By Robert Amter – Colorado Real Estate Journal – May 18-May 31, 2016

Commercial real estate investors and developers need to be aware of the implications of obtaining a commercial real estate loan with recourse as opposed to obtaining a loan that does not require recourse. Recourse loans, which are the norm for almost all bank-funded commercial real estate loans, require a personal guaranty. If the borrower is an individual, then the act of signing the Promissory Note creates personal liability (i.e., recourse) on their part. If the borrower is an LLC (which is typical for most commercial real estate loans), then the individuals behind the real estate deal sign a guaranty agreement creating personal liability to the lender on the part of the individuals who have signed the guaranty agreement.

On the other hand, most institutional lenders, such as life insurance companies, do not require recourse. These loans tend to be much larger than typical bank commercial real estate loans. It is relatively easy to get a non-recourse loan for $25,000,000 from a life insurance company, whereas it is difficult to get a $2,500,000 non-recourse loan from a bank.

Banks consider the financial strength of the guarantor for a loan as one of the most important factors in their loan approval process. If the developer or investor does not have a strong enough personal financial statement, then the prospective borrower often has to offer part of their equity to someone with a strong personal financial statement in order to obtain bank approval. Giving up equity to a guarantor may be a less desirable alternative than paying higher rates to a bridge lender in exchange for keeping most, or all, of the equity.

A guarantor agrees to put their entire financial net worth behind their bank loan. If the loan goes bad, then the bank has the choice of whether to only accept the property to satisfy their loan or to file a lawsuit against the guarantor and attempt to collect on his or her personal guaranty. Obviously, having a bank obtain a judgement against all of the guarantor’s personal assets is a very serious matter. Lenders are not obligated to prove a deficiency in order to pursue a personal guaranty. Rather, the lender must make a decision at the beginning of the collection process between the two collection procedures. They can decide to file foreclosure immediately upon a default and determine prior to the foreclosure sale date whether to bid an amount lower than the sum they are owed. If they choose this option, they can still pursue the personal guaranty for any deficiency. However, the lender also has the alternative to skip the foreclosure process and immediately take legal action to collect under the personal guaranty. If they are successful and judgement is entered, they can then proceed to foreclose the judgment. This is a less common choice for lenders, but foreclosing a judgment is very similar to foreclosing on a deed of trust with the potential advantage of allowing the lender to begin collection efforts against any and all of their guarantor’s personal assets as soon as the judgement is entered.

An alternative that is sometimes overlooked is to find a lender that will provide a non-recourse loan. Private capital lenders, sometimes called bridge lenders, are more likely to consider a non-recourse loan on commercial real estate than banks. However, there are many complex factors to consider in non-recourse financing. One important factor is to carefully review what are called carve-out provisions in the loan documents. Carve-out provisions, also known as “bad boy” guaranties, spell out certain factors that may allow the lender to pursue a guarantor’s personal assets in spite of the fact that the loan itself is referred to as a non-recourse loan.

Actions such as filing for bankruptcy, perpetrating fraud or misrepresentation, failing to maintain the required insurance, failing to pay property taxes, performing any environmental indemnification, or committing a criminal act may allow the lender to pursue the guarantor individually. These carve-out exceptions are complex legal issues and any borrower/guarantor should carefully review the carve-out language with their legal counsel to make sure they understand its implications.

If the lender chooses to foreclose against the property, whether the loan is recourse or non-recourse has important ramifications. In Colorado, a lender must provide a bid to the Public Trustee as the foreclosure moves forward. If the loan principal and delinquent interest and loan costs combined equal $1,000,000 (for example), then the lender may bid $1,000,000 and, as a result, will not be able to pursue the guarantor individually for any shortfall. However, if the loan is a recourse loan and the lender decides that the property is not worth $1,000,000 and bids only $900,000, then the lender may (in the case of a recourse loan) take steps to obtain a judgement against the guarantor for the $100,000 deficiency. With a non-recourse loan, this is not possible. The borrower/guarantor may raise certain defenses to prevent the lender from obtaining a personal judgment for the deficiency, but with a non-recourse loan this issue would not arise (unless a carve-out issue is raised by the lender).

In a perfect world, all borrowers/guarantors would have non-recourse loans and not have to risk their personal assets in order to get a bank-funded commercial real estate loan. Unfortunately, in the real world, this issue needs to be addressed by the borrower. Does the ability to obtain non-recourse financing from a bridge lender (at a higher interest rate) offset the advantage that bank financing with its record low interest rates can provide? This is a case-by-case decision that real estate developers and investors need to carefully consider.