Underwriting a Multifamily Refinance
A cash-out refinance in multifamily is a beautiful occurrence for real estate investors. Leveraged borrowers can pull equity out of the project and recycle those funds elsewhere with little tax consequences.
This article strives to answer whether or not it is prudent to count on refinancing proceeds in commercial real estate underwriting while vetting a multifamily acquisition or development opportunity.
Unfortunately, refinancing is a double-edged sword. While it can be a considerable boon to investment outlook, capital markets are fickle. When forecasting a cash-out refinance multiple years into the future, there aren't guarantees that refi proceeds will ever hit your P&L.
Multifamily Refinance Contents
When to Underwrite Multifamily Refinance Proceeds
My rule of thumb has always been to incorporate a multifamily cash-out refinance assumption when your business plan dictates that you have to. These instances could be:
Note: If you are developing new construction with HUD, a refinance won’t be available, but you could check to see if you’re eligible for the BSPRA credit.
Suppose you're building a project ground up, converting a commercial building into a multifamily property, or rescuing a distressed apartment building. In that case, construction or bridge loans will likely be your only financing options.
If you want to hold the property long-term after completing renovation/construction, accounting for a refinance in your underwriting is necessary.
Construction mortgages and bridge loans are short-term, interest-only (no amortization), and more expensive (higher interest rates).
Often, interest terms will be adjustable (hopefully with an interest rate cap), meaning the interest rate can change every quarter. They are excellent loan programs early on but will eventually need to be replaced with long-term financing.
If you can obtain agency debt on day one, such as Fannie Mae/Freddie Mac, or even a 10-year bank loan, I'd argue that underwriting a refinance is too speculative. It would be best if you excluded it from the analysis. The project should check off all the return metrics regardless of refinance feasibility.
Anytime extensive construction is involved, the project will be inherently riskier than a recently constructed apartment building or a turn-key, cash-flowing project. IRRs, cash-on-cash returns, and equity multiples should be higher to account for the increased execution risk.
The refinance assumption, which is far from guaranteed, is appropriate for a project more elevated on the risk spectrum than other forms of commercial property investment.
Dangers of Accounting for a Multifamily Refinance
I’ve seen projects continually have to "extend" their construction financing because the property is not performing well enough to refinance. I have heard investors gripe about being "underwater" on their construction financing and unable to pull money out of the project or facing a ‘cash-in refinance.’ These experiences have significantly impacted why I am against underwriting a refinancing unless it is vital to the business plan.
Many operators I talk to love the idea of refinancing but never explicitly count on them when assessing the investment feasibility of an apartment purchase. Like me, they know refinances are far from guaranteed for different reasons. I believe this is the correct mindset. Below, I summarize seven reasons why underwriting refinances is risky.
Cap Rate Expansion
Refinance proceeds will be determined by the market cap rate of your property. The cap rate and your desired loan-to-value (LTV) percentage determine the apartment loan amount.
Cap rates are in constant flux. Factors outside of any investors' control will determine the market cap rate. When making future refinance assumptions today, you must predict the future market cap rate. This assumption is speculative. Markets could be entirely different in two or three years, and cap rates could be much higher than today, reducing total refinance proceeds.
Rising Interest Rates
The Federal Reserve aims to curb inflation by raising interest rates. Many investors with a balloon payment looming in 2023 or 2024 may see mortage rates more than double what they were just a few years ago.
If you were lucky enough to lock in historically cheap debt with a 10-year term in 2020, why would you want to blow it out with likely costlier financing terms in the future? What interest rate are you using for your future refinance loan assumption? Is the cushion big enough?
Assumable loans originated during the 2020s will one day be coveted, thanks to their historically low-interest rates.
Changing Lender Preferences
Like cap rates, which are fluid and constantly in flux, so are lender preferences. I'm hearing that lenders who used to offer attractive non-recourse financing terms with low debt service coverage (DSCR) and debt yield requirements are no longer lending on commercial real estate.
High Prepayment Penalties
Prepayment penalties are expensive. Yield maintenance or other prepayment fees will eat into refinancing proceeds if you are refinancing into a different loan product (from bank debt to agency financing or from a HUD loan to an agency option, etc.). You will also need to pay fees for the refinance loan in the form of origination fees, appraisal, legal, etc.
Poor Operating Performance
We learned during COVID-19 that operations could take a hit from factors outside our control. Nothing will kill the prospects of a successful refinance like elevated vacancy, rent concessions, loss-to-lease, or bad debt (residents not paying rent). When there is a significant revenue dip as your refinance looms, total loan proceeds could diminish significantly.
Location & Preferences
Location is crucial in real estate investment, but resident preferences change. You may look at a property in a sought-after neighborhood today, but it may not be as in demand in the future. COVID exposed some prominent warts in urban apartment buildings. When restaurants, bars, and other walkable entertainment sources shut down, residents didn't see the value of living in the city. Many residents flocked to the suburbs in search of more space.
Migration patterns are seen at the state level as well. Many northeastern residents flocked to the sunbelt in 2020 and 2021 for better weather, lower taxes, and cheaper real estate. If a renter's interest in the property's location wanes, diminishing operations are almost assuredly to follow along with a reevaluation (increase) of market cap rates.
Investor Expectations
If you raise equity for your investment property from limited partner (LP) investors, promising a refinance creates massive LP expectations for GP performance. The syndicators I speak with would love to refinance if the opportunity presents itself. However, they would never mention it in any investment package (assuming it's not a total repositioning effort or ground-up development).
Most investment packages for standard value-add or core-plus do not include refi proceeds in their proforma underwriting. I would be skeptical if the GP targeted a 14% IRR, but the proforma included an aggressive refinance in Year 2. The first question I would ask is what the IRR would be if there were no refinance, as it could add 200-300 basis points (bps) to the IRR yield.
"Underpromise and overdeliver" by underwriting conservatively —the motto our proforma tools gravitate towards in real estate investment.
Summarizing Multifamily Refinance Underwriting
More capital-intensive projects like multifamily development or repositioning a distressed asset will likely require a refinance to pay down short-term construction or bridge financing. Other existing projects may benefit from a refinance if market fundamentals stay strong but shouldn't be dependent on when assessing investment opportunities' financial feasibility.
Many factors could sour the prospects of a refinance. An existing property should pencil out on cash flows alone. A refinance should be considered icing on the cake if market factors combined with your project expectations are favorable.
