Cash-in Refinance

For commercial real estate owners seeking to strategically leverage their existing equity without selling, a cash-in refinance can be a powerful tool. This article explores the mechanics and benefits of this financial strategy, illustrating through a practical scenario how it can unlock capital for portfolio repositioning or other business needs.

Scenario:

Property Type: A 20,000 square foot multi-tenant retail center located in Menifee, California.

Initial Loan (5 Years Ago):

• Loan Amount: $5,000,000
• Interest Rate: 3% per annum
• Loan Term: 10 years (with a balloon payment due at the end of year 10)
• Annual Debt Service: Using a standard mortgage calculator or formula:
  • Monthly Interest Rate = 3% / 12 = 0.0025
  • Number of Payments = 10 years * 12 months/year = 120
  • Monthly Payment = $5,000,000 * [0.0025 * (1 + 0.0025)^120] / [(1 + 0.0025)^120 – 1]
  • Monthly Payment ≈ $48,264.48
  • Annual Debt Service ≈ $579,173.76

Refinancing Situation (Today):

• The original loan is maturing in 5 years (the balloon payment is coming due).
• Current market interest rates for commercial real estate loans are at 7% per annum.
• The owner wants to refinance the remaining loan balance but wants to ensure the annual debt service does not increase from the current $579,173.76.

Calculating the Remaining Loan Balance:

After 5 years (60 months) of payments, the remaining principal balance on the original loan needs to be calculated. We can use the amortization formula in reverse or an online calculator. The remaining balance will be approximately $3,977,787.83.

Determining the New Loan Amount to Maintain Debt Service:

The owner needs a new loan with a 7% interest rate and a 5-year term (to match the remaining term of the original loan) that results in an annual debt service of $579,173.76.

Let’s calculate the maximum loan amount the owner can take out at 7% to keep the debt service the same:

• Annual Debt Service (Target) = $579,173.76
• Annual Interest Rate = 7% = 0.07
• Loan Term = 5 years

We can use the annual payment formula:

A = P * [r(1+r)^n] / [(1+r)^n – 1]

Where:

• A = Annual Debt Service = $579,173.76
• r = Annual Interest Rate = 0.07
• n = Loan Term = 5 years
• P = Principal (New Loan Amount) – This is what we need to find.

$579,173.76 = P * [0.07(1+0.07)^5] / [(1+0.07)^5 – 1]

$579,173.76 = P * [0.07 * (1.40255)] / [1.40255 – 1]

$579,173.76 = P * [0.0981785] / [0.40255]

$579,173.76 = P * 0.243888

P = $579,173.76 / 0.243888

P ≈ $2,374,776.88

This means the owner can only borrow approximately $2,374,776.88 at a 7% interest rate for a 5-year term to maintain the same annual debt service of $579,173.76.

Calculating the Cash-In Required:

The remaining balance on the original loan is $3,977,787.83. The new loan amount the owner can secure without increasing debt service is approximately $2,374,776.88.

Cash-In Required = Remaining Original Loan Balance – New Loan Amount

Cash-In Required = $3,977,787.83 – $2,374,776.88

Cash-In Required ≈ $1,603,010.95

Conclusion:

In this example, the commercial real estate owner facing a refinancing need in an environment where interest rates have risen from 3% to 7% would need to bring approximately $1,603,010.95 in cash to the refinancing in order to keep their annual debt service at the same level of approximately $579,173.76. This “cash-in” bridges the gap created by the higher interest rate requiring a smaller loan principal to maintain the same payment amount. This scenario is a direct consequence of the increase in interest rates and is a common challenge faced by commercial real estate owners in the current economic climate

Have you reviewed your portfolio to identfy your class A, B, and C assets? Are the environmental trends continuing to indicate jobs growth? Would a new acquisition in a growth market improve the strength of your portfolio?

Let’s look at some follow-on concerns that some may have.

