One of the major benefits of a commercial real estate investment is that the property produces income that can be used to service debt. As a result, most commercial real estate asset purchases are made with some amount of debt, provided by a lender. But, debt markets are not static. They are constantly changing, which means that they could become more or less favorable over the course of an investment holding period. If they become more favorable, the property owner/investor may choose to refinance.
In this article, we are going to discuss one specific type of refinance known as a cash out refinance. We will define what it is, how it works, and why it can be extremely beneficial for property owners and investors. By the end, readers will have a greater understanding of how a cash out refinance works and can use this knowledge as part of their pre-investment due diligence process.
At First National Realty Partners, we specialize in the purchase and management of grocery store anchored retail centers. As part of this effort, we seek opportunities to refinance property debt when it is in the best interest of our investors. If you are an Accredited Investor and would like to learn more about our current investment opportunities, click here.
What is a Refinance?
In order to understand what a cash out refinance is, it is first helpful to understand what a refinance is in general.
To refinance a loan simply means getting a new loan to pay off an old one.
In a commercial real estate context, it is common for investors to utilize the option to refinance in one of two ways. First, in a value add-scenario, an investor may purchase a property with a relatively short term loan, make improvements, lease it up, and then refinance into longer term, permanent debt.
Or, in a scenario where debt terms have become more favorable, an investor may execute a refinance to save money in debt service costs.
There are several different types of refinances, but the focus of this article is one particular type known as a “cash out refinance.”
What is a Cash Out Refinance?
A cash out refinance occurs when an investor obtains a new loan in an amount greater than the existing loan balance. The loan proceeds are used first to pay off the existing loan balance and the difference is provided to the investor in cash. To illustrate this point, an example is helpful.
Suppose that an investor purchases a property for $1.25MM. As part of this purchase, they obtain a loan for $1MM that requires principal and interest payments monthly.
After five years, the value of the property has risen to $1.5MM and the loan balance has declined to $900M. In addition, interest rates have declined and the owner senses an opportunity to refinance their loan at a more favorable rate. The lender has indicated that the maximum loan to value ratio (LTV) is 80% or $1.2MM
So, the borrower gets a new loan for $1.2MM and uses it to pay off the old loan balance of $900M. The remaining $300M is cash that goes into their pocket. This is the essence of a cash out refinance,
Elements of a Cash Out Refinance
In order to determine the amount of cash that can be taken out of a property, there are a number of elements that investors and lenders must consider.
Cash Flow
The first, and perhaps most important, element that dictates the amount of cash that can be taken out of a property is the amount of cash flow that it produces.
Although there are variations, cash flow is calculated as the property’s gross income less operating expenses. The result represents the amount of money that can be used to service debt on the property. In short, the more cash flow a property produces, the larger refinance loan amount it can support.
Loan Amount
As the example above describes, there are two loan amounts to consider. The supportable loan amount given the cash flow produced by the property and the current loan amount.
The supportable loan amount represents the maximum possible loan amount given the property’s cash flow. The actual amount can vary by lender and property type so it isn’t necessarily fixed. As a general rule, investors and property owners want to aim for the largest loan amount available.
The other loan amount to consider is the outstanding balance on the existing loan. This can be found on loan statements and it represents the amount of money that must be used to pay off the balance with the new loan.
The difference between the supportable loan amount and the existing loan balance is the amount of cash available to the investor/owner.
Fair Market Value
The Fair Market Value of an investment property is assessed with an independent appraisal and it is a major factor in the calculation of the maximum supportable loan amount.
As a general rule, loan terms dictate that a lender is willing to advance a certain percentage of the fair market value of a property. This is known as the loan-to-value (“LTV”) ratio and typically depends on the property type. LTVs for less risky properties, like multifamily apartment buildings, may be as high as 85% while riskier property types, like land, may be capped at 50% or 60%. The exact terms vary by lender.
How a Cash Out Refinance Works
In the simplest terms, the mechanics of a cash out refinance are such that the new loan is used to pay off the old loan. To illustrate this point, let’s continue the example from above.
In the example above, the new commercial mortgage loan of $1.2MM is used to pay off the old commercial real estate loan of $900M.
Costs of Refinancing a Commercial Property
In theory, completing a cash out refinance can make a lot of sense for owners/investors. But, it is important to note that they are not free. There are a number of closing costs associated with the completion of a cash out refi and their total can make or break the financial logic of the decision.
As a general rule, closing costs on a new loan program average 3% – 5% of the total loan cost. So, a $1MM loan would have closing costs of ~$30,000 – $50,000. The savings in the monthly payments or the cash out obtained must justify this expenditure.
