As mentioned in previous articles, one of the greatest benefits of multifamily investing is the ability to obtain government (“agency”) backed non-recourse financing with exceptional terms. Most conventional agency debt has the added benefit of being assumable by a new borrower (i.e. new buyer). Essentially, the new borrower is stepping into the shoes of the existing borrower upon acquisition. In most cases, the seller has a very high loan prepayment penalty that necessitates them to sell as an assumption.
Many buyers shy away from assumptions because they are more complex and can come with a lot of surprises if they aren’t prepared. This decreases the number of potential buyers, which helps in a competitive market. Also, deals on loan assumptions can be bought at good discounts as opposed to buying with a new loan. These two reasons can make for a compelling investment opportunity if the buyer can align their business plan with the loan and execute well.
In this article, we cover the major nuances related to loan assumptions and how to prepare yourself as a potential investor on a loan assumption:
Increased Lender Scrutiny
The lender will have more scrutiny on the new borrower as they are essentially changing horses and they want to ensure the new borrower is as strong, if not stronger, than the original borrower. The lender will be looking for the new borrower to have a solid balance sheet, liquidity, experience, etc. that ensures their risk does not increase by doing the assumption. As such, it’s very important for the new borrower to understand who the seller is and assemble a strong team. The lender can deny the assumption request if they are not comfortable with the borrower and as such, contracts should be worded carefully especially in an era where financing contingencies are not commonplace.
Business Plan Alignment
Loan assumptions can work out well when the interest rate on the existing loan is lower than the current market rate. Conventional thinking in the industry the past years was to take out long-term fixed rate debt at ‘historically’ low interest rates, which would make the loan attractive should interest rates go up. However, the opposite has occurred as rates have dropped significantly and as such, loans being assumed have higher interest rates (which also increases the prepay penalty). In addition, the following are some key considerations when aligning the business plan to the loan being assumed:
- Interest-Only (I/O): Most value-add deals have a few years of interest-only payments to help the deal cash-flow during the rehab phase. Often, the I/O period is dwindling or has already expired when the deal is put for sale via assumption. As a buyer, it’s very important to understand how that can impact cash-flow going forward. If the deal is not stabilized and still requires a heavy lift, it may not cash flow well. If it is stabilized and being purchased with decent leverage, then it can work out better for the buyer since the P&I payments are modeled from day-1 and the risk of I/O burning off is eliminated. Further, paying principal will help increase the IRR upon sale.
- Leverage / Supplemental: Leverage is one of the keys to generating solid returns in real estate. On most new deals, loan-to-value (LTV) is in the 70-80% range. For example, a property purchased for $10M with a $8M loan would have a 80% LTV. Assuming the deal is performing well, it would be listed at a price higher than it originally cost and this would reduce the LTV via assumption. If the property mentioned above were listed at $12M, then the going in LTV by assuming the $8M would be 66%. This requires more equity upfront and drags down returns. To help alleviate this, most agency loans can qualify for a supplemental loan, which is a second loan that ‘resizes’ the loan to 70-75% LTV. In our example, the property may qualify for a $1M supplemental, bringing the total loan to $9M or 75% LTV. This results in less equity required by the borrower and will help increase returns. The challenge with supplemental loans is knowing when to take them as typically they are only available one-time per borrower and have LTV/DCR constraints depending on time remaining to maturity.
- Time to Maturity: Agency loans being sold on assumption usually have original terms of 10 or 12 years, whereas most business plans are +/- 5 years. One challenge with assumptions is the limited exit options especially if the time to maturity is a lot longer than the intended hold period. For example, if there are 10 years remaining on the loan and the business plan is to sell in 3-5 years, there will likely still be a large prepayment penalty upon sale. Further, presuming the value has increased during the hold, the LTV would be very low, which makes it unattractive for another assumption. On the other hand, if there are only 7 years remaining to maturity, then a 5 year plan may align better as the prepayment penalty at the end of 5 years would be much smaller and allows for exit flexibility.
Additional Equity Needed to Close
In addition to the larger down payments required, loan assumptions also require more cash to close due to the following:
- Escrows / Reserves: Escrows for taxes, insurance and replacement reserves are standard for agency loans. As a new borrower is stepping into the shoes of the original borrower, the lender will require that these escrow buckets be replenished upon closing. This usually involves the new borrower to bring cash to table. In some instances there could even be large interest reserves setup initially that have to be replenished upon closing as well.
- Immediate Repairs: The lender reinspects the entire property and in addition to any new lender required repairs, the borrower would also be responsible for any required repairs that were not completed by the original borrower. As such, it’s very critical to understand the status of the original required repairs and negotiate in the contract, otherwise, the onus will be on the new borrower to address.
- Rehab Budget: On new loans, rehab dollars can often be financed but on loan assumptions the rehab budget must be raised via equity. This can bring down returns depending on the size of the rehab, but one positive aspect is that the new borrower controls the rehab money and doesn’t have to deal with the challenging lender draw processes.
Summary:
Loan assumptions can be complex and make some buyers shy away from them. But with a good understanding of the nuances, loan assumptions can make sense and enable a purchase in a less competitive environment. It is very important to thoroughly understand the existing loan terms, request the full loans docs and work with an attorney that has significant experience in these types of transactions.
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