Recourse vs. Nonrecourse: Commercial Real Estate Financing Which One is Right for You?

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Lorin Conley
6 years ago
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The followig iformatio ad opiios are provided courtesy of Wells Fargo Bak, N.A. Recourse vs. Norecourse: Commercial Real Estate Fiacig Which Oe is Right for You?

1 The followig iformatio ad opiios are provided courtesy of Wells Fargo Bak, N.A. Recourse vs. Norecourse: Commercial Real Estate Fiacig Which Oe is Right for You? Prepared by: Bill White, Director of Commercial Real Estate Ledig. David Kitche, Maagig Director, Iterest Rate Risk Maagemet. I this white paper 1 Commercial real estate leders 2 Characteristics of recourse ad orecourse loas 2 Flexibility i pricig ad loa structure 3 Ogoig maagemet 4 Persoal liability vs. property costraits 4 Coclusio

2 Recourse vs. Norecourse: Commercial Real Estate Fiacig Which Oe is Right for You? Give the curret historically low yield eviromet, addig icome-geeratig commercial real estate (CRE) to your portfolio of assets is oe possibility you may be cosiderig to diversify your ivestmet holdigs ad/or to potetially geerate a recurrig icome stream. It s importat to ote real estate ivestmets carry uique risks icludig lack of liquidity ad potetial complex tax cosequeces ad may ot be suitable for all ivestors. If you are cosiderig a ivestmet i CRE, oe of the most importat decisios you will make is how to structure your borrowig ad who you work with to get fiacig. The fiacig decisio for CRE has the potetial to have a sigificat impact o the ivestmet s iteral rate of retur (aualized effective compouded retur rate). Ivestors typically have two fiacig optios for their CRE ivestmets loas with recourse ad loas without recourse: With recourse loas, the leder has the ability to collect the differece betwee the sale price of the property ad the amout owed to the leder from the borrowers should the property sell for less tha the amout owed. I other words, there is a secodary source of repaymet should the value of the property prove to be isufficiet to repay the loa. With orecourse loas, the leder is prohibited from collectig ay shortfall i the differece betwee the sale of the property ad the amout owed the leder. The leder s oly source of repaymet is the property that was pledged as collateral. Beyod these basic descriptios, however, there are other characteristics of recourse ad orecourse loas that should be carefully cosidered durig the fiacig decisios. Factors, such as flexibility, what kid of relatioship you wat to have with your leder, ad persoal liability are all importat cosideratios. I this white paper, we discuss the beefits ad drawbacks to both optios. Commercial real estate leders. Before explorig the differeces betwee recourse ad orecourse loas, it may help to get a sese of who the players are ad how these loas are structured so that you ca make a iformed decisio about the right type of loa for your specific circumstaces. Geerally, there are three primary types of commercial real estate leders: Commercial baks Commercial mortgage-backed securities (CMBS) leders Life isurace compaies Each leder has a differet source of fudig which, i tur, leads to differet limitatios. Commercial baks obtai their fuds from depositors, while CMBS leders securitize their loas by poolig a large amout of the mortgages ito a sigle security ad sellig the iterest to the public market. Borrowers must be sigle purpose etity, which is a limited liability compay or corporatio that holds title to real estate ad owes moey to a leder as the result of a mortgage o the property, but which has o other assets or liabilities. Life isurace compaies draw o moey from policyholders to fud their loas. Commercial baks geerally do the most recourse loas, comprisig almost half of the overall CRE ledig market. Norecourse loas are geerally offered by CMBS leders ad life isurace compaies, ad they make up roughly 29 percet of the market. For multifamily properties, the govermet also serves as a leder through govermet-sposored etities (GSE) (like Faie Mae ad Freddie Mac) ad the Federal Housig Admiistratio. Each of the govermet agecy loa programs fuctio much like the CMBS leders i terms of beefits ad drawbacks. Recourse vs. Norecourse: Commercial Real Estate Fiacig Which Oe is Right for You? 1

