Why NOT pursue a rate buy-down on a DSCR constrained Agency loan?
Context: I work in originations at a debt shop, and we do lots of FNMA business. Figured I would come to WSO to ask this question since nobody in my company (or Chat GPT, lol) can provide a real answer besides “some Borrowers prefer the simplicity or don’t understand the mechanics.”
I understand why a borrower would not want to buy down an interest rate on an LTV-constrained loan… because it doesn’t result in additional proceeds/cash out and thus there is a period of time it would take to “recoup” the cost of the rate buy-down via interest savings.
However, on a loan that is constrained by DSCR (almost every single one), buying down the rate (for example 28bps for 1.25% of the loan amount on a 5 year deal) not only results in net higher proceeds (higher loan amount that is more than offset by the cost of the buydown on settlement statement), and thus more cash out, but also lower annual debt service on an IO and amortizing basis.
I’ve also noticed loans with rate buydowns trade better at rate lock with MBS investors.
So, what gives? I’m a naturally skeptical person, but I’m struggling to see why a Borrower whose goal is to maximize cash out, leverage, and cash flow would not elect the rate buy-down.
Yes, it's 29bps on the 1.25% buy down. Disco's trade better, so at Rate Lock time, deals will usually get an additional 2-3bps on the investor bid vs a par bond and 5-6 vs a 101%. Also, an easy way to get the higher proceeds, most firms seem to be able to net it as well so it never is a check being written. I think if DSCR is constrained, it's a no-brainer.
I think borrowers are stuck in their ways and didn't understand them, some borrowers just don't trust it, Idk. I heard once it was they thought the lender was keeping premium, but the deal has to go at a discount so they are limited to what they can collect in mkt. I mean 2022 when discounts started I know Fannie didn't even understand them, though it is in the pricing memo. It had been that long since people had used them lol
We have one rather prolific borrower who always forgoes the buy-down, claiming he “doesn’t want to owe more later”. This is funny to me since his entire goal is always to maximize every last dollar of cash out. We’ve run every analysis under the sun to show him that it’s in his best interest (lower rate, net increase to cash out, higher leverage, lower monthly payments that could be deployed/invested elsewhere) but he just isn’t interested in hearing it. The guy is worth a gazillion dollars so I’ve tried to get inside his mind on this topic to see the drawbacks, but he ultimately just thinks it’s gimmicky.
Bingo this was what I was getting at, they just are stuck in their ways. Haha my one question is what does he mean he'll owe later?
Lenders were keeping the premium! Fannie continually tweaks their pricing memo and they made sure if you collect money for a discount you actually sell the loan for said discount. It's amazing this ability has been around forever and no one did it.
You can still offer a 2pt buy down on a 10-year and keep 1.99% in premium just got to trade at a discount.
Because the IRR may drop as the first period CF gets discounted the least....
Bingo - many people are taking 5-yr debt to give them the cheapest option to refi into a hopefully lower rate environment. While the buydown fee can be covered by additional proceeds, you're still taking that hit in Y1 of a DCF model.
Buy downs are just prepaid interest. If you know you'll hold to maturity, they can be accretive. If you plan to refi or sell if rates go lower, it may turn into a sunk cost.
The true purpose of buy downs are to get borrowers an extra 50 bps of net leverage (because they need every last dollar) and to allow bankers to gloat low rates on a sick "recently closed" LinkedIn post (often w/out mention of said buydown).
Good answer
Since buydown cost is less than proceeds gained due to DSCR constraint, wouldn’t there be a smaller cash outlay on day 1 (higher leverage) increasing IRR? Also, lower annual P&I payments would increase IRR. Unless I am missing something here.
.
That’s to say, on a DSCR constrained scenario, the cost of the buydown isn’t coming out of your pocket, but rather being paid with increased loan proceeds that cover it and then some. On the settlement statement, net cash from Borrower would be lower on an acquisition and more cash to Borrower on a refi.
You are borrowing more than you are paying upfront, so it's all about the timing of the higher repayment of the additional proceeds (negatively impacting IRR in the final period).
Off topic but how many of yall are based in DMV? Would love to do HH or something….
On the same note, would love a group (whatsapp?) where it's just us Agency folks. It's a niche space so more people we know in this space it can help us all. I am in SoCal.
Enim perferendis beatae sed. Optio est nihil iste similique ullam at non. Odit amet velit aut recusandae commodi in et.
Et rerum repudiandae est possimus. Enim incidunt maxime aut aut. Quam sed a sed quos molestiae ratione fuga.
Ex voluptatum omnis itaque aut dolorem et. A consequatur dolor voluptas autem rerum dolores. Magni iure voluptatibus deleniti quis consequatur et. Sint laborum quae nihil eius quia minus. Dolorem est iusto adipisci saepe necessitatibus occaecati. Vero voluptate et ut magni est enim.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...