One of the biggest questions for new real estate investors is “where will I get the money to invest in real estate?” Buying investment properties is not cheap, a property purchase could be several hundred thousand dollars to multiple millions of dollars depending on the market, size and class of the investment property you are purchasing.
Fortunately, you don’t need to have all the money to be able to make an investment in quality real estate, such as multifamily apartments. If you want to invest passively and just receive returns on your money, then you can use syndication to join in with a group of other investors and pool your money together to invest. If you are an active investor, then there is onus on you to help secure all the money needed to make the investment purchase. Note that I didn’t say you needed to have all the money but rather you need to secure it. Via syndication you can help organize investors together to provide the funds (also known as equity) to make the purchase. (If you need a primer on the overall syndication cycle check here.)
One of the benefits of real estate is that you don’t have to get all the money from investors, but you can get around 70-90%+ of the funds you need from a bank or other type of lending institution in the form of debt. This mix of cash from investors and from lending institutions will make up the capital stack for the investment opportunity. Both passive and active investors need a good understanding of the capital stack to help vet the merits of the deal they are going to invest in.
In this article we are going to explore more about debt. Specifically, the differences between recourse and non-recourse debt.
What is debt?
As it relates to the world of financing, debt is typically cash that is borrowed by one entity from another. The entity that borrows the money does so under the agreement that they will pay back the money to the lender on an agreed upon schedule. The lender agrees to loan this money based on the prospect of being compensated, usually in the form of interest payments, for the money lent.
The use of debt is referred to as leverage. Debt financing is a huge benefit in real estate as it allows investors to make leveraged purchases backed by physical assets i.e. the investment property. The property is considered collateral for the loan. Because banks have such confidence in the prospects of real estate investments, they gladly partner with investors to provide this leverage.
What is Recourse Debt?
One of the oppositions that some people have towards investing in real estate is because they do not want to use a large amount of leverage and do not want the liability of having to pay the loan back. They do not want to guarantee the loan. When individuals say this, they are most often thinking of recourse debt.
There are two broad categories of debt: Recourse and Non-Recourse. On the surface both loan types look very similar, but the key differences are highlighted when the borrower defaults (i.e doesn’t pay as agreed) on the loan. If you have acquired a loan that is recourse debt, then you have made a personal guarantee of the repayment of that debt. You will be held 100% liable to pay that debt off regardless of the performance of the investment property. Further since you are personally liable for the debt a lender can not only take back your investment property, but they can take your personal property to help pay off all the debt. (Ouch!)
What is Non-Recourse Debt?
Non-recourse debt refers to debt where the borrower is not personally liable to pay off the debt. If the borrower is not able to pay the loan back, then the lender would only be able to take possession of the property which the debt was used to purchase. That means even if the value of the property is less than the amount of loan outstanding the lender would not be able to seek further compensation for that decrease in value compared to the outstanding loan amount.
Compared to the recourse debt, a non-recourse loan would help you sleep a bit better at night. For the lender on the other hand there is increased risk, so they won’t give out a non-recourse loan to just anybody.
What is an example of recourse debt? Are home mortgages recourse or nonrecourse?
Recourse and non-recourse really rely on the agreement between the lender and borrower. Most individuals are familiar with debt from a home mortgage as an example of debt – but is this recourse or non-recourse? Believe it or not, there are lenders out there that may offer non-recourse home mortgages but typically if the lender is not a government agency the home mortgage is a recourse loan. Other types of recourse loans are hard money, personal and credit card loans.
In the scenario of a home mortgage loan imagine that you have a house worth $100,000. You purchased the house with $85,000 debt. Each month you pay $1000. After a few years, you encounter a hardship as there is an economic crash and the value of the houses also dropped. You find yourself unable to continue paying the loan as scheduled and the bank must foreclose on your home. The bank would then sell the house to get the cash to pay off the loan. The house is now worth $70,000 however and you still have a $78,000 loan balance. That is an $8,000 shortfall. The bank could seek legal means to obtain the $8,000 shortfall by seizing your other properties, income or savings.
What is an example of non-recourse debt? Are commercial real estate loans recourse or non-recourse?
If you take our previous example of the house that is valued at $8,000 less than the outstanding loan balance you can see the difference of a recourse vs non-recourse loan. If the loan is non-recourse, then the lender would only be able to seize the investment property and could not go beyond that. That means the lender would have to take an $8,000 loss.
The benefits of investing in large apartment real estate, however, are that you will more likely get a non-recourse loan. As the dollar amounts of loans get larger, they are more often non-recourse; most lenders do not offer non-recourse loans below $1Mn however there are a few lenders who still offer these options.
Do you have to pay back a non-recourse loan?
You may be thinking “great! A loan that I don’t have to pay back, sign me up!” But hold on, not so fast. Non-recourse loans, due to their higher risk profile, typically have a higher requirement for approval. Also, these loan agreements come with language that refers to “bad actors” who may, due to fraud or some other intentional act, default on the loan. If you fall into this category of individual that is not acting in good faith, you may find out that your non-recourse loan converts to a recourse loan and you would become fully liable.
Interested in learning more about investing in multifamily apartments? Give us a call or check out some of the other free resources we have available at Investupmultifamily.com.
Comments