Given the current capital markets and high interest rates, I wanted to share a quick breakdown of what owners should consider when doing loan assumptions as a strategy to get lower cost debt.

While loan assumptions can potentially be leveraged for lower debt service, assumptions simultaneously impact risk factors for an investment. Investors must evaluate the trade-off of a competitive interest rate against its concurrent variances in price, interest rate, leverage, term, and interest only period to determine if it matches their business plan. Furthermore, each of these variables are affected differently in low vs high cost debt markets. Following the recent interest rate rises in capital markets, this article will give a full breakdown of loan assumptions but will focus on loan assumptions in a high debt cost market.

Loan Assumptions in High Debt Markets

As mentioned above, the primary considerations in a loan assumption scenario are the price, interest rate, leverage, term, and interest only period of the in-place debt.

Price - While it may be tempting to first consider the interest rate when looking at loan assumptions, its price implications are more important for the risk/return evaluation of the debt structuring for a deal. Purchase price is permanent, financing is temporary. Debt has the optionality to be refinanced, supplemented with mezzanine financing, or restructured with the lender. Purchase price, however, cannot be modified once a deal is acquired. Operators must consider if the lower interest rate provided by an assumption outweighs the stresses a higher purchase price enacts on return metrics for investors. Especially in a high debt cost market, sellers may feel (rightfully) entitled to an increase in purchase price by allowing the buyer to conduct a loan assumption of their lower rate debt.

Interest Rate - A lower interest rate on your debt means a lower debt service, which results in higher cash flow for the property. While higher free cash flow will boost IRR, it is not the only factor for returns. As alluded to above, the interest rate benefits provided by a loan assumption are inexorably tied to price considerations. Enhanced cash flow from lower debt service in exchange for a higher purchase price may still result in a net lower return. Returns may suffer from the now smaller delta between acquisition price and eventual sale price. This is especially true for value-add investment strategies, in which the majority of internal rate of return (IRR) for the property typically comes from sale as opposed to generated cash flow. Even if the lower interest rate and resulting debt service may lower the risk of the investment, other risk factors in the assumed debt must also be considered.

Leverage - Often used synonymously with risk, the leverage of the loan is the next consideration for an assumption. While leverage can typically be quasi-tailored for an investment's risk-return appetite when securing new financing, buyers are limited in their leveraging options in a loan assumption. In acquiring the existing senior debt on a property, operators inherit both the interest rate of the debt and the amount of the debt. Presuming that the acquisition property has appreciated since its last acquisition, the now higher valuation will result in lower leverage if the debt amount remains constant. Lower leverage provides less risk of default, but also limits an investment's return metrics as the rest of the acquisition price will be now filled with equity, the same equity that is expecting returns. Leverage can be increased by expanding the capital stack with mezzanine debt or preferred equity, but these added layers require higher payouts than senior debt, even in high debt cost markets. Furthermore, risk is added to common equity investors who are now even farther down the distribution waterfall. These risk factors are in the capital stack of the investment, but the loan assumer must also account for risk factors from the timing of the investment as well.

Term - The term of the loan is the source of timing risk for the execution of the business plan for an investment. For example, if at the time of assumption a seller is 8 years into a 10 year term loan, then the buyer now only has 2 years remaining before said loan comes to maturity. A short runway on the term of the loan stresses both a buyer’s business plan and exit options. In regards to business plan, a value-add buyer would have to renovate, rent increase, and stabilize an asset within the remaining term period in order to avoid a potentially catastrophic capital event during the asset repositioning. Even if the buyer can complete their business plan within the remaining term, they now are forced into a capital event in whatever the prevailing real estate market conditions are, with no option to extend the hold period without additional financing. The timing risk of an investment is also intertwined with the interest-only period of the assumed loan.

Interest Only Period - While the expiration of an interest only period will not force an operator into a capital event, the timing of the remaining interest-only period on the assumed loan will limit their ability to customize it to their business plan. As an example, let's say the seller financed a deal 2 years ago, with a 10 year term, and is looking to sell on assumption. The term remaining is 8 years. If the seller got 0 zero years of interest only, the loan started amortizing two years ago. The debt constant in this case is going to be high, which is going to be less attractive to a buyer, as they are going to have weaker cash flow. If instead the seller structured that same loan with 10 years of interest only, that would be more attractive to the buyer. The loan is not paid down at all so the new acquirers are getting the full loan amount, and they are getting interest only for the remainder of the loan term, allowing the buyer to drive both leverage and cash flows.

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