Pros and Cons of Securing a Supplemental Loan

As a passive investor in an apartment syndication, there are three main ways to receive a large portion or all your equity investment back:

In this blog post, I will discuss what a supplemental loan is, the pros and cons of the supplemental loan compared to a refinance or a sale, and why we at Ashcroft Capital secure supplemental loans.

What is a supplemental loan?

A supplemental loan is a type of loan that is subordinate to the senior indebtedness.

The senior debt, which must be paid first by the GPs, is the original debt used to acquire the apartment community. The supplemental loan is another loan that is obtained and is paid after the senior debt is paid.

A supplemental loan is only available if the senior debt is an agency loan (i.e., Fannie Mae or Freddie Mac). It can be secured 12 months after the origination of the senior debt or the most recent supplemental and through the same agency.

A supplemental loan is not the same as a refinance. The supplemental loan is a second loan and the original debt stays in place. A refinance is replacing the original debt with a new loan.

 

Pros of getting a supplemental loan:

  1. Converts equity created in property to cash that can be distributed and/or used for further capital improvements: The entire purpose of supplemental loans, refinancing or sale is to access the equity created in the asset.  Supplemental loans are one of the ways to do that.
  2. Supplemental loans close quicker and with less risk than a refi: Supplemental loans require less due diligence and underwriting than a refinance.  For a typical supplemental loan, the lender will order an appraisal, physical needs assessment and T-12 financial review.  With a refinance, the same is required, but additionally full underwriting on the sponsor and due diligence are required, which add both time and risk to not being able to secure the refinance.
  3. Supplemental loans are less expensive: Similar to the speed in which they close, supplemental loans have lower closing costs than a refinance.  Because less due diligence is required, the overall fees to obtain the loan are reduced.
  4. Increased LTV helps make assumable debt more attractive to buyer: Securing a supplemental loan increases the loan-to-value on the property. Normally, agency loans are more stringent on their LTV requirements, which are capped around 70% at origination. In other words, they will lender up to 70% of the purchase price and we put down the remaining 30%. As we implement our value-add business plan and increase the value of the property, the LTV drops below 70%. Supplemental loans generally allow for up to 75% LTV. For example, an agency lends 70% on a $10 million project, which is $7 million, and we put down $2 million. If we increase the value of the property to $13,000,000, the new LTV is ~54%. 75% LTV is $9,750,000. Therefore, we can secure a supplemental loan for $2,750,000. We increase the leverage, which allows us to pull out more equity and allow a potential buyer to assume the senior and supplemental loan with less money down.
  5. Ability to secure multiple supplemental loans: Fannie Mae limited the number of supplemental loans to one. However, if the loan is assumed, another supplemental loan is allowed. Freddie Mac allows for unlimited supplemental loans as long as the most recent supplemental loan was secured 12 or more months prior

 

Cons of getting a supplemental loan:

  1. Increased debt service: Since the GP is taking out more debt, the debt service on the property increases.  However, the same would be true with a refinance as well. Additionally, since these are amortizing loans, versus interest only, monthly payments tend to be higher, even at lower interest rates.
  2. Only available through Agencies (Fannie Mae and Freddie Mac): Only having two lenders available limits the GP’s ability to bid lenders against each other for the best terms.  However, because both lenders are government-backed entities, rates are already generally lower than private lenders.
  3. Limited flexibility with exit strategies: Agency loans are ultimately securitized and sold to investors as bonds.  Because of this, it adds a hurdle to the exit of the property.  A loan assumption is always possible, and if the terms of the existing loan are better than market at time of sale, this typically is not an issue.  However, if market rates are lower at time of sale, a defeasance fee is required to sell the property free and clear.  This fee is typically paid by the seller.
  4. Interest rates can be higher: The spread on floating-rate supplemental loans tend to be higher than the spread rate on senior debt, thereby making the supplemental loan’s interest rate higher. For fixed rate senior and supplemental loans, the rate fluctuates with the market at time of origination.

 

Why does Ashcroft secure supplemental loans?

Supplemental loans are a great tool for deals with long-term agency financing on them as it also allows the us and our investors to get rewarded for executing our business plans and adding value to a property.

Normally, agency loans are more stringent on their loan-to-value (LTV) requirements than private debt funds (bridge financing) and those loans are normally capped around 70% at origination. As we continue our business plan and the overall value of the property increases, that LTV shrinks below the cap at origination, thus creating an opportunity for the us to obtain a supplemental loan.

 

On supplementals, we can go up to 75% LTV if the DSCR also allows, therefore a supplemental is a great tool to reward us and our investors for good performance while methodically adding leverage to the deal in careful manner. Supplementals allow us the ability to distribute equity back to investors which lowers their overall basis.

 

Are you an accredited investor who is interested in learning more about passively investing in apartment communities? Click here for the only comprehensive resource for passive apartment investors.

 

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Joe Fairless