A bridge loan is a temporary real estate loan with a term of 12 to 36 months for the purpose of quick acquisition, rehab, or repositioning a property. A non-recourse bridge loan is most desirable in that no personal guarantees are required and thus the borrower’s personal assets are not at risk.
The Danger of Recourse Bridge Loans and the Death in Unit 146B
If you are reading this, you are likely already thinking about a non-recourse bridge loan and now wondering what this has to do with a death in unit 146B. This article is about why you really should obtain a non-recourse bridge loan as opposed to a recourse one. My bias viewpoint on the subject is solely based on my 21 years as a commercial loan broker and stories very much like the one I’m about to tell you.
Dr. Dave was beyond excited when he called me about purchasing at a steal a 206 unit low income apartment complex in Greeley, Colorado that was “34 years young” as he said. This was in 2009 when the great recession was ramping momentum, and it was a buyers’ market. I glanced at photos that showed a stately freshly painted complex with park like mature landscaping. The olive green applicances and linoleum in the interior pics told another story. This property would need all new interiors. The seller was 84 years old, not young and had not raised rents in 14 years on mostly long-term tenants. However, it appeared that he had maintained the investment. At first glance, it seemed like the perfect opportunity for my client to do some interior remodeling and raise rents. So I asked “why was this 94% occupied complex being offered for only $18,000 per unit? Dr. Dave answered, “Apparently, someone died a horrible death in unit 146 B”.
The seller was a straight shooter and told Dr. Dave right away about the meth lab explosion in unit 136B and the owner operator’s death from third degree burns. The good news was that this happened 5 years prior and the 12 units in building B had been professionally decontaminated and certified livable by the state department of health. Dr. Dave was ecstatic about negotiating the purchase price down to $3,700,000 from $4,200,000 and as a bonus, one third of the units had been remodeled. He would need to put in about $7,500 per unit or $1,027,500 into rehabbing mostly the interiors of the 137 dated units which would also get new HVAC. What a deal. Dave found a recourse bridge lender who provided a 70% of total project cost loan on the property for 12 months at 12.00% interest only. There was an opportunity to extend for 6 months by paying an additional point. Dave’s exit strategy was to take the bridge loan out with a non-recourse Fannie Mae loan that we were going to provide.
A Story of Four Disasters
All started out great for the first 7 months, then the first disaster struck. Dave had his skilled general contractor remodel 6 units at a time every two weeks. He was on a roll having renovated 78 units and re-renting over half of them at $200 more per month. Then there was an electrical fire that pretty much totaled a newly remodeled 16 unit building. Although the building was fully insured for replacement cost it would take time for the insurance company to pay out. Dave’s bridge lender allowed him to put money from the loan into repairing the fire damaged building, and agreed to have the insurance money paid directly to the lender to pay down the loan when it came in.
I forgot to mention that Dave lived in Boston, and as you know, the property was in Colorado. His medical practice became more demanding and he stopped making visits to the property after the first 7 months. An investor rehabbing a property being out of state can be a recipe for failure if they do not manage their property manager. The second disaster hit after 13 months, a month after Dave extended his Bridge loan for an additional 6 months. He had already been alarmed that releasing the remodeled units was going much slower than expected. But now occupancy was actually dropping. Upon closer examination of the books he discovered that collections were much lower than they should be and that quite a few tenants were paying late, or not paying at all. He called a buddy who lived near the property and asked him to go out to inspect the property. Dr. Dave was told some alarming news. Tenants in some of the buildings were tossing trash off their balconies, and many tenants were storing extra belongings and junk on their balconies. Worse yet – a mattress was molding outside the trash area and the pool was full of decaying leaves. It was obvious that the property management company needed to be fired.
What Dave did not know when he purchased the property was that it was in a high crime neighborhood. Prospective renters who had well paying jobs and could afford the increased rents did not want to live there since. Also, it was well known that a meth lab had exploded there and someone had died. The seller had mostly senior tenants who could not afford a better place, but paid the rent and took care of their units. Now the remodeled units were being rented to a younger, shiftier group with rent concessions. Pay one month’s rent and a $250 deposit and get your second month rent free. Well, many of these tenants never got around to paying the third month’s rent.
