I have gone to 2 tic seminars and keep hearing about something called non recourse debt.  What is that? 

Texasrealestate is right on the money. 

TIC Investments are syndicated real estate transactional offerings.  The offerings typically already have financing in place, and the financing is generally non-recourse to the investors.  Non-recourse means that in the event of a default under the terms of the note and deed of trust or mortgage and a subsequent foreclosure action, the lender can only go after the real property to satisfy the balance due on the note and can not go after the investors assets above and beyond what the investor actually invested into the TIC Investment offering. 

The non-recourse financing is a huge benefit of TIC Investment offerings. However, many TIC Investment offerings also have "Bad Boy Provisions" or loan carve outs, which would void the non-recourse status if you trigger one of the Bad Boy Provisions.  So, be sure to read the Private Placement Memorandum (PPM) and make sure that you know what the Bad Boy Provisions are.

Perhaps one of our Guest Experts can weigh in here as well. 

Non-recourse financing means that, under most circumstances, the lender can not go after the borrower for any deficiency in the case of a foreclosure; they can look only to the value of the property.  Most financing for investment property is on a non-recourse basis (except, typically, in the case of construction financing).  For example, assume that an investor borrows $1,000,000 to acquire a property, but that the property does not perform as expected and the loan falls into default.  The lender forecloses on the property, but can re-sell it for only $800,000 leaving a deficiency of $200,000.  But, because the loan is non-recourse, the lender can not go after the borrower for the difference.  The bad news here is that the $200,000 deficiency will be treated as income to the borower by the IRS.  The ability for the lender to foreclose quickly, without interference by the borrower, is the benefit to the lender of the bargin between the borrower and the lender.

 All non-recourse financing, however, includes certain circumstances where the non-recourse nature of the loan is stripped away.  Fortunately, these are almost alway under the control of the borrower,  The typical carve-outs from the non-recourse provisions are fraud, misappropriation of funds, waste, bankruptcy or failure to maintain the special purpose entity (typically a LLC) by the borrowing.  The final carve-out from the non-recourse nature is environmental contamination.  This carve-out is not always under the direct control of the borrower, as it typically covers any form of contamination, whether caused by the borrower or not.  It is very important that an investor carefully read all of the carve-out provisions so that they are fully aware of the circumstances underwhich a non-recourse loan my become a recourse loan.

Jim

I have also heard that most TIC financing is CMBS? What does that mean, and how is it different than Non-recourse?

Yes, most TIC financing is CMBS financing.  CMBS stands for Collateralized Mortgage-Backed Securities.  In fact, most financing for investment properties is CMBS financing, also known as ‘conduit’ financing.

Most CMBS financing is also non-recourse financing, which means that, generally speaking, the lender can not look to the borrower for any deficiency in the case of a foreclosure.  CMBS financing really ushered in the era of non-recourse financing, as I will discuss below.

Prior to the mid-1990’s, most financing was what we call ‘portfolio’ lending.  A bank, S&L, life insurance company of other financial institution would use its deposit base to make loans, which they then serviced to receive repayment.  The problem was that this tied up the lender’s capital until (and unless) the loan was repaid, which limited their ability to make new loans.  Since most mortgages for investment property are fixed rate, this also meant that a lender could be under-water, with the interest rate on a long-term fixed-rate mortgage being less than the rate that they paid on deposits.  Combined together, these issues led to periodic credit crunches and caused many financial institutions to face severe financial strain.

During the mid-1990’s, the commercial mortgage market took a page from the residential mortgage and started packaging pools of commercial loans into one big bond offering, which could then be sliced and diced into multiple pieces, or tranches, based on the credit quality of the different loans, which are then sold to bond investors (the lender is effectively acting as a ‘conduit’, originating loans for the bond investors).  This way, lenders could quickly recover their original capital, plus (hopefully) a profit on the sale of the loans.  As a result of the growth of the CMBS market, borrowers can find much easier access to mortgage capital, lenders can get their capital back in order to make new loans and bond investors can select the tranches of these pools that best match their investment objectives.

One offshoot of the CMBS market is that there are very few remaining ‘portfolio’ lenders.  Why hold the loan to maturity when you can select just those pieces that fit your investment needs?  Another change is the rise of non-recourse financing.  The bond investors want either the debt payment or the property; they don’t want to waste time going after borrowers (unless, of course, those borrowers commit ‘bad-boy’ acts against the lender or the property).  The final big change is that almost all commercial mortgages carry potential severe pre-payment penalties.

Love it or hate it, CMBS financing has completely changed the world of commercial lending.

Jim

Wow, thorough answer, thanks. So... what is the result then when these lenders package bad debt and can't find investors willing to buy the securities? Is this the big "crisis" that all the papers etc. keep referring to, or just a part of it?? Do the lenders default on the loans, or are they forced to take them in house?

Great questions, especially given the current turmoil in the markets.  Most, if not all, securitizations contain a ‘buyback’ provision that requires the issuer to buy back loans that default during an initial period.  This is one small part of the current meltdown as such a large percentage of recently made sub-prime loans have gone bad so quickly (who in their right mind would EVER make a mortgage loan to a low-credit score borrower based on ‘stated income’?).  More frequently, the loans start going bad after several years, when the projections have not occurred and the reserved have been burnt through.  In those cases, the bond buyers typically have no claim against the issuer.  That is why the loans are sliced into the different tranches of credit worthiness and return.

Unfortunately, the market is now finding that their models for projecting risk and reward were flawed (which has been the case for virtually every bubble).  While the models did project certain levels of default, they did not project that home prices would fall significantly and they did not project the consequences to the overall economy if the housing market had a significant slowdown.  These consequences are now appearing in all sectors of the economy, which is scaring the pants off of Wall Street.  The concern now among lenders is that sectors in which the fundamentals are still strong will be hurt and that the economy could drop into recession.

When the models stop working the markets make irrational decisions, which are showing up in the daily volatility in the markets.  We spoke with one major lending shop last week who was told by their warehouse lender that while they recognized that 100% of their loans were paying 100 cents on the dollar, the warehouse lender had simply decided that the value of the loans were impaired by 20% and, therefore, the lender needed to come with hundred of millions of dollars to ‘rebalance’ the loan to value ratio of the warehouse loan.

No one can say when the meltdown will thaw, but there is still massive liquidity in the markets and investors can not stay on the sidelines forever.  This crisis, like all credit/liquidity crises is about market confidence.  Once the markets have confidence that they can reasonably price risk, they will com back into the markets.  They may price risk differently for a while, but sooner or later we will see the same blind faith in models and lack of discipline that created this ‘crisis’.

Jim