What are Non-Recourse (CMBS) Loans? How Investors REDUCE RISK

Feb 01, 2024

Today, we're diving into the world of non-recourse loans — it's a fascinating but intricate topic with nuances tied to timing and specific properties. Understanding this subject is crucial for leveraging it in your overall strategy, especially in the realm of self-storage. It's been instrumental in our growth, allowing us to manage risk, take on more debt, and sleep better at night.

While we invest in properties we believe won't falter, we recognize the unpredictability of the future. In the single-family home market, individual income often dictates decisions. However, commercial real estate, including self-storage, functions differently.

Commercial real estate serves as vital infrastructure for society—providing office space, housing, industrial facilities, and more. Unlike residential properties, these assets are essential for our society to thrive. Traditional financing models, based on individual income, would be impractical for deals involving hundreds of millions or even billions of dollars, like building stadiums or skyscrapers.

Non-recourse loans offer a significant advantage in commercial real estate. They aren't dependent on personal income but rather on the viability of the business or the asset itself. This flexibility allows us to engage in substantial projects, contributing to the functionality of society.

Many people might not be aware of this unique aspect of commercial real estate, particularly in the context of self-storage. Stay tuned as we explore the ins and outs of non-recourse loans and how they play a crucial role in navigating the complexities of this dynamic market.

The Bond Market: Unraveling Misconceptions

This concept may seem perplexing, and I've addressed it on my Instagram where I discuss various financial topics. Surprisingly, many misconstrue it as a Ponzi scheme or deceptive to investors due to a lack of understanding about this financial instrument. The reality is, we're accustomed to traditional financing models, like 30-year mortgages or credit cards. However, the vast and influential market lies elsewhere—the bond market, or the debt market. The bond market dwarfs the stock market and other markets globally, serving as the go-to place for companies seeking debt to fuel their growth. 

Non-Recourse (CMBS) Loans

Unlike traditional banks, which directly lend money, the bond market operates uniquely. When I seek a non-recourse loan from a bank, they don't directly lend the money. Instead, they collateralize the debt, bundling it with others and selling the package on the bond market. The payments I make go to the bondholders or investors.

The unique packaging and collateralization significantly reduce the risk of bond failure since it involves a diverse set of assets. Notably, the bank doesn't retain the debt; it's transferred to willing participants holding bonds. This transfer of risk creates a safer avenue for end-users and investors to generate returns and manage debt.

Critics may argue that this resembles a Ponzi scheme or fear a market collapse, drawing parallels to historical housing market crises. However, this financial concept has deep roots, originating in Europe centuries ago. Over time, debt and risk analysis have refined this approach, making it a longstanding and reliable system. It's crucial to distinguish it from the housing market crisis, where collateralized debt obligations (CDOs) played a detrimental role. In the current scenario, the structure and investments are different, devoid of the risks associated with CDOs.

In essence, this approach, with a rich historical foundation, allows me as an investor to engage in the property market with a more secure financial strategy.

The Bird Method: Maximizing Returns and Minimizing Risk

Investing capital wisely involves not only acquiring assets but strategically leveraging them to optimize returns. Enter the Bird Method—a concept we've coined, a twist on the popular BRRR method. With this approach, we Buy, Improve, Refinance, and then move into a Non-Recourse loan, ensuring ownership of both wealth and income.

The beauty of the Bird Method lies in risk mitigation. By refinancing and transitioning to a non-recourse loan, a significant portion of the investor's capital is extracted, providing a safety net. If the venture faces challenges, the investor can relinquish the keys and walk away, having already recouped their initial investment after the refinance. 

This method enables a continuous cycle of property acquisition, improvement, and refinancing, thanks to the unique features of non-recourse loans. The primary market for such transactions is the CMBS market, although private investors and insurance companies may also offer non-recourse loans. Insurance companies, in particular, leverage their float—the money they invest to secure insurance.

However, this advantageous strategy does come with its drawbacks. Since the debt is solely secured by the asset, lenders scrutinize the property more closely. They demand significant reserves, detailed reporting, and ongoing monitoring to safeguard their interests. While this might require substantial upfront capital and stricter adherence to reporting standards, it pays off in the current competitive market.

In today's market, characterized by stiff competition and changing economic conditions, the terms associated with non-recourse loans are highly favorable. However, it's crucial to acknowledge that market dynamics can shift, influenced by factors such as inflation and interest rates. 

Reflecting on our journey, we initially navigated personal guarantees before discovering the potential of non-recourse loans around 2010. Even now, personal guarantees play a role in initiating the process, gradually paving the way for non-recourse loans. This evolution aligns with the changing landscape of the market, emphasizing the importance of adapting strategies to prevailing conditions. 

As we delve into the intricacies of the Bird Method, it becomes clear that its effectiveness lies in its adaptability, risk mitigation, and strategic exploitation of non-recourse loan options.

Prepayment Penalty

Another drawback associated with non-recourse loans is the prepayment penalty schedule. This schedule is embedded in the loan structure because, as part of a bond, paying it off isn't a straightforward process. The bank must utilize the funds to settle the bondholders, introducing both benefits and drawbacks.

On the positive side, assuming a non-recourse loan at a low interest rate locks in favorable terms. As interest rates increase, the assumability of the debt becomes valuable, making the asset more attractive to potential buyers. However, if interest rates decrease, the prepayment penalty comes into play. The bondholders are entitled to a higher payment, reflecting the difference between the original and current interest rates.

Due to these complexities, we adopt a strategic approach, refraining from immediate repayment. Instead, we wait until the asset has been enhanced, yielding a significant return, and then proceed with refinancing to extract our initial investment. Immediate repayment is only considered in stable, well-performing assets where extracting high yields in the future seems unlikely

Additionally, the approval of non-recourse loans depends on the asset's stability and the operator's track record. To overcome this, partnering with a sponsor with a proven track record becomes a viable solution. Although the terms and conditions of non-recourse loans may evolve, this financing tool remains invaluable for commercial real estate, particularly for storage facility owners. It empowers scaling without incurring incremental risks, making it a crucial differentiator in the industry.

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