The Difference Between Recourse and Non-Recourse LoansPaul Winterowd
I don’t have the exact quote, but the star quarterback turned real estate mogul Roger Staubach was asked about his biggest regret in building his real estate portfolio. His response was he wouldn’t have used debt with an unlimited personal guaranty attached to it. He felt that over years of experience a non-recourse approach was preferred.
That said, the point of this article isn’t to judge the merits or pitfalls of either recourse or non-recourse loans, but to provide context and understanding about the two options.
So what is the difference between a recourse and a non-recourse loan? In commercial real estate both types of loans are common depending on the stage and type of financing. Let’s look the difference between the two and we’ll also examine what’s covered in the “Bad Boy” carve outs common in non-recourse loan documents.
Recourse Loan Definition
A recourse loan is a loan where the borrower(s) or guarantor(s) are personally liable for repaying any outstanding balance on the loan, in addition to the collateral itself.
In other words, if the collateral securing a loan needs to be sold at foreclosure, but those proceeds aren’t adequate to cover the total amount owed on the loan, there is a deficiency in making the lender whole. “Recourse” enables the lender to go after the guarantor(s) personally to cover this deficiency.
Full recourse loans are common with most loans funded by banks and credit unions. Additionally, most new construction and other shorter term commercial real estate financing, such as a bridge loan that enables rehab, lease-up, the and stabilization of a multifamily asset are recourse loans.
Non-Recourse Loan Definition
A non-recourse loan is a loan where the borrower(s) or guarantor(s) are NOT personally liable for repaying any outstanding balance on the loan.
Non-recourse loans are typically found on longer term permanent commercial real estate loans (HUD, Fannie, Freddie, CMBS, Life Co) placed on stabilized and performing assets. However, a common misconception with non-recourse loans is that if a loan is non-recourse, then a borrower or guarantor can never be held personally liable in the case of a loan default.
This is not always true and there are several exemptions commonly covered under what is known as the “Bad Boy” carve out provisions or the Bad Boy Guaranty.
The Non-Recourse Loan Bad Boy Guaranty
These carve out provisions protect the lender and enable personal recourse to be in effect in the case of certain events, such as fraud. Essentially, Bad Boy guaranties are exceptions to the non-recourse status of a loan that were originally created to prevent the borrower from siphoning cash out of a property in the months leading up to a loan default.
This varies by state, but here are some common carve out provisions of Bad Boy clauses included in non-recourse loans:
- Filing for bankruptcy
- Fraud or misrepresentation
- Failure to maintain required insurance
- Failure to pay property taxes
- Any environmental indemnification
- Committing a criminal act
Another common misconception with non-recourse loans is that the Bad Boy guaranty is limited to just these major events or bad acts. In the past this was typically true, but over time, the Bad Boy guaranty has slowly expanded to include more and more minor provisions. This may include failure to deliver financials to the lender or permit lender inspections of the property. These and other minor carve out provisions may or may not be appropriate or acceptable.
As always, it’s critical to read and understand the loan documents. It’s always best to have them reviewed and negotiated by a competent commercial real estate attorney.
Recourse vs Non-Recourse Loan Example
Let’s take an example to illustrate the difference between recourse and non-recourse loans. Suppose a borrower has the following loan for a multifamily property:
- Apartment Value: $10,000,000
- Loan Amount: $7,500,000
- Loan to Value Ratio: 75%
Now, suppose we have a global pandemic and the vacancy goes up much higher than expected resulting in market lease rates declining significantly. It is an extreme scenario, but the borrower can’t keep up with their loan payments and ends up going into default on the loan.
With a non-recourse loan, the lender can take back the real estate – which is obviously the collateral for the loan. Sometimes this will be adequate. But what if the liquidation value of the property isn’t enough to repay the outstanding loan balance?
Let’s further pontificate that the higher than expected vacancy and reduced NOI cause the property value to decline to only $7,000,000. This is less than the outstanding loan balance of $7,500,000.
In this scenario, the lender does not have any personal recourse to cover the shortfall, so when the building is foreclosed and liquidated, the lender will take a loss.
Now let’s look at what would happen if this were a recourse loan. Assume the guarantor has the following personal financial statement:
|Real Estate Owned||$28,000,000|
If the above loan were recourse, then the lender would not only be able to sell the collateral for $7,000,000, but the lender would also be able to go after the guarantor personally for the deficiency of $500,000. This means the bank could levy or legally seize the guarantors bank accounts, wages, and other assets in order to satisfy any outstanding debt.
We’ve covered recourse and non-recourse loans, as well as some common misconceptions and pitfalls to avoid. Recourse puts the borrower or guarantor on the hook for the loan, in addition to the collateral itself. For new construction, most bank and credit union, and some bridge loans – a full personal guarantee from the sponsor is almost always required.
This aligns incentives to get a property fully constructed, leased, and stabilized. Longer term loans from the “Secondary Market” on stabilized properties are typically non-recourse, unless otherwise triggered by various “Bad Boy” clauses. This limits the personal exposure for borrower, but also protects the lender and allows them to go after the borrower/guarantor personally in the case of certain events such as fraud.