Recourse vs. Non-Recourse Commercial Loans
Non-recourse loans have lower risk to the borrower, but typically these loans have higher costs. Understand which type of loan works best for you with our guide.
Recourse vs. Non-Recourse Loans
At its core, the difference between the two types is relatively straightforward: If a borrower defaults on a recourse loan, a lender can pursue the borrower’s personal assets and cash flows — even wages — if the collateral is insufficient to cover the outstanding debt. With a non-recourse loan, the lender is limited to the collateral itself to recoup losses.
An Example of Recourse and Non-Recourse Financing
Let's use an example: Sarah owns a small apartment building, and she is making payments on a recourse loan with a principal of $2 million. Because of severe vacancy issues, Sarah can no longer afford to make her monthly debt service payments. The lender decides to foreclose on the property.
However, let's say the property's value is only $1.5 million. That leaves the lender $500,000 in the hole — and because it's a recourse loan, they can go after Sarah's personal assets. This could mean her wages, her own home, or another investment property in her name.
But what if that were a non-recourse loan? Using this same example, once the lender foreclosed on the apartment building, that's the end of it. The lender would not have any possibility to pursue Sarah's wages or assets, unless the borrower had acted in bad faith (e.g., fraud or misrepresentation).
What Loans Are Non-Recourse?
Typically, most bank, bridge and construction loans are recourse, while Fannie Mae, Freddie Mac, HUD/FHA multifamily and CMBS loans are generally non-recourse.
Because of the difference in risk to borrowers and lenders, there are some key differences in loan terms and requirements. In brief:
Recourse Loan | Nonrecourse Loan | |
|---|---|---|
Risk Profile | Riskier for borrowers | Riskier for lenders |
Default Event | Lenders may pursue a borrower's personal assets | Lenders may generally only pursue a loan's collateral. |
Borrower Profile | Typically less experienced | More experienced, financially stronger |
Interest Rate | Generally lower | Generally higher |
Asset Types | Any | Often restricted to "strong" assets and locations |
LTV | Generally higher | Generally lower |
Examples | Most bank loans, bridge loans, construction loans | Most Fannie Mae®, Freddie Mac®, CMBS loans |
While borrowers broadly prefer nonrecourse financing, lenders favor recourse loans due to lower risks. Due to this imbalance, these types of loans tend to have rather different terms associated with them.
Different Loans for Different Assets
While recourse loans are widely used for most asset classes, nonrecourse lenders are typically far more selective, generally opting to finance stronger, lower-risk properties with one eye fixed on a market’s overall strengths and outlook.
For example, the owner of a stabilized Class A multifamily property in Manhattan may have little trouble landing a nonrecourse loan, but a first-time investor seeking a hotel refinance in suburban Boise, Idaho, would likely have little choice but to look to recourse financing.
Non-Recourse Loans: Not for Everyone
Because of the higher risk to lenders, nonrecourse loans carry with them stricter terms. A Federal Reserve study from December 2021 estimates recourse loans have interest rates an average of 52 basis points lower than their nonrecourse counterparts. Similarly, LTV ratios tend to be 2.8% higher in recourse loans — enabling borrowers to increase leverage.
In a similar vein, the criteria used by lenders to qualify borrowers also may vary significantly. An experienced borrower with a proven investment strategy will typically be in a much better position for a nonrecourse loan compared to a first-time commercial property owner.
Non-Recourse Burn-Off
In some situations, a lender may originate recourse financing that may transition into a non-recourse loan once certain conditions have been met.
For example, let’s say an investor takes a recourse loan to acquire and upgrade a dated multifamily asset. The lender may stipulate that the financing can become a non-recourse loan once the property has stabilized at, say, an occupancy rate of 90% or higher for a three-month period following capital improvements. In most situations, the asset will also need to achieve a certain debt service coverage ratio, or DSCR, during that same timeframe: usually 1.20x or 1.25x.
This type of loan has what is known as a burn-off provision, as the recourse element of the financing effectively fades away when the property reaches the determined metrics. Commercial construction financing packages frequently include these provisions, due to a lack of property income prior to a building’s completion.
Understanding Liabilities in Recourse Loans
When taking out a recourse loan, it is important to understand the potential liabilities that could arise. Recourse loans are typically riskier for borrowers, as lenders may pursue a borrower’s personal assets in the event of default.
This means that if the collateral is insufficient to cover the outstanding loan amount, a lender could attempt to recover losses by going after a borrower’s personal assets, including wages. It is therefore essential that borrowers understand their personal liability and exposure when taking out a recourse loan.
Additionally, borrowers should be aware that certain activities, such as fraud or misrepresentation of financial strength, could trigger a bad boy carve-out, which would allow the lender to pursue recourse options. Knowing the potential liabilities associated with a recourse loan is critical for any borrower looking to explore their commercial real estate finance options.
Bad Boy Carve-Outs
Non-recourse loans also generally have provisions to convert into recourse loans. Under provisions known as bad boy carve-outs, a lender can change a loan to full recourse should the borrower engage in activities including fraud, misrepresentation of financial strength, intentionally declaring bankruptcy, or failing to keep necessary insurance policies in place.
