Recourse And Non-Recourse Debt In The Commercial Real Estate Context

The coming banking crisis, and suggestions of an incoming bust in commercial real estate, has given rise to some questions about recourse versus non-recourse debt and what impact the differences in those types of debt may have on these areas of the economy. The bottom line is that it probably will not make much difference, if indeed any, to the banking crisis, but it may have some probably slight consequences for the commercial real estate market.

Let’s first start with the basic differences between recourse and non-recourse debt. We will start with recourse debt, because then it will be easy to distinguish and contrast non-recourse debt. All the debt (also known as loans or financing) is secured debt, meaning that the lender takes a security lien on the property being purchased with the loan proceeds.

The term recourse debt (or recourse loans or recourse financing) refers to debt where, in the event of the borrower’s default on the loan, the lender can satisfy the debt by both foreclosing on the collateral and also by pursuing the borrow for any shortfall (known as a deficiency). Thus, if there is a loan for $100 million and the borrower defaults, the lender will foreclose on the collateral, being the property purchased with the loan. When that property is sold, it only nets $80 million which goes to pay down the loan. That leaves a deficiency of $20 million and the lender may then pursue other assets of the borrower to satisfy that deficiency (plus, of course, attorney’s fees, costs, and interest). This ability of the lender to pursue the borrower for the deficiency is the recourse.

By contrast, non-recourse debt is fundamentally different to the extent that, as the name suggests, there is no ability of the lender to seek recourse by pursuing a deficiency against other assets of the lender. Basically, the totality of the lender’s recovery will be by foreclosing against the collateral put up for the loan. If the sale of the collateral does not equal the loan, well, too bad so sad. Note that even non-recourse loans have certain provisions where in some circumstances there can be recourse, usually involving misconduct by the borrower (which is why these carve-outs to the non-recourse provisions are known as Bad Boy Guarantees).

The differences between recourse and non-recourse debt usually differ in two predictable ways. The first is that with non-recourse debt, the lender will want to have liens against enough assets that it is adequately collateralized, if not outright over-collateralized, so that if there is a borrower default the collateral that is foreclosed upon will fully pay off the loan. By contrast, recourse debt will often not be as well collateralized because the lender may believe that the borrower will have other assets with which to make the lender whole.

The second difference is that most non-recourse financing comes from so-called commercial mortgage-backed securities (CMBS
CMBS
), which means that non-recourse loans are packaged into securities and sold to investors as fixed-income investments. The CMBS loans, known as conduit loans, often offer a lower interest rates but carry greater pre-payment penalties. By contrast, traditional banks only offer recourse financing.

So how does any of this affect the banking crisis? The simple answer is: It doesn’t. Most (but not all) bank crises are caused because there is a wave of defaults by borrowers combined with a loss of faith by depositors. The current bank crisis is not caused by any significant increase in borrower defaults, but rather was caused by ― fundamentally ― the failure of the involved banks to correctly deal with an increasing interest rate environment such that they ended up holding a bunch of low-interest bonds that they couldn’t unload except at a substantial loss. The financial weakness caused by the bad bond bets then lead to a loss of depositor confidence and the ensuing run on the bank. The point being that this instant bank crisis is quite unlike the 2008 banking crisis, which arose primarily from borrower defaults exacerbated by junk derivatives.

I’m also skeptical that the difference between recourse and non-recourse debt will have much of an impact upon commercial real estate. There may be some slight effect insofar as if a commercial property is underwater (debt exceeds market value), the borrower with non-recourse debt might be more inclined just to turn the property back over to investors and walk away, whereas with recourse debt a borrower will usually fight to the bitter end to make the project work so as to avoid personal liability if the loan defaults. Thus, non-recourse property may be foreclosed upon more quickly, leading to more commercial properties coming back on to the market more quickly, and thus exacerbating any bust that does develop. But it is difficult to see that this will be more than a minor factor in any commercial property downturn.

In a sense, it might be that non-recourse financing helps to mitigate the worse effects of a commercial property crash. Consider that most recourse financing is made by banks, that banks fail, and when banks fail there is a liquidation of their assets. Whenever a crash happens, the market is flooded with properties being sold by the bank’s liquidators. By contrast, most non-recourse debt is issued by market investors who have bought the non-recourse loan after it has been repackaged and sold as a security. These investors are not going to be taken under supervision, as a bank might be by regulators, and may decide that instead of liquidating the property at a large loss, the investors will simply hold the property (known as land banking) until the market recovers somewhat. Of course, this presumes that the investors themselves do not fail and go into bankruptcy, and also to a degree that the particular commercial property has a positive cash flow.

There is one thing that is quite positive about non-recourse financing in the longer term and that is that lenders and borrowers do not spend many years after a default litigating the amount of the deficiency or in the enforcement of the final judgment. With non-recourse financing, when the loan defaults, the property either goes back to the lender or it is liquidated, and that is usually the end of the story. With recourse financing, there will be litigation for many years thereafter (we’re still clearing out a few cases from the 2008 crash), such as against personal guarantors. The great benefit of non-recourse financing is, therefore, that it allows everybody to close the books immediately on a bad deal and move on. That’s good for those parties, and it is good for the economy in general.

Crashes of commercial real estate are nothing new, and are as Chauncy Gardener might suggest, simply another season of our economy. However, each crash is always a little bit different insofar as it involves new financing methods, such as all the limited partnership deals during the 1980’s savings & loan crisis, or as with the collateralized debt obligations which supercharged the 2008 crisis. Although very difficult for many of those involved, the crashes can be interesting from a creditor’s rights perspective. Just as long as it does not get a little too interesting, of course.