A very unique feature of agency loans (Fannie Mae and Freddie Mac) is the supplemental loan program. With the supplemental loan program, a borrower is able to go back to the senior lender after the first 12 months and request additional loan proceeds based on the current value of the property. These additional proceeds do not require a refinancing of the entire debt, but rather adds on supplemental loan proceeds on top of the existing mortgage, as the name implies. This supplemental loan program can be extremely useful on long-term fixed-rate loans since refinancing in an effort to tap into cash-out loan proceeds can be uneconomic due to the onerous prepayment penalties associated with fixed-rate debt. This makes the supplemental option over a refi a no brainer in fixed-rate senior loan scenarios. However, the question becomes more challenging to answer when dealing with floating rate debt.

With floating rate agency loans, the prepayment penalty is only 1%, making the option to refinance much more viable at almost any point in the loan term. This makes the refi vs supplemental question more complicated with the determining factors being proceeds, interest-only period remaining, prevailing interest rates, and transaction costs. Supplemental loans require there to be at least three years remaining on the existing senior loan. However, the underwriting constraints are tighter when there is less than five years of term remaining. This means supplemental proceeds get pretty unattractive when there is less than five years of term remaining since the DSCR constraint goes up to 1.35x (it is usually 1.30x for longer term supplementals). This means a greater percentage of net operating income is required relative to the amortized debt service, thus lowering the amount of supplemental proceeds available. In either case, a refinance would be more attractive if the DSCR constraint was only 1.25x, thereby allowing for greater loan proceeds. An important point to consider is the ability to negotiate a waiver of LTV/DSCR limitations on the supplemental loan upfront in the senior loan documents. This can be done in exchange for a small increase in the senior loan’s interest rate. For example, a borrower can pay an extra 5-6 basis points on a senior loan, which is sizing to 65% on acquisition, which allows them to increase the total LTV up to 70% using a supplemental in the future. Nevertheless, in some cases, refinancing is going to allow for the greatest increase in total loan proceeds.

The next point to consider is interest rates. Supplemental loans are priced at 100 basis points over prevailing pricing. This means that if a senior loan from Fannie Mae or Freddie Mac prices at 3.5%, a supplemental loan on the same deal would cost 4.5%. This is true even if the existing senior loan is out of line with current pricing. For example, if the senior loan was originated 3 years ago at 5%, the supplemental loan would still be priced based on prevailing mortgage rates including the 100 basis point adder. This obviously differs refinancing since the existing loan would be paid off and the entire new loan would be priced based on prevailing interest rates. This means a supplemental loan could be more attractive from a weighted average cost of capital perspective if the existing debt is cheaper than prevailing mortgage rates.

Let’s say you have a senior loan at 65% LTV and 3% interest rate, and you want to borrow up to 75% LTV. If prevailing mortgage rates are 4% then the supplemental loan up to 75% LTV would be 5% interest rate. This means the blended rate would only be 3.27%. Conversely, if you were to opt for a refinance instead of the supplemental, then your blended rate would be 4% (since the refi would place a new 75% LTV loan entirely at 4% interest rate). Of course, the inverse is also true. A refi would be much more favorable if the existing loan is 5% and prevailing rates are 3%. This is especially true since the existing 5% mortgage would greatly negatively impact the all-in DSCR calculation used to size the supplemental loan.

The next determining factor is the transaction cost of each financing option. Supplementals are definitively cheaper than refinances since the financing fee is a percentage of the supplemental loan proceeds whereas the refi financing fee is paid based on the entire new loan amount. Additionally, legal and title is slightly cheaper for supplemental loans. Lastly, there is no exit fee to pay on the existing mortgage when receiving a supplemental loan. In contrast, a refi requires paying off the existing loan and any prepayment penalties/exit fees as well as an origination fee on the refi loan amount. Sometimes exit fees can be waived but typically, refinances cost twice as much as supplementals and can be much more in cases of more severe prepayment penalties.

The last point to consider is the interest-only component. Interest-only payments are a very important to investors since they allow for a maximization of cash-on-cash returns. Supplemental loans typically match the remaining interest-only period of the senior loan but do nothing to extend the interest-only payment period. Conversely, if the senior loan has four years of interest-only but only one year remaining, refinancing could put on a fresh four years of IO, avoiding amortization. This part of the equation is the least mathematical because there are qualitative reasons for wanting more IO, mainly the fact that investors appreciate greater cash flows and don’t fully appreciate any equity build up or “implied” cash flow due to amortization.