The names of many twentieth-century authors have morphed into shorthand for certain tropes shared by the educated middle class. You don’t even need to have read the applicable books to throw the names around, because they are more often used as performative speech acts than anything else. Kafka – bureaucracy. Beckett – absurdity. Behan – Guinness. Freud – …what do you think? But the granddaddy of them all is Orwell. When you say “Orwellian”, everyone knows what you are talking about. A rule, a regulatory regime, or a contractual provision is Orwellian if it twists logic in such a way as to centralize and concentrate power in the hands of the already powerful. “Heads the DMV wins, tails you lose”; “The Executive hereby exercises its right to obstruct Congress’ investigation of the Executive’s obstruction of Congress” – that sort of thing.
The term comes from a novel that Orwell wrote in 1948 that describes a dystopian, Orwellian society set in the near future. It is not the only book that he wrote. He wrote another book about a revolt by barnyard animals that is often taken to be a parable about a revolution that had recently occurred in an eastern European country. He wrote another book which was a first-hand account of his participation in a civil war that occurred in a southern European country, which served as a prolegomenon for a larger war that engulfed most of Europe and much of Asia in the next decade. He wrote another about being homeless in two European capitals, and another about serving as a colonial policeman in a southeast Asian country whose treatment of a certain religious minority has recently been in the news. But he is best remembered for the novel set in the dystopian near future. In the novel, behavior is regulated by, inter alia, four ministries, i.e., the Ministry of Love, the Ministry of Peace, the Ministry of Plenty, and the Ministry of Truth. The Ministry of Love enforces obedience to the government through torture and mind-control. The Ministry of Peace oversees the country’s war effort. The Ministry of Plenty rations food, and the Ministry of Truth is in charge of propaganda. Don’t agree? You must not like love, peace, plenty, or truth. You must be dealt with.
What does this have to do with real estate financing? Quite a bit, I recently found. The language of many real estate loans has come to contain language worthy of the Ministry of Truth, and someone has to call bullshit. Secured loans fall into two categories. Recourse loans grant the lender recourse to the borrower in the event of default. Say you borrow $75 on a fully recourse basis to buy a mobile home park that is worth $100 on Day 1. Then a sink hole opens up under the park and the local population is wiped out by a mysterious plague, the park stops producing revenue and the resulting sink hole is worthless for any use other than as a memorial to Congressional Republicans from the latter part of the second decade of the twenty-first century, and would yield at most $10 in an arm’s-length sale. In this case, the bank can come after you personally for the resulting difference between the value of the property and the principal amount of the loan – here, $65. By contrast, non-recourse loans do not grant the bank personal recourse against the borrower. For example – assume the facts are the same as in the example above, except (i) the loan is a non-recourse loan, and (ii) shortly after the sink hole opens up, you are smitten with a rare form of cancer, and your wife, who has been threatening to divorce you for some time, takes you to the cleaners. In this event, if the loan is truly non-recourse, you can simply hand the keys to the park to the bank and walk away.
Why does anyone care about the recourse value of a loan? From a business perspective, it should not be a deal breaker. If you are so scared about the future success of a real estate investment as to require non-recourse financing, the investment is probably not a great deal in the first place. If you are not comfortable with projected cash flows and equity cushion on Day 1, you should put your money elsewhere. Nevertheless, non-recourse funding is a nice-to-have, because it covers unknown unknowns and tail risk. I do not expect a sink hole to open up under either of my parks. I do not expect to be hit with a nasty divorce and a rare form of cancer – but I would like to mitigate my risk in the case of a black-swan event of this type. From a tax perspective, the recourse nature of a loan taken out by a partnership is important because partnership obligations are passed through to partners for tax purposes to the extent of partners’ economic interest in the partnership’s obligations. A loan for which a partner is not personally responsible is not imputed to a partner beyond the amount attributable to the partners’ share in the property which secures the debt.
Most non-recourse loans include certain “bad boy” carve-outs to the limitation on personal recourse. If a borrower, say, acts fraudulently in presenting a deal to a lender, or if a borrower acts recklessly in operating a property, the borrower is personally on the hook for the entire principal amount of the loan. Bad boy carve-outs make sense; after all, you can not kill your parents and say, “Take pity on me! I am an orphan!”
