First and foremost, what is refinancing?
Refinancing is the process by which an existing loan (s) on a property is paid off, making it possible to take a new loan which would cover the mortgage of the property in question. More often than not, the need for refinancing, as well as the timing of such a move is highly dependent on the type of business you invest in. For instance, if one invests in a syndicate, the need and timing would be determined by the syndicator. However, it must be noted that the new loan obtained after refinancing is usually based on factors such as: the history of loan, the syndicator’s credit worthiness and property value.
To drive the point home, the following are some reasons why one should refinance.
- Friendlier Terms
As mentioned earlier, refinancing opens the door for new loans (which would go a long way in settling mortgages and other payments on the article or property being refinanced), particularly important is the fact that these new loans come with friendlier and better interest rates. The friendlier interest rates obtained would therefore lower the annual debt payable by improving cash flow. Also, this might allow room for reloading the amortization for the loan up to 30 years, which indicates that the new loan obtained would not be due until about 30 years from the time the loan was obtained, thereby allowing the search for better terms or rates for the loan obtained without the fear of the loan being due in a few years. Again, the refinancing process allows one to consolidate several loans to make a whole. Thus, merging the strengths of a lot of properties with the weaknesses or risk of others, would make it possible and feasible to obtain nicer terms or rates from lenders alongside reduction in fees charged as well. In short, it gives the opportunity maximize business investments.
- Equity-free tax
One of the major reasons why refinancing is essential is the fact that it removes equity from the property or article in question after the article appreciates in value. For instance, if a building is worth $10 million with a 70% Loan to value (LTV) which equals $7 million in financing terms, after a year , the buiding appreciates to a value of $12 million, with another loan of 70% being available, then, the LTV totals up to $8 million. If the business owner refinances, the original loan (of $7 million) can be returned, thereby enabling the business owner to place a new loan of $8 million on the property distributed at $1 million (excluding prepayment penalties).
Benefits of Refinancing for Investors
As earlier mentioned, one of the major benefits of refinancing properties or business articles is to recover equity. Depending on the type of refinance engaged, take for instance, in ‘cash-out refinance’ a significant amount of money is used as working capital (i.e the amount which covers the difference between current asset and liabilities) for the purchase of other business articles as well as a pass to other investors. Often, syndicators are able to refund up to 75% of their investor’s initial investments when such investors refinance properties (usually at 2 or 3 year intervals). The money comes tax free since no tax liability on the loan proceeds after the refinancing process is complete.
The process can be illustrated as follows:
When the amount owed (as loan) is less than the amount of new loan, the new loan is tax free. This is due to the fact that, the difference between the old and new loan would be kept by the investors. Thus, equity is turned into cash. In the ‘cash-out refinance’ discussed earlier, one would be able to remove up to 75% of the property’s LTV (the LTV value indicates how much the property is worth as it is).
In addition, the refinancing process helps one to pay rehabilitation costs, especially in value added properties. The funds generated from the refinancing process would also improve the property’s value. More importantly, when the money is distributed to investors, it is tax-free. This is because no tax liability on the loan proceeds beyond the refinancing process. Also, for mortgages, additional tax benefits exist with mortgage interest deduction on the new loan obtained. This is usually a win-win situation for virtually all investors. Thus, investors must have experienced sponsors who would advise them on the best course of action to embark upon as well as provide them workable refinancing strategies.
Things to watch out for
It is important while reviewing the syndicator model (if you are interested in investing in syndicates) to make sure that your syndicator of choice does not include numbers relating to the refinancing process. This is because the interest rates as well as the terms of service in the future cannot be predicted (only the syndicators can give a guess). However, if the syndicators cannot refinance the property in their care due to high interest rates (or other reasons) the returns on such investment would be severely impacted. Thus, it is advisable to avoid adding refinance numbers to the syndicate model one intends to invest in. Interestingly, if the refinancing and the timing is right, the funds generated would be an extra return for investors.
Best time to refinance a multifamily property
It is important to point out the fact that each multifamily property encountered is unique. Therefore it is difficult to give a general specification on the best time to refinance multifamily properties. However, there are some rules to follow, based on the peculiarity of the multifamily property which would determine how good refinancing might be for the particular situation.
First, if the net operating income (NOI) which stands for the difference between income and expenses, is significantly increased and stabilized, the property value must have increased as well. Thus, such condition is a good pointer to taking out the cash and passing it on to investors. Usually, investors are happy to participate in as many multifamily properties as are available in this condition.
Again, refinancing could be considered when the property has stacked up tons of equity. This makes room for you to withdraw a sizeable amount of cash which can be used to purchase other properties as well as it can be useful in making significant improvements to the property itself.
Lastly, refinancing should be considered carefully if you have a loan which is about to be due. You must be sure that the property in question has its net operating income (NOI) maximized. Also, the property should be at least 90% rented at the time of consideration. This is because, lenders consider properties as being distressed when the vacancy rate is high or the rents have not been paid on timely basis, which indicates that higher rates or poor amortization schedules could ensue.
Costs of Refinancing
Usually, a lot of cost is associated with the refinancing of commercial properties. These costs involved have been found to be higher than those involved in residential properties and consumer lending. It is important to take into cognizance the fact that, although usual costs could be within the range of $2,000 to $5,000 it could be higher for larger properties. Also, inspection fees, closing costs involved in the lending process as well as the origination fees are other fees that must be fit into the bill of refinancing a property.
The cost mentioned above aimed at orienting you on making choices between cost-effective and cost-ineffective refinance opportunities which would present itself at various instances.
Most commercial origination fees are typically about 1% of loans obtained, therefore, if you’re looking to get a loan of $1 million, the origination fee would amount to $10,000.
It is important that you plan the direction and aim of your investment and refinancing before dabbling into the process, as the fees are highly competitive and negotiable (particularly made easy for you when you have an aim for investment and refinancing). Also, it is important that you familiarize yourself with the various terms, definitions and ratios employed in the process. This would hone your negotiation skills and make you able to maximize the benefit inherent in every deal as well as negotiate rates and fees.
Usually, lenders are interested in seeing a minimum of 20% equity on the property to be refinanced and the debt-to-loan ratio must not be too bad. Also, the debt service coverage ratio describes the process in which lenders divide the NOI by the annual debt payable on a property. In order to be considered for a loan, the debt service coverage ratio should not be less than 1.25
The refinancing process is a valuable option that has been tested and proven over the years. It is particularly useful when you aim to boost your returns on investment. An important aspect of the process is that the proceeds cannot be taxed (since they are loan proceeds, not income), thus they present attractive opportunities. Furthermore, passive investors must ensure that the projected returns on investment put forward by syndicators usually do not include the refinancing returns due to the uncertainty associated with the lending sphere generally and interest rates particularly.