Loan Assumption Ins and Outs

Before the most recent economic downturn, many investment real estate transactions were structured with sales being made subject to the existing financing. Whether it was because the prepayment premiums under the existing loan were cost prohibitive, the existing loan was locked out to prepayment, the terms of the exiting loan were not readily obtainable in the current marketplace or some other reason personal to the parties the assumption of the existing loan used to be a great alternative to obtaining new financing. However, given the current economy, in many instances this process has become problematic.

Many of today’s lenders, when faced with an application for the assumption of an existing loan are now using this as an opportunity to re-underwrite the loan as if it were a new loan. Whereas in the past they simply confirmed that the new borrower satisfied certain financial and management criteria, today they also confirm that the properties satisfy certain loan-to-value and debt service coverage tests; as well as other underwriting criteria that existed when the loan was originally placed. In many instances lenders even apply new standards to the underwriting process that did not exist at the commencement of the loan.

The loan assumption process has become a less attractive option when purchasing and selling investment real estate because of the time it typically takes to obtain the consent of the lender (90-120 days, or longer). In addition, if the existing loan comprises only a small percentage of the purchase price, the deal would require a greater investment of capital by the purchaser. On the other hand, if the existing loan is too large, the lender may require additional capital to partially pay down the loan. Sellers also have become concerned, following a proper termination of the contract by the buyer, that this assumption process may reveal to the lender the failure by the property to satisfy certain covenants in the loan documents, causing the lender to require the seller to partially pay down the loan, or worse, declare the seller in default.

Notwithstanding these concerns, should a seller and purchaser look to structure the sale of a property subject to the existing financing, there are a number of issues a purchaser should address, including:

1) Confirm (a) the existing loan documents permit the assumption of the existing loan by a third party, (b) any and all fees and costs that may be required as per the assumption section, and (c) whether there are any loan to value or debt service coverage ratio tests provided anywhere in the loan documents.

2) Negotiate an assumption contingency provision into the contract to provide for the right to terminate the contract if the lender does not indicate its approval of the assumption of the loan within 90-120 days following the date purchaser submits the assumption application to the lender.

3) Start the application process for the assumption of the existing loan as soon as possible (keeping in mind that you will likely be required to pay up front certain costs and fees which will be non-refundable if you elect to rightfully terminate the contract).

4) Obtain a complete set of existing loan documents and confirm whether their terms and conditions are reasonably satisfactory to purchaser.

5) Obtain a representation and warranty from the seller confirming there are no defaults under the loan on the contract date nor will there be at the time of closing. If a default occurs prior to closing, reserve the right to terminate the contract, with a refund of the deposit and reimbursement for any costs incurred.

6) Try to negotiate the applicable assumption documents executed at closing with the existing lender to limit the purchaser’s liability for any claims which may have occurred prior to the closing.

7) Try to limit the ability of the lender to change or modify any of the existing loan terms, except for those changes customary in the mortgage industry.

The assumption of the existing loan can provide an effective alternative to obtaining new financing in today’s difficult credit environment. However, the parties need to determine whether the current financial position of the subject property fares well in the face of the underwriting process associated with the assumption of the existing loan.

Allen J. Popowitz is chair of the real estate practice group of Brach Eichler LLC, a Roseland-based law firm. Contact him at [email protected]. The views expressed here are those of the author.