Every investment involves risk. Investing in multifamily real estate is no exception. The ability to use leverage when purchasing real estate is one of the most powerful attributes of this asset class. However, leverage is a double-edged sword. It can both increase and decrease risk. Fortunately, the added risk can be mitigated and one of the greatest tools for doing so is non-recourse debt.
A non-recourse debt is a type of loan that is secured only by a property as collateral. The borrower does not personally guarantee the loan and therefore has no personal liability for it. If the borrower defaults, the lender's sole recourse it to seize the collateral. The lender cannot go after the borrower for any further compensation, even if the value of the collateral is less than the amount of the defaulted loan.
On the other hand, recourse debt gives the lender the ability to sue the borrower for the total debt owed in the event of default after liquidating the collateral.
The biggest difference between bank financing and financing provided by Government Sponsored Entities (GSEs) for an apartment building is whether the loan is recourse or non-recourse.
Government Sponsored Agency's such as Fannie Mae and Freddie Mac loans are typically non-recourse. If you default on one of their loans, they will simply foreclose and take back the pledged collateral. They won’t go after your personal assets. This avoidance of personal liability is one of the biggest benefits of working with non-recourse lenders.
Local banks that finance apartment buildings will typically do so in the form of a recourse loan. They'll require the Key Principals of the deal to sign as guarantors of the loan. This means that those who sign will be held personally liable for the full loan amount in the event of a default. They will still take back the collateral property and sell it off. However, if the proceeds from the sale of the property doesn't cover the loan amount, the lender will then go after personal assets of the Key Principals such as their personal bank accounts, personal residences, other properties they own, etc. to make up the difference.
Some banks may offer non-recourse financing, but since this creates more risk for them, that increased risk will be reflected in a higher interest rate.
The agency lenders like Fannie Mae and Freddie Mac are able to offer non-recourse financing to multifamily borrowers because they carefully underwrite many aspects of a deal to confirm the borrower’s creditworthiness and ability to successfully operate the property that will be held as collateral for the loan.
During their evaluation, they'll review quantitative and qualitative data on the Key Principals including their net worth, liquid assets, access to additional liquidity, number of units owned, past performance of units owned, prior experience in the market where the subject property is located, prior experience with properties of the same type as the subject property, management experience, reputation, debt maturities and lender exposure.
In summary, securing non-recourse debt limits the investors' exposure to potential loss to his or her initial capital investment and nothing more. It protects the borrower against personal liability and it's one of the many unique advantages that real estate investing offers. However, non-recourse debt creates greater risk for the lender. If you're looking for non-recourse debt, be prepared for higher qualifying standards and/or higher interest rates.
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