The key determining factor in every real estate credit decision is what collateral the borrower is pledging as security and whether there is additional security the lender requires.
Real estate loans generally have two financing options – loans with recourse and loans without recourse (“non-recourse”). The primary difference between these types of loans is as follows:
- Recourse loans: The lender has the ability to collect the difference between the sale price of the property and the amount owed to the lender from borrower should the property sell for less than the amount owed. In other words, there is a secondary source of repayment should the value of the property prove to be insufficient to repay the loan.
- Non-recourse loans: The lender is prohibited from collecting any shortfall in the difference between the sale of the property and the amount owed the lender. The lender’s only source of repayment is the property that was pledged as collateral.
There might be instances where the loan is non-recourse unless the borrower violates certain warranties, conditions, or covenants of the loan. For example, a “Bad Boy Guaranty” is one way for a lender to make a simple non-recourse loan have certain protections of a recourse loan. This “Bad Boy Guaranty” creates personal liability to the borrower or principals of the borrower upon the occurrence of certain enumerated “bad acts” (i.e. criminal or fraudulent acts) committed by the borrower or its principals. This allows for lenders to provide borrowers with a non-recourse loan, while protecting the lender against extraordinary actions the borrower could take.
Recourse and non-recourse can come in many varieties and versions, which can make the difference between the two types seem somewhat hazy. However, the key difference here is whether the lender can seek to collect any amount owed on the loan from the borrower. Or if the lender’s only source of repayment is from the property pledged as collateral.
Why this is important
After understanding the key distinction, it’s critical to understand why this is so important in commercial real estate credit.
A borrower’s particular situation and objectives are key to understanding whether a recourse or non-recourse loan is preferred. Of course, limiting personal liability is ideal in every scenario. However, the flexibility provided by certain recourse loans can make them much more preferable to the non-recourse alternative.
One of the ways a lender assesses and prices risk for a loan is the security available to the lender. Often times this is oversimplified into one metric in underwriting – “loan-to-value” (or “LTV”). This LTV is the loan amount as a percentage of the value of pledged collateral. Often times the pledged collateral is simply the property either being purchases or refinanced. However, sometimes the borrower will offer (or the lender will require) other real property the borrower owns as additional collateral. This additional collateral can serve to drive down the LTV percentage.
Understanding LTV is important, because the loan amount as a percentage of pledged collateral indicates the lender’s security in the loan. The lower the percentage, the greater security the lender typically has. Many lenders require that LTVs be below a certain percentage – with the lower the LTV, the more attractive the loan.
Many lenders have LTV requirements. Where LTV might be maxed out or there is a lack of LTV flexibility, this is where lenders may require the loan to be recourse in order to provide additional security to the lender, as protection against downside risk. Certain lenders have LTV requirements and require recourse in addition to that. While others lenders are more flexible on both or either requirement.
Either way, when a borrower accepts a recourse loan, generally what they get is a more flexible loan some of the other loan terms to be negotiated. For example, recourse loans often include greater flexibility in pricing and loan structure, or might include less ongoing restrictions on cash flow or operation of the property. Conversely, non-recourse loans limit personal liability while often restricting flexibility on these other (often times more relevant) terms.
Commercial Real Estate Credit Market
Depending on your loan type or the type of lender you’re negotiating with, certain lenders have strict recourse requirements. In other words, you may not be able to negotiate for a non-recourse loan.
For example, Commercial Banks, whose source of funding is generally its depositors, usually only offer recourse loans. This is because when lending money from its own customers and keeping the loans on its own balance sheet, the banks have strict and conservative credit requirements that demand they maintain all forms of available recourse on every loan.
Commercial mortgage-backed securities (CMBS) lenders, Life insurance companies, and lenders who work with Government-Sponsored Entities (GSEs), like Fannie Mae and Freddie Mac, make up most of the remainder of the commercial real estate lending market. These types of lenders, who generally provide very narrowly tailored loan programs, offer non-recourse loans as part of their offerings. This is because their source of funding and specific funding purposes, including certain prepayment penalties or other maintenance requirements, provide the flexibility to accept only the pledged collateral as security for the loan.
Private (“Bridge”) Lenders are often somewhere between these lender types. Private lenders, who lend out their own or their investors’ own money, can provide recourse and non-recourse options, depending on the specific loan and the borrowers’ situation. Some private lenders make it a matter of course to have standard recourse or non-recourse programs and to not negotiate on a case-by-case basis. However, private lenders generally have the most flexibility here, but it often comes at a cost to the borrower. Some lenders, who will offer non-recourse, may require greater amounts of pledged collateral or charge more in terms of fees or interest rates.
It is also important to understand where a lender cannot negotiate recourse vs. non-recourse. For example, in certain states, like California, lenders can be restricted from seeking recourse or collecting any deficiencies from the borrower in certain instances. In California, a foreclosing lender cannot get a deficiency judgment after a non-judicial foreclosure. This is important because many residential and commercial loans in California are secured by deeds of trust with “power of sale” clauses that the lenders intend to use to non-judicially foreclose on the property. And even if the lender uses a judicial foreclosure process in California, a deficiency judgment is not allowed where it was a “purchase money loan” for an owner-occupied 1-4 unit dwelling, seller financed, or a refinance of purchase money loan executed on or after January 1, 2013.
Other states provide similar statutory deficiency protections for the borrower. These do not change whether a loan is recourse or non-recourse on its face, or if other provisions, like “Bad Boy Guaranty” apply to the contracting parties. But it is important to understand limitations lenders have on recourse in your particular state when negotiating for recourse or non-recourse.
Choosing between a recourse and non-recourse loan is one of the most important decisions in the commercial real estate lending process. Sometimes the decision is made for a borrower based on the borrower’s transaction type or situation, and the loan programs available to them. Sometimes it is a deal point that is to be negotiated. No matter what, it is in the borrower’s best interest to know his or her own situation and the commercial real estate credit market. To make sure, they are not giving up personal liability in a recourse loan “for free” but on the other hand also not just defaulting to a non-recourse loan and unknowingly being constrained to the restrictive terms those programs can offer.