Self Storage University Podcast: Episode 26

The Truth About Debt Assumption

One way to borrow money is to simply step into the shoes of the prior owner. In this Self-Storage University podcast we’re going to review the ins and outs of doing debt assumption on a property. In many cases, debt assumption may be your best option, yet many buyers do not even realize that the potential is there.

Episode 26: The Truth About Debt Assumption Transcript

Webster's dictionary defines assumption as the action of taking on power or responsibility, but in the self-storage world, it's all about debt. This is Frank Rolfe of the Self Storage University Podcast, we're talking about debt assumption. Now, what the heck is debt assumption? Well, basically what it means is you step into the shoes of the existing borrower, the existing owner of the self-storage facility. You basically take their lender and make their lender your lender. So how does that work, and when is that important? Well, let's first start off when you're looking at buying that storage facility, and let's assume that that person has a bank loan on it. Now you're thinking, "Well, I'm gonna buy it from this guy, and I'm gonna go out and get a new bank loan." But what better candidate for that bank loan than the bank that already has the property and already has a loan on it? 

Now, why would they be so good? Well, they've already undergone the learning curve, they know all about that facility. They know where it's located at, they've probably already seen a phase one environmental. They've seen a survey, they've visited it many times. So you don't have to start from scratch with the lender and trying to explain to them all about the property, they already know most of the basics. On top of that, they've had a track record of success. Hopefully, they have. Hopefully, the borrower has been paying every month like clockwork. And so over time, they've come to respect that that property can create sufficient enough cash flow to pay the bills. So as a result, that bank probably more than any other bank in America at that moment would be your number one most likely candidate to make that loan.

And remember, if you buy that facility and pay off that bank loan, all of that time they spent learning all about it, that's all lost. It's no longer an active loan, and they're gonna have to go out and get a new loan to replace that loan, and who knows if that new property will be as good as the one that they already had the loan on. It's scary when you're a banker trying to make loans, you cannot really afford to have any default. The way banks work, they make money off of giving loans, right? That's how they make it. The spread between the loan interest rates and what they pay the person who puts the deposits in the bank. But they just don't have a lot of room for error. They can't really afford to make a lot of mistakes, as a banker you won't last long in your career. So, all the time they're trying to play it safe, they like things that are known commodities, and there's no more known commodity in the world of storage to them than the property they've already had the loan on.

So don't think you can't go to the existing bank and simply try and re-up the loan. Now, how will that work? Well, I'm sure you're probably gonna be paying more than the person that you're assuming the loan from paid, that would be complete sense, They probably didn't wanna make a profit, they probably have raised the revenue, they've raised the rents or increase the occupancy over time, but that doesn't mean the bank won't make another new loan and even more money. As long as the properties meets the appraisal, the bank shouldn't have a problem with doing that. That function. So don't be shy asking the bank, "Hey bank, I'm looking to buying this thing would you wanna carry the loan on that?" Just because it's higher, that's not necessarily gonna scare them off, but they're such a natural player for it.

We've done assumptions over the years, we find the banks are actually appreciative of you going to them, because it saves them from the pain and suffering of going out there trying to find a new loan. So first stop, if you're buying a storage facility for someone who has a bank loan is talk to that bank, see if they would wanna make the loan. Now, let's assume there's not a bank involved in the deal, let's assume it's just mom-and-pop, they sold the property and they carried back a loan on the property, it's the same story, mom-and-pop is getting a great interest rate on that debt, far, far higher than anything they can make in any other channels down at the old stock brokerage. What does the CD play today? Well, not much, maybe one point, if you're lucky, half a point more typically. What are they making an interest on their loan that they're carrying? I don't know, it could be 4%, 5%, maybe even more.

That means every year, if you're getting 5% versus a CD at half of a percent, you're getting 10 times more in interest than you would conventionally. And don't forget that mom-and-pop know that property better than anybody. They built it in all likelihood, or if not, if they didn't buy it they've owned it for a long time, and they've got a first lien on that property, if you default, they get their property back and they can either then just operate it, or they can resell it again. That's a lot more available that having some just paper document from John Deere's junk bond department.

