We are often are asked when is the optimal time to refinance a commercial real estate loan. Many factors such as market interest rates, prepayment penalties, existing loan terms and the overall goals of the borrower come into play. There are however no set answers, but below are some real world thoughts on how you might analyze your own commercial refinance.
Traditionally, the analysis to keep an existing loan in place or to refinance into a new commercial loan can become very complex. Financial advisors like to use the Discounted Cash Flow method which essentially compares the two loans on the Net Present Value basis.
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We have found though, that most commercial building owners are primarily interested in how the proposed loan will:
1. Affect their monthly cash flow.
2. What the closing costs will be and how these costs will affect their equity.
3. What the out of pockets costs will be.
4. How long will it take for the increase in cash flow to "pay back" the owner.
Principal pay down is obviously another important component of any commercial loan. However, for most owners, especially those with highly leveraged properties, cash flow is more pressing than above. This is due to the relative high debt payment versus net cash after all the expenses have been paid.
Example 1. Owner occupied office building.
Borrower is 3 years into a 5 year fixed, 20 year amortized loan and is considering refinancing into a 30 year fixed, 30 year amortization commercial loan. The borrowers primary motivation is a desire to increase cash flow to help businesses overall profitability. In addition the borrower has concerns over future rate increases when the existing loan balloons
Existing Loan - 5 year fixed 20 year amortization.
Property Value $1,500,000
Current Loan Balance $1,075,000
Original Loan Balance $1,125,000 (Purchased building with 25% down)
Current Loan to Value 72%
Current Equity 28% or $420,000
Interest Rate 7.25%
Monthly Payment $10,418
Proposed Loan - 30 year fixed, 30 year amortization. Borrower is planning on rolling as much of the closing costs as possible into the loan amount to reduce "out of pocket" cash.
Property Value $1,500,000
Current Loan Balance $1,075,000
Closing Costs $19,638
Proposed Loan Amount $1,094,638
Proposed Loan to Value 73%
Interest Rate 8%
Monthly Payment $8,582
* Closing Cost Break Down (Title at $2000, Lender Legal Fees $2000, Origination Fee at 1% or $10,838, Appraisal $3,000, Environmental $1,800).
Increase in cash flow is $1,835 per month or $22,028 annual. Essentially, from a cash flow perspective, the borrower would recoup the costs of loan in less than one year, despite the rate increase by 75 basis points. Although the borrower would have to pay for the appraisal and environmental report upfront, they would be "refunded" for these costs at close if desired.
In our experience most business owners would be very interested in pursuing the proposed refinance.
Example 2. Investment Property, 10 Unit Retail Center.
Borrower has owned the property for 7 years and has two loans on the subject property. First loan is a conventional floating rate loan that adjusts annually, amortized over 25 years and the second is seller held. It is amortized over 20 years and has a fixed 20 year rate. Neither loan has a balloon provision; however the first loan does have a prepayment penalty of 5% of the remaining loan balance, which is in effect for 3 more years.
Property Current Value - 9% Cap $2,600,000 (Purchase for $2,300,000)
Combined Current Loan Balance $1,635,000
Original Loan Balance, 1st $1,610,000 (70% Loan to Value)
Original Loan Balance, 2nd $230,000 (10% Loan to Value)
Current Loan to Value 61%
Interest Rate, 1st 6.65%
Interest Rate, 2nd 7%
Current Debt Coverage Ratio 1.27
Net Operating Income $235,000
Combined Monthly Payment $15,448
Proposed Loan - 10 year fixed, 30 year amortization. Borrower is planning on combining the two loans together and wants the security of having a fixed rate loan. Borrower also wants to roll in as much of the closing costs as possible into the loan amount to reduce "out of pocket" cash.
Property Value - 9% Cap $2,600,000
Combined Current Loan Balance $1,635,000
Closing Costs $83,500 *
Proposed Loan Amount 1,735,568
Proposed Loan to Value 67%
Interest Rate 7.5%
Current Debt Coverage Ratio 1.54
Net Operating Income $235,000
Monthly Payment $12,743
Closing Cost Break Down (Pre Pay $72,500 [5% of 1st loan amount], Title at $3000, Lender Legal Fees at $2,200, Origination Fee at 1% or $17,185, Appraisal $4,000, Environmental $1,800) .
Cash flow increase is $2,704 per month or $32,449 per year while the cost to close the loan is high at $83,500 due primarily to the prepayment penalty. The borrower is facing a closing cost payback period of over two and a half years. In addition the interest rate has gone up considerable on the proposed loan, which of course increase the overall cost of the loan.
Not an easy decision for the borrower. The option to go forward would probably rest heavily on the borrower's opinion of where the future interest rates will be when the prepayment period ends.
It is interesting to note that the borrower would be able to increase his loan amount to $2,333,964 (cash out proceeds would be approximately $598,000) if he choose too. This is due to the increase in cash flow. The building Debt Coverage Ratio would improve to a 1.54 - the typically minimum is DCR is 1.2. If the borrowers intent was to pull cash out of the property to inject into another property (or for any other reason) this would probably be a much easier decision to go forward with the loan.
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