The last couple of years have shaped up to be a success for liquidity in commercial real estate. Investors have been busy acquiring and refinancing income producing properties due to a historically low yield environment. These investors often find themselves looking at two financing options; loans with recourse and loans that are based on non-recourse basis.
- Recourse loans generally give the lender the ability to collect the difference between the sales price of the property and the amount owed to the lender from the borrower(s) should the lender take back the property and sell it for less than the amount owed. The borrower essentially guarantees full repayment of the loan amount.
- Non-Recourse loans generally preclude the lender from collecting any shortfall between the sale of the property and the amount that is owed to the lender. The lenders source of repayment is the actual property that was pledged as collateral in the loan documents.
There are other characteristics that exist between recourse and non-recourse loans such as pricing, flexibility, servicing and prepayment structure, among others. We will discuss the pros and cons of each option in greater detail.
Whether an acquisition or a refinance, every commercial real estate investor has a different financing objective for their income producing property. First let’s try to understand what financing institutions provide these loans. Generally, the three primary lenders that finance commercial properties include:
- Commercial Banks
- Life Insurance Companies
- Conduit (CMBS) Lenders
Each of these lenders has a different capital source and employs its own unique underwriting criteria. Commercial banks for example, obtain funds from depositors while life insurance companies generally draw their funds from policyholders to inject it into the loans they make.
Conduit lenders (CMBS) typically pool a large amount of mortgages into a single security and sell the interest of these pools in the open market through a process called securitization. In the case of CMBS financing, lenders require that the borrower be an SPE (Single Purpose Entity) that holds title to the real estate but does not hold additional property under same SPE or any encumbrances associated with it. The SPE is usually a limited liability company “LLC” or a Corporation “(Corp).
Most of the recourse loans are originated by commercial banks, comprising nearly half of the overall commercial real estate lending market. Life insurance companies and CMBS lenders are the driving force behind non-recourse financing. Multifamily properties are generally financed through government sponsored entities (GSE) such as Freddie Mac, Fannie Mae and FHA. The government agency loan programs mirror that of a CMBS lender, as it relates to benefits and drawbacks of such loans.
Main Characteristics of Recourse and Non-Recourse Loans.
The benefits of obtaining a recourse loan include flexibility of the loan structure, a personal banking relationship (since most banks service their own loans in-house) and at times a lower interest rate, depending on the banks appetite for risk and its cost of funds. What makes the full recourse loan unattractive to some borrowers, is the personal liability aspect that is associated with these loans. Recourse loans from commercial banks also impose limitations on maximum Loan-to-Value LTV ratios and use shorter amortization periods when compared to CMBS loans.
There are also pros and cons in financing an investment property through a CMBS conduit. The positive attributes include the non-recourse nature, higher leverage (LTV), longer amortization period and ability to finance out-of-state borrowers with properties in secondary or tertiary markets. Conduit lenders can also offer full term interest-only loans at the right leverage. Novice real estate investors would likely have an easier time getting financed via CMBS than a balance sheet recourse lender.
Although there are positives in financing a property through a conduit lender, there are also drawbacks that need to be considered. Non-recourse borrowers need to be aware of the standard “bad boy” carveout provisions – describing certain events which, if they occur, can create partial or trigger a full recourse liability. Such carveouts generally include bankruptcy, illegal or unethical practices such as fraud, misrepresentation and willful dumping of waste at the property. There are several other triggers that focus on “bod boy” acts. Since the loan is non-recourse, the lenders attempt to protect themselves and their collateral. The range of these carveouts vary by lender.
Prepayment flexibility can be an issue for some borrowers when dealing with a CMBS lender. On a fixed-rate 10-year term loan, there is usually a 2-year lock out on prepayment of the loan followed by defeasance. This is a form of prepayment penalty, even though it technically isn’t. Simply put, by defeasing a loan, the borrower substitutes the collateral that the loan is made against with a U.S. Government security instrument that would yield the same return to the bond holders that bought into the loan upon securitization. This substitution allows the borrower to replace the lien on the property with an acceptable security.
Another component to CMBS loans that needs to be considered is the servicing of the loan post-closing. Because conduit lenders usually sell the loan after it closes, the servicing of the loan is conducted by a third party vendor. Unlike portfolio recourse lenders and life company lenders who service their own loans in-house, conduit lenders typically outsource this assignment.
Pricing and Loan Structure
Recourse and non-recourse lenders often use different benchmarks when pricing their loans. Balance sheet recourse lenders generally price their loans with a spread over an index rate, such as Prime Rate or LIBOR (London Interbank Offered Rate). It is common for recourse lenders to offer borrowers a floating rate product, which in a low-yield interest rate environment can be attractive. Borrowers can also opt to buy an interest-rate cap that would prevent the interest rate from exceeding a certain threshold should the market rates spike. Even though floating rate loans are exposed more to market and interest rate risks, they generally do not have prepayment penalties and can be refinanced without a big financial burden on the borrowers part.
Traditional Life Insurance Company and Wall St., conduit lenders price their loans with a specific spread over a corresponding Swap or U.S. Treasury benchmark. If the borrower opts out for a 10-year fixed-rate loan for example, the spread would be based over a 10-year Swap or U.S. Treasury. Both lenders can offer floating rate financing but are predominantly issuing fixed-rate loan products.
Life Insurance Company lenders have the ability to offer more flexibility in pricing and early prepayment structures because they are able to hold the loan on their balance sheet, unlike CMBS lenders that ultimately securitize their pool of loans into bonds. While many investors vie for life insurance company financing for these reasons, it is important to note the complexity of being approved by one because of the life company’s stringent requirement of financing higher quality properties (Class A/B+) at lower LTV levels (generally tops out at 65%). In addition, life company lenders place a lot of emphasis on the strength of the borrower, stronger demographics and prefer properties that feature a diversified tenant roster with long-term leases.
Post-Closing With Recourse and Non-Recourse Lenders
Because recourse lenders have the personal guarantees of their respective borrowers, they generally forego the requirement of establishing a lock box, escrows and impound accounts. Certain life companies act in similar fashion because their loans are conservative and often range between 50-65% LTV. As mentioned previously, recourse lenders retain their servicing and continue to communicate with the borrowers directly.
CMBS lenders on the other hand, generally require lockbox and escrow/impound accounts to be set up prior to loan closing. Once a loan is securitized and sold, the management and oversight will be conducted by a third party servicer that acts on behalf of the bond holders as their fiduciary.
Loan Assumption Upon Sale
Commercial banks, CMBS and life insurance companies are often able to provide borrowers with loan assumption rights upon a sale of the property. This is something that gets pre-negotiated into the loan documents prior to the closing of the loan and generally carries a set fee that could range between .50%-1% of the loan amount. The new buyer would have to be qualified and approved by the lender. Loan assumptions may provide several advantages to a prospective buyer:
- Buyer can save time and money since obtaining new loans can be costly and certainly time consuming.
- Buyer can benefit from a lower interest rate if the prevailing market rates are higher.
Investors may want to consider a recourse loan if they:
- Want the flexibility to customize the loan structure and pricing
- Want the potential to modify or restructure the loan post closing
- Want to limit prepayment issues
- Do not want to divert cash flow to escrow or impound accounts
- Are investing in distressed properties or new construction
Investors may want to consider a non-recourse loan if they:
- Do not want to provide personal recourse for repayment
- Plan on holding the property for the length of the loan
- Don’t expect to change or modify the loan during the term
- Are comfortable with diverting property cash flow to escrow or impound accounts
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