So again, the mom-and-pop who formally were the seller, they don't really wanna give up that loan, and many, many people and their loan documents on the seller financing, they have the ability to have you assume that loan. So if there is an assumable loan on that with mom-and-pop, that's definitely gonna be your best means probably of getting a loan on that property. Now, can you increase the amount though? Little harder, because while the bank is in the lending business, mom-and-pop really are not. So if you try to increase the amount of debt, if you try to pay a significantly higher amount than what that loan was, you might have to do it through the form of a second lien, leaving the seller's first lien in position and getting a second lien to bridge the gap between your down payment and the total price of the deal, but if you can work a deal using the assumption of that seller note, that's typically a very, very good idea.

Now, let's move on to another variety, which is the conduit loan, also known as the CMBS, Commercial Mortgage Backed Security. How does that assumption process work? Well, the answer is very, very difficultly. Here's the deal. What a conduit loan is, is it's a loan that originates typically from a bank, but it doesn't have to be a bank, and then the loans if you add in many of the properties are grouped together in a bag and basically sold out of Wall Street to the American public at a certain yield. And when you go from the loan product to where they're gathered and bundled and sold, the act of doing that is called a conduit or a Commercial Mortgage Backed Security, and that is no longer in the form of a bank loan exactly. Instead, at that point on, it is serviced by what are called loan servicers. Very different to bank officers who originate the loans, so the servicer typically does not originate the loan at all, they simply manage the loan.

They collect in the payments, they disperse the payments, and they also oversee the property, there's typically an annual inspection, things like that. Now, here's the problem when you have a conduit assumption of a loan, that servicer did not originally bless the deal, so they do not have their next stuck out whatsoever, because no one can criticize them if the loan goes bad because they never said, "Hey, let's make this loan." All they do is just service the loan that's already been made. When you ask a conduit group to bless the assumption of a conduit loan, now you bringing them into predicament, because now they have skin in the game, if that loan should fail, they know they'll be criticized.

Because they're the ones that said, "Okay, it's okay that we can go ahead and do this loan transaction." Yet at the same time, perhaps it wasn't the best of ideas, and if that fails, then guess it will be blamed, that's right, the service or who going into the transaction has an absolutely no responsibility to the loan at all. So to get around that hurdle in the servicing world typically, they want three different people to bless the assumption. There's a regular servicer, there's another servicer called the master servicer, and yet another one called the special servicer. And they all three have to do it independently without talking to each other. This is considered a safeguard for the investors to make sure that nothing happens to that loan and to their payments. But personally, I think it also gives them each the ability to make the loan and with a little more comfort that they're not personally responsible for it being approved. If it ever went bad, they could say the other two guys screwed up.

But that's how it works. Now because of this an assumption on a conduit loan can take a really long time. On the bank loan doesn't take that long, really, seller loan doesn't take that long either. But we've had conduits loans that have taken almost up to a year to get the assumption worked out. That's a long time, it's really hard to get any seller to stay in position and continue on with that deal if in fact, they have to wait around a year for you to be approved. Now, why would they even do that? Why would someone even agree to letting a year pass before you can close on the deal? Well, here's why, when you have a conduit loan and you try and pre-pay that conduit loan, and you pay a horrible penalty called defeasance. So if you've never looked up defeasance, look that up on the computer. There's even a website, you go to call, and you could enter in all the numbers of the loan, it will tell you what the penalty will be, but they can be substantial.

I've seen defeasance penalties as much as a third of the entire value of the loan, you can imagine if you have a million-dollar loan, how horrified it would be to have to pay $300,000 as an early payment penalty. However, if you assume the mortgage, there's no such penalty. Now another problem you have with assumption, which need to be pointed out, they can't resize the loan, they're not a bank, so if you're gonna be paying more than that person and that borrower pay for the property, you're gonna have to pay a bigger down payment, because you're not gonna be able to increase not even $1 in the amount of that existing loan, and a lot of buyers, they don't wanna go ahead and have to put it up in the form of cash, or maybe they're at 50% down payment.

So that's another issue when you're trying to have assumptions of conduit debt. But nevertheless, the very fact that that conduit loan can be assumed, it definitely needs to be on your list of possibilities on that property. Now, I don't think the industry will go that route, but you need to learn all of the ins and outs in terms of how that loan would work. The bottom line to it all, the best source on any loan on any storage property is what's already in position. First step you should have as a buyer when looking at a property is to find out who is the current lender, because they might very well be the best lending source for you. This is Frank Rolfe of the Self Storage University Podcast. I hope you enjoyed this, talk to you again soon.