Real estate borrowers often prefer nonrecourse loans, which can eliminate or reduce the risk of having to satisfy a deficiency judgment if a project goes bad. However, most nonrecourse loans have carve-outs or exceptions to the nonrecourse aspects of the loan. The project’s sponsor must guarantee these exceptions, which generally fall into one of the two following categories:

  1. The first category of carve-outs includes matters that could impair the value of the collateral. For this category, the guarantor’s liability is typically limited to the lender’s actual losses resulting from such impairment. Examples include a borrower’s waste of the collateral or failure to pay property taxes.
  2. The second category of nonrecourse exceptions includes events that impair a lender’s ability to realize upon the collateral. Lenders will accept the concept of a nonrecourse loan only on the condition that they have unimpeded access to that collateral in the event of a default. Accordingly, events that prevent a lender from exercising its remedies as to its collateral typically trigger full recourse. A common full recourse event would be a borrower bankruptcy filing that stays the lender’s ability to foreclose on the collateral.

Because a nonrecourse lender’s remedies are limited to the collateral property, the lender will also want the ability to control the property’s cashflow, particularly in the event of a default or erosion of the collateral’s financial performance. Nonrecourse loans may therefore also include cash management provisions under which the cash receipts of the collateral property must be deposited into a lender-controlled account for application in accordance with a contractually agreed payment “waterfall” of property expenses, debt service payments and required reserves, with the remaining balance (if any) paid to borrower. Cash management may be required from the inception of the loan or triggered by certain events, such as the borrower’s failure to maintain a stipulated debt service coverage ratio or debt yield or failure to meet other financial covenants; major or key tenants terminating or failing to renew their leases or going into default; or a loan default occurring.

Impact of COVID-19

The COVID-19 pandemic will have important ramifications for both nonrecourse carve-out (loss only and full recourse) and cash management provisions. Some of these will result from the pandemic’s disastrous financial impact on many tenants, particularly brick and mortar retailers. For example, tenant rent payment defaults may result in “busted” financial loan covenants or a “material adverse change,” triggering either cash management or possibly a loan default. “Major tenant” lease terminations may also result in cash management or again, depending on the loan provisions, even a loan default. During this period, it is also possible for borrowers to “foot fault” under their loan documents in negotiating with tenants by failing to obtain required lender approvals for any lease work-out amendments or terminations.

These tenant problems quickly become landlord problems, creating a new source of nonrecourse carve-out exposure for building owners. For example, if a borrower fails to pay all property expenses or debt service to the extent it has the cash to do so—e.g., in an effort to conserve cash in the short run—that will likely constitute “misapplication of rents” from the property, a common nonrecourse loss carve-out (in addition to being a loan default).

Borrower Actions Could Trigger Recourse

Further, in work-out negotiations with lenders, borrowers will be tempted to paint a bleak picture of their situation. However, borrowers should note that their admission of insolvency or inability to pay debts may constitute a full recourse event under many nonrecourse loans, and they should therefore exercise caution about making such statements. Borrowers entering into work-out negotiations with their lenders will be well advised to execute pre-negotiation letters providing both parties with protections against their work-out communications being used against them.

Likewise, a borrower’s failure to maintain its single purpose entity (SPE) status may also trigger full recourse, at least to the extent that such failure is a factor in the substantive consolidation of borrower with another entity in bankruptcy. Many SPE requirements will be impacted by the property’s financial performance and thus by the pandemic. For example, SPE requirements often mandate that the borrower pay its debts in the ordinary course within a certain period of time, maintain adequate capital for its operations and maintain a sufficient number of employees for its business operations. Borrowers should confirm whether these kinds of requirements are present and, if so, whether they are limited to the extent to which the property produces sufficient cashflow to comply with them.

In fact, one of the first steps nonrecourse borrowers should take during this period is to determine whether the failure to pay certain property expenses or meet certain SPE requirements trips a nonrecourse carve-out only if the property produces sufficient cashflow to pay such items or meet such requirements. If that is the case, and if the borrower controls the cashflow of the property, the borrower should consider whether it should first pay property expenses that are not subject to that qualification. By doing that, any cash shortfall is allocated to those categories that are subject to such a qualification.


Nonrecourse borrowers must ultimately evaluate the likelihood that they will be able to retain a pandemic distressed property versus having to give it back to the lender. In the former instance, building operation and leasing concerns may trump legal issues, at least in certain cases. However, if the borrower anticipates having to give back the property to the lender, managing the situation to minimize any guarantor’s exposure for nonrecourse carve-outs and full recourse events becomes critically important.