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If you have spent any time looking into real estate, you’ve probably seen the term “cash-out refinance.” This concept is quite popular with residential real estate as banks market it as a method to get money to pay for vacations, repairs, renovations or anything you want. However, you may not know that you can also do one of these refinances in commercial real estate. What, exactly, is a cash-out refinance in the world of commercial real estate, and why would you want one? Read on to find out!
Cash-out refinance for commercial properties
Whether you’re looking to buy a single-family home or a multi-million dollar commercial property, the basic principles of the mortgage remain the same. There’s a property that will back the mortgage that has some value. Mortgages provide a certain percentage of that value to buy the property. In most cases, they will provide up to 80% loan-to-value (meaning that the bank will lend up to 80% of the property’s value, and the buyer will have to put down the remaining 20% as a down payment).
You’re lowering your balance with the lender as you pay off the mortgage. You’re also reducing the loan-to-value (LTV) ratio if the property’s value remains the same or goes higher. For example, if you borrowed $800k to buy a $1 million property, you’d have a loan-to-value ratio of 80%. You pay $100k on that mortgage, and the property is now worth $1.4 million. Your LTV is now 50% ($700k balance / $1.4 million valuation).
Continuing with this example, if your bank will lend up to 80% LTV, you can “cash out” that extra equity by doing a cash-out refinance. You’d essentially wipe out the old loan of $700k by getting a new loan for $1.12 million (80% of $1.4 million). The excess $420,000 would be yours as cash!
The way it works for commercial properties is the same as any other type of real estate (e.g., single-family homes). Having a cash-out refinance can be quite beneficial for real estate syndications with commercial properties. Indeed, there are three main reasons why syndications will do this:
1. Tax-free financing for capital expenditures
Once you have some equity in the commercial building or have managed to boost its NOI so it has a higher valuation, you can take some of that equity out to finance capital expenditures. You may want to perform significant value-add real estate upgrades.
You could, in theory, wait for the rents to build up your company’s bank account to the point where you can do this with cash. Or, you can pull the equity out and do the upgrades to get higher rents faster. Those higher rents will increase the valuation and let you sell the building much quicker and with less risk than waiting to build your fund. Plus, profits from rents are taxable — but pulling equity out is tax-free!
2. Pay investors back faster
The goal of any syndicator in a real estate syndication is to pay investors back as quickly as possible. Returning investors’ money is a significant goodwill gesture and will make them more likely to re-invest with you. Furthermore, it’s what you, as a fiduciary for their money, must do legally. You can return money to investors through a cash-out refinance and reduce their overall risk.
3. Avoiding balloon payments
Commercial real estate loans typically come due much faster than residential ones. You might be looking at a loan that comes due in as little as two years. Suppose you don’t have the funds to pay that loan off. In that case, a cash-out refinance can help you in two ways: Change the loan’s terms (better interest rate or longer duration, maybe) and give you operating money, including an extra cushion for making the mortgage payments.
If you’re looking to avoid a balloon payment, you must refinance before the loan is due (even if you refinance without a cash-out option)!
A detailed example
To illustrate how powerful cash-out refinances are, consider the following detailed example:
Suppose you start a commercial real estate syndication that wants to buy an apartment building for $10 million. You raise $3 million in capital and secure a commercial loan for $8 million. Since the market isn’t great, it’s a loan at 5% interest and only for two years. Still, this loan lets you buy the building, so you take it.
With your $1 million in leftover capital, you get to work renovating the building. You can renovate 20% of the units with that $1 million, and over the next 18 months, you can raise the overall rent by about 10%, including significant increases for those renovated units.
However, your balloon payment is coming due. Since you have raised rents by 10%, your apartment building is worth more, say $11 million. And during those 18 months, you’ve paid off $1 million of the loan, so you only owe $7 million.
So, instead of selling the building, you do a cash-out refinance. Eighty percent of the building’s equity is $8.8 million, so you take out $1.8 million ($8.8 million – $7 million owed) for two years at 5%. With that $1.8 million, you renovate another 40% of the units, increasing the overall rent by 20% this time.
After 18 months, you’ve been in this building for three years. Most syndications run for five, so you do one more cash-out refinance. The building is worth $13 million, and through your increased rents and expense cutting, you’ve paid off $1.8 million of the mortgage. Eighty percent of the building’s equity is now 10.4 million, and you owe $7 million. You do a cash-out refinance of $10.4 million, with $3.4 million in cash, but rates have gone down, so this one is only at 3%.
With that $3.4 million, you can take half of it and renovate the remaining 40% of the units to increase the rent by another 20%. The other half, $1.5 million, can go to pay investors back almost all of their capital nearly two years early!
Finally, the two-year loan comes due. You sell the building for $15 million, 50% more than you paid initially. The loan balance is now at $8 million, because it was easier to pay it off with the lower interest rate and higher rents. You can take that $7 million profit and distribute it to investors.
This example shows how powerful these refinances can be! By using the cash to improve the building, this hypothetical syndication could boost the valuation while returning money to their investors early. And they did so while also avoiding balloon payments and lowering their interest rate!
A cash-out refinance is a potent tool for commercial real estate. It provides investors with tax-free liquidity that they can use in several ways to further their real estate goals. Assuming you can get a low-interest rate on your refinance, take a look to see how this concept could improve your investments. Check your mortgage balances relative to their property’s equity, and see if there is a way a cash-out refinance could benefit you!