Assumable Real Estate Loans Explained

When a real estate loan is assumed, the buyer of a property is able to assume the existing mortgage, and take the place of the seller to service the remaining debt.

And on the surface, loan assumptions can look like huge opportunities for buyers right now to increase cash flow and returns on a deal, but the interest rate alone doesn’t paint the whole picture when it comes to assumable loans.

So in this post, we’ll walk through what a loan assumption is on a commercial real estate deal, some key things to consider when assuming an existing loan, and some of the potential downsides associated with going this route.

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What Is a Real Estate Loan Assumption?

To step back and first define what a real estate loan assumption is, this just refers to the process by which a buyer of a commercial property takes over the existing mortgage from a seller, instead of going out and originating new debt.

When this happens, the buyer of the property also takes on all of the rights and responsibilities of the seller related to the loan, including making monthly loan payments, abiding by all loan covenants, and paying off the loan in full at the time of loan maturity.

In commercial real estate, assumable loans tend to be most common on CMBS loans (commercial mortgage-backed securities), or agency loans (Fannie Mae or Freddie Mac loans on multifamily properties).

The Benefits of Real Estate Loan Assumptions

From a seller’s perspective, offering a loan assumption will often generate higher sale proceeds if interest rates have risen since the loan was originated. This can also have the added benefit of potentially allowing the seller to avoid a costly prepayment penalty that would otherwise be due when the property is sold. And from a buyer’s perspective, assuming a loan allows them to lock in an interest rate that might be significantly lower than the interest rate they could get on a new loan today.

However, just because a loan offers a lower interest rate doesn’t necessarily mean that the deal itself is automatically a home run, and these types of transactions can also have some downsides that are worth considering.

Downside #1: Higher Purchase Prices

The first potential downside for a buyer is that, in many cases, sellers will expect buyers to pay more for deals with assumable debt than they would for comparable properties that are offered free and clear.

This can often result in a buyer paying a below-market cap rate on a deal solely due to the terms of the loan, and a purchase price that’s significantly above where the deal would trade without that debt in place.

This ends up making investors extremely reliant on interest rates coming back down by the time they either need to refinance or sell the property outright, which can introduce a significant amount of risk into the deal.

When a loan is assumed, the term remaining on that loan is also usually going to be significantly shorter than what the term of a new loan would have been if the buyer didn’t assume the existing debt, which also brings that refinance risk closer for a buyer if rates don’t end up coming down as expected.

Downside #2: Reduced or No Interest-Only Period

Even if there’s a significant amount of term remaining on the debt, one of the most valuable tools for investors to increase cash flow on a deal is maximizing a loan’s interest-only period. And in many cases, any interest-only period that was originally offered to the seller will have either partially or even fully elapsed by the time the assumption occurs.

Even though a buyer might be assuming a loan at a significantly lower interest rate than they would have been able to get in the current lending environment, if the majority of those loan payments on the assumable debt include both principal and interest portions, this may actually make debt service even higher on the existing loan than it would have been on new debt with an even higher interest rate.

A Real Example of How This Works

If an assumable loan had an interest rate of 4%, if we assume a standard 30-year amortization period, the loan constant on that loan would be 5.73%. This means that the annual debt service on the loan would be 5.73% of the original loan balance.

And if a buyer could either assume this loan or finance the acquisition with a new loan at a 6% interest rate, but with an additional 2-3 years (or more) of interest-only payments and more flexibility on terms overall, this might actually make the new loan a more attractive option.

Downside #3: Higher Equity Requirements

In a real estate loan assumption scenario, the up-front equity requirement of a borrower is also usually going to be higher than what it would be with a new acquisition loan. This is usually due to an increase in property value since those proceeds were originally issued and the loan being paid down by the seller over time, which tends to be a material downside for investors raising third-party capital through syndications or funds.

To use an example to put some numbers behind this, let’s say that a property was purchased for $10 million, and financed with an assumable 65% LTV loan at 4% interest with a 30-year amortization period. And at the end of three years, the outstanding balance on the loan would be just $6.14 million, and annual debt service on the loan would be just over $372,000 per year.

Now, if the value of the property increased by 25% over that 3-year period, and the property owner was now selling the deal for $12.5 million, if a buyer were to assume the existing loan, this would make up just 49% of the total capital requirements (before including closing costs).

And assuming just a 65% LTV ratio on a new loan, this would result in over $1.98 million of additional loan proceeds to fund this deal, and would reduce the equity raise necessary for the buyer by over 31%.

Because that loan payment would also stay the same on that original loan, even if a buyer were to finance the deal with a new loan at a 49% LTV ratio to just replace the existing debt, assuming a 6.0% interest rate with interest-only payments, this would result in annual debt service of just $367,500, which is even less than the $372,000 of annual debt service on the existing 4% loan.

Additional Considerations

Loan assumptions can also add additional fees to a deal, which can make the equity requirements even higher for buyers in these types of scenarios.

By assuming an existing loan, a buyer also loses any flexibility on terms related to things like guarantors, prepayment flexibility, or reporting requirements to the lender on a monthly or annual basis.

The Bottom Line on Loan Assumptions

While loan assumptions can improve the economics of a deal at the right price, these can often have unintended downsides for investors. Even though a lower interest rate can look great on paper, it’s important to factor in all terms of an assumable loan, including total loan proceeds, monthly debt service, and the risks you’d be taking on at the time the loan matures.

If you want to learn more about the concepts we talked about in this post, like loan constants, prepayment penalties, and how to model commercial real estate debt in Excel, make sure to check out our all-in-one membership training platform, Break Into CRE Academy.

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