The third disaster happened when Dave burned through the funds from his loan in month 17 and still had 18 units to rehab. To make matters worse, the 16 unit fire damaged building was not occupied because it needed a new certificate of occupancy. The reason was that the building, having been almost completely rebuilt, was now not in compliance with many new codes including the Americans with Disabilities Act. Dave requested a second 6-month extension from his bridge lender and was denied. He was told that he had done an awful job - the rehab was not completed, and worse yet the occupancy was continually going down. 68% occupancy was not acceptable when market occupancy was at 92%.
The fourth disaster happened when the bridge lender called the loan due and payable. Although Dave was still making the payments on time, and putting his own money into the project. The lender foreclosed on the property two months after the loan term was up and stopped accepting loan payments from him. Colorado does not have a right of redemption period so a lender can foreclose rather quickly. The foreclosure still took 9 months to go through the judicial system and the property was deeded to the lender. Seven months later the lender resold the property for $650,000 less than the principal balance of the loan. The lender then obtained a deficiency judgement from the court for the deficiency plus payment arrears, and attorney fees totaling $1,260,00. This judgement could be attached to any of Dave’s personal assets except his retirement. Dave moved all his personal money into his business accounts so it would be safe there. But he did get a judgement attached to his primary residence and Florida condo. If Dave had taken out a non-recourse bridge loan and had the same disasters he would have simply given the property back to the lender in lieu of foreclosure. After all the loan would not have been made to him personally but to a single asset entity like a LLC, so the lender would not be able to go after Dave personally.
1. What occurs if you get a recourse bridge loan?
Now, let us examine what happens if you default on a recourse bridge loan.
Often the borrower/sponsor (also called key principals) will vest the property in a single asset entity like an LLC, a Corporation, or Limited Partnership (LP). This entity can be owned by just one key principal or many. Also, there may be owners that are simply equity investors. It is usual that the managing partner is the one who places the different parts of the deal together. This includes forming a business plan, negotiation of the acquisition, getting equity together and applying for a mortgage. Although the loan will be made to the single asset entity, because the loan is recourse, the borrowers and principal investors will be required to personally guarantee the loan.
When it comes to a bridge loan that is recourse, most often the managing partner, plus any investor that owns over 20% or puts in 20% of the equity or more will be required to personally guaranty the loan. The guarantee can be proportionally assigned or up to 100% assigned to each guarantor. It is wise to negotiate partial recourse – proportional is best, or 50% to 65%. Often commercial banks get as many partners as they can to personally guarantee the loan sometimes seeking 50% to 100% recourse from each key principal. When it comes to collateral, the loan source gets a first position security interest in the property, and also gets a scary thing – the sponsor has to pledge up to 100 percent of their assets. Wow! Speaking of risk.
The sponsor has no exculpation from any amount of loss. This amounts to the sponsor giving the lender something of great value. It’s an insurance policy that protects against all the lender’s potential financial loss, including a deficiency in the resale of the property, back payments owed and attorney and court fees.
Keep in mind that in a recourse loan the lender is looking for guarantors that have good net worth and liquidity. After all, it would be counterproductive to allow an investor to guarantee a loan who has little to lose.
If it should happen that the borrower/sponsor could not repay, there are a number of avenues for the lender to go after. And these avenues depend on the laws of the state involved:
The Lender's Recourse:
i. The lender can file a lawsuit to go against the borrower/sponsor to be able to foreclose the loan, get the property title, and get the sponsor to have personal liability covering the cost of any loss the lender may have when the property is foreclosed upon and sold.
ii. Regarding the debt, file a lawsuit demanding full payment of the debt by the sponsor(s) only.
iii. If there are a number of sponsors involved who have personal guarantees that are signed and are joint and several, the lender in their discretion can file a lawsuit toward the one sponsor/guarantor who has the greatest amount of assets or all guarantors.
iv. The lender can be awarded a deficiency judgement by the court including arrears, and attorney fees that can be attached to any of the guarantor's personal assets.
