This article is about cash out refinance for investment properties. Accordingly, we’ll describe what it is, how it works and what rates to expect. Importantly, we’ll also cover when you shouldn’t do a cash out refinance for investment properties. Finally, we’ll answer some Frequently Asked Questions about the subject matter.
What Is a Cash Out Refinance for Investment Properties?
Cash out refinance for investment properties is a way to convert equity into cash. You do it by taking out a new loan for more than the current balance on your current loan. Some of the new loan proceeds are used to pay off the existing loan and the rest can be pocketed as “cash out.” In this way, investors and developers can free up their money for new investments. Alternatively, the owners can use the money to upgrade or renovate the property. In other words, a cash out refinance for investment property creates liquidity from an illiquid asset.
The Three Components of a Cash Out Refinance
In order to evaluate a cash-out refi, you’ll need to know these three components. Specifically, they are the property’s current loan balance, fair market value and the new loan amount.
Current Loan Balance
This is the pay-off amount for the current loan (usually a mortgage) on the property. Conventionally, it should include any prepayment penalty that applies to the refinance. Normally you need at least 30% equity in the property, assuming you get a cash-out refi for 75% loan-to-value (LTV). That is, it makes sense to cash out if you will receive at least 5% in cash. Clearly, anything less might not result in enough cash, after fees, to justify the transaction. Of course, if rates have dropped, you might want to refinance the property with or without a cash out simply to take advantage of the lower rates.
Fair Market Value (FMV)
This is a current assessment of the property’s value if you sold it today to a willing buyer. Obviously, it assumes there is no duress on the buyer or seller that would distort the sale price. Often, the property will have appreciated by the time you want to refinance. Consequently, this increases the amount of cash you can extract from the cash out refi. Usually, a third-party expert assesses the property’s current FMV.
New Loan Amount
The lender will apply its required LTV to the property’s FMV to determine the maximum new loan amount. Generally, you should expect an LTV of 75%, although different ratios are of course possible. For example, a hard money lender might only allow a very low 60% LTV, meaning you must put up 40% in equity. Also, the new loan is contingent upon the rules established by the lender. It always seems to come down to the golden rule…“He with the gold, makes the rules!”
Suppose five years ago you took out a $12 million mortgage on an office building you purchased for $16 million (75% LTV). Currently, the mortgage balance stands at $9M, and the prepayment penalty is $1 million. Furthermore, the property has an FMV of $20 million (it appreciated $4 million in 5 years). Also, let’s assume that the lender requires a 75% LTV (loan-to-value ratio).
The maximum new loan amount is (.75 x $20M), or $15M (million). Clearly, the payoff amount on the old loan is ($9M balance + $1M penalty), or $10M. Furthermore, the origination and other fees may add an additional $100,000 to the refinance costs. Therefore, the net cash resulting from the refi is as follows: $15M — $10M — $0.1M = $4.9M ($4,900,000).
Video: Commercial Real Estate Loan Refinancing: What it Means and Why Investors Do It
Cash Out Refinance Rules
While each refinancing transaction is unique, here are the general cash out refinance rules of thumb for investment properties:
- Seasoning: You must own the property for at least twelve (12) month, unless you qualify for a delayed financing exception.
- Property Status: The property must not be listed for sale.
- Debt-to-Income Ratio: From 36% to 45%.
- Equity: At least 30% in the current property.
- Cash Reserves: At least one-half year.
- Debt Service Coverage Ratio (DSCR): At least 1.20.
- Owner’s Credit Score: 640 minimum.
- Owner’s Tax Returns Required: Two years (this is on a case by case basis depending on the lender).
Naturally, you will need a higher DSCR and greater cash reserves if you have a lower credit score.
Delayed Financing Exception
The delayed financing exception allows cash-out refinancing on properties held for less than six months if:
- The borrower is a natural person, LLC, partnership, revocable trust or eligible land trust.
- A current loan balance is below the original purchase price, including closing costs.
- The original purchase was an arms-length transaction.
- The borrower submits a settlement statement for the original transaction.
- If the property wasn’t collateral for the original loan, then the new loan must first pay off the old loan.
