What are the Advantages of Non-Recourse Loans?
Non-Recourse Financing Limits Risk for Investors
Fortunately for borrowers, Freddie Mac Small Balance Loans are generally non-recourse. When a borrower signs a non-recourse loan agreement, they do not have to sign a personal guarantee (PG), putting their personal property up as collateral if they default on their loan. Instead, lenders can only go after the property itself if a borrower defaults.
"Bad Boy" Carve-Outs and Non-Recourse Financing
Nearly all non-recourse loans, including Optigo Small Balance Loans, are subject to “bad boy” carve outs. These are additional agreements that “carve out” sections of the recourse agreement, making the loan full recourse under certain conditions. Typical actions that could trigger “bad boy” carve out provisions include committing criminal acts, intentionally declaring bankruptcy, and avoiding violating any of the covenants of the Special Purpose Entity (SPE) that will actually own and hold the collateral property. While some carve out provisions are only triggered upon a borrower committing seriously fraud or negligence, others can be triggered by minor administrative issues. Therefore, it’s extremely important for borrowers to carefully read and understand all the components of any carve outs included in their loan agreement-- before they sign on the dotted line.
Some Freddie Mac Small Balance Loans Have Limited Recourse
While Freddie Mac’s terms for the Optigo SBL loan program can be strict, they aren’t set in stone. For loans that stretch Freddie Mac’s loan terms-- such as having a DSCR below the standard requirements, or having an LTV slightly above the regular limits, the lender and/or Freddie Mac may add a limited recourse provision to the loan in order to reduce their risk.
What are the benefits of non-recourse loans for commercial real estate?
Non-recourse loans offer investors the security of not having to repay any of their personal capital should the property they invested in become unsuccessful. The only loss would be the property itself, as that is used as the collateral. This can be a great option for investors who are comfortable with riskier investment plays, as it eliminates the need to worry about being personally on the hook for losses if something goes wrong.
The primary benefit of non-recourse loans is that they provide a greater degree of protection for the borrower. Without a personal guarantee, the lender cannot seize the borrower's personal assets if they default on the loan. This can be especially beneficial for developers who are just starting out and don't have a lot of assets to protect.
Another advantage of a non-recourse loan is that it can enable an investor to borrow more. This is because the debt isn’t tied to the borrower’s income or total assets — as they aren’t involved in non-recourse financing. With recourse debt, banks and other lenders can place a cap on how much debt they can accept, relative to an investor’s personal income.
Finally, non-recourse loans can be significantly less complicated for a syndication or partnership.
What are the risks associated with non-recourse loans?
The main risks associated with non-recourse loans are tied to the loan terms a borrower can receive. Because the risks to a lender are higher than with recourse debt, a lender will typically pass this on in the form of higher interest rates, or lower loan amounts relative to the property value to offset the risk. This typically makes non-recourse financing more expensive.
Another potential risk is tied to exceptions to the non-recourse clause in the loan. While it’s true that a lender generally cannot pursue a borrower’s personal assets or income outside of the property itself, most non-recourse loans include language for what are known as bad boy carve-outs. These provisions essentially state that, should the borrower misrepresent a property or themselves, or file fraudulent financial documents — like tax returns or financial statements — the borrower is no longer protected by the non-recourse clause and is fully responsible for the loan. They may also cover other acts, such as raising subordinate financing when it’s not allowed, or even paying real estate taxes late.
What types of commercial real estate properties are eligible for non-recourse loans?
Non-recourse loans typically only accept certain property types and classes for financing. For example, a Class A office or multifamily property in a major MSA (i.e., New York or Los Angeles) may easily get a non-recourse loan, while a Class B retail property in a tertiary market is unlikely to qualify. Source
Lenders will typically set more stringent debt service coverage ratio requirements and may cap leverage at a certain amount, as well. Source
Most non recourse programs can only be utilized for the financing of certain property types and classes. For example, a borrower might find it much easier to secure non recourse financing for a class A office or multifamily property in a major MSA (i.e. New York or Los Angeles), while a class B retail property in a small market is likely to not qualify for non recourse lending. Source
What are the requirements for obtaining a non-recourse loan?
In order to qualify for a non-recourse loan, commercial lenders often have strict eligibility requirements. Most non-recourse programs can only be utilized for the financing of certain property types and classes. For example, a borrower might find it much easier to secure non-recourse financing for a class A office or multifamily property in a major MSA (i.e. New York or Los Angeles), while a class B retail property in a small market is likely to not qualify for non-recourse lending. The income that a commercial property produces (both past and present) is also a determining factor. Additionally, lenders tend to analyze the requested amount of leverage.
Non-recourse commercial mortgage loans tend to have higher interest rates than their recourse counterparts, and are also generally only available to borrowers that have a very strong financial profile. Lenders can be pretty strict about this, the thought process being that a default is significantly less likely in this scenario because the borrower has the financial means to make sure that the property’s income is reinvested into the property. Aside from strong finances, commercial mortgage lenders also require a very experienced borrower with ample "skin in the game" for non-recourse financing.
What are the differences between recourse and non-recourse loans?
At its core, the difference between the two types is relatively straightforward: If a borrower defaults on a recourse loan, a lender can pursue the borrower’s personal assets — even wages — if the collateral is insufficient to cover the outstanding debt. With a nonrecourse loan, the lender is limited to the collateral itself to recoup losses.
Typically, most bank, bridge and construction loans are recourse, while Fannie® Mae®, Freddie® Mac®, HUD/FHA multifamily and CMBS loans are generally nonrecourse — though exceptions are not rare.
Because of the difference in risk to borrowers and lenders, there are some key differences in loan terms and requirements. In brief:
Recourse Loan Nonrecourse Loan Risk Profile Riskier for borrowers Riskier for lenders Default Event Lenders may pursue a borrower's personal assets Lenders may generally only pursue a loan's collateral. Borrower Profile Typically less experienced More experienced, financially stronger Interest Rate Generally lower Generally higher Asset Types Any Often restricted to "strong" assets and locations LTV Generally higher Generally lower Examples Most bank loans, bridge loans, construction loans Most Fannie Mae®, Freddie Mac®, CMBS loans
While borrowers broadly prefer nonrecourse financing, lenders favor recourse loans due to lower risks. Due to this imbalance, these types of loans tend to have rather different terms associated with them.
While recourse loans are widely used for most asset classes, nonrecourse lenders are typically far more selective, generally opting to finance stronger, lower-risk properties with one eye fixed on a market’s overall strengths and outlook.
For example, the owner of a stabilized Class A multifamily property in Manhattan may have little trouble landing a nonrecourse loan, but a first-time investor seeking a hotel refinance in suburban Boise, Idaho, would likely have little choice but to look to recourse financing.
Recourse loans require the personal guarantee of the borrower(s) so that in the event of loan default if the bank doesn't recoup their full investment from selling the property, the borrower and their personal assets are on the line for the remainder of the funds to make the bank whole.
In the case of non-recourse commercial loans, the bank’s only way to recoup lost investment and yield in the event of a default is through the property itself and the income the property generates. This is obviously an advantage for borrowers, because who wouldn’t want less risk and exposure? Conversely, non-recourse loans carry significantly higher risks for lenders and investors.