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Numerous empirical studies have shown that generally the value of an assumed loan in a market transaction is substantially less than the mathematically calculated value. No truly satisfying explanations have been derived for this market phenomenon. This article uses a simple residential case example to show that the problem may well lie with the way we have been modeling cash equivalency in assumption financing situations. When the need for a second junior loan is added to the mathematical model, the resulting calculation of cash equivalent value is more in line with empirical market evidence.
This may be an inappropriate time to think about the value of assumable financing. After all, mortgage interest rates are low,1 and most of the outstanding loans on existing properties are at or above current interest rates. In today's financing environment, there is little to be gained by a loan assumption. However, there was a time in the not-too-distant past when mortgage interest rates were very high and a low interest rate assumable mortgage had a great deal of value.2 When interest rates again cycle upward, today's relatively low mortgage interest rates could add value to the real estate in situations where a loan is assumable. Therefore, this may actually be an opportune time to prepare to deal with the value of assumable financing and to brush up on the topic of cash equivalency.
In order to address valuation problems encountered during the high interest rate cycle of the early 1980s, the American Institute of Real Estate Appraisers (which in 1991 merged with the Society of Real Estate Appraisers to form the Appraisal Institute) adopted Guide Note 2, "Cash Equivalency in Value Estimates in Accordance with Standards Rule 1-2 (b)," to the Code of Professional Ethics and Standards of Professional Appraisal Practice on November 2, 1986. This Guide Note emphasizes that:
[T]he sum of the value of owner equity and the face amount of the balance(s) of the mortgage(s) may or may not be equal to the free and clear value of the property... If sufficient data to permit a direct market comparison is not available, the cash equivalency of existing or proposed financing can be estimated by discounting the contractual terms at current market rates... However, such mathematical methods...