If you don’t know the essential aspects of a non-recourse loan, you could be in serious trouble.
Multifamily real estate is a popular investment for investors interested in reliable cash flow, property appreciation, and spreading their risk. As with any investment, money plays a key role. Non-recourse loans are a common financing option used by investors to finance multifamily deals.
Below, we’re diving into the relationship between non-recourse loans and multifamily real estate, expanding on the benefits of this financing option as well as the potential pitfalls investors can fall into if they’re not careful.
So when it comes to non-recourse loans, why should you proceed with caution?
What is A Non-Recourse Loan?
A “non-recourse loan” is a financing option that offers protection to the borrower. In the event that the borrower defaults on the loan, the lender can’t go after any of the borrower’s personal assets aside from the collateral, which is oftentimes the property itself. It’s evident why this is a popular financing option among multifamily investors.
Non-Recourse vs Recourse
A recourse loan is obviously the opposite of a non-recourse loan. With this kind of debt, the lender is allowed to go after the borrower’s personal assets outside the collateral or the property itself in order to make up for the amount outstanding on the loan.
Pros of Non-Recourse Loans
Personal Asset Protection: We’ve already mentioned the first big benefit of going with non-recourse debt. The personal assets of the borrower are protected from angry lenders who want to recover their losses in the event of a loan default. For this reason, investors can take on bigger deals without putting their personal assets on the line. However, this doesn’t mean investors can be reckless or take dumb risks. According to The Tax Advisor, “Bad boy provisions typically provide that liability for a nonrecourse loan will become recourse if the borrower engages in any of a number of "bad" acts, such as declaring bankruptcy.”
Tax Advantages: When it comes to losses, non-recourse debt comes with some tax perks. In some cases, if a property purchased with non-recourse debt sells for a value less than the remaining loan balance, the difference can be reaped by investors without it being taxed at the high rate of “ordinary income.”
Better Debt Terms: Since the borrower has lower risk and liability with non-recourse debt, this type of financing is usually accompanied by better interest rates and loan terms. Lenders place emphasis on the property’s strength and the credibility of the investor, which can often result in favorable debt terms for borrowers who meet the qualifications.
But non-recourse loans aren’t all sunshine and rainbows…
The Dark Side of Non-Recourse Debt
Strict Criteria: Lenders usually require borrowers to meet strict qualifications in exchange for the favorable loan terms they offer with non-recourse debt. This allows them to mitigate the risk that comes with the “non-recourse” nature of this type of financing. These loans might come with bigger down payments, smaller loan-to-value ratios, and in-depth credit history checks.
Interest Rate Hurdles: Interest rates can also be higher with non-recourse loans. The rate charged is usually in correlation with how much risk the lender is taking on with the property and the borrower.
Strings Attached: Since lenders are taking more risk with non-recourse debt, they usually enforce stricture guidelines. For example, certain property management elements may be required, or there may be restrictions on putting more debt on the property.
The Impact of Non-Recourse Debt
Go Big(ger) Or Go Home: Non-recourse loans allow investors to pursue bigger multifamily deals since they aren’t putting their personal assets at risk. This can result in more development and investment in cities and improvements in housing throughout the nation.
Reliability During Recessions: If the economy takes a dip, lenders can’t go after the personal assets of borrowers when it comes to non-recourse loans. This helps curb the potential for a wave of pain throughout the economy, which reflects the strength of real estate even during hard economic times.
The Bigger Picture
Non-recourse debt has spread in popularity and prominence in the multifamily space. It allows investors to benefit from asset protection while also expanding the pool of opportunities they can pursue. The benefits of this financing option are apparent, but they don’t come without their own risks and caveats. Investors need to understand the complexities of this financing option in order to maximize its usage and take advantage of it without surpassing their appetite for risk. As an industry, multifamily promises to continue to evolve and shift, forcing investors to stay on their toes. Non-recourse debt will certainly continue to be at the forefront of the industry, regardless of the changes to come, and will likely have a significant contribution to the changes to come.