Cash-out refinance
Also called Refinance proceeds, Cash-out refi, Recapitalization.
A cash-out refinance replaces an existing loan with a larger one and distributes the difference, after costs, to the owner. The new loan is sized by the same three tests that size any loan, applied to the property's income on the refinance date rather than at purchase.
How it works
It is the mechanism that returns capital without a sale, and on a value-add plan it is frequently the point of the plan. Borrowed money is not income, so the proceeds are not taxed on receipt, the owner keeps the asset and its depreciation, and returned capital lifts both the equity multiple and the IRR because it arrives early.
The constraint that surprises people is that a refinance is sized on income, not on value created. A property whose value has risen by ten million dollars can still borrow only what its NOI covers at the required coverage ratio, and in a market where the loan constant sits well above the cap rate, coverage binds long before loan-to-value does. Creating value and being able to borrow against it are two separate events, and the second one depends on rates nobody controls.
The costs are not small and they belong in the model: a new origination fee, new third-party reports, legal and title, and any prepayment penalty on the loan being retired. On a fixed-rate loan with yield maintenance still running, the penalty can exceed the proceeds, which is the case where the refinance a model shows cannot actually be executed.
Formula
Cash out = new loan proceeds - outstanding balance - refinancing costs - any prepayment penalty- New proceeds are the LESSER of the loan-to-value cap, the coverage test and the debt yield floor, at the rates in force on the refinance date
- The outstanding balance depends on how much principal amortized, so an interest-only loan leaves the full original balance to repay
- Distributed proceeds are a return of capital in a partnership, not profit, and the preferred return normally keeps accruing on whatever capital remains unreturned
Worked example
The sample property at stabilization. Stabilized NOI $3,578,201, market cap rate 5.40 percent, the existing $36,335,000 loan still interest only. Refinance terms as at purchase: 65 percent LTV, 1.25x coverage on a 7.467 percent constant, an 8.25 percent debt yield floor.
| Stabilized value at a 5.40% cap | $66,262,981 |
|---|---|
| LTV test at 65% | $43,070,938 |
| Debt yield test at 8.25% | $43,372,133 |
| Coverage test at 1.25x on the amortizing constant | $38,337,183 |
| Outstanding balance to repay | $36,335,000 |
| Cash out before costs | $2,002,183 |
The property is worth $10.4 million more than it was bought for and the refinance releases $2.0 million, because coverage binds while the other two tests sit nearly five million dollars higher. Value creation and borrowing capacity are not the same thing, and on a low cap rate asset they are not close.
Conventions worth knowing
- Check the prepayment provision before choosing a refinance date. Yield maintenance or defeasance can make an otherwise sensible refinance uneconomic.
- Size the refinance at a rate you are willing to underwrite rather than at today's. A refinance five years out is a bet on a curve nobody can see.
The common mistake
Sizing the refinance off the new value
A model that computes refinance proceeds as a percentage of the stabilized value has run one of the three tests and skipped the two that usually bind. On this property the loan-to-value cap allows $43.1 million and coverage allows $38.3 million, a $4.7 million difference that lands entirely on the equity distribution and therefore on the reported return. Run all three at the assumed refinance date, on the assumed rate and amortization schedule, and take the minimum, exactly as at purchase.
Related terms
- Loan sizingLoan sizing is the process of determining the maximum loan proceeds a property supports. A lender runs three independent tests, a loan-to-value cap, a minimum debt service coverage ratio at a stressed rate, and a minimum debt yield, and lends the lowest of the three.
- Debt service coverage ratioThe debt service coverage ratio is net operating income divided by annual debt service. A 1.25x means the property produces $1.25 of income for every $1.00 of principal and interest owed, so net operating income could fall by 20 percent before coverage reaches 1.00x and the loan stops being covered.
- AmortizationAmortization is the repayment of loan principal through the regular payment, computed over a schedule that is usually much longer than the loan term itself. It is cash leaving the property that never appears as an expense, and the length of the schedule decides how much of it there is.
- Yield maintenance and defeasanceYield maintenance and defeasance are the two standard mechanisms that make a fixed-rate commercial mortgage expensive to repay early. Yield maintenance charges the lender's lost interest as a lump sum; defeasance substitutes a portfolio of government securities for the property as collateral.
- Stabilized NOIStabilized NOI is the net operating income a property produces once the business plan is finished: renovations delivered, lease-up complete, concessions burned off, rents at plan. It is the income a yield on cost is measured against and the income an exit value is usually built from.
- Equity multipleThe equity multiple is total distributions divided by total equity contributed, expressed as a multiple. A 2.0x means an investor received two dollars back for every dollar put in, counting the original dollar.
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