Refinancing can significantly impact an investment's overall success and return metrics. We explore the reasons for refinancing, the refinancing process, and the benefits of refinancing in real estate syndications.
Table of Contents
Commercial real estate syndications offer an attractive opportunity for sponsors to pool investor capital and access larger-scale, normally higher quality real estate investments.
One of the unique components of how sponsors and investors can make outsized returns in these syndications is through refinancing, which can significantly impact the investment's overall success and return metrics.
Read this article if you’re looking for clarity of the refinancing process, a walkthrough of a fictional case study, and summary of the advantages and common misconceptions.
Refinancing is the process of replacing an existing loan with a new loan, often with better terms or a lower interest rate.
In commercial real estate syndications, sponsors may pursue refinancings for several reasons:
As market conditions change, lower interest rates may become available, reducing the overall cost of borrowing and increasing the investment's profitability.
Many loan agreements sometimes have prepayment penalties or yield maintenance provisions that can make refinancing less attractive in the earlier years. However, commercial real estate loans can have 20 or 30-year durations, which create opportunities for refinancing into lower interest rates as the market evolves and the property's performance improves.
Refinancing can enable sponsors to negotiate more favorable loan terms, such as extended repayment periods, reduced prepayment penalties, or interest-only periods.
These adjustments can provide greater flexibility in managing the investment, allowing sponsors to better align their debt obligations with the commercial property's cash flow and long-term financial goals.
Refinancing can free up equity in the property, which can be used for additional investments, property improvements, or distributions to investors.
This aspect of refinancing can significantly impact the overall success of a real estate syndication and will be discussed in more detail later in the article. By unlocking equity through refinancing, sponsors can actively manage the property's capital structure and enhance its value, ultimately benefiting both the sponsor and the investors.
The attractiveness of refinancing depends on various factors, such as the:
The refinancing process typically involves the following steps.
It can often be difficult for real estate sponsors to effectively communicate all the moving pieces, even when using investment management software to manage their communications.
The reason for that is there is often a lot of uncertainty and moving pieces during the process. Hence, limited partner investors are normally informed post-fact of the refinancing once it's a done deal.
The mechanics and benefits of a refinancing can be more clearly understood through an example.
Let's take a fictional real estate syndication of a $20 million multifamily asset you purchase in Portland, Oregon, consisting of $10 million of equity and $10 million of debt that grows to a $30 million valuation over 5 years.
The investment performs strongly over the first three years, resulting in an increased NOI and subsequent commercial property value.
At this point, you decide to refinance the property, with the aim of returning some equity to the investors while maintaining the same 50% equity and 50% debt leverage.
The key points to note here is that the contributed equity was $10m, but the market value of the equity is now $15m.
You complete a $12.5m refinance, pay off the original $10m debt facility and use the remaining $2.5m to pay back equity investors. These investors invested $10m in the original investment, so $2.5m equals 25% of their original capital back with $7.5m as the remaining book value.
Following the refinance, the preferred return calculation for investors will be based on their new reduced capital account balance, which is now $7.5 million (the initial $10 million equity minus the $2.5 million returned to investors).
The investment is then held for an additional two years before being sold at the end of Year 5 for a total valuation of $30 million, with a remaining debt of $12.5 million.
The proceeds from the sale are used to pay off the remaining debt, leaving $17.5 million in equity.
To distribute the equity to investors, you would follow these steps:
Upon receiving their portion of the $10 million in remaining profits, investors will have realized a total return on their initial $10 million investment, which includes both the $2.5 million returned during the refinance in Year 3 and their share of the remaining profits from the sale of the property in Year 5.
This fictional example demonstrates how investors benefit from refinancing commercial real estate, allowing investors to receive a portion of their initial equity while maintaining the desired leverage ratio and adjusting the preferred return calculation based on the new equity balance.
Refinancing offers several benefits to both sponsors and limited partner investors.
Refinancing can significantly improve an investment's Internal Rate of Return, which is a time-based financial metric measuring the profitability of an investment over its entire holding period.
By returning a portion of the equity to investors through a cash-out refinance, the investment's IRR can increase substantially. This occurs because investors receive a substantial portion of their initial capital back earlier in the investment's life cycle, effectively increasing their return on investment in a shorter period.
Consequently, refinancing helps investors achieve higher IRRs, making their investment even more attractive - and also more quickly unlocking promote for sponsors.
By obtaining a lower interest rate, sponsors may be able to reduce the monthly loan payments, which in turn increases the investment's profitability.
Lower loan payments can result in higher cash flow, which can be used to cover operating expenses, fund property improvements, or make distributions to investors.
Cash-out refinance proceeds can be used to invest in new opportunities, potentially yielding higher total returns than the cash-on-cash return the equity was generating before the refinance.
These new ventures are likely to yield a higher total return than the cash-on-cash return the equity was generating before the refinance, as the refinanced deal is most likely stabilized and has limited upside remaining to be captured.
By using the equity released through refinancing for commercial property improvements or additional investments, sponsors can potentially increase the property's value and the overall net worth of the investment.
Capturing and understanding all these advantages does take research and understanding of the refinancing.
In doing this, you should carefully consider the following aspects of a refinancing transaction:
Sponsors (and ultimately investors) should assess the potential increase in cash flow and the impact on their returns. This includes evaluating the new commercial real estate loan terms and considering its implications for the investment's overall risk profile. While sponsors will ultimately have the decision making on a refinance - its important that can communicate how it is beneficial for investors and that the terms make sense.
In a real estate syndication, investor distributions are often determined by a waterfall structure. This structure outlines the priority of distributions among investors and the sponsor.
An example of a typical waterfall includes an 8% cumulative and compounding preferred return, followed by a 100% return of capital, and subsequent distributions split 80% to investors and 20% to the sponsor. Understanding the waterfall structure helps investors grasp how cash-out refinance proceeds impact their distributions and returns.
In the (common) case of additional debt being taken on by the investment, this may lead to a reduction in total free cash flow on an absolute dollar basis. However, the cash-on-cash return may potentially increase, given that the remaining cash invested in the deal is reduced through the cash-out proceeds.
There are three common misconceptions about refinancing in real estate syndications.
Some sponsors and investors may worry that refinancing will change equity ownership percentages in the commercial property. While refinancing can unlock equity for reinvestment of distributions, it does not necessarily result in a change of ownership stake for investors.
If an investor owned 5% of the investment before the refinance, they would continue to own 5% of the investment after the refinance. The preferred return calculation will be based on the new capital account moving forward, and the investor will continue to receive 5% of any distributions, just as they had previously.
A cash-out refinance is not considered a taxable event, as the cash distribution arises from a loan rather than a capital gain.
The investor's capital account on their K-1 will be reduced by the distribution amount and could even become negative, but this is entirely normal and does not result in any tax consequences. When the commercial property is sold, capital gains taxes and depreciation recapture will be due.
Some investors may be concerned that refinancing will extend the commercial real estate loan term, delaying the property's eventual sale or payoff. However, refinancing can also provide greater flexibility in managing the investment, potentially leading to better long-term outcomes.
Refinancing is an important aspect of real estate syndications that can provide significant benefits to both sponsors and investors.
When refinancing commercial real estate investments, sponsors should keep investors informed and be ready to answer questions related to the refinance. Similarly, as an investor, you should understand how refinancing works and how it can contribute to your long-term financial success.