In the case of non-recourse commercial loans, the bank’s only way to recoup lost investment and yield in the event of a default is through the property itself and the income the property generates.
Understanding Non-Recourse Loans
If a borrower takes out non-recourse commercial financing, they are not personally liable if they default on their loan. Instead, the lender may only repossess and sell the property in order to recoup their losses. Non-recourse loans are the opposite of recourse loans, which allow a lender to seize and sell a borrower’s personal property. Most bank loans, mini-perm loans, and commercial construction loans are typically recourse loans, while CMBS financing, Fannie Mae® and Freddie Mac® multifamily loans, mezzanine loans, life company loans, and HUD multifamily loans are generally non-recourse financial instruments.
Recourse vs. Non-Recourse Loans
Recourse loans require the personal guarantee of the borrower(s) so that in the event of loan default if the bank doesn't recoup their full investment from selling the property, the borrower and their personal assets are on the line for the remainder of the funds to make the bank whole.
In the case of non-recourse commercial loans, the bank’s only way to recoup lost investment and yield in the event of a default is through the property itself and the income the property generates. This is obviously an advantage for borrowers, because who wouldn’t want less risk and exposure? Conversely, non-recourse loans carry significantly higher risks for lenders and investors.
How to Qualify for Non-Recourse Financing
Because of the increased risk of non-recourse financing, commercial lenders often only accept certain property types and classes for non-recourse financing. For example, a Class A office or multifamily property in a major MSA (i.e., New York or Los Angeles) may easily get a non-recourse loan, while a Class B retail property in a tertiary market is unlikely to qualify. Property income — both past and present — is also a determining factor, as well as the requested amount of leverage. In general, non-recourse loans typically have a higher interest rate than their recourse counterparts.
Non-recourse commercial mortgage loans are also generally only available to borrowers that are very strong financially. In these cases, a default is significantly less likely because the borrower has the financial means to make sure that the property’s income is used for the property. Commercial mortgage lenders will also require a very experienced borrower for making a non-recourse loan.
Non-Recourse Loan Burn-Offs
In certain situations, a lender may issue a recourse loan that will become non-recourse if the property meets certain conditions. For example, if a property has only 60% occupancy, but has been purchased by a new owner with superior management skills, a lender may issue a recourse loan that will become non-recourse if the property reaches 90% occupancy for a certain period of time (often 3 months). In most situations, the property will also have to hit a certain debt service coverage ratio (DSCR) for the same period of time, often 1.20x or 1.25x.
This is called a burn-off, as the recourse “burns off” when the metric is reached. Burn-offs are also common for commercial construction loans, as it’s highly risky for a lender to offer fully non-recourse financing when a property does not yet have any income.
“Bad Boy” Carve-Outs and Non-Recourse Debt
To sum things up, non-recourse loans are harder to get but are very much the norm in the market of commercial loans over $5–$10 million. There is one caveat: most non-recourse loans come with bad boy carve-outs, which give the lender full recourse if a borrower is negligent or does anything fraudulent. Fraudulent activity in this scenario could equate to a borrower materially misrepresenting their financial strength to the lender, intentionally declaring bankruptcy, failing to pay their property taxes, or failing to maintain required insurance coverage. These carve-outs can quickly convert a non-recourse mortgage loan into a full-recourse loan.