On paper, the immediate return of your money looks excellent. However, it may reduce your portfolio’s return and increase risk.
(As always, I’m simply an investor giving my personal view and not a financial counselor. Always call your financial advisor before making any investment decisions.)
In general, equity investments will keep your money for an extended period (5 to 7 years for a typical value-added investment). This event is because your funds are used to purchase property during the holding period. Also, you only get it back when it’s bought (hopefully for a more excellent price.) This tie-up of your money is a massive annoyance for real estate investors.
Some clever sponsors have devised a method to “fix” this problem for investors via a cash-out refi (refinance) strategy. The sponsor intends to refinance the property sometime during the investment (maybe in year 3), based on its (hopefully) substantially higher value. The revenues are then used to refund some or all of your principal early.
It appears to be a no-brainer, and many sponsors promote it. But is this usually the case?
A refinance, or “refi,” changes and alters the terms of an existing credit agreement, most commonly a loan or mortgage.
When a company or an individual agrees to refinance a credit obligation, they attempt to make advantageous modifications to their interest rate, payment schedule, and contract terms. If the loan is granted, the borrower receives a new contract that replaces the old agreement.
Borrowers frequently prefer to refinance when the interest-rate environment changes significantly, resulting in possible debt-payment savings from a new agreement.
How Does a Refinance Work?
Consumers typically seek to refinance certain financial obligations to obtain better borrowing terms, frequently in response to changed economic conditions. Common refinancing goals include:
- Lowering one’s fixed interest rate reduces payments throughout the loan’s life.
- Changing the loan’s duration.
- Switching from a fixed-rate mortgage.
Refinancing requires effort, but is it worth the added paperwork and costs? There are several compelling reasons to invest time and money in a refinance:
● You can obtain a lower interest rate.
The opportunity to cut your interest rate is the most compelling reason to refinance. Whether your credit has significantly improved since you first secured your mortgage or the market has changed, getting a lower interest rate can save you significant money over the life of the loan. However, in today’s rate market, you’re unlikely to save much unless you obtained your original mortgage at least ten years ago.
● You can borrow some money by using your equity.
In addition to saving money, refinancing may allow you to access more funds. Cash-out refinancing allows you to borrow additional money using your established equity. While this increases your debt, it may enable you to obtain low-interest financing for primary necessities such as a home repair.
A refinance’s obvious benefit is getting your money back sooner. This method effectively removes your chips from the table (assuming there are no clawback provisions in the PPM, which we’ll discuss in a moment). And doing it causes your investment ROI to increase (because you have less money invested after the cash out).
So, what is there not to like? Well, maybe a couple of things.
When the ROI up matches the ROI down
First, while refinancing increases your investment ROI, it can reduce your portfolio ROI. The reason is that your money is currently sitting in cash, earning nothing until you effectively deploy it. Also, if you can’t put it into an investment that pays a better rate of return than the refi investment, your total portfolio return will suffer.
This situation can be challenging when margins and returns are shrinking, and fantastic offers are becoming increasingly difficult to locate. The deal you discovered years ago is tough to replicate now.
Second, refinancing is accomplished through debt additions. This approach increases the property’s debt load or the amount it must achieve to avoid a catastrophic default and the loss of your remaining investment.
Besides, the funds you withdrew early may still be in jeopardy. If the PPM in the investment has a clawback provision, you will be required to refund the money previously granted to you from the refi.
Furthermore, suppose the price of the property has not increased significantly enough. In that case, the amount of debt in comparison to the value of the property will increase (loan-to-value or LTV). The higher the LTV, the more expensive it is to get into debt and the more vulnerable the whole investment becomes if things go wrong.
So, strangely, the refi may make the investment worse by making it “safer.”
“Should you refi or not refi?”
So, when is it beneficial, and when is it detrimental? In my perspective, it is determined by the riskiness of the deal, its conditions, and the market alternatives accessible.
Removing part of your chips from the table may be worthwhile if the transaction is hazardous and there is no clawback.
It may also make sense if you need the money for non-investment purposes sooner than 5 to 7 years. However, there is no guarantee that any refinancing will occur because it can only occur if the property is perceived to be worth more. If the market turns against you, the refi will be canceled.
On the other hand, I believe the quality of the deals is deteriorating rather than improving. If you feel as strongly, and you’re in a low-risk deal that you think will weather a downturn well (and you want to retain your money invested in something productive), refinancing is wrong.
Refinancing can be a profitable financial decision. If you want to live in your home for an extended period, lowering your interest rate can considerably influence your budget. Learn when it’s a good idea to refinance your mortgage.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.