Demystifying Recourse vs. Non-Recourse | LinkedIn.
This question came across my desk yesterday morning: “We’re taking this (commercial) property in X entity and the broker asked me if I need non-recourse financing. What should I tell them?”
This is a great question because 1. it gives us a chance to talk about the creative financing ecosystem without the pressure of a deal bearing down on us and 2. it highlights a question I think a lot of investor owner/operators have about real estate finance. Here’s a paraphrased version of what I shared with him:
Definition: “Non-recourse” means that the bank is entitled to repayment from the profits of the project only. “Recourse” means the bank has the right to repayment from the assets of the borrower if the project doesn’t perform.
As a commercial investment banker, I start every thought involving “recourse” or “non-recourse” with the idea that the borrower needs to be successful. If a borrower’s project fails, then we fail. We need to return to whatever our funding sources are and explain to them why and how we lost their money. That is not good for business, so we take precautions to ensure it doesn’t happen – or when it does, that we can make our funding sources whole again.
Bankers also want, to the extent possible, what’s called “alignment of interest.” Simply put, this means we share the risk and reward.
With these two principles in mind, each financing scenario is unique. Management team experience varies. Markets vary. Security for the loan varies. Terms are negotiated.
Typically, the borrower asks for non-recourse in all scenarios. They perceive that it lowers their personal exposure to risk. The bank may insist upon recourse under some conditions.
If a project fails, the bank needs the option to control assets to try and stop a hemorrhage. Bankers owe it to their funding sources to do everything possible to keep them whole.
The question about the use of non-recourse vs recourse is complicated a little when entities are involved. We add the condition of who or what the bank has a recourse relationship with: the entity or an individual or individuals within the entity.
If an entity is structured as mine are, it may not own anything by itself – or it may be a special purpose entity, owning only one of a portfolio of projects controlled by an individual(s), entity, or trust. If the entity owns nothing beyond the failed project – then going after an entity is a waste of time. If recourse is tied to an individual, the bank might try working with the entity, then go after individual’s assets once it realizes that the entity has nothing to offer that will remedy the situation.
Non-recourse makes sense when the capital outlay is too big for any individual to cover. If a borrower wants $400 mm, for example, it’s not likely that the borrower or the team of borrowers is going to have that kind of money lying around in assets that can be used to recover from a failure. The only way to mitigate losses is to install new management or a execute a speedy exit.
Similarly, if the loan period is long, ownership may change – or if revenue streams fluctuate or are inconsistent, non-recourse may be the way to go. Remember: banks don’t want borrowers to fail, so putting undue pressure on operations or killing exit strategy options isn’t appealing.
To answer a specific question about whether or not to use non-recourse, a banker would need more specifics. They need to know the strength and track record of the general partnership, sources and uses of all funds in the deal, size of the deal, status of the market, soundness of the plan, the exit strategy, etc.
If you understand the motivation a banker has – to structure away the risk in deals and do everything possible to help it succeed – the next discussion you have with your banker might be earlier in the deal process and sound more like a mutually beneficial partnership. I always try to encourage owners / operators and brokers to connect early and keep communication lines open. When the relationship works, money flows and deals get closed.
If you or someone you know has a commercial real estate deal in the making and would like to talk with a commercial real estate investment banker, reach out to us through our Web site at http://MLCcapitalpartners.com. We have a 24 hour rule for responding to your inquiries and would be happy to get to know you better.
TLC FOREX 