Recourse vs. Non-Recourse Loan—What Do They Mean to Real Estate Investors?

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Real estate-secured loans can be broken down into either recourse or non-recourse loans. You may be asking, what's the difference?

A recourse loan permits a lender to seek additional assets if a borrower does not repay their loan. This happens when the amount of the debt is greater than the liquidation value of the collateral.

A non-recourse loan is different from other loans. It only allows lenders to seize the collateral stated in the agreement. The value of the collateral is subject to the bad acts carve out.

In either situation, the loan agreement will define the type of recourse the lender has. A recourse debt gives the lender the authority to demand more from the borrower. This demand exceeds the collateral's worth if the debt cannot be fully repaid.

This blog post will compare these two loan options and further examine their differences.

Recourse loans

A recourse loan is a type of loan where the lender can go after the borrower's assets if the borrower defaults on the loan and there are damages after the lender has foreclosed and liquidated the assets in an attempt to make themselves whole.

To simplify, if you can't pay your loan and the lender doesn't get enough money from the foreclosure and liquidation of the collateral, they can go after your other assets like your car, home, or savings. It can be scary to think about this in a "what if" scenario, even though most people don't plan on defaulting on loans.

Recourse loans are more common in residential real estate transactions. The lender may require a personal guarantee from the borrower when it comes to residential rental properties. This means the borrower is responsible for repaying the loan. The main advantage of recourse loans is that they typically offer lower interest rates and can provide the lender with more comfort with the deal at hand. 

However, the downside is that they can be risky for borrowers because they are personally liable for the loan. This means they could lose other assets if they default on the loan.

In most of the U.S., conventional Fannie Mae and Freddie Mac residential mortgage loans are usually recourse loans. This means that if the borrower fails to repay their mortgage, they must give the lender additional assets. As mentioned, this happens in the event of a default if the lender is not made whole through foreclosure and liquidation of the property or properties. 

Non-recourse loans

A non-recourse loan is a type of loan where the lender cannot go after the borrower's personal assets if the borrower defaults on the loan and the lender is not made whole through the foreclosure and liquidation of the property if the carve-outs were not violated.

In other words, if you default on your loan for some reason, the lender can only seize the property to cover the remaining balance if the carve-out guarantee was not violated.

In commercial real estate transactions, like cross-collateralized rental portfolio loans, non-recourse loans are more common. Used by institutional investors, these loans don't make the borrower personally responsible for repaying damages if the carve-out guaranty was not violated.

Lenders offering this type of loan may require a higher interest rate or more stringent loan structures. The main advantage of non-recourse loans is that they offer the guarantor protection from personal liability.

The borrower's personal assets are secure in the event of foreclosure. The lender will not recover their money if the assets are liquidated, and the carve-out guarantee isn't violated. In other words, the borrower is safe. However, the downside is that non-recourse loans typically offer less flexibility and may be more expensive than recourse loans.

The bad boy carve-out guarantee, also called a limited recourse to carve out a guaranty

When a borrower takes out a non-recourse loan, they may be held personally responsible if the business violates any of the carve-outs in the loan agreement, sometimes called the “bad boy carve-outs”. These typically include, but are not limited to, fraud, misrepresentation, and environmental indemnification.

The bad boy guarantee safeguards the lender from any potential misconduct by the borrower. It's highly recommended to seek legal advice from a certified real estate attorney when evaluating your options. 

What are the differences between recourse and non-recourse loans?

The main difference between recourse and non-recourse loans is the level of personal liability for the Guarantor. In a recourse loan, the Guarantor has personal liability for certain actions. In a non-recourse loan, the Guarantor does not have personal liability. 

Non-recourse financing offers more protection for the borrower, though lenders generally prefer recourse loans. Lenders tend to prefer recourse because it can act as a sign of good faith for the sponsor's investment in the deal.

When taking out a loan, the lender has the right to take possession of the collateral asset(s). This applies in both default and non-default scenarios, regardless of the type of loan. When investing in real estate, property usually secures the loan. 

Recourse financing gives lenders the right to take legal action against borrowers who cannot meet their debt obligations. This action is intended to obtain any additional assets the borrower may have.

Nonrecourse loans protect the borrower from legal action by the lender. If the borrower fails to repay the loan, the lender must accept the difference in debt value. This is only so long as the borrower has not violated any of the bad act carve-outs.

Bottom line

When investing in property, it's important to consider your preference for personal recourse or non-recourse loans. Both have their own pros and cons that should be taken into account.

Recourse loans offer lower interest rates and more flexible terms, but they also come with the risk of personal liability. Non-recourse loans offer protection from personal liability, but they may be more expensive and less flexible than recourse loans.

Ultimately, the choice between these two types of loans will depend on the borrower's financial situation and risk tolerance.

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