In the world of commercial real estate investing, there are various types of loans that buyers and borrowers might encounter. Among these are assumable loans, a type of commercial real estate loan that can potentially offer significant benefits - if you can get one. In this article, we'll look at what assumable loans in commercial real estate are and why they're so difficult, but not impossible, to get.
What is an Assumable Loan?
An assumable loan is a loan that allows a new buyer to take over, or assume, the existing loan obligations from the current owner of a commercial property. Eddie Blount with Pinnacle Financial Planners explains that it preserves the original loan terms, including the interest rate and loan amount. "The buyer of a property would try to keep the existing loan on that property in place at the existing terms and just change the responsible party from whoever the seller is over to who the buyer is." The difference between the sales price and the amount still owed on the loan would be the down payment that the buyer pays to the seller at the time of purchase.
Eddie offers this simplified example of how an assumable loan might work in commercial real estate.
"A buyer and seller agree on a price of $1 million dollars for a particular property. The seller's original loan amount was $800,000, but that's been paid down to $700,000. What the buyer would like to do is just say, 'I'll take that $700,000 loan, and I'll be responsible for making payments on it. The lender will then come to me instead of going back to the seller.' If that happens, there would be a $300,000 difference, which the buyer would normally pay as a down payment or equity directly to the seller."
What Types of Commercial Loans Aren't Assumable?
While the simplicity of Eddie's example of how an assumable loan works would be ideal for a buyer and often for the seller, it's important to note that it doesn't usually work that way. In fact, Eddie says that many traditional banks or lenders will not allow new borrowers to assume a commercial loan. "It's a lot of work. The bank is basically having to do all of the underwriting for the new buyer that they would have to do with a new loan. The bank is usually going to say, 'If we're doing all this anyway, we're just going to do a new loan. Instead of trying to fit a square peg into a round hole with this existing loan, we're going to have the old loan paid off and start fresh with the new borrower.' "
It's also important to note that if the seller's loan has a due on sale clause, that loan is not going to be assumable. According to Eddie, "What that clause is saying is that when you sell a property, then the loan is due in its entirety at that time. So you have to satisfy this loan completely to sell it and transfer ownership to somebody else. That would be how the bank documents that a loan is non-assumable. If you sell it, you've got to pay it off."
What Types of Loans Are Assumable With Commercial Property?
While loan assumption is not as common as it used to be for commercial real estate, there are at least a few options where the buyer may be able to assume a loan.
- HUD Multifamily Loans. U.S. Department of Housing and Urban Development (HUD) multifamily loans that are backed by Fannie Mae and Freddie Mac "are typically assumable, subject to review and approval of the proposed new borrower’s financial capacity and experience1." These commercial mortgages can be used to build, rehabilitate, acquire and refinance apartments and health care facilities2.
- CMBS Loans. According to Investopedia, one of the advantages of commercial mortgage-backed securities (CMBS) loans is that "the new owner is able to assume the previous owner's loan for a fee3.”
- Private loans. Eddie says that wealthy investors in a community often want to diversify their portfolio, so they'll make private commercial loans to individual business owners or companies. These lenders can handle the loan however they want, so in many situations, they're open to considering an assumable loan.
Pros and Cons of Assumable Commercial Real Estate Loans
Here's a look at some of the pros and cons of assuming a loan in commercial real estate.
For the buyer, the primary advantage of assumable loans in commercial real estate is the potential for a lower interest rate, especially if the original loan terms are more favorable than the current market rates. For the seller, the most significant benefit is that it might make a problematic property more attractive to potential buyers or it might make a property stand out in a competitive market.
The cons associated with assumable loans for the buyer is that the process can be as time-consuming, if not more so, than getting a new loan. Eddie says that banks have to document everything and be able to show the FDIC why it's a good loan. "If your loans are assumable, and they're jumping from one borrowing group to another, you kind of lose the ability to demonstrate that. For that reason, most banks are going to say it's easier to do a full new underwriting so they can document that their risk management practices for the loan comply with all requirements and that the new borrower has the means to repay the loan." The fact that the loan assumption process can be so drawn out can also be a challenge for the seller as well.
Factors for Buyers to Consider When Assuming a Loan
There are several factors that buyers should consider before assuming a loan.
- The interest rate of the current loan. Since having a loan with a lower interest rate is the primary reason for assuming a loan, it is essential to compare it with current market rates to assess whether it is competitive or favorable.
- The terms and conditions of the existing loan. Understanding the terms and conditions of the existing loan will play a significant role in determining whether you can or should assume the loan. Some of the key considerations include:
- Loan Balance and Repayment Period: The outstanding loan balance and the remaining repayment period will determine the size of the loan assumption and how long the borrower will be committed to repaying the loan.
- Amortization Period: The amortization period refers to the length of time over which the loan will be fully repaid. It is essential to evaluate whether the remaining amortization period aligns with your financial goals and capacity to repay the loan.
- Prepayment Penalties: Some loans might impose penalties for early repayment or refinancing. Understanding the prepayment penalties and assessing their impact on your flexibility to modify the loan terms or sell the property is crucial.
- Loan Assumption Fees: Some loans might have fees associated with the assumption process. Understanding these fees and considering them in the overall cost analysis is necessary.
- Loan Covenants: Loan covenants are requirements imposed by the lender to ensure certain conditions are met during the loan term. Analyzing the reporting requirements and covenants is crucial to determine if they align with your business plans and capabilities.
Steps to Assume a Commercial Loan
The loan assumption process involves a thorough review of the new borrower's financial capacity and creditworthiness. The lender needs to be sure that the borrower has the financial means to repay the loan and is willing to assume the existing loan terms. In some cases, the approval process can take longer than obtaining a new loan, with requirements such as two to three years of tax returns and financial statements, leases and rent rolls, and adhering to reporting requirements and covenants.
Once all documentation requirements have been satisfied, it will be time to complete the loan assumption paperwork and obtain lender approval. Pickett Sprouse broker Brad Gregory says this part of the loan approval process includes documentation from the lender that says the buyer of the commercial property can take over the loan. The seller of the property would then receive paperwork releasing them from their obligation for the loan.
How to Know if a Loan is Assumable?
Eddie Blount says that looking at the seller's loan documents to see whether they include an assumption provision is the first place to start in knowing whether a loan is assumable. That provision is a clause that says the loan can be assumed by a different borrower. If that type of provision is included, you have your answer right away.
If that provision is not included but neither is a due on sale clause, you'll need to work with the lender to see if assuming the loan might be a possibility.
The Bottom Line on Assumable Loans in Commercial Real Estate
Assumable loans offer a potentially attractive option for investors in commercial real estate, especially in a rising interest rate environment. However, the assumption process can be complex. That's why it's essential to work with experienced professionals and conduct thorough due diligence when considering whether to assume a commercial mortgage.
- Fannie Mae. Workforce Housing: Sponsor-Initiated Affordability.
- U.S. Department of Housing and Urban Development. Looking for FHA Multifamily Financing?
- Investopedia. What Is a Commercial Mortgage-Backed Security (CMBS)?