– Will Coleman Director of Finance at Rand Capital
Leverage is one of the most powerful tools in commercial real estate. It allows you to acquire an income producing asset, without having to bring all the capital yourself. However, as with most powerful tools, necessary precaution must be taken in order to avoid injury.
Generally, there are two scenarios in your business plan that you can use leverage to capitalize your property. The acquisition and the refinance. This article focuses on the details and process of a refinance to give you strategic insights into when is the best time to refinance a multifamily property.
Table of Contents:
- How Long Should You Hold Your Multi-Family Property Before Refinancing?
- How to Structure Your Pre-Payment Penalty?
- How Does a Refinance Impact Your Taxes?
- Speaking with Industry Experts.
- Molding Your Business Plan Around the Market Cycle.
*This article focuses on Community Banks, Fannie Mae, Freddie Mac, and Credit Unions. If you have any questions on HUD, Private Lenders, or CMBS reach out to us at firstname.lastname@example.org.
*Additionally, this is a description of the lending environment as it stands in May of 2020. Please note: This is an ever-changing industry.
How Long Should You Hold Your Multi-Family Property Before Refinancing?
It is no secret that cash is worth more today than it will be tomorrow. Therefore, the sooner you can pull equity out of the property the better. But often if you refinance too soon you will miss out on maximizing the amount of equity you can pull out of the property.
Lenders generally like to see “seasoning”, which refers to the length of time you have owned the property. If you have owned the property for only 2 months, there is a higher degree of risk in the eyes of the lender since this property’s track record is not longstanding. Therefore, if you ask for a refinance after 2 months it may be possible to get a loan with certain lenders however, they will limit the leverage and terms to hedge against their perceived risk. Additionally, when you refinance you want to show a higher value than what you bought it for and it is difficult to show are higher value after 2 months of ownership. Each type of lender will have a different appetite for seasoning. In the following paragraphs we will analyze some of the more active lenders in the multi-family industry.
Keep in mind that each sponsor is different. Lenders are in the business of mitigating risk, the stronger your balance sheet and experience the less risk in the eyes of the lender which will lead to better terms for you as a borrower. As they say, all is fair in love, war, and lending.
Fannie Mae and Freddie Mac:
Both Freddie Mac and Fannie Mae really like to see a minimum of 1 year of ownership before they will consider a refinance. However, even after a year they will prefer to limit the leverage based on a cost basis rather than a value basis. For the most part, if you have owned the property more than 12 months and less than 24 months your loan will be limited to approximately 80-90% of your original cost. For example, if you purchased the property for $10,000,000 and put $500,000 into the property as capital improvements, your loan will be limited to approximately 90% of $10,500,000 which would equate to $9,450,000. The downside of this is that your new value of the property may be much higher let’s say $13,000,000 in this example the $9.45MM loan amount would equate to a 73% LTV (loan-to-value). If you were to wait for year two, you could have potentially reached 75-80% LTV.
Once you reach the 2-year mark, the cost basis is no longer as much of a constraint and you can base your refinance leverage on the current value of your property. With all of this being said each deal and lender is different and if you can prove a significant increase in income that is sustainable, and you have put a significant capital expenditures into the property you may be able to get a lender to put less weight on the cost basis.
Make sure to speak with your lender about your plans to refinance as they can assist you to understand the potential terms and structure the acquisition accordingly.
Local Community Bank:
Community banks are tricky because each bank is owned and operated differently. The bank’s ownership structure, balance sheet, and overall appetite for certain asset types will determine the terms they can offer. To articulate this point, we spoke with three banks and have summarized their feedback below.
This bank is pretty risk averse; they may not be the best gauge for terms on a multi-family refinance as they do not have a huge appetite for cash out refinances. Generally, they like to keep the loan at 80-90% or so of the original cost for at least the first 3-4 years. The only time they may overlook this restriction is if you have put a considerable amount of rehab into the property and increased the value with a large verifiable capital expenditure budget.
This bank is a bit more comparable to Fannie Mae and Freddie Mac. They will require at least 1 year of ownership to entertain a cash out refinance. If you are within in the 12 to 24-month range, they will keep the loan around 80-100% of the original cost. Once you have owned it for about 2 years and have put capital improvements into the property, they will start to put more weight to the value over the original cost.
