When is a Full Recourse Loan Acceptable?Brian Hansen
The answer to that question is, complicated. Let’s start with a simple definition and talk through some of the scenarios that make sense.
A recourse loan is a loan where the borrower is personally liable for repaying the outstanding balance of the loan, above and beyond the underlying collateral. For example, in a worst-case scenario where the underlying asset must be liquidated, the borrower is still on the hook for the unpaid balance after the liquidation.
In a non-recourse loan, the borrower is not personally liable beyond the collateral. Of course, there are some exceptions to the rule and these are called “Bad-Boy Carveouts or Guaranties”, which means if you commit fraud or let the taxes or insurance lapse, you’re back on the hook.
Which lending institutions offer which kind of loan?
- Banks, Credit Unions and many private capital lenders offer recourse loans.
- HUD/FHA, Fannie Mae, Freddie Mac, Life Insurance Companies and Commercial Mortgage Backed Securities offer non-recourse loans.
Non-recourse loans have more customizable structures and features that most banks can’t or won’t match.
Banks are lending from their own deposits. As such, it’s not in their interest to offer long fixed rate contracts. They usually offer a 3, 5 or 7-year fixed rate period to begin the loan, followed by a longer period of rate adjustability, usually tied to one of the indices or prime rate. They are famous for sticking with a 25-year amortization schedule (in most cases), which is less risky for them, but the shorter amortization lowers the cash flow to the sponsor.
The non-recourse lenders know they are competing with banks and have instituted many of the desired structures and features banks don’t offer, beyond the obvious benefits of the non-recourse structure. These features include:
- Fixed rate loans with terms of 10, 15, 20, 35 and even 40 years.
- Amortization schedules based on 30, 35 and 40 years. The amortizations can match the loan term or there can be a balloon payment.
- A 10/30 is one of the most popular structures for a commercial loan. The term is 10 years, which gives the sponsor a good block of time for the property to appreciate while the 30-year amortization delivers better cash flows. A balloon payment is due at the 10-year mark.
- Another option is an interest-only structure for a few years or even the life of a loan.
Why would anyone choose a full recourse loan?
Investors oftentimes choose to work with their local bank or credit union because of their existing relationships with those institutions. In many cases the lender will have a comfort level with a client because of deposit accounts and/or a record of successful projects.
Additionally, there are many circumstances where a securitized loan product isn’t a good fit or isn’t available at all. One of these is a construction loan. Banks and credit unions are the biggest source of construction financing and these are typically recourse loans. In some limited cases, where a borrower is well known to the lender and a higher interest rate is in play, a non-recourse construction loan may be extended but that’s the very small exception, not the rule.
Mini-Perms are another kind of recourse loan that make sense when a property isn’t fully stabilized or seasoned. Following construction or major rehabilitation of a property, a mini-perm loan acts as a bridge to permanent financing, so the property can go through its lease-up process to full stabilization.
First time investors need experience owning and managing multifamily assets before seeking financing from HUD/FHA, Fannie Mae, Freddie Mac. These lenders demand some experience before they can qualify for a non-recourse loan. Of course, there are exceptions here as well; Freddie Mac SBL will look at a sponsor with extensive property management experience combined with a portfolio of single family residences, duplex, tri-plex and 4-plex ownership.
Non-conforming properties that wouldn’t qualify for HUD/FHA, Fannie Mae, Freddie Mac. These would include mixed-use properties with less than 60% of the rent-able square footage in multifamily. Each of these programs have different minimum thresholds. When they can’t be met, a bank loan will have to suffice.
Should I perform a portfolio review and realignment?
The first step is the review, we recommend reviewing your portfolio annually with a 3rd party (not emotionally tied to the portfolio). We have met several investors that have been acquiring commercial multifamily properties for many years, in some cases every property is financed with a recourse loan. There are also concerns with saturation.
Many investors are familiar with a bank or credit union with which they have done several loans only to find out they won’t / can’t extend any more loans. Like investments, it’s a better strategy to diversify lending sources well before you are required to do so.
Regarding realignment of your portfolio; one thing we warn our clients of is the potential house of cards that multiple recourse loans can become. During a future downturn, should your property experience higher than expected vacancies, troubling collections and / or unplanned expenses, you could feel quite a squeeze as your positive cash flow disappears and even be forced to start subsidizing the mortgage out-of-pocket.
If as the investor, this starts happening with multiple properties in your portfolio, you can run through your cash reserves much quicker than anyone plans. When the bank decides you are no longer a good risk because you’re in default, you can plan on foreclosure. After they have taken back the property, and liquidated it, they will be coming after your personal deposits and other assets, including other properties you own, until the outstanding balance is satisfied. This is when you could have a “house of cards” portfolio crash.
We help investors review and evaluate the optimization of their existing financing in their portfolios, refinancing specific properties into non-recourse loans when appropriate.
We find the most savvy and successful investors do everything in their power to build their portfolio with non-recourse financing.