3 Outstadig CRE Leveragig/Credit/Fiacig CMBS, CDO ad other ABS Issue 15% Agecy ad GSE Portfolio ad MBS 17% Life Isurace Compaies 14% Baks ad Thrifts 39% CMBS: Commercial mortgage-backed securities leders CDO: Collateralized Debt Obligatios ABS: Asset backed securities GSE: Govermet-Sposored Eterprise MBS: Mortgage backed securities REIT: Real Estate Ivestmet Trusts Source: Federal Reserve Ecoomic Research & Data, as of 12/31/15 REIT 3% Other 12% Characteristics of recourse ad orecourse loas. The key to determiig which loa type is best suited to meet your eeds depeds o your ivestmet objectives ad your comfort level with certai loa characteristics of recourse ad orecourse loas. The beefits of recourse loas iclude greater flexibility i pricig ad loa structure, ad a persoal ad relatioship-based process for ogoig maagemet of the loa. The biggest drawback for recourse loas stems from the persoal liability associated with the loa. O the flip side, with orecourse loas, the biggest beefit is the elimiatio of persoal liability. However, sice orecourse leders oly have the property as a source of repaymet, they impose certai restrictios associated with the property s cash flow ad operatio to esure the property maitais its value. These restrictios ofte take the form of escrow ad impoud accouts, as well as the establishmet of lockbox arragemets for ret paymets (we ll discuss this further whe discussig characteristics of orecourse loas). Norecourse loas are typically structured i a set maer. I other words, there is limited flexibility i how orecourse loas are structured. Norecourse borrowers also eed to be aware there are certai provisios of orecourse loas called bad boy carve outs. These provisios allow the leder to covert a orecourse loa ito a full recourse loa i the evet of bakruptcy or illegal/uethical activities (such as fraud). Each leder will differ i its expectatios aroud carve outs. Flexibility i pricig ad loa structure. There are differeces betwee recourse ad orecourse leders whe it comes to pricig, structurig, ad prepaymet restrictios, stemmig from how the leders fud their loas. The mai beefit to recourse loas is the flexibility i how the loa is structured ad priced. As metioed earlier, commercial baks fud most recourse loas ad hold the loas o their balace sheet. This direct coectio betwee the leder ad the borrowers sets the basis for a relatioship as the bak will eed to get to kow ad uderstad the borrowers fiacial situatio ad borrowig eeds. Recourse loas typically require full fiacial disclosure ad uderwritig for each borrower. Havig this complete picture of the borrowers uique fiacial situatio allows the leder to customize ad tailor the loa to meet their specific eeds. Ad o a ogoig basis, the leder is able to work directly with the borrowers whe it comes to loa hadlig, restructurig eeds, capital improvemets, ad property maiteace. Recourse loas from commercial baks typically are priced o a floatig iterest rate basis at a spread over a idex rate, such as the Lodo Iterbak Offered Rate (LIBOR) or the prime rate (the rate at which baks led to each other). The floatig iterest rate allows the bak to match fud the iterest rate eared o the loa with the iterest rate paid to depositors, which is also a floatig rate. As log as the loa is o a floatig rate basis, there is usually o prepaymet pealty associated with the loa. Borrowers may cosider borrowig at a floatig rate ad usig iterest rate hedgig strategies as alteratives to fixed-rate loas, which ca have advatages ot foud with typical fixed-rate loas. If you would like iformatio about maagig iterest rate risk with hedgig strategies, we ca refer you to our swap specialists. The key to determiig which loa type is best suited to your eeds depeds o your ivestmet objectives ad your comfort level with certai loa characteristics of recourse ad orecourse loas: Flexibility i pricig ad loa structure. Ogoig maagemet. Persoal liability vs. property costraits. 2 Recourse vs. Norecourse: Commercial Real Estate Fiacig Which Oe is Right for You?