This bank is a bit more aggressive; they prefer to see 12 months of ownership before they will consider a cash out refinance however, they have seen some situations where they would do it sooner. Once the borrower has owned the property for 12 months or more, they are willing to do a refinance at approx. 80% of value. They did mention that they normally have a leg up on their competition as most other banks will rely heavily on the amount of the original cost put into the property but they feel comfortable with a value based loan as long as the borrower qualifies and the property meets it’s DSCR requirement.
Credit Unions differ slightly from banks due to their business model. They will have members that deposit money into accounts at the credit union in order to lend, administer demand deposits, and provide other products. Credit unions are nonprofits and any generated income is used to fund projects and services meant to benefit the community.
You must be a member of the credit union to be a borrower. They can offer similar terms and rates as a community bank. Like banks, each credit union will have a separate appetite and rules that impact their aggressiveness on cash out refinances of multi-family properties.
For the sake of this article we spoke with a credit union that was willing to do 80% LTV after 1 year of ownership. They will consider a refinance prior to one year but that would be considered on a case by case basis.
How to Structure Your Pre-Payment Penalty.
Understanding your Pre-Payment penalty is crucial when determining the best time to refinance your deal. Multifamily is all about never being forced to sell and the best way to do that is to have multiple exit strategies that allow you to be flexible. Generally, you will have two main types of pre-payment penalties, Yield Maintenance and Step Down. Like seasoning, each lender will have a preference to the type of pre-payment penalty, therefore we will look at each lender type and each pre-payment type. First, let’s look at each pre-payment penalty type.
What is Yield Maintenance?
Yield Maintenance is calculated by taking the net present balance of the loan and multiplying it by the difference in the interest rate on the loan and the correlating bond yield. In principle, this allows the lender to earn the total amount of interest as if the borrower had paid off the loan over the full amortization and is generally more expensive than the step-down option. Below is an explanation and calculation of yield maintenance per Investopedia.com.
“Yield Maintenance = Present Value of Remaining Payments on the Mortgage x (Interest Rate – Treasury Yield)
The Present Value (PV) factor in the formula can be calculated as (1 – (1+r)-n/12)/r
r = Treasury yield
n = number of months remaining in the term
For example, assume a borrower has a $60,000 balance remaining on a loan with 5% interest. The remaining term of the loan is exactly five years or 60 months. If the borrower decides to pay off the loan when the yield on 5-year Treasury notes drops to 3%, The yield maintenance can be calculated in this way.
Step 1: PV = [(1 – (1.03)-60/12)/0.03] x $60,000
PV = 4.58 x $60,000
PV = $274,782.43
Step 2: Yield Maintenance = $274,782.43 x (0.05 – 0.03)
Total Yield Maintenance = $5,495.65”
What is a Step Down?
Step down is calculated as taking a predetermined percentage and multiplying it by the loan balance. If it is a 5-year term generally your step down will be 5% year 1, 4% year 2, 3% year 3, 2% year 4, and 1% year 5.
Fannie Mae will generally lean more towards a yield maintenance pre-payment. You can request a step-down option for Fannie however this will cause your interest rate to be increased at a higher rate than it will be for Freddie. If you plan to sell or refinance the property in year 2 or 3 it will probably make more sense to get a step-down option.
Freddie Mac’s small balance loan (SBL) program was created to compete with local community banks. Most community banks have less expensive pre-payment penalties therefore, Freddie Mac SBL will offer competitive interest rates and the ability to have a step-down pre-payment penalty.
For Both Fannie and Freddie, you can request Yield Maintenance if you are going to hold for long term or Step Down if you expect to sell or refinance in a few years. As mentioned, Fannie will price up their loan a bit more than Freddie if you choose to go with a Step-Down, it is important to compare both options when choosing your loan structure.
Local Community Bank Pre-Payment Penalty:
As previously mentioned, each community bank will operate a bit differently however most of the time they are more relaxed on their pre-payment penalty. You should always ask the banks you are calling how they structure their pre-payment penalty to make sure your underwriting reflects the appropriate cost. Community banks will likely have one of the following three scenarios.
- No pre-payment penalty at all
- A 1% refinance fee (if the property is sold there is no penalty)
- A reduced step down (3%, 2%, 1% or 3%, 3%, 2%, 2%, 1%)
Another huge benefit of working with a community bank or credit union is that a lot of their terms are negotiable. If having a reduced pre-payment is something that is important to you. Ask about your ability to negotiate this and see what you can offer to the bank in order to lessen this cost.