Cash Out Refinance Rates
The terms of the new loan might resemble those of the old one. Typical characteristics are:
- Loan Amount: Up to 75% LTV
- Interest Rate: Look for rates in the range of 5% — 6% if you have excellent credit. Otherwise, higher rates will most probably apply.
- Lender Fees: 0% — 3%
- Closing Costs: 0% — 1%
- Loan Term: Up to 30 years
- Time to Funding: Up to 45 days for approval, then up to three days to receive funds.
- Debt-to-Income Ratio: 36% — 45%
- Cash Reserves: Up to six months
Usually, cash out refinance rates are good, but closings costs can be high. Normally, the cash out loan proceeds are net of the closing costs.
When You Should (Not) Do a Cash Out Refinancing for Investment Properties
Cash out refinancing has its advantages and disadvantages, which we review here.
Advantages of Cash Out Refi
Cash out refinancing for investment properties is advantageous in several ways:
- Free Up Cash: You can spend the net proceeds of the cash-out refinance any way you desire after repaying the old loan. For example, you could use the cash to help with a down payment on another property. Or, you might reinvest the money into the property so that you can raise rents or reduce vacancies.
- Consolidate Debt: You can use the cash proceeds to consolidate multiple loans on the property. For example, you might have taken out a mortgage and a rehab loan on the same property. A cash out refi allows you to pay off both loans and consolidate them into one new loan.
- Reduce Interest Cost: Ideally, the interest rate on the refi will be lower than that on the original loan. Moreover, refinancing lets you cut your interest expense, another way to have more money for other investments.
- Receive Favorable Tax Treatment: A cash out refinance is not a taxable event. However, the closing costs and other fees are tax-deductible.
Disadvantages of Cash Out Refi
Even good deals have a dark side:
- Loan Term: You might end up with a longer loan term. Significantly, the impact might be higher long-term costs, even with a reduced interest rate.
- High Fees: You may have to shell out 5% in points and closing costs and even more if a prepayment penalty applies. Obviously, even if these are tax deductible, they are an expense you’d rather not have.
- Waiting Time: Unless your lender will agree to a delayed financing exception, you’ll have to wait six months to refinance the property.
Frequently Asked Questions: Cash Out Refinance on Investment Property
The IRS does not consider the cash proceeds from a cash out refinance to be earnings. Therefore, you don’t owe taxes on it. However, you do include the fees from the refi with your other business tax deductions. Explicitly, if you own the property through a pass-through entity, use a Schedule C. Alternatively, you might include expenses on a corporate return. You can pull out the money left over after you repay the old loan, including closing costs and prepayment penalties. Usually, you wait to do a cash out refi until you have at least 5% more equity than required. Certainly, you can pull equity out of an investment property, that is, if you have enough equity! Clearly, a cash out refi is one way to proceed, as you borrow cash based on your excess equity. Also, you can harvest equity by selling some of it to other investors. Additionally, a third method is mezzanine financing. That depends on how much equity you have in the property. Obviously, if your equity barely exceeds the minimum required, you should probably not consummate the cash out refi. Also, you might avoid a refi if you already carry too much debt that you cannot consolidate.
The IRS does not consider the cash proceeds from a cash out refinance to be earnings. Therefore, you don’t owe taxes on it. However, you do include the fees from the refi with your other business tax deductions. Explicitly, if you own the property through a pass-through entity, use a Schedule C. Alternatively, you might include expenses on a corporate return.
You can pull out the money left over after you repay the old loan, including closing costs and prepayment penalties. Usually, you wait to do a cash out refi until you have at least 5% more equity than required.
Certainly, you can pull equity out of an investment property, that is, if you have enough equity! Clearly, a cash out refi is one way to proceed, as you borrow cash based on your excess equity. Also, you can harvest equity by selling some of it to other investors. Additionally, a third method is mezzanine financing.
That depends on how much equity you have in the property. Obviously, if your equity barely exceeds the minimum required, you should probably not consummate the cash out refi. Also, you might avoid a refi if you already carry too much debt that you cannot consolidate.