Are Commercial Real Estate Loans Nonrecourse?
Your business is booming and you are looking to move your business into a newer, larger space. Maybe you are a commercial real estate investor looking to purchase property. Regardless of the reason why you are purchasing commercial real estate, you may need to secure financing for the purchase.
Most loans require you to put up collateral to back the loan against default. Should you default, the lender can go after you, personally, for any outstanding debt on the loan. These “traditional” loans are called recourse loans. However, did you know there are non-recourse loans that protect your personal finances are available for your commercial real estate purchase?
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What Is a Non-Recourse Loan in Real Estate?
Non-recourse loans are commercial loans that prevent the lender from pursuing the full value of the loan in the event of default. They tend to benefit the borrower while recourse loans benefit the lender. However, both types of loans require the borrower to put up collateral to be liquidated should the borrower not pay back the loan.
For example, say a business owner obtains a non-recourse loan for $750,000 for a commercial real estate property purchase. During the next eight months, commercial real estate property values decline as businesses are moving elsewhere. The business defaults on the loan and the lender takes possession of the collateral (the commercial property). When the lender takes possession of the property, it is worth only $525,000, but the lender can’t collect the remaining amount from the borrower and its personal guarantor.
Most lenders require all individuals who own 25% more of the business or asset to be guarantors for the loan. There are non-recourse loans options for a real estate purchase, though it will take more effort to find lenders who will be willing to make these riskier loans.
How Does a Non-Recourse Loan Work?
Non-recourse loans work like a typical recourse loan, but are typically reserved for borrowers with high credit scores. First the borrower must put up collateral, then they obtain access to the necessary capital. Non-recourse commercial real estate loans are uncommon, as they limit the lender’s ability to recoup the full amount of the loan should the borrower default. With lenders wanting to ensure they get their money back, many are hesitant or refuse to offer non-recourse loans.
Borrowers, on the other hand can benefit from non-recourse loans as they will be protected from personally paying the remainder of their defaulted loan. This can be a great benefit for small business owners or family owned business owners who would otherwise be forced into bankruptcy to pay back the remainder of the loan if they lack a financial buffer.
There are some caveats to non-recourse loans that borrowers need to be aware of. Non-recourse loans come with higher interest rates than recourse loans. Defaulting on a non-recourse loan will also damage your credit like it would for a recourse loan. A large hit to a borrower’s credit score can make obtaining future loans with good interest rates more difficult. In most cases non recourse loans require a large equity contribution by the borrower and lower debt to equity ratio.
What is the Difference Between a Recourse and Non-Recourse Loan?
The main difference between a non-recourse loan and a recourse loan is that for a non-recourse loan, the lender cannot go after the lender for any outstanding debt the collateral does not cover. The lender, in essence, takes a loss on the outstanding unpaid loan amount. While a non-recourse loan offers protection to the borrower, it comes with the trade-off of higher interest rates and more strict qualifications.
Are Commercial Real Estate Loans Non-Recourse?
While non-recourse loans do exist for commercial real estate, they are harder to find and tend to apply only to certain types of commercial real estate loans. Non-recourse commercial real estate loans are also offered by select lenders.
Small Business Loans
A small business loan is commonly used for business owners who want to purchase commercial real estate. However, because of the risk, lenders will require borrowers to pay back the entirety of the loan amount, making these recourse loans. The business owner signs a personal guarantee that allows the lender to come after and liquidate their personal assets including real estate and personal bank accounts to repay the loan amount.
There are traditional and non-traditional small business loan lenders. Traditional lenders consider the guidelines set by the Small Business Association while non-traditional lenders have their own set of qualifications. Regardless of which avenue you pursue, the common qualifications include:
- A demonstration of the business’ capacity to repay the loan
- The business’ its creditworthiness
- The amount of collateral available
- How the business currently pays off debt
- The amount of equity the business owner has invested in the business
- The amount of working capital.
Additionally, the following financial statements will be required when applying for a small business loan:
- Balance sheets
- Overall net-worth
- Business and personal financial statements
- Business Plan
Since it’s hard to predict how business will do, lenders will often work with small business owners who default on their loans. Each lender has different procedures on dealing with borrowers who default, but common practices include implementing a grace period and setting up a loan repayment-restructuring plan.
Institutional Loans from Insurance Firms
An institutional loan is another option for obtaining commercial real estate. Unlike small business loans, there are institutional loans that are non-recourse. Each lender has different qualifications, but they often include a borrower’s creditworthiness, available collateral, and their ability to pay back the loan.
There are some financial institutions which offer non-recourse loans both locally and nationwide. These institutions have stipulations on what type of property the loan can be applied to. With the added risk of small business ownership and the possibility of not recouping the full value of the loan amount, many institutions only grant non-recourse real estate loans to private residences and apartment complexes.
For better luck of finding a non-recourse loan for your commercial real estate property purchase, try non-traditional lenders. The most common non-recourse lenders are private individuals and angel investors. As with small business loans and institutional loans, the qualifying requirements differ from lender to lender.
Another way to secure a non-recourse commercial loan is through a self-directed individual retirement account (IRA). A lender extends credit to your IRA, which can then be used to purchase a property. Should you default, our own funds in your IRA are safe from collection, and the lender may only obtain your property.
Non-recourse loans are better options for businesses looking to buy commercial property for their own use. Though non-recourse loans will have higher interest rates and are harder to find and qualify for, they will protect the personal assets of the business owner in the event of default. Recourse loans are better for commercial real estate investors who can put multiple properties up as collateral should they default on the loan. Consider your own needs carefully and the future prospects of your property before making a commitment.