I keep seeing real estate syndications that include a refinance during the third year of the deal. I’m not going to tell you that refinancing is a bad thing, but when I see a passive investment deal that requires a refinance, that’s a big red flag for me.
And no one tries to downplay the refinance in their deals. It’s not buried in the small print. In fact, it’ll just be presented as a sensible, regular part of their business plan. So, that means it should be OK, right? Based on an article that I published in late 2021, before the Fed really started raising interest rates.
Refinancing Explained
When you purchase an investment property, it’s natural to add value through renovations so that you can rent the property at a higher amount and eventually make a larger return when you sell the property.
But instead of waiting for a sale of the property, keeping that value trapped in the property, you might want to unlock this equity you’ve created.
You could speak with a lender and get a “cash-out refinance” where you get a new mortgage and walk away with money in your pocket due to the increased value of the property. This allows you to turn the equity you built into cash and also continue to own the property (and hopefully enjoy the cash flow) for a number of years before you eventually sell the property.
Sounds great, doesn’t it?
Your property value goes up, most (or all) of your initial capital gets returned to you early on, you hold on to a cash-flowing asset, and then you sell further down the line for a nice profit.
It’s a home run!
But can you see some assumptions that need to hold true for this to work out?
Relying On The Future Is A Bet
None of us has a crystal ball. We often don’t know what the market is going to do in 6 months’ time, let alone in 3 years’ time. The fact is that you can’t be certain that a refinance will even be possible, or what the terms might be if it is possible.
Relying on being able to execute a refinance or get a supplemental loan is a bet with uncertain odds. If you purchased a property in October 2020 with a plan to refinance at a similar interest rate in just 2 years, you might be in a bit of a pickle since rates increased by more than 400 basis points during that time.
In this scenario, your new debt payments would be one and a half times higher than the original mortgage.
If your eyes are wide open on this and you still want to enter such a crapshoot, have at it. Personally, I prefer to invest in deals that have a much more solid foundation. Call me cautious but I think gambling should stay in the casinos. This is business and I’m here to invest, not speculate.
The myth is that refinancing will always be possible during a deal. The truth is that we just don’t know what the interest rates will be at any given time in the future, or what the value of the property will be due to possible changes in cap rates.
Why Refinancing Can Make A Deal Look Tempting
If relying on a refinance is a gamble, why would anyone invest in such a deal?
One reason is because of the way the numbers are presented makes the returns look attractive. But all might not be what it seems.
The investor will theoretically receive a large amount of their capital back at the time of the refinance. This will produce a higher IRR and since they would have very little capital left in the deal, the proforma will often show a high Cash-on-Cash return after the refinance. Consider a 5-year example like this:
- Year 1: 5%
- Year 2: 5%
- Year 3: 5%
- [Refinance at end of year 3]
- Year 4: 15%
- Year 5: 15%
The sharp uptick in the years after the refinance means that the Cash-on-Cash average for the whole deal goes up. Here’s the Math: (5% + 5% + 5% + 15% + 15%) / 5 = 9%.
So, you might see a deceptively attractive deal promoted with a higher IRR and 9% average Cash-on-Cash return. And yet the reality is that you’d get only 5% per year for the first 3 years.
And what happens if that refinance doesn’t work out as you expected?
Suddenly that 9% Cash-on-Cash and high IRR doesn’t seem like the slam dunk it appeared to be before.
Without understanding how the deal is structured, you might invest in a deal that doesn’t match your investment criteria.
I’m not saying refinancing is bad across the board. I’ve been involved in many deals that have included a refinance. It’s actually something I think is a great idea and it’s even one of the keystone concepts I share in my book.
When Refinancing Works
While you might not want to invest in a deal that doesn’t meet your criteria if that magical refinance in year three doesn’t materialize, there are a lot of reasons why a refinance can be great. Invest in a deal that meets your requirements on its own merits and a refinance can be a windfall.
Here are some reasons why refinancing can be a boon:
Faster Growth: When refinancing is possible, it gives you the chance to reach your goals faster, because the unlocked equity can be put into other passive investments, generating more income.
Tax Advantages: The money you receive as part of a refinance isn’t income (it’s a loan), so you won’t pay income taxes on it.
Long-Term Investments: Refinancing can be great if you purchase a property you want to hold for a long time. You might be able to refinance every 5–10 years and do very well.
Icing On The Cake: For deals that stack up well without refinancing, a successful refinancing on top could make that deal even sweeter. When a deal works out like this, everyone’s smiling.
Know Your Deal
I always remind my investors that they need to vet their sponsors, the market, and the deal. In the case of refinancing, make sure you truly understand the deal.
Keep these general rules of thumb in mind:
- If a deal works only with refinancing, that’s a red flag.
- If a deal works without a refinance, that’s a good sign.
- If a deal works without a refinance but a refinance may be possible, you may be able to achieve a greater return.
End Game
Finally, it is important to note that even if a refinance is possible, in practice most people who get to year 3 tend to sell for a guaranteed return. That’s often the smarter play instead of holding on for a few more years for only a slightly bigger return (or even just the same return if the market doesn’t go the right way).