Thread by @sweatystartup

The holy grail of real estate investing is the cash-out-refinance.

I completed one in Nov of 2019 and $2MM of tax free cash was put into my checking account at closing.

Heres a thread on how it works, how folks make it happen, how to plan for it and the risks. 👇👇👇

Commercial real estate isn't valued like residential homes.

Residential homes are about comparable sales. What did the house down the street with similar features sell for?

Commercial real estate is valued, mainly, on one factor:

Net Operating Income (NOI)

The more money it makes, the more its worth. The less it makes, the less its worth.

Banks lend based on two things:

Its appraised value and its cashflow.

Appraisers value buildings based on CAP rate comparisons...

Heres how that works:

A CAP rate is the NOI divided by overall cost. 6% = 6 cap. 7% = 7 cap.

The higher the cap rate the better the returns.

If you spend $1MM on an asset that has an NOI of $50k you purchased it at a 5 cap. If its $60k thats a 6 cap. etc.

A lot of things effect the cap rate.. mainly interest rates. With cheap debt and long interest only periods folks can afford to accept less NOI and buy at lower cap rates.

Location, risk, quality of tenants, quality of building, perceived risk also effect the cap rate.

If the same asset down the street sold at a 6.5 cap then the appraisers use that as the market figure to determine value.

The banks loan-to-value (LTV) percentage is also important. In most asset classes its 65-75% LTV. Meaning the bank will loan 65-75% of what its worth.

Banks also consider DSCR (debt service coverage ratio). How much do you cover your debt service obligations with your net operating income?

1.25x is generally the baseline in self storage. They want your NOI to be 1.25x the debt obligations. I like mine even higher.

So now lets talk about my cash-out-refi and how it worked.

We built a ground up self storage facility for $2.9MM in 2016. Opened for business in May 2017.

Our original LTV was ~75%. So our loan amount was $2MM and we put in $900k in cash.

We got to work leasing up the facility

By 2019 we were getting near stabilization and our NOI was $420k a year.

So we went back to the bank and said - hey, this thing is worth a lot more money now. Let's get it appraised and put more debt on it.

They determined an 8 cap was a safe market value to use (I was hoping..

for a 7, but whos counting...)

So $420k in NOI divided by .08 (8 cap) = $5.25MM.

Another way: $5.25MM * .08 = $420k

So our property is now worth $5,250,000... We've created a lot of value! Bazinga!

So the bank will now loan 75% of that new value to me as long as we have the 1.25x DSCR covered, which we do.

$5.25 * .75 = ~$4MM

$4MM is the new loan amount.

Use $2MM to pay off old loan, you have $2MM left over.

Take original $900k investment off the table, $1.1MM extra.

So that $2MM goes into the checking account. Tax free.

We turned our $900k investment into $2MM in cash AND we still own the building which is cash flowing $250k a year.

A Christmas miracle! And a way to get very wealthy very fast!

We're spending it on more storage...

Now sometimes there are expensive prepayment fees to repay loans. Banks like having loans out and it defeats the purpose for them to do all the work to write loans if you're just going to pay it back right away...

So I negotiated with our bank on day one...

If I clear the loan there won't be a prepayment penalty IF I replace it with a loan from your bank.

They agreed.

Other times, if you know you have a big value-add deal, you can pay a higher interest rate on a shorter term and avoid prepayment penalties.

The risk here is that you get stuck with an over-levered building when rates go back up, cap rates widen, and the building gets less valuable.

You can owe more than the asset is worth. That happened to a ton of RE investors in 2009 when the market dropped 40-50% in some sectors.

Its a wild, wild world. A lot of money to be made and value to be created! Get your piece!