their books as a liability, which is something most equity investors do not want to do.
Easier to obtain future loans.
Recourse loans are considered “contingent liabilities.” In other words, it is only a liability 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 bank is more inclined to give a loan to someone who has few contingent liabilities on their books. Another way of looking at it is if someone needs to get a recourse loan for one reason or another, they’ll have better luck getting one if they don’t already have several outstanding contingent liabilities. The bank will then need to quantify all of those liabilities. For the investor who only does one or two projects at a time, this might be no big deal. This becomes a bigger consideration for a developer doing many projects at once (and therefore, has several loans on their books).
More leverage with the bank if things go awry.
Here’s a little secret that not many people talk about: with a non-recourse loan, if something with the deal goes wrong, the borrower has the upper-hand when trying to renegotiate with the bank. The borrower can basically tell the bank, “work with me here, or I’ll walk away…”. This makes the bank much more likely to negotiate with the borrower on new terms that help the borrower see the deal through to the other side.
Other Considerations for Non-Recourse Loans
As you can see, there are clear advantages to obtaining a non-recourse loan. So why doesn’t every borrower go this route when trying to finance their commercial real estate deal? There are a few other factors to take into consideration when looking at recourse vs. non-recourse loans.
First, not everyone can get a non-recourse loan. A borrower’s ability to obtain a non-recourse loan depends on a few factors, including:
The risk profile of the deal. The riskier the deal, the more likely the bank will want to have enhanced collateral.
The reputation of the borrower. The reputation of the sponsor is critically important. Typically, only experienced sponsors can obtain non-recourse loans. They must have a proven-track record and be considered highly reputable in their local marketplace or with that asset class. Many borrowers will have to “earn” their way to being able to get a non-recourse loan by doing several recourse deals first before banks will trust them enough to do a non-recourse deal.
The amount of equity in the deal. There are some cases in which a bank will offer a non-recourse loan on a higher-risk deal sponsored by a relatively unknown borrower. These cases typically require the borrower to put substantial equity into the deal, resulting in a lower loan-to-value (LTV) ratio. This shows the bank that the borrower has substantial skin in the game and therefore, is less likely to walk away from the deal if they encounter challenges. Similarly, the lower LTV offers more protection for the bank if the borrower defaults and the lender needs to repossess the property. Non-recourse loans with a low LTV are sometimes considered a “prepaid guarantee”.
A second consideration is that both recourse loans and non-recourse loans have what are known as “badboy carveouts”. This means that a loan can be non-recourse except in the case of a list of certain prohibited 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-recourse loan. The only time a borrower will want to take on a recourse loan is if the deal and/or marketplace requires it.
That said, those who need to utilize a recourse loan should know that recourse is entirely negotiable. Recourse loans are incredibly nuanced. For example, some deals can be done with just partial recourse that burns off after achieving certain milestones. Other deals can be done so that recourse 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.