By Terry Painter, Mortgage Banker
Member of the Forbes Real Estate Council
What is the difference between a non-recourse loan and a recourse loan, and which is best for you?
A Non-Recourse Loan is made to a single asset ownership entity like an LLC. If the property fails, the lenders only recourse is to take the property back. A Recourse Loan is made to an individual(s) required to sign a personal guarantee. After a foreclosure and the lenders sale of the property, should there be a deficiency (property sold for less than owed), the lender can obtain a court judgment to go after any of the borrowers personal assets to make up the deficiency.
For this article we are referring to recourse and non-recourse loans primarily in the commercial real estate industry.
Why is it that the financial advisors, real estate attorneys, and estate attorneys of wealthy owners of commercial properties insist that their clients only get non-recourse financing? The Bottom line is that for every recourse loan you take you risk the wealth that you have worked so hard to accumulate, and your children’s inheritance as well.
On the other hand, if you are just getting started investing in commercial real estate and do not have many other assets, a non-recourse loan from a community bank may be easier for you to obtain and have lower loan costs. You will also have more lenders to choose from with a recourse loan.
Five Reasons Why A Non-Recourse Loan Might Be Right for You
1. Non-Recourse Loans Do Not Require Personal Guarantees — The personal assets of the borrower are at risk with a recourse loan because the borrower(s) always sign a personal guarantee. If there is a default, the lender can use a court judgment to put a lien on any of your personal assets except your retirement accounts or private residence that is homesteaded. This includes your bank accounts, security accounts, home, vacation home, cars, boats and even your child’s 529 education account. And, do not forget that when you filled out the lender’s loan application you listed all the items you own as assets. Therefore, they know what to go after should you stiff them. Banks especially like it when a borrower has many assets. This is an insurance policy for them. Furthermore, the bank will require you to update your list of personal assets annually (annual reporting requirements) so they always know what to go after should you default on their loan.
If there is a foreclosure, the lender will sell the subject property likely at a public auction. If they receive less than what you owe, they can get a court judgment to go after any or all of your personal assets to make up this deficiency. They can also add to this deficiency: delinquent property taxes, back mortgage payments, real estate commissions, as well as expenses for maintenance and management of the property during the time the property is being sold by the lender. Also included are court costs and bank’s attorney fees.
2. The Recourse Loan Documents Could Mandate a “Non-Judicial Foreclosure” and a “Power of Sale Clause” — This means that the bank can foreclose outside of the court system, which for example is legal in Oklahoma. This means that the lender does not have to file a lawsuit in order to initiate foreclosure.
3. A Recourse Lender Can Quick Sell Your Property — After a foreclosure with a recourse loan a lender might choose to just sell a property quickly and not wait to get a fair price. Community Banks often do this if bank regulators are pushing them to get non-performing loans off their books. A commercial property could have a fair market value of $2.4 million and have a loan principal balance of $1,900,000. If the lender should get a quick $1.4 million dollar offer and take it, this would leave the property owner with a $500,000 deficiency to make up from their other assets.
4. A Non-Recourse Loan Could Be Better For Estate Planning. For estate planning it is important to know that upon your death, if you have a recourse loan, your heirs might not qualify to assume your loan or even refinance with another lender. With your existing recourse loan, they will have to qualify under the same terms you did. If they do meet the credit, cash, income or net worth requirement the lender can call the loan. At a minimum they will have to reapply and sign a guarantee. The loan guarantee you signed is worthless. With non-recourse financing the loan was made to the single asset entity (such as an LLC). When you pass on, your heirs inherit the LLC. As long as the LLC keeps making the loan payments, the loan keeps going.
5. Investing Your Income Property in a Self Directed IRA — You can only do this with a non-recourse loan as required by the federal government. Investing your retirement funds in income producing property can be an intelligent move since rents usually increase faster than inflation and your cash on cash return is usually higher. This avoids the roller coaster ride of the stock market.
Six Reasons Why a Recourse Loan Might Be Right For You:
1. You Do Not Have Commercial Property or Income Property Ownership Experience – Since non-recourse loans are made to the property they really want to make sure the key principals have experience owning and or managing similar properties. So it is easier to get started with a recourse bank loan or a private recourse loan.
2. You Do Not Have the Net Worth, or Liquidity Requirement for Non-Recourse Financing – A recourse loan from a commercial bank is more likely to let this slide – especially if you have other qualifications that mitigate. These include that you are a customer of the bank, you have more than one deposit account with the bank, you have good income, more than one income in the family and excellent credit. You do not have to have all of these, but the more, the better. Non-recourse lenders prefer the key principals to be strong financially. Usually, you need to have a net worth equal to or greater than the size of the loan, and 10% of the loan amount in post-closing cash.
3. Recourse Loans Usually Have Lower Loan Costs – Non-Recourse loans almost always have higher costs for third party reports such as the appraisal, environmental report and property condition report. But the highest loan expense will most likely be lender legal which can run over $10,000. Commercial bank recourse loans seldom charge the borrower for legal.
4. Recourse Loans Do Not Require Replacement Reserves – Replacement reserves required by many non-recourse lenders are rainy day repair savings accounts. Based on the age and condition of your investment property, you are required to put from $150 to $400 per unit per year towards repairs and replacements weather you need them or not. This money is added to your loan payment each month and adversely affects your net cash flow. This is still your money to use for repairs, but instead of you controlling it, the lender does. Let’s say one month you have a hot water heater that needs to be replaced in one of your apartment units. That same month you do some roof repair. Well, you get these done with your own money and then send a request with receipts to the lender to get reimbursed. A month or more later, the lender sends you a check from your replacement reserve account.
5. There Are Many More Recourse Loan Programs to Choose From – there are over 78,000 bank branches in the United States that make commercial real estate loans and investment property loans. Many of them are regional banks and can lend outside of their geographic location. They love and need deposit relationships, so putting your personal and investment property bank accounts with one of them can grease your chances of getting the loan you want.
Most bridge lenders, and hard money lenders require recourse. There are many more of them to choose from than non-recourse hard money and bridge lenders.
6. Non-Recourse Lenders Require Larger Loans – If your loan request is under a million dollars, it will be difficult to find a non-recourse loan program. Many more recourse lenders welcome smaller loans. Community Banks will welcome a investment property loan under $100,000.
By Terry Painter/President Apartment Loan Store and Business Loan Store