Purchasing real estate with debt financing involves working closely with financial professionals.
You will have to sign a lot of documents, and there will be a ton of fine print. As you might expect, some of the fine print is more important than others. One of the most important terms you need to discuss when financing your project is recourse.
What is recourse?
Just like the word indicates, recourse deals with the options the lender has in the event of default. In the past cycle, most real estate loans have been non-recourse loans. The main reason for this is collateral. When you purchase real estate, the main form of collateral is the property itself. For a home loan, if you don't make payments you lose your home. For an office building, most loans were written the same way. So if a lender has a non-recourse loan, they are limited to the property itself in the event of default. A recourse loan, however, gives the lender options to come after other assets you own in order to get the compensation they need to cure your default.
Most loans have typically involved a limited loan-to-value ratio, with no recourse. In essence, this meant that the lender would only give you about 80% of the value of your project in financing. The collateral for the loan, your property, is worth more than the loan itself at this point. This practice is referred to as over-collateralization. It gives the lender confidence knowing that the asset they are lending on is worth far more than they are loaning on it.
Real estate volatility
As you can imagine, the most recent real estate cycle has left many lenders searching for answers. A building with a mortgage at 80% loan to value that closed in 2006, could be in trouble today. With values falling as far as 40%, the loan could be worth far more than the building itself. Lenders want the cash flows they were promised, they typically are not looking to take back the property. The answer to this problem, in their eyes, is to originate more recourse loans.
What recourse means for you
As a property owner, avoiding a recourse loan if at all possible is a good thing for you. However, if the lenders demand it and it is the only way you can finance your project, then you have to play by their rules.
A recourse loan means that your other financial and material assets could be at risk based on the piece of real estate with the recourse loan. A simple example will illustrate this. Let's suppose you purchase a building that is worth $10 million. With an 80% loan-to-value loan, you have debt of $8 million on the building. Suppose tenants start to move out and go out of business (as seems to be happening in the current cycle in 2009). You are unable to pay your debt, and selling the building will only produce about $6 million.
With a recourse loan, the lender will have the ability to come after your other assets in order to get back the $8 million they are owed. If you borrow as a business, this means that all of the assets of your business could be used up. If you borrowed as an individual, and provided a personal guarantee, your personal assets including your home could be at risk. Given these facts, pay attention to your loan terms and do your best to secure a non-recourse loan for your real estate.