Loan Assumptions

The ability to assume existing debt can be a great way to make a deal work for both buyer and seller. In a relatively flat or declining rate environment as we have seen in recent years, prepayment penalties on securitized loans can be extremely expensive. That additional expense will often diminish a potential seller’s returns to the point where a sale is not feasible.

Why assume the existing debt? There are a few reasons why it makes sense to assume the existing debt when purchasing an asset. The most obvious reason is when the existing debt is more attractive than new debt being offered at that time. In a rising interest rate environment, it makes sense to assume the existing debt at a lower rate. Conversely, in a relatively flat or declining rate environment, the loan terms are not the driving factor. There would need to be another compelling reason to assume a less attractive debt structure than what you could get in the current market.

The most common reason to assume a less attractive debt structure is to avoid additional cost of a prepayment penalty to the seller. The goal is to help keep the cost of sale low for the seller with the expectation of sharing in that benefit and subsequently buying the property at a reduced price. Most securitized fixed rate debt structures will have a penalty associated with paying the loan off prior to the “Open Period.” This open period is usually anywhere from three to six months prior to maturity.

When entering a negotiation to purchase a property with the intention of assuming the existing debt, you need to have a clear understanding of the amount of the prepayment penalty. Although you will not trigger the prepay with an assumption, this will allow you to determine how much of an economic benefit the seller is realizing by you assuming the debt and you can then gauge your offer accordingly. If you are taking on a less attractive debt structure that what is available in the market at that time, there needs to be an economic benefit to you to help offset that additional cost of funds. This is usually a reduction in the purchase price.

Another area of interest when assuming an existing loan is how the existing reserve balances will be handled. Keep in mind that the lender will not release those reserves to the seller at closing as they are considered part of the collateral and loan structure that you are assuming. The seller, however, sees those reserves as part of their historical cashflow and will want to be made whole for those reserve balances as they would have been on a typical sale. This means you will need to bring additional cash to the table to make the seller whole for those amounts.

Fees associated with an assumption are very similar to a new origination, usually one percent of the unpaid balance. The expense deposit is close to that of a new origination as well. While they will most likely not order new third-party reports (appraisal, property condition assessment and Phase 1 environmental report), the lender will absolutely take this opportunity to do a deep dive into the property performance and condition as well as the credit worthiness and financial strength of the proposed borrower.

In the event the asset is not performing or not generating sufficient underwritten cashflow to support the debt, the lender may require the proposed borrower put up a reserve of anywhere from 6 to 18 months of debt service depending on the deficiency. This underwriting analysis is based on the lender’s stressed expense model, NOT the actual expenses. Therefore, taxes will be based on the potential re-assessed amount and insurance is based on the current quote etc. Operating expenses will also get trended by approximately three percent. This higher expense load will result in a lower underwritten Debt Service Coverage Ratio (DSCR) than actual.

Timing is another consideration when negotiating your purchase contract with a loan assumption. It is expected that an assumption will take longer to process than a new origination; however, if the borrowers are diligent with supplying the lender with the required documentation, the timing can be quite consistent with a new origination. That said, it is highly recommended to build in an extension into your purchase contract that is based on lender approval of your assumption request. Unlike a new origination, the proposed borrower has a third hurdle to clear—whether they are strengthening or weakening the borrower quality.

The reality is net worth is not necessarily the only metric used when comparing the proposed borrower to the existing borrower. They will also consider your renovation plan, fresh equity you bring to the deal, and asset quality. This is compared to the seller that may be phasing out of the market and simply not maintaining or operating the asset as well as they could be. Present sufficient financial strength, experience, and a solid improvement plan and you should be fine.

Once the underwriting is complete, your processor will present to committee for approval. It is not uncommon for this process to take up to two months when working with Fannie Mae. If you are assuming a CMBS loan or a Freddie Mac Loan, it may take longer due to the securitization framework as additional approvals may be required from the master servicer. Again, this is a primary reason why you want the extension baked into the purchase contract if needed by the lender.

The big picture is that while assumptions may me a bit more cumbersome than a new origination, proper planning, calculated negotiations, and a diligent buyer group can make things run smoothly. Given the heavy volume of securitized debt we have seen in recent years coupled with the historically low rates that have been locked in for the long term, assumptions are most likely going to continue to be commonplace in the market. Understanding how to navigate them and use them to your advantage is sure to prove profitable!