By now you’ve probably noticed that there are dozens of loan types when it comes to securing funding for a commercial real estate property project. Whether you’re purchasing land for the sake of developing on it, rehabbing an existing property, or building a property from the ground up—you need funding. Most investors turn to commercial real estate loans to get the funds they need to move forward.
But how do you choose between the many unique loan structures and types that are available? And how can you possibly be expected to know all of their differences?
Fortunately, that’s where we come in. At Clopton Capital, we think that the relationship between lenders and borrowers is strongest when borrowers feel empowered with the knowledge they need to make an informed decision.
With that in mind, we’ve prepared this guide to understanding non-recourse loans—one of the most common types of commercial real estate loans. They come with strong advantages over some other types, but they’re not right for every scenario. In this guide we’ll help you understand non recourse financing, the difference between recourse and non-recourse loans, how to obtain a non-recourse loan, and how to read a non-recourse loan agreement. We’ll also dive into examples of non-recourse loans to help you see how they’re structured, and lay out the pros and cons of non-recourse loans for your unique situation. So without further ado, let’s get started!
Understanding Non-Recourse Financing
Non-recourse loans are similar to other loans in many ways, but they hold a few key distinctions. One of these is that borrowers who take out non-recourse commercial real estate loans aren’t personally responsible if they ultimately end up defaulting on the loan. That means that the lender can only repossess the property in question and sell it in order to re-obtain funds lost in the transaction—they can’t attempt to collect personal property from the borrower themselves. This lowers the risk for borrowers, and helps make non-recourse financing more accessible. Non-recourse loans are also unique in that lenders often intend to sell these loans in bundles to other companies, which means that you’re likely to be dealing with someone different than the company you initiated the loan with at the start.
The Difference Between Recourse and Non-Recourse Loans
When it comes to recourse loans, the lender is looking for guarantees and sure things. Essentially, they want to ensure that if the borrower can’t pay them back and the loan defaults, they’re still going to be able to recoup their lost costs fully. The way recourse loans do this is by making anything the borrower owns fair game in the case of default. This means that if a borrower defaults, the lender can come after personal property like personal bank accounts, homes, and other property unconnected to the commercial real estate or business.
Non-recourse loans, on the other hand, are much less risky for borrowers because they place the risk in the hands of the bank. If you default on the loan, it’s on the lender to find a way to recoup their costs. They can’t seek financial repayment by seizing your personal assets or properties.
How to Read a Non-Recourse Loan Agreement
Fortunately, a non-recourse loan agreement is structured much like any other commercial loan agreement. There are some specific key differences—one of which is that a recourse loan agreement will feature the terms that determine how, when, and to what degree a lender can pursue financial recourse in the event of the loan’s default or the borrowers inability to pay it back.
In a non-recourse loan agreement, the lender isn’t permitted to seize personal assets or property. So this language will be absent, though there will be a section outlining how the property funded by the loan can be sold by the lender in order to recoup their costs.
Otherwise, each non-recourse loan agreement will be unique as it pertains to the terms and conditions of your specific loan. Be sure to pay careful attention to all of the language and terms within the agreement so you know exactly what to expect from the loan and how it will be serviced.
If you value flexibility in pricing and loan structure, transparency about who will be managing your loan, and freedom from property constraints, a non-recourse loan may not be for you. But if you want to enjoy the freedom from personal liability a non-recourse loan offers, than it’s worth consideration on your part.
Understanding Non-Recourse Loan Structure
So if lenders are assuming so much risk themselves with non-recourse loans given their inability to pursue your personal assets and property as collateral, how do they protect themselves? One way is by structuring non-recourse loans in such a way that they have a say in how the property is operated and how cash flow is maintained. By doing this, the bank is helping assure that the property will remain profitable, which makes you more likely to be able to pay the monthly payments on the loan. These rules are generally not overly restrictive, though they can affect factors like how rent payments are handled or which forms of escrow you can use during the course of doing business with your property.
Why Should You Pursue a Non-Recourse Loan?
There are multiple reasons why a non-recourse loan is a strong bet when it comes to funding your commercial real estate project.
The first is that non-recourse loans remove your personal liability from the equation. Obtaining a business loan can be incredibly stressful, particularly because it often requires you to make a personal investment of risk that if you’re unable to pay back the loan, your personal property and assets will be at stake.
With non-recourse loans, that risk is completely removed. There is the business risk of the funded property being taken back by the bank and resold to recoup their costs, but you can at least rest assured that your personal property is safe.
What is a Non-Recourse Carve Out?
There is one area where a non-recourse loan can be converted to a recourse loan, and it’s worth knowing about before you get involved. Known as the ‘bad boy carve out,’ this rule protects lenders in the case of borrowers who engage in illegal, unsafe, or otherwise unacceptable activities or behavior relating to the property and the loan.
What does this mean in straightforward terms? It means that if the lender engages in loan fraud to secure the loan, or fails to maintain insurance on the property, or engages in any other activity that’s illegal or deliberately breaks the terms of the loan agreement, then the lender can transfer the non-recourse loan into a recourse loan and have the ability to seize personal assets and property in order to recoup any losses that have occurred as a result of the activities.
While it’s unlikely you plan to commit loan fraud, it’s important to know that there are special exceptions when a non-recourse loan can behave like a recourse loan.
Ongoing Management of Your Non-Recourse Loan
Another factor that’s important to keep in mind when it comes to deciding between recourse or non-recourse loans involves who you’ll be dealing with for the management of the loan.
Non-recourse loans are often designed by lenders for the express purpose of being bundled and sold to other companies. While this won’t affect the loan terms that you agreed to at the beginning, it will change who you make your payments to and who you must deal with in the case of any issues or requested changes to the loan.
If consistency in the ongoing management of your loan is important to you, you may prefer to consider a recourse loan instead.
Choosing the Right Non-Recourse Loan Provider
To obtain a non-recourse loan, your first step will be to find a lender who deals with them. There are three primary sources when it comes to obtaining a non-recourse loan—commercial lenders like banks, CMBS lenders, and sometimes life insurance companies.
Our recommendation? Go with a proven and established commercial lender who’s experienced in non-recourse lending and can provide you with the beneficial terms and expertise to help you along the way. The process of obtaining a non-recourse loan can be complicated, so you want to work with an establishment that knows what’s involved and can help you understand how to find favorable terms for you and your commercial real estate goals.
Remember that each unique lender type gets the funding they use for loans in different ways. This will affect how much money they have to offer, the potential terms of loans they underwrite, and other factors that will affect your loan. Keep this in mind when on the hunt for the right lender for your non-recourse loan needs.
Non-recourse loans can be a powerful way to access the funds you need to move forward on a real estate project without putting your personal assets and property at risk. If you want to learn more about non-recourse commercial real estate loans, speak with one of our experts at Clopton Capital. We’ll be happy to give you the custom-tailored guidance, expertise, and advice you need to know for your specific situation. And when you’re ready to obtain a non-recourse loan, we’ll be waiting to guide you through the process step by step.