4 Norecourse loas geerally have much less flexibility i terms of loa structure ad pricig. Where recourse loas are relatioship-based, orecourse loas are geerally more trasactioal sice the leders typically do ot hold the loas o their balace sheets. As metioed earlier, orecourse loas offered by CMBS leders are aggregated with other loas that are similarly structured ad the securitized ito bods. These bods are the sold o the ope market to fixed icome ivestors. Thus, there is a eed to have fairly stadardized ad cosistet loa structures which ecessarily limits how customized a CMBS loa ca be. This process is very similar to how mortgages o sigle family resideces are structured ad sold. As for life isurace compay loas, there is geerally more flexibility whe it comes to loa structure tha CMBS loas sice life isurace compaies (like commercial baks) hold their loas o their balace sheet. It is worth otig, however, that life isurace compaies geerally have a arrower scope of acceptable properties tha CMBS leders ad commercial baks. They prefer to cocetrate o properties that have low leverage, are high quality (class A properties are ewer properties built withi the last 15 years with the most ameities, highest icome earig teats, lowest vacacies, ad will typically demad the highest rets with o deferred maiteace), ad located i major metropolita areas. Also, projects that have uique characteristics, such as groud up costructio, reovatio or distressed properties, typically are difficult for orecourse leders to fiace due to their speculative ature ad the itese oversight eeded for these types of projects. These projects are most ofte fiaced by recourse leders. Norecourse loas are geerally offered o a fixed rate basis, although floatig rates are available. With CMBS leders, the iterest rate eared o the loa is trasferred to the bod ivestors. With life isurace compaies, the iterest rate eared o the loa is used to maage the compay s ow balace sheet ad pay life isurace claims. The actual loa pricig betwee the three differet types of leders will vary based o umerous factors, but geerally speakig, they are typically closely priced whe viewed over a log period. A issue may arise with orecourse loas whe borrowers wish to prepay the loa prior to maturity. CMBS bod ivestors expect to ear a set retur for the life of the bod (or the life of the loa). Likewise, life isurace compaies try to maage the expected retur o their assets (the loas) accordigly ad early prepaymet of a loa causes problems i how they maage their balace sheet. To compesate for early loa repaymets, CMBS leders ad most life isurace compaies usually require early termiatio amouts or eforce make whole / yield maiteace provisios which attempt to make up the lost reveue the bodholders ad life isurace compaies expected to make if the loa was repaid o the origial term. Ogoig maagemet. Oce the loa is i place, with recourse loas, the relatioship betwee the leder ad the borrower serves as the foudatio of how the property is maaged ad maitaied. Sice recourse leders have a secodary source of repaymet, they typically do ot require the establishmet of escrow/impoud accouts or lock boxes. Discussios aroud timig ad what kids of capital improvemets are eeded ca be more fluid, ad drive by the relatioship betwee the leder ad the borrowers. Oce orecourse loas are securitized ad sold, the oversight ad maagemet of the loa is hadled by a third party servicer that acts o behalf of the bodholders. The servicig compay is boud by a servicig agreemet that expressly details the servicer s fiduciary duty ad abilities. This, i tur, sigificatly limits the amout of flexibility the servicer has i maagig the uderlyig loa. This limited service model for orecourse loas cotrasts with the more persoal model of recourse loas, where the relatioship with the leder drives the coversatio about how the property is maitaied. As for life isurace compaies, like commercial baks, they geerally have more flexibility i terms of loa oversight sice the loas are held o their ow balace sheet ad ot trasferred to a third party. That beig said, life isurace compaies are geerally less flexible tha commercial baks sice they oly have oe source of repaymet the uderlyig property. Persoal liability vs. property costraits. As metioed earlier, the overwhelmig beefit to the borrower for orecourse loas is the elimiatio of persoal liability if the loa defaults. This provides sigificat protectio to the borrowers. I exchage for this beefit, however, orecourse leders typically impose various restrictios to the property s cash flow ad property maiteace schedule to help protect their oly source of repaymet. These ofte takes the form Recourse vs. Norecourse: Commercial Real Estate Fiacig Which Oe is Right for You? 3

