What is a Non-Recourse Loan in Multifamily and Commercial Real Estate?
When it comes to multifamily and commercial real estate loans, there are two main types of financing; recourse and non-recourse. When a borrower gets recourse financing, they are typically personally liable if they default on (or do not pay back) their loan. This means that the bank or lender may be able to seize their personal property to achieve repayment of the debt. In contrast, if a borrower has a non-recourse loan, the bank or lender generally can only take back the property as collateral for the debt instrument.
What Types of Multifamily and CRE Loans are Non-Recourse?
In general, CRE loans from GSEs (Government Sponsored Enterprises) such as Fannie Mae multifamily loans and Freddie Mac multifamily loans are non-recourse. HUD multifamily loans are also generally non-recourse.
These agencies structure their loans as non-recourse debt instruments in order to encourage more borrowing by real estate investors, which increases the overall liquidity in the housing market, leading to greater housing industry supply and lower apartment rental prices for average Americans. In addition, most multifamily and CRE loans offered by life insurance companies and CMBS/conduit lenders are also typically non-recourse.
While these lenders generally offer non-recourse financing to borrowers, they also have some of the strictest sponsorship and net worth requirements on the market. They may also be strict when it comes to things like DSCR (debt service coverage ratio), borrower credit scores, and the legal and financial history of borrowers and loan sponsors.
In contrast, most loans from banks and credit unions are full-recourse loan instruments, which means that these lenders could potentially "go after" a borrower's personal possessions or other investments, such as other commercial real estate, stock portfolios, stock in private businesses, or even their car or primary residents. There are certain ways to make this less likely, such as using trusts, however, a full-recourse lender typically wants to see a certain amount of collateral that they can easily access should a borrower default on their loan.
In addition, other common types of full-recourse loan instruments include hard money loans and soft money loans from private debt investors, as well as loans from mezzanine lenders.
What is a "Bad Boy Carve-Out" in a Non-Recourse Loan Agreement?
In the above paragraphs, we mentioned that HUD/FHA, Fannie Mae, Freddie Mac, and CMBS multifamily loans are typically non-recourse. However, there are several exceptions to this rule. Typically, a non-recourse loan will contain counter-guarantees, which are generally referred to as "carve-outs" or "bad boy carve-outs." These protect the lender by making the loan either partially recourse or fully recourse should the borrower engage in certain prohibited "bad boy" behaviors, such as committing fraud, avoiding their property taxes or fees, lying to a lender or insurance company on their personal financial statements (or on property financial statements), failing to pay their insurance policy, or declaring bankruptcy for non-essential reasons (the specific meaning of non-essential being up to the exact language of the carve-out agreement).
What is a Technical vs. Non-Technical Default for Non-Recourse Loans?
Particularly when dealing with CMBS loans, borrowers should be careful to understand that there are actually ways for a lender to declare a loan is "in default" even if the borrower has paid their mortgage payment on time. For instance, a loan agreement could state that a loan will go "into default" should the borrower fail to send in quarterly or annual profit and loss (P&L) statements to their lender. Usually, a mistake like this can be worked out via negotiation with the lender (or, in the case of CMBS, a special servicer), but this is not always the case.
Therefore, when dealing with non-recourse loans, a borrower should always have an experienced real estate lawyer review all the loan agreement documents. Some lenders or loan servicers (though this is not common) may include deceptive or unethical "carve-outs" in their agreement in an attempt to repossess profitable properties, something which could be disastrous for a borrower/investor.
What is Burn-Off in a Non-Recourse Loan?
In certain cases, a loan will start as a full or partial-recourse loan but will revert to a non-recourse loan if the borrower (and the property) achieves a certain level of profitability or occupancy. In many cases, commercial and multifamily construction loans may start as a full recourse loan, but as the property meets certain checkpoints (such as construction loan draws following building inspections) the recourse slowly "burns-off" or is removed, in stages, from the loan agreement.
Other "burn-off' requirements could include achieving a certain property DSCR or a certain level of occupancy, such as 85% or 95%.