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What it Takes to Cash-Out Refi
May 25, 2021
Many investors, beginner and experienced, are enamored with the strategy of buying a value-add deal, raising the value of the property, then doing a cash-out refinance to return 100% of the originally invested equity. While this is a tremendous strategy which is not only a great way to generate outsized returns and build a growing portfolio, but also extremely tax-efficient, since a refinance is not a taxable event.
However, 100% cash-out refinances are not a common occurrence today even on a heavy value-add deal, since prices are high and takeout leverage is constrained to around 75% (except HUD 223(f) loans which can be levered up to 83%). Stabilized core-plus or value-add deals are nearly impossible to pull off a 100% cash-out refi, not only because prices are high, but also because this deal strategy and financing strategy are a mismatch.
The reality is value must be increased so substantially through the business plan and potentially through appreciation (which can come in the form of rent increases or cap rate compression) that the total capitalization of the deal must be 75% or less of the new appraised value on a refinance. This math makes logical sense since you would have to get a 75% LTV loan based on the new value of the property and use those new loan proceeds to pay off the old debt as well as return all of the original equity (making up the deals acquisition total capitalization).
Let’s take a deeper dive into these numbers and really look at the metrics of a deal that would produce this level of value increase, such that a 100% cash-out refinance is a potential reality.
Here we have an example 150-unit multifamily deal we will use to draw conclusions about the qualities of a deal which make it more likely to achieve a full cash-out refi:
As you can see, this is a very prototypical value-add deal. The property is being purchased at a 5% cap rate and the capex budget is $8k/u for both interior and exterior upgrades in order to achieve a $100 rent premium, resulting in a 12.5% revenue increase. For this hypothetical deal, we are keeping expenses the same from in-place to pro forma.
We are assuming 80% going-in leverage on a Freddie Mac floating rate loan which only has a 1% prepayment penalty, allowing for an economical refinance. The projected returns are 14.2% gross IRR over a 3-year hold which is in-line with market averages for a value-add deal of this profile today. The stabilized yield on cost is 5.95%.
Now if we project a refinance after 24 months of ownership after the value-add business plan is complete (assuming an 18-month stabilization period to raise rents on all 150 units), the cash-out would be about 35%. This is assuming 75% LTV on the new loan and a refi cap rate of 5.5%.