For the lender to have a joint and several guarantee is like having a super weapon in his arsenal – He can go after one or all guarantors or leave it to the sponsors to fight it out and determine how they will split up the obligation–Ouch! For an in-depth explanation of a joint and several guarantee this article is recommended: https://en.wikipedia.org/wiki/Joint_and_several_liability
Quite often recourse lenders will pursue more actively the sponsor/guarantor with the deepest pockets. Thus, one entity becomes responsible for much more than their fair share of the debt. This means that if the lender gets a ruling in court in his favor, the sponsor/guarantor will get a judgment of being required to pay in full from his personal assets. This judgment includes having to pay the lender’s legal fees, having to lose the house, college savings, retirement savings, RV’s, boats and autos. This is why it is often difficult to obtain high net worth individuals to invest in your income property if you are planning on taking out a recourse loan.
There is one phrase that says it all: “As Far as Recourse goes, Do Not Do It Unless You Absolutely Have To.”
2. What Occurs When You Get a Non-recourse Bridge Loan?
If foreclosure happens for a bridge loan secured solely by a deed of trust or mortgage made to a single asset entity and not individual as borrower, the key principals will risk losing ownership of the subject property only. This of course does means that the investment in equity the borrower has in the property will be totally lost. However painful this might be, it is much, much better than losing the subject property plus some or all of your personal assets in a recourse loan.
When you get a non-recourse loan, you are getting an “insurance policy.” This is because the loan source made an agreement to limit recourse to the subject property only.
The legal term for this is that the borrower is “exculpated” from being liable.
At the closing of the non-recourse loan, it is probable that additional money will be paid to the lender through a mix of higher interest and higher fees compared to what is paid for a bank recourse loan. Thus, it might costs additional money to do non-recourse, but it is likely well worth it.
The types of commercial real estate loans in which you will typically see non-recourse are some commercial construction loans, permanent commercial loans, and bridge loans.
There is a common misperception regarding non-recourse loans. It’s that the borrower can never have personal liability. This is not true if the key principals do something fraudulent, or has the single asset entity that owns the property declare bankruptcy.
These exceptions are called bad Boy carve outs. Nearly all non-recourse loans require the borrower to sign for these. The bad boy carve outs have the purpose of protecting the lender, and will give the lender personal recourse if one or more of the following happen:
i. The borrower commits a fraud by either misrepresenting the financials of the subject property
ii. The borrower is engaged in doing something criminal on their property.
iii. The borrower gets insurance that doesn’t meet lender requirements or the borrower allows their insurance to expire.
iv. The borrower fails to make property tax payments over a prolonged time period intentionally
v. The borrower declares bankruptcy on the entity (single asset) that has ownership of the subject property.
vi. If the borrower does something that is not in accordance regarding the environmental indemnification.
vii. The borrower doesn’t allow inspections that may be required and conducted by the lender.
A Few More Characteristics of Non-recourse loans:
Commercial construction loans, permanent commercial loans, bridge loans and blanket residential loans on 5 or more residential properties are the kinds of commercial real estate loans in which you will typically see non-recourse lending. Note that non-recourse lending is not granted to everyone. Key principals still have to have experience, and not be broke after the loan is taken out. Often the property has to be stronger since the lender can only go after the property.
Many non-recourse loans require the key principals to have a net worth equal to the size of the loan and have 12 month’s mortgage payments in post closing liquidity. Bridge loans, CMBS loans and private loans are often an exception to this.
If you have very good credit scores you are more likely to get a non-recourse permanent loan, however many non-recourse bridge loans are ok with mediocre credit.
Having more cash in the bank or in publically traded stocks as post closing liquidity will make you a much stronger sponsor for a non-recourse lender.
Even if it is the type of loan that does not typically grant a non-recourse loan, ask the lender to see if you can get one. Remember that if you don’t ask for something, you are getting an “automatic no”.
By Terry Painter/President Apartment Loan Store and Business Loan Store
Multifamily Mortgage Bankers and Brokers since 1997
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