Advantages of a Cash Out Refinance
There are a number of advantages to a cash out refinance, but there are two that are most important in the context of this article.
First, a cash out refinance allows a property owner/investor to put cash in their pocket. This cash could be used to pay for needed capital improvements, reduce debt, or even provide a cash distribution to investors.
Second, if the cash out refinance comes with a lower interest rate or longer amortization, the monthly mortgage payments are lower. Ultimately, this has the same impact, which is to put more cash in the pocket of the property owner and/or their investors.
Drawbacks of a Commercial Cash Out Refinance
There are two prominent disadvantages of a cash out refinance.
The first is the cost. As described above, the total closing costs can range from 3% – 5% of the loan amount. So, as the loan amounts get larger, so does the cost. As such, the cash received or the savings achieved in the monthly payments must be enough to justify the cost of the loan. In general, the goal is to recover the cost in ~12-18 months. For example, if it was $12,000 in closing costs to get a new loan, the savings would have to be ~$1,000 per month to recover the closing costs in one year,
The second disadvantage to consider is that there may be contractual obligations that can make a commercial real estate refinance tricky. For example, it is common for a lender to write into a Loan Agreement that a borrower may not take on any new debt without their approval. If the lender on the original loan was stubborn, they may make it very difficult to get the new loan.
Determining If a Cash Out Refinance is a Good Option
As with any major investment decision, those considering a potential cash out refinance should carefully consider the pros and cons and make the choice that is in their best financial interest given the circumstances of the refinance scenario. Although every situation is unique, a refinance decision typically comes down to one option…do the savings or need for cash in the transaction justify the cost?
This calculation can be a bit different for everyone, but investors should generally work with their lender to determine the cost of the refinance and weigh it against the need for cash or savings. Again, as a general rule, the goal is to be able to recover the cost, through savings, within 12-15 months of the refinance.
Other factors to consider in the underwriting phase include:
- Down payment: Will there be an additional down payment in the new transaction?
- Mortgage Rates: Will the interest rate on the new loan be better than the existing mortgage? Will it have a fixed rate or an adjustable rate?
- Payments: Will the new payments be principal and interest monthly? Or, will they be interest only? Is the loan fully amortizing, or will there be a balloon payment at the end?
- Net Operating Income / Cash Flow: Post refinance, what will be the net operating income (“NOI”) on the property? Is it better or worse than the existing NOI?
- Penalties: Are there any prepayment penalties that will be assessed if the existing mortgage is paid off early?
- Real Estate Investors: If the ownership of the property includes investors, will they be supportive of a cash out refinance?
Clearly, there are a lot of factors to consider when trying to determine if a cash out refinance is a good idea. Investors and property owners should consider each one of them carefully before making a final decision. As a general rule, the numbers don’t lie. They will provide the ultimate justification for the cash out loan or not.
Commercial Cash Out Refinancing Private Equity Real Estate Syndications
As the previous section describes, the decision as to whether or not to pursue a cash out refinance can be complex, and driven by a complex numerical calculation. For many individual investors trying to make this assessment on their own, the sheer number of variables to consider may be intimidating.
For this reason, it may be a good idea for individual investors to invest their capital in a private equity commercial real estate syndication. In such an arrangement, the transaction, property, and all refinance decisions are managed by a professional private equity firm with years of experience, dozens of transaction repetitions, and the resources to make the refinance decision on behalf of the investing “syndicate”.
Summary of Cash Out Refinances
A cash out refinance is a type of lending transaction in which an investor gets a new loan and uses the proceeds to pay off the balance of the old loan. The difference between the old loan amount and the new loan amount is cash that is distributed to the investor/borrower.
There are a number of reasons why an investor may consider a cash out refinance, but the most common includes a need for funds to complete renovations or upgrades or to pay a cash distribution to investors.
There are a number of factors to consider when completing a cash out refinance, including the property‘s cash flow, the property value, the type of loan offered, and the cost of the loan.
The major advantages of a cash out refinance are that funds can be extracted from the property and the post-refinance payments may be lower.
The major disadvantages of a cash out refinance are that they can be costly and they can be made more difficult by existing contractual obligations.
Because of the complexity involved in a cash out refinance, it may be a good idea for investors to work with a private equity firm when investing capital. This way, it is possible to leverage their experience and expertise to ensure the right decision is made.
Interested In Learning More?
First National Realty Partners is one of the leading private equity commercial real estate investment firms in the United States. We leverage decades of expertise to find world-class, multi-tenanted assets available below intrinsic value. We seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our investment opportunities, contact FNRP at (800) 605-4966 or info@fnrpusa.com.
