By Fred Matera, CIO, Redwood Trust A lack of affordability will lead to near-term weakness,…
by Ramsey Kassih
One of the greatest advantages of utilizing private lenders when investing in real estate is that some of these lenders, CoreVest included, offer non-recourse debt.
Recourse vs Non-Recourse
To understand the benefits of non-recourse, it is first important to understand what the difference between recourse vs non-recourse is. The distinction comes down to whether the borrower will need to sign a personal guarantee. A personal guarantee is a legal promise to repay debt taken on by a business. This means that if the business is no longer able to repay the loan, the individual is responsible to pay off the balance. With a recourse loan, the borrower signs a personal guarantee. With a non-recourse loan, they do not sign a personal guarantee. At a fundamental level, the distinction between the two would only come into effect during a default scenario.
During a default scenario with a recourse loan, if a balance is still owed after the collateral real estate is sold, then the lender would be able to go after the borrower’s personal assets such as their primary house, additional real estate investments, retirement accounts, etc. until the lender is made whole and the debt is paid in full.
On the other hand, during a default scenario with a non-recourse loan, the lender does not have the ability to pursue the borrower’s personal assets even if money is still owed after the collateral real estate is sold. In this scenario, the lender is assuming a higher risk since they would take on losses if the sale of the collateral real estate does not cover the total debt.
Benefits of Non-Recourse Debt
The most obvious benefit of non-recourse debt is the decreased liability the borrower would take on. Simply put, the business or real estate stands alone. The borrower’s personal assets are not in potential jeopardy if the business or real estate does not perform as expected. This allows real estate investors the ability to take on calculated risks without having to worry that their personal property and assets may be taken from them.
Many investors are confident in their ability to service the debt they take on. They may think the benefit of non-recourse is not applicable to them since the benefit of non-recourse only comes into play in a default scenario, right?
Wrong. Continue reading below.
Non-Recourse Can Allow Investors to Borrow More
This likely goes without saying, but the ability to borrow more is a huge advantage since leverage is one of the greatest benefits of investing in real estate. This may be the most significant benefit of non-recourse debt, especially for those looking to scale their real estate investment portfolio.
The reason non-recourse debt provides this benefit is because these loans do not count towards an individual’s personal credit or debt-to-income ratio since there is no personal guarantee. This is significant because traditional lenders, such as banks, will track in detail a borrower’s existing personally guaranteed liabilities when factoring in whether the borrower has additional bandwidth to take on more financing.
Different lenders and banks have different upward bounds or debt-to-income ratios they underwrite to. But they will only allow an individual to take on so much recourse debt before they will stop providing financing. This causes an issue for many real estate investors using traditional recourse financing. As they grow their rental portfolios and take on more debt, at some point banks will no longer want to lend to them based on their high existing personal debt-to-income ratio.
It is common for investors who hit this upward bound to refinance their real estate assets into non-recourse loans. In doing so, their recourse loans would be paid off and they would affectively “clear their deck”. Their existing personally guaranteed liabilities have been dwindled down to their primary residence and car payment. They now have access to all financing avenues again as they look to continue growing their portfolio. This is how non-recourse debt allows investors to continue growing their real estate portfolios.
Better for Partnerships and Funds
Non-Recourse loans are less complicated for partnerships or syndication investors. If a partnership is pursuing a recourse loan where a personal guarantee is required many concerns arise that are tough to sort out. Who signs the personal guarantee and takes on the liability? Does one partner sign? Do all? These are questions that can be tough to sort out. For syndications or fund type structures where there are many investors who invest their capital together, it is likely that no one individual would feel comfortable personally guaranteeing a loan for the collective.
It gets even more complex when one partner has more assets than the others. That partner would view themselves as a higher risk for being a target in a default scenario. Non-recourse debt avoids these issues since the real estate would stand alone.