Once we’ve identified a great property, negotiated a great price, created a great budget, locked in great financing, and closed on the deal; we’ve put ourselves in a powerful position to achieve an outstanding return on our investment. Even though a massive amount of work goes into the identification, negotiation, and closing process; the closing date is really only the starting line. And every decision from that point forward is made with the finish in mind – increase NOI so that, in minimal time, we can achieve a maximal refinance or sale. Again, because we buy well-constructed buildings in great locations, we want to hold these assets. While a future sale is inevitable, our intention when purchasing a property is always to refinance before selling. For this reason, this blog is all about the refi.
Before we get into our strategy on how to maximize a quick and huge refi, we need to understand something far more important – WE DON’T NEED TO REFI. This blog episode on refinancing follows the last blog episode on financing because first financing is far more important. The wrong first financing can absolutely ruin a refinance or sale. I’ll tell you how.
Bridge Debt
Raven properties are financed with long-term, fixed-interest rate loans; but not all investment properties are. Some investment properties, especially value-add properties with significant upside (similar to the ones we buy) are financed with a “bridge loan”. While they vary, bridge loans are typically either fixed or variable-rate loans with a 12-24 month term. The typical business plan for one of these properties is to close on them, and then work as hard and as fast as possible to increase NOI before the loan needs to be paid back in 12-24 months. Sounds familiar except for that last payback detail, right? Here’s the problem. These loans are taken on with two assumptions:
- The NOI will increase considerably (we make that same assumption)
- The financing and/or real estate market will be friendly at the end of their term
While we may believe #2 is accurate, we’re not willing to bet our ROI on something that we have no control over. Here’s why. Let’s assume that a $10MM property currently brings in $300,000 of NOI and the lender requires a 1.0 DSCR. So, they’ll make a loan with an annual debt service of $300,000. You can input that data into an online loan calculator to find that a $7.5MM loan with a 4% rate and 12-month interest-only term would produce that $300,000 annual payment. You can take my word for it, or take some time to go online and test it yourself.
Let’s assume that the market cap rate is 4% at the time of purchase, but the buyer assumes that they can bring the NOI up to $600,000 in 12 months. So, they were willing to buy it at a 3% cap rate ($300,000 NOI ÷ $10,000,000 price), because it’ll be a 6% cap rate a year later. As you can tell from previous blog episodes, this business plan, operationally, mirrors ours.
If that buyer is a great operator and executes on their business plan, and the market remains the same, they can now decide to (a) hold the property and refinance, or (b) sell. If they want to refinance into a 30-year loan, it’ll probably require a 1.3 DSCR – meaning the debt service will be $462k ($600k NOI ÷ 1.3 DSCR). At 4% interest, that’s an $8.1MM loan (again, you can use an online calculator for this). If they spent $500k in renovations during that year, that means the new loan pays off their old $7.5MM loan and the renovations, plus an extra $100,000. This isn’t what we’d consider a home run, but now they own a good property with a secure, long-term loan. If there’s additional upside left (say, for example, they can increase NOI to $800,000 by the end of the next year), then this deal is looking like a win.
If they want to sell after those first 12 months, instead of refinancing, they’re well-positioned for a considerable profit. At a 4% cap rate, $600,000 in NOI will generate a $15MM sale. After the $500k in renovations, that’s $4.5MM of profit,
$15,000,000 sale price – ($10,000,000 purchase price + $500,000) = $4,500,000 profit
in just 12 months. Let’s assume they raised the $2.5MM downpayment and the $500k renovations up front – that’s a 50% ROI ($1.5MM profit ÷ $3MM investment) in 12 months. Who wouldn’t take that?
But here’s the hangup. What if that buyer does the exact same thing – works their butt off, makes all the right moves, and doubles the NOI..and the market takes a nose dive? What if interest rates and cap rates are at 7%? Well, I’ll tell you what.
At 7% interest, now, that 30-year loan is about $5.8MM. To refinance, they’ll need to raise the extra $1.7MM,
$5.8MM refinance – $7.5MM initial loan = -$1.7MM
to pay off their bridge loan. After the $500k they spent on upgrades, they’re $2.2MM in the hole on a property they just doubled the NOI on… ouch.
Maybe they choose to sell, instead. At a 7% cap rate, a $600,000 NOI will get them a sale price of roughly $8.57MM. That’s $1.93MM less than the $10.5MM it cost them to buy and renovate it.
So, they’re forced to choose between (a) selling and walking away with an almost $2MM loss, or (b) spending over $2MM to refinance the deal and try to turn a future profit. If they don’t have that extra $2.2MM to stay in the deal, that decision is made for them – they’re forced to sell.
Could you imagine that? You close on a property and make all the right moves; you capitalize on your calculated risk by bringing your 3% cap to a 6% cap in 12 months; the path is paved for you to bring it to an 8% cap in 12 more months (not quite to our standards, but not bad!); and the rug is completely pulled out from beneath you.
Well, that’s the risk you’re taking if you make a bet on something you cannot control, like the market. There is risk associated with any investment, any investment property, and any Raven property. For example, if we think we can spend $1MM to bring NOI from $250k to $750k in 24 months, but we manage the renovations poorly or hire the wrong manager, we may only bring that NOI up to $450k. At a 5% cap rate, that means we just created $4MM of value (from the +$200k of NOI) instead of the $10MM we projected. Not a loss, but that’s a major under-delivery on our promise to our investors.
That’s why we micromanage our construction and operational processes – every bit counts. We’re not here to create the false illusion that we mitigate all risks – but we certainly favor the risks over which we have some control. So, while a poorly financed deal is subject to that a&b decision from a few paragraphs ago; we get long-term financing to secure option c: do nothing. That way, we’re never forced to make a major financial decision at a point of weakness.
In the next blogcast article, we’ll reveal how we finance and refinance the right way.
- Financial Disclaimer: The financial figures shown above are intended for illustrative purposes only to explain general real estate concepts and are not guaranteed by Raven Real Estate Acquisitions or any of its affiliates. Real estate investing involves many risks, variables, and uncertainties. No representations or warranties are made that any investor will, or is likely to, attain the returns shown above since hypothetical or simulated performance is not an indicator or assurance of future results.
- Investment Advice Disclaimer: This content is for informational purposes only. Raven Real Estate Acquisitions and its affiliates do not provide legal, tax, investment, financial, or other advice. All content presented is information of a general nature and does not address the circumstances of any particular individual or entity.
- Investment Risk Disclaimer: There are risks associated with investing in real estate and securities in general. Investing involves risk of loss including loss of principal. Some high-risk investments which use leverage may accentuate gains and losses. Past investment performance is not a guarantee or predictor of future investment performance.