Recourse vs. non-recourse

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There is a major, major difference between recourse and non-recourse loans, as developers all over the country have found out to their distinct displeasure over the past few years.

A recourse loan is a loan where one or more of the borrowers agrees to personally pay back the loan, regardless of what happens to the property. If the loan payments are not made, the loan documents give the bank the right to go after the borrowers’ personal assets, like their houses or other assets. This makes recourse loans pretty safe from the bank’s perspective, and pretty dangerous from the borrower’s perspective. For example, say the neighborhood changes and, through no fault of the borrower, the rents go down, making the building unable to carry the mortgage. If the loan is recourse, that’s the borrower’s problem.

A non-recourse loan is one where the bank’s only choice, in the event of non-payment or other default by the borrower, is to take the property. In California, all residential loans (for properties of 1-4 units) are non-recourse by law. For larger properties of 5+ units, getting the bank to give you a non-recourse loan usually means paying the bank a slightly higher interest rate in exchange. In the example above, the borrower could theoretically walk away from the building, losing whatever downpayment he had but avoiding any additional penalty.

In my opinion, it is nearly always worth paying the premium to avoid recourse (so long as that premium is reasonably priced). Obviously, no borrower ever wants to default. For me, paying back all of the money I have ever borrowed is a point of pride and honor. But you never want to put yourself in a position where a deal going bad could cost your family their home or retirement savings.

One more thing to keep in mind: It’s incredibly important to pay close attention to the loan documents. Almost all non-recourse loans contain what are called “bad-boy carve-outs”. These are terms which mean that, if the borrower takes certain actions, the loan automatically changes from non-recourse to recourse. They’re called “bad boy carve-outs” because the actions they mean to prevent are things like lying on the loan applications, stealing rent money, failing to maintain the property, etc. So even if you have what you think is a non-recourse loan, be careful to continue to behave in an honorable way, lest problems with the asset rebound on you (which is what you were trying to avoid by going non-recourse in the first place!).

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