Opinions expressed by entrepreneur Contributors are their own.
If you’ve ever looked into real estate, you’ve probably come across the term “cash-out refinancing.” This concept is very popular in residential real estate as banks market it as a method of getting money for vacations, repairs, renovations or anything you want. What you may not know, however, is that you can do one of these refinances with commercial real estate as well. What exactly is a cash out refinance in the commercial real estate world and why should you have one? Read on to find out!
Commercial real estate cash-out refinancing
Whether you’re looking to buy a single-family home or a multimillion-dollar commercial property, the basic principles of the mortgage remain the same. There is a property backing the mortgage that has some value. Mortgages offer a percentage of that value to buy the property. In most cases, they offer up to 80% loan-to-value ratio (meaning the bank will lend up to 80% of the property’s value and the buyer will have to put the remaining 20% down).
You lower your balance with the lender when you pay off the mortgage. They also reduce the loan-to-value (LTV) ratio if the property’s value stays the same or increases. For example, if you borrowed $800,000 to buy a $1 million property, you would have an 80% loan-to-value ratio. You’re paying $100,000 on that mortgage, and the property is now worth $1.4 million. Your LTV is now 50% ($700K balance / $1.4M valuation).
Continuing with this example, if your bank lends up to 80% LTV, you can “pay off” that extra equity by doing a payout refinance. You would essentially wipe out the old $700,000 loan by getting a new loan of $1.12 million (80% of $1.4 million). The excess $420,000 would be yours in cash!
The way it works for commercial real estate is the same as for any other type of real estate (e.g. single-family houses). Cash-out refinancing can be very beneficial for commercial real estate syndications. In fact, there are three main reasons syndications do this:
See also: 5 ways to get the most out of commercial real estate ownership
1. Tax-free financing of investments
Once you have some equity in the business building or have managed to boost its NOI so it has a higher valuation, you can take out some of that equity to fund capital expenditures. You may want to make significant value-added property upgrades.
Theoretically, you could wait until the rents have funded your company’s bank account enough to do it with cash. Or you can pull out the equity and make the upgrades to get higher rents faster. These higher rents increase the valuation and allow you to sell the building much faster and with less risk than waiting for your fund to build up. Plus, gains from rentals are taxable – but withdrawing equity is tax-free!
2. Repay investors faster
The goal of any syndicator in a real estate syndication is to repay investors as quickly as possible. Returning investors’ money is a significant gesture of goodwill and increases the likelihood that they will invest with you again. In addition, it is what you are legally required to do as a trustee for your money. You can give investors money back and reduce their overall risk through a cash-out refinance.
See also: Learn how to invest in real estate safely
3. Avoiding balloon payments
Commercial real estate loans tend to mature much faster than home loans. You may be looking for a loan that is due in just two years. Suppose you don’t have the funds to repay that loan. In that case, a cash-out refinance can help you in two ways: change the terms of the loan (better interest rate or longer term, maybe) and give you working cash, including an extra cushion to meet mortgage payments.
If you want to avoid a balloon payment, you must refinance before the loan is due (even if you refinance with no payout option)!
A detailed example
Consider the following detailed example to illustrate how powerful cash-out refinancing is:
Let’s say you are starting a commercial real estate syndication company that wants to buy a $10 million apartment building. They raise $3 million in capital and secure an $8 million commercial loan. Since the market is not so good, it is a loan at 5% interest and only for two years. Still, with this loan, you can buy the building, so take it.
With your remaining capital of $1 million, you set about renovating the building. With that $1 million, you can renovate 20% of the units, and over the next 18 months, you can increase the total rent by about 10%, including significant increases for those renovated units.
However, your balloon payment will be due soon. Since you increased rents by 10%, your home is worth more, say $11 million. And during those 18 months, you paid off $1 million of the loan, so you only owe $7 million.
So instead of selling the building, you do a payout refinance. Eighty percent of the building’s equity is $8.8 million, so take out $1.8 million ($8.8 million – $7 million owed) for two years at 5%. With that $1.8 million, you’ll renovate another 40% of the units, this time increasing the total rent by 20%.
After 18 months, you’ve been in this building for three years. Most syndications run for five, so do another payout refinance. The building is worth $13 million, and your rent increases and spending cuts have paid off $1.8 million on the mortgage. Eighty percent of the building’s equity is now $10.4 million, and you owe $7 million. They do a $10.4 million payout refinance with $3.4 million in cash, but interest rates have gone down so it’s only 3%.
With that $3.4 million, you can take half of that and renovate the remaining 40% of the units to add another 20% to the rent. The other half, $1.5 million, can return almost all of their capital to investors nearly two years earlier!
Finally, the two-year loan comes due. You’re selling the building for $15 million, 50% more than you originally paid. The loan balance is now $8 million because the lower interest rate and higher rents made it easier to pay off. You can take that $7 million profit and distribute it to the investors.
Related: Learn the basics of long-term real estate investing
This example shows how powerful these refinancings can be! By using the cash to improve the building, this hypothetical syndication could boost the valuation while returning the cash to its investors early. And they did so while avoiding balloon payments and lowering their interest rate!
A cash-out refinance is a powerful tool for commercial real estate. It offers investors tax-free liquidity that they can use in a variety of ways to meet their real estate goals. Assuming you can get a low interest rate on your refinance, take a look at how this concept could improve your investments. Check your mortgage balances against the equity of your property and see if you could benefit from a payout refinance!