5 of escrow ad impoud accouts specifically dedicated to the property ad held by the leder, as well as a set schedule for whe capital improvemets are eeded ad performed. This protects the leder by makig sure fuds are available to perform eeded maiteace ad improvemets, ad restrictig the borrower s ability to defer those items. These escrow or impoud accouts are typically set up to pay for capital improvemets, taxes, isurace, teat improvemets, etc. ad established at loa closig. Thereafter a portio of the property s cash flow is directed to these accouts o a regular basis. At times, orecourse leders also require that the property s teats sed their ret paymets directly to a lock box cotrolled by the leder. From this lock box, the leder makes the loa paymets ad deposits ito the various escrow accouts, ad the distributes the remaiig cash flow to the property ower. Aother factor to ote with orecourse loas is that most have claw backs ad bad boy carve out provisios, which allows the leder to covert a orecourse loa ito a full recourse loa, icreasig the borrowers potetial liability. Examples of these carve outs ca iclude fraud ad misrepresetatio, bakruptcy filig by the etity that ows the property, ret skimmig, diversio of isurace proceeds, ad udisclosed evirometal cotamiatio, to ame a few. As stated previously, each leder will vary i their specific carve outs. I geeral, the followig are some poits to cosider whe you re makig a decisio regardig the fiacig of your CRE property with a recourse or orecourse loa. Ivestors may wat to cosider a recourse loa if they: Wat the flexibility to customize the loa structure ad pricig Wat the potetial to modify or restructure the loa post closig Wat to limit prepaymet issues Do ot wat to divert cash flow to escrow or impoud accouts Are ivestig i distressed properties or ew costructio Ivestors may wat to cosider a orecourse loa if they: Do ot wat to provide persoal recourse for repaymet Pla o holdig the property for the legth of the loa Do t expect to chage or modify the loa durig the term Are comfortable with divertig property cash flow to escrow or impoud accouts Coclusio. If you are cosiderig addig commercial property to your ivestmet portfolio, there are may decisios that go ito determiig whether it will be a good ivestmet, such as buildig locatio, mix of teats, the amout you are prepared to ivest i upgrades over time, etc. Of equal cosideratio, the type of leder you approach to fiace the buildig ad the type of loa you decide to take out are sigificat decisios that will impact the flexibility, maagemet, ad persoal liability associated with your CRE ivestmet. Give the complexities ad the importace of these decisios, it s a good idea to discuss your desire to pursue CRE ivestmets with your relatioship maager so that it ca be weighed i the cotext of your overall fiacial pla. 4 Recourse vs. Norecourse: Commercial Real Estate Fiacig Which Oe is Right for You?

6 Disclosures. Wells Fargo Wealth Maagemet provides products ad services through Wells Fargo Bak, N.A., ad its various subsidiaries ad affiliates. All loas are subject to credit approval. The iformatio ad opiios i this report were prepared by Wells Fargo Wealth Maagemet. Iformatio ad opiios have bee obtaied or derived from sources we cosider reliable, but we caot guaratee their accuracy or completeess. Opiios represet Wells Fargo Wealth Maagemet s opiio as of the date of this report ad are for geeral iformatio purposes oly. Wells Fargo Wealth Maagemet does ot udertake to advise you of ay chage i its opiios or the iformatio cotaied i this report. Wells Fargo & Compay affiliates may issue reports or have opiios that are icosistet with, ad reach differet coclusios from, this report. This iformatio is provided for educatio ad illustratio purposes oly. Wells Fargo ad compay ad its affiliates do ot provide legal advice. Please cosult your tax or legal advisors to determie how this iformatio may apply to your ow situatio. Whether ay plaed tax result is realized by you deped o the specific facts of your ow situatio at the time your taxes are prepared. This report is ot a offer to buy or sell, or a solicitatio of a offer to buy or sell the strategies metioed. The strategies discussed or recommeded i this report may be usuitable for some cliets depedig o their specific objectives ad fiacial positio. Wells Fargo Bak, N.A. (the Bak ) offers various advisory ad fiduciary products ad services. Wells Fargo affiliates, icludig Fiacial Advisors of Wells Fargo Advisors may be paid a ogoig or oe-time referral fee i relatio to cliets referred to the Bak. The role of the Fiacial Advisor with respect to Bak products ad services is limited to referral ad relatioship maagemet services. The Bak is resposible for the day-to-day maagemet of the accout ad for providig ivestmet advice, ivestmet maagemet services ad wealth maagemet services to cliets. The views, opiios ad portfolios may differ from our broker dealers: Wells Fargo Clearig Services, LLC ad Wells Fargo Advisors Fiacial Network, LLC, Members SIPC, o-bak affiliates of Wells Fargo & Compay. Wells Fargo Advisors is a trade ame used by Wells Fargo Clearig Services, LLC ad Wells Fargo Advisors Fiacial Network, LLC, Members SIPC, separate registered broker-dealers ad o-bak affiliates of Wells Fargo & Compay Wells Fargo Bak, N.A. All rights reserved. Member FDIC. NMLSR ID TPB01321 ( BD) Valid through 11/01/2017 CAR

Recourse vs. Nonrecourse: Commercial Real Estate Financing Which One Is Right for You?

The following information and opinions are provided courtesy of Wells Fargo Bank, N.A. Recourse vs. Nonrecourse: Commercial Real Estate Financing Which One Is Right for You? 1 2 2 3 3 4 Commercial real