Non recourse finance is a loan where the lender is only entitled to repayment from the profits of the project the loan is funding, not from other assets of the borrower.
These types of projects are characterized by high capital expenditures, long loan periods and uncertain revenue streams. Analyzing non-recourse financing requires a sound knowledge of the underlying technical domain as well as financial modeling skills.
Non recourse financing, which is often considered a fairly high-risk undertaking on the part of lenders, does not include access to any of the borrowers’ assets beyond the agreed upon collateral, even if they default on the loans. Payments on such loans can only be made as the funded projects generate revenue. Due to the uncertainty, loan periods are generally long to give ample time for projects to produce returns. Additionally, interest rates are generally higher on non-recourse loans, corresponding to the elevated risk involved. If projects produce no revenue during the loan periods, lenders receive no payments on the debt and cannot go after the borrowers for remaining balances after collateral is seized.
Examples of Recourse versus Non-Recourse Loans
If two people are looking to purchase large assets, such as a homes, and one receives a recourse loan and the other a non-recourse loan, the actions the financial institution can take against each borrower are different. In both cases, the homes may be used as collateral, meaning they can be seized should either borrower default. To recoup costs when the borrowers default, the financial institutions can attempt to sell the homes and use the sale price to pay down the associated debt. If the properties sell for less than the amount owed, the financial institution can pursue only the debtor with the recourse loan. The debtor with the non-recourse loan cannot be pursued for any additional payment beyond the seizure of the asset.
Non-Recourse Loans and Tax Liability
With a recourse debt, if the financial institution forgives any part of the debt after the associated asset is seized and sold, the forgiven amount may be treated as ordinary income that the debtor must report to the Internal Revenue Service. In contrast, non-recourse loans are considered paid-in-full once the underlying asset is seized regardless of the price at which the asset is sold. Since most commercial real estate is owned in a partnership structure (or similar tax pass-through), non recourse borrowing gives the real estate owner the tax benefits of a tax-pass-through partnership structure (that is, loss pass-through and no double taxation), and simultaneously limits personal liability to the value of the investment.
Recourse Loans and State Law
Whether an individual or an organization can enter into a recourse loan for a particular asset is often determined by state law. Some states, such as California, have strict regulations limiting the ability of financial institutions to issue recourse loans, especially for residential real estate purchases.
Non Recourse Debt
Non recourse debt is a secured loan (debt) that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable.
If the borrower defaults, the lender can seize and sell the collateral, but if the collateral sells for less than the debt, the lender cannot seek that deficiency balance from the borrower—its recovery is limited only to the value of the collateral. As such, non recourse debt is typically limited to 50% or 60% loan-to-value ratios, so that the property itself provides over collateralization of the loan.
The incentives for the parties are at an intermediate position between those of a full recourse secured loan and a totally unsecured loan. While the borrower is in first loss position, the lender also assumes significant risk, so the lender must underwrite the loan with much more care than in a full recourse loan. This typically requires that the lender have significant domain expertise and financial modeling expertise.
Non recourse debt is typically used to finance commercial real estate, shipping, or other projects with high capital expenditures, long loan periods, and uncertain revenue streams. It is also commonly used for stock loans and other securities-collateralized lending structures.
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