Unlike in residential real estate, mortgages in the commercial space are structured in various ways and often come with significant prepayment penalties if paid before maturity. These prepayment penalties can be millions of dollars and this is the reason why most agency loans can be assumed as I explained in the Understanding Multifamily Loan Assumptions article.
The agencies, Fannie Mae and Freddie Mac, have supplemental loan programs to help borrowers capture equity as they add value to properties via physical and operational improvements. This article covers what a supplemental loan is, its pros/cons, how it can be obtained and some strategies to maximize proceeds.
What is a Supplemental Loan?
A supplemental loan is a second loan that resizes the borrowers LTV to 65-80%, depending on the loan type and use of proceeds. This loan is provided by the same lender and usually matures at the same time (coterminous) with the first loan. This is very different from a refinance whereby your original loan is replaced by a brand new loan. In the case of a supplemental, nothing has changed on the original loan.
As an example, let’s assume a property was purchased for $10M and received a $7.5M first loan on acquisition, which would be 75% LTV. After 24 months of operations and renovations, the property is now worth $12M, but the LTV is now only 62.5%. Assuming that the property can be resized to 75% LTV ($9M loan), the supplemental loan would be $1.5M of additional proceeds for the borrower.
Pros and Cons of Supplemental Loans
The table below shows some advantages and disadvantages of supplemental loans as compared to refinancing:
More often than not, the fact that the prepayment penalty can be avoided is the most compelling reason to take out a supplemental loan especially early on in the term of the loan to capture equity and increase the deal’s internal rate of return (IRR) on exit.
How to Qualify for a Supplemental Loan?
A borrower, in good standing, can apply to the original lender for a supplemental loan 12 months after the first loan has been originated or assumed. The terms of the loan vary by agency but can generally be summarized as follows:
- LTV: 65-80% (combined 1st and supplemental)
- DCR: 1.25x and greater (combined 1st and supplemental)
- Term Remaining: At least 3 to 5 years remaining to maturity
- Loan Amount: Minimum $750K – $1M
- # of supplementals: One per borrower (Fannie); Unlimited (Freddie)
The supplemental will require an appraisal to support the value, a property condition assessment (PCA) and possibly an updated Phase 1 environmental report.
Key Strategies when Planning a Supplemental
Though the programs for supplemental loans are fairly straightforward and programmatic, there are some nuances and strategies to consider when planning to execute one. These mainly relate to timing impact on LTV/DCR constraints and whether a new or existing borrower is taking out the loan.
LTV/DCR Constraints:
Generally, the longer the remaining term to maturity, the higher the LTV and lower the DCR requirements, which results in higher proceeds. For example, if there are 7+ years remaining on a Freddie loan, the borrower can generally get up to 80% LTV at 1.25 DCR. However, if there are less than 7 years remaining, the LTV drops to 75% and the DCR constraint increases to 1.3.
Hence, it is very important to keep these timing and LTV/DCR constraints in mind when planning to execute a supplemental.
New vs. Existing Borrower:
As mentioned above, from a lender’s perspective, a supplemental loan adds risk, which they mitigate via higher interest rates and additional scrutiny. They are particularly more conservative if the supplemental is being taken out by the existing borrower. However, if the supplemental is being taken out on the assumption of a loan by a new borrower, the agencies tend to be more aggressive since a new borrower usually has a fresh stack of capital to make improvements to the property.
Hence, it’s often advantageous to take out a supplemental upon acquisition as a new borrower as the agencies are more accommodating. This strategy is further strengthened if you had 7+ years remaining to maturity, as explained above.
Requesting Waivers:
The agencies provide guidelines to their lenders on underwriting parameters. However, every deal is unique and there is the ability to request waivers on these predetermined underwriting guidelines. The types of waivers vary, but some examples include waivers to get more leverage if you are the existing borrower and have spent a considerable amount of Capex on the property or if you’re a new borrower with a heavy rehab plan and are willing to escrow the dollars with the lender.
Summary
Supplemental loans are a great way to capture equity on an existing asset that has increased in value due to operational improvements. These loans are relatively quick to execute, have competitive terms and help avoid potentially large prepayment penalties. There are various strategies to optimize the execution of these loans and it is important to carefully plan ahead and have all the necessary information to convey the story of the property to the lender. An experienced mortgage broker or lender can significantly help in these executions as well.
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