An Investor’s Guide to Commercial Property Refinancing
One of the major benefits of a commercial real estate (CRE) 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 will explain what it means to refinance a commercial property, why investors might consider refinancing debt, and we will examine two of the most common types of refinancing options. At the end of this article, readers will have the information they need to understand their options for refinancing and whether or not it might be beneficial to them.
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 it Means to Refinance a Commercial Property
A “refinance” transaction is one where a borrower/investor obtains a new loan, often at a lower interest rate, and the proceeds are used to pay off an existing loan. The pay off of the existing loan is usually handled by the lender or mortgage servicer during the origination of the new loan.
In the context of commercial real estate loans, 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 (often a bridge loan or hard money loan), make improvements, lease it up, and then refinance into longer term, permanent debt.
Or, in a scenario where loan terms have become more favorable, an investor may execute a refinance to save on debt service costs.
Types of Commercial Property Refinance
The two most common types of refinance options used by real estate investors are the traditional commercial refinance and the cash-out refinance. Let’s take a look at how each one works, and the pros and cons of each.
Traditional Commercial Refinance
The most common type of refinance is the traditional refinance. A traditional refinance occurs when the property owner takes out a new commercial mortgage loan in an amount equal to the existing loan amount. The property owner will likely incur closing costs as part of the refinance, which are sometimes paid upfront and sometimes rolled into the new loan balance and paid according to the new repayment schedule.
Traditional refinancing usually occurs when a property owner finds that the interest rates available in the market are lower than they were at the time of purchase. For example, a $1M loan with a 20 year term and a 7% fixed rate of interest has a monthly payment of $7,753. The same type of loan with a 5% fixed rate of interest will have a monthly payment of $6,600. If an investor purchases a rental property with the 7% loan and later refinances into a loan with a 5% interest rate, the investor stands to reduce the monthly payment by $1,153!
This is an important concept to understand because in the example above, the $1,153 decrease in the monthly payment represents cash flow that the investor gets to spend or reinvest into additional investment property. Understanding the available financing options can be very beneficial to investors.
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 acquires a multifamily property at a purchase price of $1.25MM. As part of this purchase, they obtain a loan for $1MM that requires principal and interest payments monthly.
After five years, the property’s value 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,
Why Investors May Want to Refinance
If the refinance comes with a lower interest rate or longer amortization, the monthly payments are lower. Over time a property loan with a lower monthly payment can free up a lot of cash flow and provide the investor with the liquidity necessary to pursue a more ambitious investment strategy.
A cash out refinance allows a property owner to convert equity in a property into cash. This cash can be used as the property owner sees fit, including to purchase another real estate investment, pay for needed capital improvements, pay other debts, or even provide a cash distribution to investors.
Cash out refinancing is a strategy used often in commercial real estate investing during value-add projects. For example, some investment partnerships focus on purchasing office space that is older and in need of improvement. The partners might purchase the property with a combination of debt and equity. Often the improvements are paid for using short-term financing from hard money lenders or a line of credit.
Because these sources of financing usually come with higher interest rates than longer-term loans, the investor group might look to refinance once the work is complete. The improvements increased the value of the property, which probably means that the investors have more equity than they did at the time of purchase. By doing a cash out refinance, the investors are able to pull some of this equity out of the property in the form of cash.
In the best cases, investors are able to pull out all of the cash they have invested into the property up to this point. They can take the cash and reinvest it into other properties, a small business, or any other asset class. It’s important to know that this strategy can be used for all property types, including office buildings, single-family rental property, multifamily residential property, among others.
Electing to Invest Through Private Equity Real Estate
As the previous section describes, the decision as to whether or not to pursue a traditional or cash out refinance is often driven by complex numerical calculations. Many individual investors struggle to make this assessment on their own and find the sheer number of variables in the analysis to 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 Commercial Property Refinancing
By refinancing an existing loan, the property owner obtains a new loan, and the proceeds are used to pay off an existing loan.
Investors usually choose to refinance for one of two reasons. First, in a scenario where loan terms have become more favorable, an investor may execute a refinance to save on debt service costs. Second, the investor might choose to pull equity out of a property that has appreciated in value due to market sentiment or improvements made to the property.
A traditional refinance occurs when the property owner takes out a new commercial mortgage loan in an amount equal to the existing loan amount. The objective in a traditional refinance is usually to get a new loan with a lower interest rate.
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.
Private equity real estate firms employ specialists who have strong backgrounds in refinancing and the analysis that goes into this decision. For this reason, many investors choose to invest with a private equity real estate firm and benefit from the experience and resources at the firm.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well 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 are an Accredited Real Estate Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.