The Scope of the Borrower's Liability in a Nonrecourse Real Estate Loan

By Stein, Gregory M. | Washington and Lee Law Review, Fall 1998 | Go to article overview

The Scope of the Borrower's Liability in a Nonrecourse Real Estate Loan


Stein, Gregory M., Washington and Lee Law Review


I. Introduction

People participate in the commercial real estate market for a wide variety of reasons. Some investors plan to construct buildings or renovate existing structures, while others intend to operate and manage commercial property as an ongoing business. Whatever their goals, real estate professionals typically form business entities to hold investment property rather than holding that property personally. Investors in the position of selecting an ownership structure usually seek to minimize their taxes and to shield themselves from personal liability on contract and tort claims.

In the past, real estate investors most often chose to hold property in limited partnerships, although limited liability companies have surged in importance during the past several years.' Partners historically have faced a substantially lower effective federal tax rate than corporate shareholders have. Nonetheless, real estate business persons sometimes form corporations and forego the enormous tax advantages of the partnership. This acquiescence to the tax collector arises primarily out of concerns about personal liability: Shareholders of corporations ordinarily cannot be sued personally by creditors of the business, but general partners of partnerships can. Thus, if someone is injured on the property or if the real estate entity does not pay its debts, general partners may encounter unlimited liability in tort or contract that corporate shareholders escape.

Real estate professionals often attempt to finesse this decision by forming limited partnerships and then trying to avoid the unlimited liability that this ownership form creates. In some cases, partnerships can minimize these risks easily. A partnership that secures adequate amounts of workers' compensation, property, and liability insurance, for example, virtually eliminates any chance that its general partners will have to pay for the costs of accidents. The partners enjoy the tax benefits of partnership status while avoiding most of the tort risks of that form of ownership.

Real estate owners also face potential contract liabilities. The largest obligation that most real estate partnerships confront is their mortgage loan. If the property owner fails to pay its lender and the property sells at foreclosure for less than the outstanding amount of the debt, then the partnership and its general partners are personally liable for the deficiency. Thus, one bad investment can poison an otherwise successful real estate portfolio, and the unpaid lender on this bad investment can eventually have its debt repaid from the partnership's more successful projects or from the general partners' personal assets.

For this reason,2 real estate partnerships often seek nonrecourse loans, in which the lender agrees that the mortgaged real estate is the only asset of the partnership and its partners that the lender will pursue if the debt is not repaid.

The other assets of the partnership and its partners are shielded, and each partner can lose no more than he or she agreed to invest. This nonrecourse status is accomplished by including exculpatory language in the documents, by which the lender agrees to look solely to the property for satisfaction ofthe secured debt.

Real estate lenders readily agree to nonrecourse loans in spite of their greater risk. Lenders are aware of the liability and other concerns facing partners in real estate ventures and may be willing to accommodate their partnership clients rather than risk losing business to competing lenders. If these lenders furnish an amount that does not exceed seventy to eighty percent of the value of the property, they generally are comfortable that the property can be sold at foreclosure for an amount sufficient to repay the debt. The slightly greater risk may translate into a modest increase in the interest rate. Lenders also may seek other forms of assurance that the debt will be repaid, such as limited personal guaranties or letters of credit. …

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