A Look at Refinancing, and How it can Help Boost Your Returns
Refinancing happens when an existing loan on a property is paid off and a new loan is taken out to cover the property’s mortgage. If you invest in a syndication, the Syndicator is generally the one who determines the need and the timing of the refinancing, and it’s usually done to provide various benefits to investors. The new loan is based on the property’s valuation, loan payment history, and credit worthiness of the Syndicator.
Reasons to Refinance
At times it may be beneficial for a syndicator to refinance a loan on the property. It could be due to a variety of reasons. Here are some of those reasons:
Reason #1: Tax Free Equity
The number one reason for refinancing is pulling equity out of the property after its value is higher. Let’s look at this example: a building is worth $10M with 70% LTV (loan to value), which is $7M in financing. A year later the building is worth $12M, and another loan at 70% LTV is available, for total of $8M. If you refinance, you can return the original loan of $7M, place a new $8M debt on the property and distribute $1M (minus prepayment penalties).
Reason #2: Better Terms
Another reason to refinance is getting a new loan with better interest rates. The lower interest rates can help improve cash flow by lowering the annual debt service. Plus, there may be an opportunity to reload the amortization up to 30-years. That simply means that the new loan won’t be due until 30-years from now, which provides plenty of opportunity to find better rates or terms without the pressure of having the loan come due in a few years.
Here’s something else to consider: refinancing provides an opportunity to consolidate several loans into one. By emphasizing the strengths of several properties against the risks or weaknesses of others, it may be possible to get more favorable rates or terms from a lender, along with a reduction in fees as well.
Whatever the reason, it’s important to continually look at all available options in order to maximize your investments.
Refinancing Benefits to Investors
As mentioned before, the main benefit of refinancing multifamily properties is to recoup equity. If it’s a cash-out refinance, there can be a considerable amount of money to be used either as working capital (which is money that’s used to cover the difference between current assets and liabilities) to purchase other properties or to pass through to investors.
Syndicators are able to return up to 75% of the investor’s initial investment when they refinance the property, which usually occurs in year 2 or 3. And of course, this money comes in tax free as there is no tax liability on loan proceeds. It’s tax free because the source of the distribution to investors is a loan, and not income from rent.
It’s really simple math: if the amount owed on the loan is less than the new loan balance, investors get to keep the difference. It is basically turning equity into cash. In a cash-out refinance of a multifamily property, you’re able to take out up to 75% of the property’s loan-to-value, which simply means how much the property is worth as is.
Another use for taking out cash through refinancing is to pay for rehab costs. If you’re in a value-add property, these funds will help complete the rehab and increase the property’s value.
The best part of this is that if the money is distributed to investors, it’s tax-free. That’s because there isn’t any tax liability on loan proceeds. And there’s another plus as well: due to the fact that it’s a mortgage, there could be an additional tax benefit with a mortgage interest deduction on the new loan. For investors, it’s a win-win situation. This is why it’s important for investors to have an experienced Sponsor advising then best course of action on the refinancing strategy.
What to Watch Out For
When you review the Syndicator’s model, make sure that it doesn’t include any numbers related to refinancing. That’s because nobody can predict what the interest rates and terms will be in the future, so Syndicators can only guess. And if they can’t refinance the property due to high interest rates, or any other reason, it will significantly impact the returns. I never add refinance numbers to my model, and if we’re able to do the refinancing when the timing is right, the funds will be an extra return for my investors.
When to Refinance A Multifamily Property
Each case is unique, so it’s hard to give blanket timing or specific reasons for refinancing a multifamily property. But there are some general rules to follow, and based on your particular situation, refinancing might be the right strategy for you.
One decision regarding multifamily properties is always whether to hold the property or sell it. If your net operating income (NOI, which is income minus expenses) has increased significantly and is stabilized, your property value has probably increased as well. That’s a good time to take out the cash and pass it on to investors. That will make investors happy, and they will probably participate in another property syndication.
Another reason to consider refinancing is when a property has built up a lot of equity. It provides an opportunity to withdraw a significant amount of cash to use to purchase another property or make substantial improvements in the existing property.
If you have a loan coming due and you’re planning on refinancing, be sure that your property is at least 90% rented and that the NOI is maximized. Lenders often look at properties as “distressed” when there is a high vacancy rate or the rents aren’t paid on a timely basis. That means you could end up with higher interest rates or a poor amortization schedule.
There are costs involved in refinancing commercial properties, and they are much higher than consumer lending or residential properties. Starting with the appraisal, you’re looking at $2,000 to $5,000, which could be higher for larger properties. There are also inspections, origination fees and closing costs involved in the lending process.
These costs are used to guide you as to whether a refinance is cost-effective. You’ll find that most commercial origination fees are about 1% of the loan, so if you’re looking at a $1M loan, the origination fee will be $10,000.
Just remember that as with everything else you plan to purchase or which direction you want to go, fees are competitive and negotiable. Whichever loan source you negotiate with, they’re going to do their due diligence to make sure you can repay the loan. To do this, they look at various ratios, and you should be come familiar with these terms in order to effectively negotiate your fees and rates.
The debt-to-loan ratio is a term relating to the property’s value and the loan amount. Lenders are looking to see that there is at least 20% equity in the property.
Finally, there is the debt service coverage ratio (DSCR), where lenders take the annual NOI and divide it by annual debt payments. To be considered for the loan, this number should be at least 1.25.
Refinancing is a valuable option when used to boost returns for investors. The most important aspect is that the proceeds are not taxable because they’re loan proceeds and not income. As a passive investor, make sure that the projected returns that Syndicators present do not include refinancing due to the uncertainty of the lending space in general and interest rates in particular.
About the author
Ellie Perlman is a real estate investor who owns over 2,000 units across the US worth over $250MM. Ellie is the Founder and CEO of Blue Lake Capital, a real estate investing firm specializing in multifamily investments. At Blue Lake Capital, Ellie helps investors grow their wealth and achieve double-digit returns by investing alongside her in exclusive multifamily deals they usually don't have access to.
She started her career as a commercial real estate lawyer, leading commercial real estate transactions for Israel’s largest development company. Later, as a property manager for one of Israel's most prominent oil and gas company, she oversaw properties worth over $100MM.
Ellie is a Forbes author on real estate investing, the host of the podcast "That REllie Happened?! Unbelievable Real Estate Stories" and a writer of a weekly blog you can find at www.ellieperlman.com.
Ellie holds a Masters in Law and MBA from MIT Sloan School of Management.