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What is a Recourse Loan?

What is a Recourse Loan?

Recourse loans offer a great opportunity for small businesses to finance commercial real estate property purchases. Here's the pros and cons of using them.

17th December 2019
Reading Time: 3 minutes

Recourse loans are a good form of raising funds to make commercial investments in property. If you’re starting your first business and are looking for office space, this is likely the option you’ll be looking to. Likewise, non-recourse loans provide an alternative for strong, established businesses. Here’s everything you need to know about what these loans are, and how they can help you run your business.

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Recourse loans

Recourse loans are the most common type of commercial loan used for small businesses in Australia. Like mortgages, they require you to offer something you own as collateral in case of default.

The borrower signs a general security agreement (GSA), guaranteeing the terms of the loan. The collateral covered in this will likely refer to ‘all fixed and floating assets’ associated with the business. This means that if the business defaults on the loan, the lender will seize and liquidate any assets necessary to repay what is owed.

Beyond the commercial real estate property, this would include any cash, inventory or non-real estate property the business owns.

However, in the event that these are not enough to cover the debt, the lender then has the right to pursue any other assets necessary to cover the debt.

This is where the term recourse comes from, as upon default there is ‘recourse’ to cover the exact value of the debt owed.

Pros

Small business start-ups often use these, as they offer low-interest rates and are easier to acquire approval for. Particularly when compared to their non-recourse counterparts (we discuss why this is in the next section).

They also don’t have any minimum loan value.

Cons

If you are a sole trader your personal assets will be liable upon default.

In the case of a small business, with limited assets, it is also likely that a directors guarantee will be required.

This refers to an agreement where the director (or partners) of the company provides a personal guarantee of their personal assets, including residential real estate, in case of default.

Hence, if your businesses assets are not enough to cover the debt your personal assets become liable.

Non-recourse loans

Much like with recourse loans, these involve signing a GSA with a lender guaranteeing the terms of a loan. The difference here is that the lender can only pursue the collateral specified in the loan agreement and everything beyond it is protected.

Pros

The key benefit of this is that in the case of default, the lender can only seize a limited amount of assets.

Likewise, a directors guarantee isn’t required.

These loans become valuable to the borrower when, upon default, the debt owed exceeds the value of the collateral. Here the lender will lose out on the difference between the value of the loan and the collateral.

Cons

Due to the risks, these types of loans are reserved for only well-established businesses with strong financial value. The risks associated with defaulting are much higher for the lender here.

In Australia, the rule of thumb is that non-recourse for are only for loans between $5-15 million in value. This is because beyond $15 million the company is likely looking for institutional financing. Likewise, below $5 million the risk of default remains too high for most lenders.

Furthermore, non-recourse loans for properties with unpredictable, fluctuating value will also be avoided by financial institutions. This means properties where trends affect the value irregularly, like pubs and cafes.

Finally, due to the higher risk to the lender, they naturally carry with them higher interest rates.

Residential non-recourse loans

Interestingly, in parts of America, these loans contributed to the housing crisis. While not as widespread a problem is often touted, during this time many individuals took out residential non-recourse loans with a low ability to repay them.

When the debt owed then exceeded the value of the house, they simply mailed the keys to the financial institution and left the house.

In Australia, non-recourse residential or personal loans are extremely rare, if not non-existent.

Conclusion

When starting a business, recourse and non-recourse loans may be vital sources of finance to establish yourself. However, each has its pros, cons and thresholds.

Determining how these relate to you and your business are vital to ensuring its success and avoiding unwanted repercussions. We would, therefore, recommend contacting a financial advisor and property lawyer before making any such decisions.

Don’t know where to start? Contact us on 1800 529 728 to learn more about customising legal documents and obtaining a fixed-fee quote from Australia’s largest lawyer marketplace.

Author
Daniel Fane

Daniel is a Legal Tech Intern at Lawpath. He is currently studying a Bachelor of Laws/Bachelor of Business at the University of Technology Sydney. His principal fields of interest are in commercial, corporate and intellectual property law.