Credit Unions are pretty much hand in hand on prepayments as a community bank as they are direct competitors in most markets. Each credit union will have their own policy. The credit unions we spoke to for the sake of this article had no prepayment penalty whatsoever.
How Does Refinancing Impact Your Taxes?
One of the biggest benefits of a cash out refinance is that the equity you pull out of the property will not be subject to income or capital gains taxes due to it being considered a loan that you will eventually pay back. This gives you the ability to pull out a significant amount of capital without losing a portion to taxes and then using this capital to invest into another property.
When you refinance however, you will have to get an appraisal and assign a new and hopefully higher appraised value to the property. While the new value of the property is not public information and should not immediately trigger an increase in the county appraisal district’s assessed value. The loan on the property is however is public information. If the county were to check the property’s increased loan balance it could trigger a re-evaluation from the county which would increase your property taxes. While this is not a directly correlated event, it is smart to remain conservative and model for an increase in taxes based off the new property value when refinancing. Each state and county operate differently so it is worth checking with your county however this is the process for most of the country.
Speaking with Industry Experts:
As mentioned, there is no exact science to determining the perfect timing for a refinance. There are a lot of variables that come into play when refinancing. We spoke with three industry leaders and asked them what they look at when considering whether to refinance their multi-family property. All three of their answers were nearly identical therefore, we have summarized it in the following paragraph.
“There is no specific metric, it all depends on what you are trying to do and what is your long-term goal for the property”. You should ask yourself what your goal for the property is, and will a refinance allow you to put a loan product on your property that will accomplish or get you closer your goal. Here are four main questions these experts ask themselves when considering a refinance. If the answer is yes to most of these questions, then it is probably a good time to refinance your property.
- Do the savings from better terms and interest rate outweigh the cost of doing the loan and how long will it take for these savings to be greater than the cost of the loan?
- Can you return the initial investment to yourself and your investors?
- Would extending the term of your loan or implementing a long-term fixed rate help you hedge against market cycle risk?
- Most importantly, does a refinance align with your long-term goal for the property?
Molding Your Business Plan Around the Market Cycle:
As Howard Marks has said “We all have the same information about the present and the same ignorance about the future”. While the future is not knowable, by paying attention to historical cycles, being aware of the present market condition, and understanding how market cycles work you can begin to understand what is likely to happen in the future. Predicting the future is an exceedingly difficult task however, understanding where you are in the present can be a very telling indicator of the future. The quote of investing legends about being active when there is fear in the market and being passive when there is greed in the market is a long list, but probably one of the best is Warren Buffet’s “Be fearful when others are greedy and greedy when others are fearful”.
Understanding where we are at in the market cycle should impact your business plan and how you determine when you will refinance your property. If the market is full of greed and investors are buying properties with the belief that nothing can go wrong, this is a great time for valuations and it will positively impact how much equity you can pull out of your deal. Remember this sentiment will not last forever. If the market is filled with fear, this is not a great time for valuations thus, if you can weather the storm and do not have any maturing debt or need to return capital to your investors. Being patient and waiting a year or 2 to execute your refinance may be worth considering. There is no cookie cutter template for it, understanding the market cycles and adapting your business plan to benefit from the changing landscape is an important tool in real estate and investing overall.
In summary, there is no right answer as to when to refinance your multi-family property, it all boils down to what is your long term goal for the property and does a refinance help you get closer to achieving that goal. By understanding the lending process, costs, and market cycles you can make an informed decision that will allow you to earn a higher return on capital than normal.
While writing this article, we reflected on how we would answer this question for our own properties and our answer ultimately aligned with the conclusion of this article, it depends on our strategy. If the goal is to sell the property quickly than a refinance may not be considered at all. In other scenarios we will want to hold the property long term. Ideally, we want to leverage the asset conservatively so that it will continue to produce cash flow and keep up with inflation while pulling out enough capital to buy assets in order to stockpile depreciation. Again, each investor is different, but this is an answer that suited us. We hope this article was helpful.
If you would like to learn more about how Rand Capital can help you with your next loan, reach out to me at my email below.
Thank you for reading,
Will Coleman – Director of Finance at Rand Capital