When ‘Non-Recourse’ Construction Financing Means ‘Recourse’
Borrower beware of these three provisions.
Borrowers understandably focus on proceeds, pricing and loan structure when negotiating multifamily construction loan term sheets. However, most lender term sheets provide very little details regarding loan guarantees, which often end up being negotiated when there is time pressure to close. While construction loans may be labeled non-recourse, completion, interest-carry and operating deficit guarantees frequently shift substantial project risk back to the sponsor. Borrowers should be wary of provisions that can operate to make a “non-recourse” loan functionally recourse during the period when the project’s risk is highest.
A completion guaranty typically requires the guarantor to ensure that the project is completed, regardless of whether the original budget proves adequate. If costs exceed budget, delays occur or contractors fail to perform, the lender can require the guarantor to contribute additional capital to achieve completion. In practical terms, the sponsor is backstopping a key portion of the lender’s repayment risk until construction is finished.
An interest-carry guaranty serves a similar purpose. If lease-up takes longer than expected or the interest reserve is depleted, the guarantor may be obligated to fund debt service and other carrying costs. Lenders commonly require additional cash support once reserves are exhausted, particularly in stressed situations.
An operating deficit guaranty extends the exposure beyond completion into stabilization, and is often a provision in bridge financing as well. Even after construction is complete, the guarantor may be responsible for funding operating shortfalls until the property achieves specified occupancy, DSCR or cash flow thresholds. In many cases, the guarantor remains exposed long after vertical construction ends.
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The important distinction, however, is that these provisions do not necessarily convert the entire loan into a full recourse obligation. Instead, they create targeted recourse for specific risks. The lender may not have the right to pursue the guarantor for the entire loan balance merely because the project underperforms. Rather, the guarantor becomes liable for completion costs, operating deficits, interest- carry obligations, or other specifically guaranteed amounts.
From a sponsor’s perspective, the economic reality can be very similar to recourse financing. If a project experiences significant cost overruns, prolonged lease-up delays or operating losses, the guarantor may be required to inject substantial capital. The practical effect is that the sponsor’s balance sheet remains exposed until key milestones are achieved.
This is why sophisticated borrowers often negotiate:
- Burn-offs upon issuance of a C/O or stabilization
- Caps on operating deficit and carry obligations
- Clear definitions of what constitutes “completion” and “stabilization”
- Time limits on post-foreclosure or post-transfer exposure
- Objective performance tests rather than subjective lender discretion
Completion, interest carry and operating deficit guarantees create a secondary repayment source that shifts much of the development and lease-up risk to the sponsor. Legally, that is not the same as full recourse debt. Economically, however, it often means the sponsor remains on the hook for precisely the risks most likely to emerge during a construction project’s life cycle.
For this reason, it is wise to employ experienced professionals to assist and advise such transactions.
Jay Maddox is a principal in capital markets for Avison Young.
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