I sometimes wonder how many real estate borrowers are in 100% full compliance, at all times, with their loan documents to ensure non-recourse if they default on their mortgage. In a bull real estate market, a borrower accidentally bending the provisions may go unnoticed as properties appreciate and operations are fruitful. In a down market, the definition of non-recourse could surprise and leave borrowers fully liable.

Disclaimer: Always consult a legal professional when interpreting loan documents and making substantial financial decisions.

Non-Recourse Loans

Non-recourse financing is a fantastic tool that can protect a borrower’s maximum downside in case of default while offering tax benefits not available to full-recourse borrowers. A lender issues non-recourse debt when they are comfortable with the commercial real estate as the sole loan collateral in case of a foreclosure or borrower default.

Beyond the value of the collateral, the borrower’s assets are off-limits. Bank accounts and unrelated investments cannot be targeted by the lender seeking repayment in the event of default if the borrower is in full compliance.

Types of Loan Offering Non-Recourse

Fannie Mae and Freddie Mac are two popular lenders in the multifamily space that offer non-recourse mortgages to borrowers. You‘d think loan terms would be more conservative (higher interest rates and lower LTV) when non-recourse is on the table. However, I’ve seen agency loan terms offering higher leverage and lower interest rates than other financial institutions only offering full-recourse loans.

HUD loans are also commonly non-recourse, specifically HUD 221(d)(4) in market-rate development and redevelopment business plans. The BSPRA credit can help increase leverage and reduce the cash equity burden.

Note: If you’re using floating-rate agency debt, they will likely require you to purchase an interest rate cap.

Related: Why forecasting future interest rates based on the forward SOFR curve is dangerous.

Because real estate is the collateral backing the loan, typically less emphasis is put on the borrower’s wages, credit score, credit history, or other personal finance metrics. However, they’ll likely all be verified as standard due diligence.

Bad Boy Carve-Outs

Lenders that offer non-recourse loans will include carve-out clauses that list violations that would void the “non-recourse“component and effectively convert the loan to “full-recourse,” meaning personal assets would be in play to make the lender whole.

These carve-outs are commonly referred to as “bad boy” carve-outs, as exclusions revolve around fraud and misrepresenting the financial performance of the real estate asset. For example, if an investor were applying for a refinance and manipulated the rent roll report to overstate occupancy and rent, this would violate the carve-outs in the loan agreement.

The dishonest act would likely lead to a higher approved loan amount that would be more challenging to service in a slowing economic environment. If the borrower defaults and the property’s market value is less than the outstanding loan balance, the lender would have an avenue to full recourse. The borrower would have personal liability because of the misrepresentations of inflating the rent schedule.

Carve-Out Provisions

I’ve seen plenty of non-recourse financing term sheets that mention something: “subject to bad-boy carve-outs.” What surprised me was how extensive these carve-outs are for certain real estate loan types. There are many steps to ensure you’ll benefit from non-recourse for the duration of the investment.

I was reading through non-recourse mortgage loan exemptions for Fannie Mae multifamily (6001.NR). Here are some exclusions that could jeopardize the non-recourse status. You could either be liable based on the lender’s loss or fully responsible for the mortgage loan.

Disclaimer: The following is my unprofessional interpretation of the loan agreements (I am NOT an attorney). Always consult a legal professional well-versed in commercial financing and local laws.

Rent & Security Deposit Management

You’ll need to pay the lender all rent and any held security deposits during a default. Failure to do so could mean personal liability. You could see how someone misappropriating security deposit funds before a default event could find themselves in hot water if operations began to unravel.

Property Insurance

You must maintain an insurance policy that complies with the loan documents and be current on payment (so it stays valid). The wrong type of insurance policy could put you in peril. Misappropriation of insurance proceeds from a claim could also invoke entire liability.

Condemnation Action

Suppose your property is subject to eminent domain, and you receive a condemnation notice. In that case, you’d be expected to notify the lender, defend any condemnation action, and promptly pay the lender any proceeds of a condemnation action. Failing to do so may lead to losing your non-recourse privilege.

Financial Reporting

Any documentation the lender requests, such as accounting records, financial statements, schedules, and reports, must be delivered promptly to the lender. Failing to produce these documents in a timely matter could be problematic.

Mismanagement

The lender expects you to service the mortgage before you use rental income to pay yourself. That seems obvious.

They also expect you to allocate rents to ”ordinary and necessary expenses of operating real estate.” I interpreted this as failing to maintain the property could eventually lead to property decline. A mortgage default due to property disrepair (could be via safety issues, vacancy, or rental loss) could mean total liability if deemed negligent. A track record of handling maintenance requests and handling deferred maintenance is essential.

Abandonment

Abandoning the property or letting it deteriorate (willingly or unintentionally) will make you personally liable.

Unintentional Gross Financial Negligence

Negligent, reckless, misrepresentation, or omission by the borrower or other key managing members related to financials/reporting is grounds for personal liability.

Tenant Opportunity to Purchase Asset (TOPA)

If you’re in a state that gives the property residents the right of first refusal to buy the apartment building, any claims, actions, or suits against you arising from TOPA could make you personally liable.

Single-Asset Entity (SAE) Requirments

A lender usually requires you to purchase real estate in an LLC with no other real estate or business interests. This will separate the real estate asset from your personal and business interests. It makes it easier for the lender to foreclose in case of default without added complexity. Keeping the SAE an SAE is paramount.

Transferring the Property

Any transfer not permitted under the loan agreement could result in personal liability for the mortgage loan.

Fraud

Any intentional material misrepresentations or omissions are grounds for personal liability for the mortgage loan.

Blanket Statement

There was also a general warning that doing something not permitted in any part of the loan agreements is grounds for total personal liability for the mortgage loan.

Non-Recourse Exclusions Observations

Three big ideas pop into my head when reviewing the fine print from above.

1. There is a lot of wiggle room in the interpretation of non-recourse exemptions.

2. Hiring a competent attorney who can interpret the exceptions to non-recourse provisions, guide you, and potentially negotiate narrower, less broad statements would be helpful.

3. Keeping communication lines open with your lender in an adverse operating setback seems rational.

When you see a non-recourse loan rate sheet with all pertinent loan terms with a quick disclaimer, stating “subject to the standard bad-boy carve-outs,” you can see that there’s likely much more to that story.

“As long as you don’t do anything fraudulent, you are golden” isn’t technically correct. An extensive list of things could go wrong, or general oversite could leave you vulnerable.

In an appreciating bull real estate market, the loan documentation language likely hasn’t been tested like it would be if the multifamily market sees any contraction that leads to borrowers defaulting on their mortgages. I’d be shocked if we didn’t start hearing stories of non-recourse status getting revoked due to broken loan provisions in a declining market.

Summarizing Non-Recourse Loans

In theory, a non-recourse loan is beneficial because the borrower’s assets are not at risk in the case of a default event. In reality, the line between non-recourse and full-recourse is blurred, and there are procedures and protocols the borrower must follow to ensure non-recourse status. Failure to interpret the loan documents and follow strict instructions (intentionally or unintentionally) could lead to personal liability in the case of loan default.

Related: See how some lenders may depend on the debt yield when sizing multifamily loans.