Realism of Time Frames:

• Initial 10-Year Loan with Balloon Payment: This is a very common structure for commercial real estate loans. A 10-year term with a balloon payment due at the end (often after a 5-year or 7-year interest-only period) is frequently used by lenders. So, the initial timeframe is realistic.  
• Refinancing After 5 Years: Refinancing after 5 years of a 10-year loan is also realistic. Many borrowers choose to refinance before the balloon payment comes due for various reasons, including:
  • Changing interest rate environments (as in this example).
  • A desire to pull out equity.
  • The approaching maturity date and the need for a new loan.
  • Changes in their business strategy or the property’s performance.
• 5-Year Term for the New Loan: Choosing a 5-year term for the new loan to match the remaining term of the original loan is a reasonable assumption if the owner wants to maintain a similar overall loan duration. However, they could also opt for a longer or shorter term depending on their financial goals and the lender’s offerings.

How Soon Should One Consider Taking Action?

The timing of when to consider refinancing depends on several factors, but generally, it’s wise to start the process well in advance of the existing loan’s maturity date (or balloon payment). Here’s a more detailed breakdown:

• At Least 6-12 Months Before Maturity: This is a good rule of thumb. Starting the process this early allows ample time for:
  • Assessing your financial situation and property performance: Lenders will scrutinize these aspects.
  • Monitoring interest rate trends: This helps you make an informed decision about when to lock in a new rate.
  • Shopping around for lenders: Getting quotes from multiple lenders is crucial to secure the best terms.
  • Undergoing the due diligence process: This includes appraisals, environmental assessments, and legal reviews, which can take time.  
  • Negotiating loan terms: This process can involve back-and-forth with the lender.
  • Closing the loan: The closing process itself can take several weeks.
• Consider Market Conditions: If interest rates are expected to rise further, it might be beneficial to start the refinancing process even earlier to try and lock in a lower rate. Conversely, if rates are expected to fall, you might consider waiting, but this involves risk.
• Review Your Loan Documents: Understand the terms of your existing loan, especially regarding prepayment penalties and maturity dates.
• Engage with a Broker or Advisor: A commercial real estate broker or financial advisor specializing in debt can provide valuable guidance on timing and the refinancing process.  

In the context of the example, with the balloon payment due in 5 years (from the initial loan), the owner would ideally start seriously considering their refinancing options at least 1-2 years before that balloon payment comes due. Given the significant increase in interest rates, they would have likely started exploring options even earlier to understand the potential impact on their debt service.

Are There Prepayment Penalties?

Yes, prepayment penalties are very common in commercial real estate loans. The example did not explicitly mention them, but in a real-world scenario, the original loan likely included a prepayment penalty clause.  

The purpose of a prepayment penalty is to compensate the lender for the loss of future interest payments if the borrower pays off the loan early. These penalties can be structured in various ways:  

• Step-Down Penalty: The penalty amount decreases over time. For example, it might be 3% of the outstanding balance in the first year, 2% in the second, and 1% in the third, and then zero.  
• Yield Maintenance: This penalty is designed to ensure the lender receives the same yield they would have if the loan had gone to full term. The penalty is calculated based on the difference between the original interest rate and the current market interest rate for a similar loan.  
• Defeasance: This is a more complex type of prepayment penalty common in securitized loans (CMBS). It involves the borrower purchasing a portfolio of government securities that will generate the same cash flow as the remaining loan payments. This can be a costly process.

Importance of Prepayment Penalties in Refinancing:

The existence and structure of prepayment penalties on the original loan are crucial factors in the refinancing decision. The cost of the penalty needs to be weighed against the potential benefits of refinancing, such as a lower interest rate (though not the case in the example), a longer loan term, or avoiding the balloon payment.

In the example provided, if the original loan had a significant prepayment penalty, the owner would need to factor that cost into the decision of refinancing now versus waiting closer to the balloon payment date to potentially avoid or minimize the penalty.

Therefore, when considering refinancing commercial real estate debt, it is essential to thoroughly review the existing loan documents to understand any prepayment penalties and factor them into the financial analysis.