Commercial Real Estate Loan Refinancing: What It Means and Why Investors Do It

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In this lesson, you’ll learn what it means to “refinance” commercial real estate loans in development and acquisition deals, why Equity Investors do it, and how it can boost their returns in deals.
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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
Resources:
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Lesson Outline:
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.

[@csanton3946]

In all hinesty this isnit a good practice, it only shows how you treat an investment which is a hot potato. By putting so much leverage and always refinancing, you are effectively putting all the risk to the debt holders or debt investors and you dont care what happens in thr business when business conditions change to the worse because your equity investment due to high returns are already recouped or you are derisked already and any additional income is just a bonus. If the business burns, the one who willabsorb those losses is the debt holders. This is corporate america, milk it to the core. I do not know whydebt holders eould even want to be inthat position of assuming all the risk while your equity partner is enjoying, i guess its because refinancing allows the transfer of risk from previous debtholder to a new debtholder while thepotato is still hot

[@financialmodeling]

I am not really sure what your argument, question, or comment is. Refinancing is common in all real estate and other asset-level finance deals. Lenders know the risks they are taking going into the deal based on the LTV, coverage ratios, etc.

[@noahd2235]

What if you want to hold for 40, 50 years... etc

[@financialmodeling]

Well then you probably don't care about short-term gains from refinancing...

[@Rafacarv0]

Why would the lenders want to redeploy their capital? They are earning their high interest rates on top of a more valuable, derisked asset. Right?

[@financialmodeling]

Different lenders target specific risk / return profiles. A lender that specializes in construction loans doesn't necessarily want permanent loans, and vice versa (or even if the lender does both but wants to maintain specific percentages in each one).

[@siboju1996]

where is excel file

[@financialmodeling]

Click "Show More". Scroll down to Resources. Click the links there.

[@Kakakaken]

Hi the excels are no longer valid, can the links be updated? thanks!

[@financialmodeling]

They should be working again.

[@ryanwhitley4627]

Hey this may seem really crazy but would you be against emailing me a copy of the spreadsheet ? If so my email is [e-mail] Great content !!