Every investment involves risk, and investing in multi-family 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 that can both increase and decrease risk. Fortunately, the added risk can be mitigated through the use non-recourse debt.
Non-recourse debt is a loan that is secured only by the property, and does not require a personal guarantee from the borrower for additional collateral. This means that If the borrower defaults, the lender's sole recourse is to seize the property and not the borrower's personal assets. The lender cannot go after the borrower for any further compensation, even if the value of the property is less than the amount of the defaulted loan amount.
On the other hand, recourse debt gives the lender the full ability to sue the borrower for the total debt owed in the event of default after liquidating the property.
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 Agencies 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 obtain possession of the property. 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 (borrowers) 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 upon default. In the event of a foreclosure sale, any proceeds that don't cover the defaulted loan amount will be owed to the bank. This allows the bank to pursue personal assets of the Key Principals, such as personal bank accounts, personal residences, other properties owned, 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.
Agency lenders like Fannie Mae and Freddie Mac are able to offer non-recourse financing to multi-family 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 secured by the loan.
During their evaluation, they'll conduct due diligence on the Key Principals that include: their total 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 the lender's exposure to risk.
In summary, securing non-recourse debt limits the investors' exposure to potential loss to their 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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