Why Non-Recourse Loans Aren’t Always Non-Recourse
Rod Khleif Real Estate Investor, Mentor, Coach, Host, Lifetime Cash Flow Through Real Estate Podcast.
In the world of multifamily financing, a non-recourse loan is considered to be the gold standard for acquisition financing because they are considered to be less risky for the borrower. Typically, these facilities are offered by specialty lenders and government-sponsored entities. The non-recourse provision is intended as a way to attract borrowers, but for anyone considering a non-recourse multifamily acquisition loan, it is important to understand that, in certain situations, they aren’t always non-recourse.
What is a non-recourse loan?
When a multifamily lender is underwriting a new loan, they typically consider three sources of repayment. In most cases, the primary source of repayment is the cash flows produced by the property. If at any point those are insufficient to make the required loan payments, the lender reserves the right to foreclose on the property and sell it so they can use the proceeds to repay the outstanding loan balance. This is the secondary source of repayment.
Now, on occasion, the proceeds from the foreclosure sale are not sufficient to repay the loan balance. Such cases highlight the difference between a recourse and non-recourse loan. In a loan with recourse, the individual borrowers are required to personally guarantee the loan, meaning they are responsible for paying off the remaining balance out of their own pocket. In a non-recourse loan, the individual borrower(s) are not required to provide a personal guarantee, so the lender will likely take a loss on the loan.
To illustrate this point, consider the following example. Assume a loan has an outstanding balance of $1 million and the borrower can no longer afford to make the payments. After foreclosing on the property, the lender makes a distressed sale for $800k. They use the funds to pay down the loan balance, but there is $200k remaining. In a loan with recourse, the borrowers who provided a personal guarantee are responsible for paying the remaining balance out of their own pocket. In a non-recourse loan, the lender has no legal right to turn to the borrower for the remaining balance. As such, they will typically have to take a loss.
For this reason, many lenders are reluctant to offer non-recourse financing, but multifamily properties are a critical component of the United States housing inventory, and, for many, an apartment offers the lowest barriers to entry when seeking affordable housing. So, there are a number of lenders, typically backed by an agency of the United States government, that offer non-recourse loans as an incentive to provide housing for Americans who need it. Borrowers like non-recourse financing because it represents a less personal risk in the transaction, but — and this is a big but — non-recourse loans are not always non-recourse.
What should you look for in non-recourse lending agreements?
One of the documents that a borrower signs at closing is known as the “loan agreement” and it contains the legal language that will govern the administration of the loan. It will contain the non-recourse lending language and it needs to be read very carefully. In some cases, the non-recourse language creates “carve-outs” that cover specific instances where a loan guarantee will “spring” into place. Two of the most common examples are the so-called “bad boy” carve-out and covenant violations.
What is a “bad boy” carve-out?
A lender expects a borrower to act in good faith, at all times, with regards to their loan. This means being honest on their application, using the loan proceeds for what they say they are going to use them for, providing all of the required documents when they are required to do so and making their loan payments on time. If a borrower does not act in good faith or they intentionally commit fraud or some other act of malfeasance the “bad boy” carveout in a non-recourse loan may specify that once the dishonest behavior is proven, a full loan guarantee will spring into place and the once non-recourse loan now becomes fully guaranteed by the individual borrowers.
The point is, it is important for borrowers and investors to conduct business with their lenders with honesty and transparency at all times. Otherwise, they may unwittingly find themselves on the hook, personally, for the entirety of the loan’s balance.
What are loan covenants?
A loan covenant is a condition, described in the loan agreement, that the borrower affirmatively agrees to as part of the terms of receiving the loan, or it can be a condition or behavior that the borrower is expressly forbidden from undertaking. For example, it is common for a multifamily loan to have a debt service covenant that states that the property’s income must be 1.25 times the debt service at all times during the life of the loan, or a covenant could state that ownership of the borrowing entity cannot change without the lender’s approval.
Covenants are tested regularly throughout the life of the loan and breaking one can have consequences, including the nullification of the non-recourse clause. If this happens, a non-recourse loan can become full recourse overnight and the individual borrower(s) could find themselves having to reach into their pocket to pay off a loan balance in a worst-case scenario.
Multifamily borrowers like non-recourse loans because they shift some of the repayment risks to the lender. However, it is important to pay close attention to the specific non-recourse language in the loan agreement because there are specific situations where a non-recourse loan can become fully guaranteed. On occasion, this can come as a surprise to the borrower, so it is best to not be caught off guard.
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