Or – in the words of a former disgraced President – you could – but that would be wrong.
Since the financial crisis of 2008, a new type of carve-out has wormed its way into the documents for many non-recourse loans. This is the bankruptcy carve-out. The bankruptcy carve-out is Orwellian. It effectively makes non-recourse loans fully recourse. It is bullshit.
By way of background – most real estate is held in a legal entity that is transparent for tax purposes, but opaque for general obligation purposes. That is a fancy way of saying that the owners of the park can not be held personally liable for the obligations of the business, but taxable income of the business is attributed directly to the owners. For example – I do not own my parks directly. Instead, I own all of the shares in an LLC (Versailles Estates – “The park – that’s me”), and Versailles Estates owns the land, the equipment, the buildings, and, possibly, the park owned homes. Since Versailles Estates is tax-transparent, there is no tax cost to doing this, but if someone sues Versailles Estates, they cannot sue me personally.
There’s the rub. When I borrow to finance Versailles Estates, I do not borrow personally. Versailles Estates, LLC borrows. If the bank wants to lend on a recourse basis, they make me personally guarantee the debt incurred by Versailles Estates.
Financing for mobile home parks can be tricky. The type of loans that everyone wants – agency loans and CMBS loans – are generally not available for loans with principal amounts under $1.5m, and for properties that do not comply with rigorous guidelines. Smaller loans, and loans for rougher parks, need to come from local banks, “hard money” lenders, or, if you are lucky, from the seller. CMBS loans, and agency loans, are non-recourse. However, local banks generally only lend on a recourse basis.
I recently refinanced one of my parks. The rate had gone up because interest rates had spiked on the date when the loan’s rates were set to be adjusted, only to go down shortly thereafter; I had paid down about $100,000 of principal; the park had increased in value significantly since I had bought it; and I needed liquidity to fill lots in my other park. I called a mortgage broker. He told me that there was a bank in Indiana that would lend on a non-recourse basis if the loan were under 65% LTV (apparently, some regional banks will lend on a non-recourse basis, if the Day 1 equity cushion is big enough). The appraisal indicated that we would be well under that. I shopped the deal around. A competing bank offered me better terms with limited recourse. I went with the competing bank. Two days before closing, I was sent a draft of the limited guarantee. In addition to the standard bad-boy carve-outs, the limited guarantee contained language to the effect that it would become an unlimited guarantee (i.e., the loan would become fully recourse, instead of limited-recourse) if the borrower (in this case, Versailles Estates, LLC) went bankrupt or became insolvent.
Let me get in front of this. In every possible event in which the limitation on the guarantee could be implicated, the borrower would be bankrupt or insolvent. This meant that the loan had limited recourse – except when I needed it. In other words, the loan was in fact, if not in word, full-recourse. A call to the bank attorney confirmed this. “If the borrower goes bankrupt, we need recourse against you.” “Uh – isn’t that why we agreed to limited-recourse?” “Sorry.” A few more calls and some on-line research indicated that this was the rule, rather than the exception. It is common for banks to require this term. CMBS loans are non-recourse, but they contain a bankruptcy carve-out. The bank in Indiana would have offered their loan on similar terms. Admittedly, I was not able to research the whole market, and readers are encouraged to correct me if I am wrong, but it appears that the market agrees with the Ministry of Truth. War is peace. Love is hate. Non-recourse is fully-recourse.
Anything to learn here? Well, for one thing, you can replace the Kubler-Ross stages of grief with the names of the Twentieth Century Canon. Beckett – “What are we waiting for?” “We are waiting for true non-recourse financing.” Freud – “How do you feel about this?” Behan – “Drink up”. More importantly – when a lender offers you non-recourse financing, address this issue at the term sheet stage. Better still, ask to see the carve-out section of the document before you sign the term-sheet. If you are very lucky, you might be able to narrow the bankruptcy carve-out to voluntary bankruptcy or collusion to enter into involuntary bankruptcy, but the chances are slim that you can eighty-six it altogether.
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