Understanding Commercial Cash-Out Refinance and Its Functioning

Apr 11, 2024By Asher Goldmann
Asher Goldmann

 Property investors can utilize commercial cash-out refinances to tap into their equity, which may otherwise be inaccessible. Reallocating capital and obtaining equity can be achieved through selling or refinancing, with the latter offering numerous benefits.

Understanding the Concept of a Commercial Cash-Out Refinance

The term "cash-out refinance" refers to the process of refinancing a property and withdrawing equity. This is known as a commercial cash-out refinance.

The property is re-financed with a reduced amount of equity involved, and the entire amount of equity gained is given to the investor. The received funds can be utilized for various purposes such as enhancing the property, purchasing new properties, distributing to the investor(s), or any other suitable use.

What is the Process of a Commercial Cash-Out Refinance?

In a commercial cash-out refinance, a new loan is obtained by using an investment property as collateral. This new loan is utilized to settle the previous loan, and the investor receives the remaining amount. The procedure follows these steps:

1. The current property holds a significant amount of equity that the investor desires to utilize.
2. A fresh loan is obtained, securing a large portion of the property's value.
3. This new loan is then utilized to settle the current mortgage.
4. The investor receives the remaining balance from the new loan.
5. The disbursed funds are flexible and can be utilized for any desired purpose.

Characteristics of Commercial Cash-Out Refinancing

Lenders have their own specific criteria and conditions for cash-out refinancing. However, the majority of lenders typically follow similar guidelines, such as:

Cash-out refinances are generally only beneficial for investors who have a minimum of 30-40% equity. When taking out new loans, investors are typically required to maintain 20-25% equity, leaving investors with a range of 5-15% equity using these numbers.
The maximum loan-to-value ratio is usually 80%, which explains the requirement of ~20% equity for new loans and the recommendation to have 30-50% equity before proceeding with a cash-out refinance.
The minimum required debt service coverage ratio (DSCR) is typically 1.2-1.5, which is consistent with most mortgage programs for commercial real estate.
Lender fees usually fall within the range of 1-3% of the new loan's value, while closing costs are typically 2-5% of the loan. It is important for investors to be aware that there may also be a prepayment penalty associated with the current loan.
Cash-out refinances are typically considered primary mortgages and have a loan term of 15-30 years.
The process of refinancing generally takes 30-45 days to complete after signing with a lender, although there may be delays in underwriting.

Illustration of a Business Cash-Out Refinancing

An instance of a commercial cash-out refinance can be illustrated by considering a building that was bought for $1 million three years ago and is currently valued at $1.3 million. The original loan of $800,000 has been reduced to $700,000, resulting in $600,000 in available equity.

A fresh loan of $1 million is acquired. Out of this amount, $700,000 is utilized to settle the existing loan, while an additional $35,000 is required for a prepayment penalty. Moreover, an extra $40,000 is necessary to cover the associated fees of 4% for the new loan.

Upon receiving the investment, $225,000 is allocated to the investor. A portion of this amount, $25,000, is planned to be used for the acquisition of additional storage units, as suggested by research, in order to increase both the NOI and cash flow. The remaining $200,000 is set aside for the purpose of buying another property worth $1 million, for which a downpayment of 20% is required.

The current property owner has increased their income by improving their property and used that to fund the acquisition of another property.

The Advantages of Cash-Out Refinancing

One option for utilizing commercial cash-out refinancing is to fund renovations, acquire more properties, distribute profits, or achieve various other objectives. The process of refinancing commercial real estate loans has numerous advantages, as outlined by Global Capital Funding. .

By utilizing the profits from selling, tax liabilities can be reduced compared to using other methods according to commercial cost segregation research.
Investors can be paid back at a faster rate than what would have been possible otherwise.
When adjustable-rate mortgages become due, balloon payments can be avoided.
If interest rates have dropped, lower rates for commercial cash-out refinancing can be secured.
Liquidity can be gained and capital can be reallocated for any desired purpose.

Drawbacks of Cash-Out Refinancing

Although there are advantages, not every scenario is suitable for commercial cash-out refinancing. It is important to take into account the following drawbacks:

There are significant charges and closing costs that need to be paid in advance for new loans.
Existing loans might have considerable early payment fees.
Not all commercial property loans are eligible for cash-out refinancing.
If interest rates have risen, it is possible to obtain less favorable loan terms.

Can Cash-Out Refinances Be Limited?

The amount that can be withdrawn through a cash-out refinance is not determined by a specific dollar amount. Instead, it is typically determined by the loan-to-value ratio requirement for the new loan. Generally, the maximum amount that can be extracted is 80% of the current value of the property.

Comparison: Commercial Cash-Out Refinance vs. Selling

There are two primary methods for achieving equity in the commercial real estate industry: cash-out refinances and property sales.

The act of selling involves releasing an investor from all responsibilities associated with the property being sold. This allows for the maximum amount of equity to be obtained, as there is no need to meet the equity and fee requirements of a new loan. In addition, any potential prepayment penalties, which can be found in this source here, can be avoided if the buyer takes on the existing loan.

Investors can use cash-out refinancing to maintain ownership of their building, potentially benefiting from future appreciation or rent hikes. This process is also quicker compared to waiting for a buyer to purchase the property.

Cash-out refinancing can often reduce tax liabilities in various situations. While taxes are typically due when a property is sold, taking out equity does not trigger any taxes. If the extracted equity is used for improvements or acquisitions, the taxes on a cash-out refinance may be waived. This tax benefit is usually greater than the additional fees associated with selling the property.

The decision of whether to sell or refinance a property is dependent on the individual circumstances of the property and the investor. It is ultimately the responsibility of the investor to make this determination.

Concluding Thoughts: Is Cash-Out Refinancing the Best Option for You?

One option for unlocking the equity in commercial real estate is to sell the property, but there is another option available. A cash-out refinance allows for the release of trapped equity, offering a viable alternative to waiting for a sale. This makes a commercial real estate refinance a beneficial option with various potential uses.