Debt financing is one of the most common methods of commercial real estate investments. It is usually used to purchase or improve a property and can be obtained from many financial institutions including banks, insurance companies, credit unions, pension funds, and private investors.
Commercial lenders typically offer both recourse (debt that can be called due if the property is not repaid) and non-recourse (debt that cannot be called due even if the property is not repaid) debt options to their borrowers.
It is important for investors to understand the difference between these two types of debt before making a decision about which one is best for them. In this article, we highlight the differences between recourse and non-recourse debt options. We will also discuss when it might be advantageous for borrowers to choose one type of debt over the other. And finally, we’ll provide some tips for borrowers who are interested in obtaining commercial real estate financing.
Recourse Debt Options
Definition: Recourse debt is a type of debt that can be called due if the property securing the loan is not repaid. This type of loan tends to benefit the lender. The main benefit of recourse properties is that they are generally easier to obtain. If you have good credit, you should have no problem getting approved for a commercial mortgage worth up to 80% of the market value or purchase price of the property. This means that if something happens and the borrower defaults on payment, the lender can attempt to collect the balance owed by repossessing and selling the commercial property. The benefit of this is that lenders can use their investment capital for all sorts of projects, typically with very little risk.
Another benefit of this type of loan is that you can usually get more competitive debt options as the lender’s risk is reduced.
Common examples: Bank loans and credit union loans are typically recourse debt options.
Non-Recourse Debt Options
Definition: Non-recourse debt is a type of debt that cannot be called due if the property securing the loan is not repaid. This type of loan tends to favor the borrower. The main benefit of non-recourse commercial mortgages is that they come with lower interest rates and stricter borrowing terms. This is because lenders know that if the borrower defaults on their loan, there isn’t much they can do about it.
A problem with this type of debt is that it’s hard to get flexible rates and terms.
Common examples: Commercial mortgage-backed securities (CMBS) are often considered non-recourse loans because they are backed by collateral that is not owned or directly controlled by the lender.
When Might It Be Advantageous to Choose a Recourse Loan Over a Non-Recourse Loan?
Borrowers may find that they can get more competitive rates and terms on recourse loans than non-recourse loans. This is because the lender’s risk is reduced if the borrower defaults on their debt payments since they have collateral (the property) to recover their investment.
If there is no possibility of default then recourse debt has little or no cost implications. The downside to recourse debt is that it makes future borrowing more expensive.
In some cases, borrowers may also want to choose a recourse loan over a non-recourse loan in order to maintain more control over the property. For example, if they are using the property as collateral for other loans or investments, they may not want the lender to have the ability to take possession of the property if it is not repaid.
Recourse loan options are often considered more conservative. Non-recourse debt is typically used by borrowers looking for lower liability solutions without having to put up additional collateral or go through the hassle of verifying all their personal financials as rigorously as a recourse lender will typically require. Non-recourse is also required in some cases depending on how the borrower sets up their entity. In cases in which you have a syndication, most of the time the loan will need to be non-recourse for these borrowers.
When Might It Be Advantageous to Choose a Non-Recourse Loan Over a Recourse Loan?
Borrowers may find that they can get more competitive rates and terms on non-recourse loans than recourse loans. This is because in some cases, these lenders are willing to take on more risk when lending money that will be bundled up and sold into bonds. This moves the risk of these loans on to the buyers of the bonds. Many investors that are buying commercial property will find that the non-recourse loans are limited to loan sizes above $2–3million. So most first-time investors that want non-recourse just simply won’t qualify for it due to the size of the asset they are pursuing. Additionally, many lenders that offer non-recourse want to see that the investors have a net worth equal to the loan amount as well as liquidity sufficient to pay not only the down payment but also what is known in the industry as, “post-closing liquidity”. This post closing liquidity generally is 9–12 months of the loan payments.
In some cases, borrowers may also want to choose a non-recourse loan over a recourse loan in order to protect their other investments. For example, if they are using the property as collateral for a personal loan, they may not want the lender to be able to take possession of the property if they default on their payments.
Tips for Investors Who Are Interested in Obtaining Commercial Real Estate Financing
1) When considering a recourse or non-recourse loan, it is important to understand the difference between the two options and how they may impact your business or investment. This will help you to better assess the risk associated with any potential investments.
2) Make a list of the top priorities of the investment. Is it leverage, rate, long term fixed, flexibility (limited pre-payment penalties). A commercial real estate consultant can advise best options to consider. Compare rates and terms on various financing options before deciding. This is especially important if you plan to use the property as collateral for other loans or investments.