Be sure to carefully read any such provisions in your loan document, as they are not always structured exactly the same.
Related Questions
What is the difference between recourse and non-recourse commercial loans?
The difference between recourse and non-recourse commercial loans is that with a recourse loan, a lender can pursue the borrower’s personal assets — even wages — if the collateral is insufficient to cover the outstanding debt. With a nonrecourse loan, the lender is limited to the collateral itself to recoup losses.
Typically, most bank, bridge and construction loans are recourse, while Fannie® Mae®, Freddie® Mac®, HUD/FHA multifamily and CMBS loans are generally nonrecourse — though exceptions are not rare.
Because of the difference in risk to borrowers and lenders, there are some key differences in loan terms and requirements. In brief:
Recourse Loan Nonrecourse Loan Risk Profile Riskier for borrowers Riskier for lenders Default Event Lenders may pursue a borrower's personal assets Lenders may generally only pursue a loan's collateral. Borrower Profile Typically less experienced More experienced, financially stronger Interest Rate Generally lower Generally higher Asset Types Any Often restricted to "strong" assets and locations LTV Generally higher Generally lower Examples Most bank loans, bridge loans, construction loans Most Fannie Mae®, Freddie Mac®, CMBS loans While borrowers broadly prefer nonrecourse financing, lenders favor recourse loans due to lower risks. Due to this imbalance, these types of loans tend to have rather different terms associated with them.
What are the advantages and disadvantages of recourse commercial loans?
The main advantage of a recourse loan is that it can enable a borrower to access more capital than a non-recourse loan. This is because the debt is tied to the borrower’s income or total assets, which can be used to secure the loan. This can also result in lower interest rates, as the lender is taking on less risk.
The main disadvantage of a recourse loan is that the borrower is personally liable for the loan. This means that if the loan defaults, the lender can pursue the borrower’s personal assets or income to recoup the debt. This can be a significant risk for borrowers, especially if they are unable to pay back the loan.
What are the advantages and disadvantages of non-recourse commercial loans?
The main advantage of a non-recourse loan for borrowers is the lack of any personal liability. If a loan defaults, the borrower can effectively walk away, after all. Another advantage of a non-recourse loan is that it can enable an investor to borrow more. This is because the debt isn’t tied to the borrower’s income or total assets — as they aren’t involved in non-recourse financing. With recourse debt, banks and other lenders can place a cap on how much debt they can accept, relative to an investor’s personal income. Finally, non-recourse loans can be significantly less complicated for a syndication or partnership.
The main disadvantages of a non-recourse loan are tied to the loan terms a borrower can receive. Because the risks to a lender are higher than with recourse debt, a lender will typically pass this on in the form of higher interest rates, or lower loan amounts relative to the property value to offset the risk. This typically makes non-recourse financing more expensive. Essentially, borrowers of non-recourse debt are paying the lender to shift the debt burden to the bank, credit union, life insurance company, or other lender.
Another potential disadvantage is tied to exceptions to the non-recourse clause in the loan. While it’s true that a lender generally cannot pursue a borrower’s personal assets or income outside of the property itself, most non-recourse loans include language for what are known as bad boy carve-outs. These provisions essentially state that, should the borrower misrepresent a property or themselves, or file fraudulent financial documents — like tax returns or financial statements — the borrower is no longer protected by the non-recourse clause and is fully responsible for the loan. They may also cover other acts, such as raising subordinate financing when it’s not allowed, or even paying real estate taxes late.
What types of properties are eligible for recourse commercial loans?
Recourse loans are widely used for most asset classes, including office, multifamily, retail, and industrial properties. Generally, any property type can qualify for a recourse loan, but the lender may require a higher interest rate and more stringent qualifications. For example, a Class B retail property in a tertiary market may have to pay a higher interest rate than a Class A office or multifamily property in a major MSA. Property income — both past and present — is also a determining factor, as well as the requested amount of leverage.
Sources: Recourse vs. Nonrecourse Commercial Loans, Non-Recourse Loans, The Bay Area's Multifamily Challenges, Commercial Mortgage Lenders
What types of properties are eligible for non-recourse commercial loans?
In order to qualify for non-recourse financing, commercial lenders often have strict eligibility requirements. Most non-recourse programs can only be utilized for the financing of certain property types and classes. For example, a borrower might find it much easier to secure non-recourse financing for a class A office or multifamily property in a major MSA (i.e. New York or Los Angeles), while a class B retail property in a small market is likely to not qualify for non-recourse lending. Source and Source.
What are the requirements for obtaining a recourse or non-recourse commercial loan?
In order to qualify for a recourse or non-recourse commercial loan, lenders typically require a borrower to have a strong financial profile and ample "skin in the game". Additionally, the requested amount of leverage and the income that a commercial property produces (both past and present) are also determining factors. Non-recourse commercial mortgage loans tend to have higher interest rates than their recourse counterparts, and are also generally only available to borrowers that have a very strong financial profile. A Federal Reserve study from December 2021 estimates recourse loans have interest rates an average of 52 basis points lower than their nonrecourse counterparts. Similarly, LTV ratios tend to be 2.8% higher in recourse loans — enabling borrowers to increase leverage.