Commercial Real Estate Loan Refinancing Tutorial (16:58)
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Table of Contents:
- 1:24 The Short Explanation for Refinancing
- 4:27 Examples with the Property’s Value Increasing
- 12:47 Different Types of Lenders and the Downsides of Refinancing
- 15:32 Recap and Summary
A pair of questions that came in the other day:
“Can you explain, in layman’s terms, why you often assume that Debt gets refinanced in real estate deals?”
“Also, why is the amount of new Debt raised often different from the amount of existing Debt repaid?”
SHORT ANSWER: Equity Investors complete refinancings to boost their returns in real estate deals – and because it’s in everyone’s best interest to do so.
“Refinancing” means repaying existing Debt – almost all real estate deals involve Debt – by raising new Debt (think of it as “replacing” existing Debt).
Refinancing boosts returns for the Equity Investors by reducing the interest expense and letting them earn back some of their initial investment before the exit (sale of the property).
There are three main, specific reasons to refinance:
Reason #1: Interest rates have fallen, or the property’s credit profile has changed, and the Equity Investors can get lower rates.
For example, maybe interest rates have fallen from 5% to 4% – that may seem like a small difference, but since property deals often use 50-70% leverage, lower interest rates could result in a significant increase in cash flow.
Reason #2: The property’s value has increased, so by refinancing at the same “Loan to Value” (LTV) Ratio, the sponsor can earn back some of its initial investment early – before the exit.
For example, if an investor pays $10 million for a property that generates $600K in Net Operating Income (NOI) in Year 1 (6% Cap Rate) and uses a 70% LTV, that’s $7 million of Debt.
By Year 3, the property’s NOI has increased to $650K, and market conditions have stayed about the same, so assuming the same 6% Cap Rate, the property is now worth $650K / 6% = $10.8 million.
The New Debt would be worth $10.8 million * 70% = $7.6 million at a 70% LTV now, so the extra $600K in proceeds go to the Equity Investors early.
We demonstrate a more complex example of this with a $54 million AUD hotel in Darwin, Australia, acquired at an 8.80% Cap Rate using an 85% LTV.
After four years, the forward NOI has increased from $4.7 million to $6.3 million, so it is worth $70.5 million at a 9.00% Cap Rate.
We refinance at a 75% LTV, slightly lower, and use a $52.9 million Permanent Loan to repay the $44.4 million of remaining acquisition debt and mezzanine at this point.
That $8.5 million “extra” goes to the Equity Investors (it’s a bit less due to the financing fees).
Without the refinancing, the 5-year IRR would be 17.9%; with the refinancing, it would be 19.1%.
This is a small difference because Cap Rates rise slightly and the LTV drops – but if Cap Rates fall or the LTV stays the same or increases, refinancing could add far more than 1% to the IRR.
Reason #3: The terms of the Debt require a refinancing. Different lenders target different risk and potential returns, and Construction and Bridge Loan investors don’t want to stay on board once a property is built or stabilized.
So, these lenders often require property owners to refinance under certain conditions or when there’s a “change of control” (someone else buys the property).
Downsides to Refinancing
The Equity Investors might not refinance if the property’s value has fallen or if interest rates have risen.
Refinancing does present some risk because it could increase the default risk, especially if the Interest Coverage Ratio or Debt Service Coverage Ratio fall.
Finally, it can sometimes be tricky to estimate the correct property value and use it in these formulas, especially if the property has not yet stabilized and will take time to do so.