How to Invest in Commercial Real Estate

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Episode #030 - Evaluating HOW and WHEN to Refinance in Commercial Real Estate Investing!

by Criterion, Braden Cheek, Brian Duck
April 16th 2021

When you realize that the majority of the capital stack (where the money is coming from; bank debt, investor equity, sponsor equity, etc.) is typically coming from some sort of debt instrument you ... More

So you know, if you raise a million dollars from your investors and you know that it was 10 investors and they had $100,000 and you gave them the option of, hey, you know, we can keep this 12% cash on cash return. We're giving you 12% every year. We can keep that going or we can give you all of your money back, but we'll give you a return that would equate to 8% on your investment. So they would say, wow, I get all my money back so I can invest that somewhere else. And you're still going to give me 8% as if you had my money and we get to keep the asset and pay down the debt and let it appreciate some more. They're gonna be like, yeah, sign me up. Do it. Your master. Okay, welcome back to how to invest in commercial real estate today is all about how to evaluate a refinance. So when you're looking at a refinance, you're, you're talking about the debt and the debt is so important because typically it's the majority of the money when you're talking about the capital sack, you know, if a property costs $1 million, you're probably getting seven or 800,000 from a bank. Um, so you need to monitor that. It's not just, you know, put it on autopilot, it's a 30 year note or it's a five year note or it's a 10 year note.

You don't think about it. It's the majority of the money to buy your property and little savings and, and watching it and monitoring can, can have a lot of benefit. And that's what we're going to get into today. Yeah. And it's important to uh, just go over the different kinds of debt, because there there are debt instruments that are uh, you know, fixed for 10 years, 15 years and they're really expensive to pay off. And so you don't have a lot of options with, with Fannie Freddie or with cmbs debt uh in order to pay that off because the penalty would be drastic. Now, let's say I get one of those types of debt and the interest rates fall and I want to take advantage of that. Well, that's going to make it really expensive to pay off. Because what they do is they take that money and they have to go by Treasury for the remaining term. And the difference between your note and that is what you have to pay over the full length of the term left. That may have been a little confusing, but in essence, whenever it's advantageous to pay off one of those loans, the penalty is going to be really big to pay off one of those loans.

So, uh, but there are plenty of types of debt. Uh and it involves banks usually where you will have an opportunity to make a change and pay off debt refinance, lower your interest rate, all that. So why do you refinance? Are you refinancing because the debt market all of a sudden you can get a quarter of a point or a full point or whatever less is that the only reason you're refinancing? Why are you refinancing? Yes. So let's ignore rate. Just for a second, we'll put a pin in that. It's not just about saving money on the amount of interest you're paying the bank, It could be amateur ization. It could be, um, you know, the amount of debt you're putting on a property. So you know, initially you're buying this deal, it has half a million dollars in net operating income or You know, it's a, it's a $5 million 80% loan to value in that $5 million $8 million dollar building.

Well, you know, you could look at at this time potentially getting more debt on the property because it's making more money. So the property can afford more debt. It can still pay a month over month and cash flow and you can potentially give your investors, you know, some or all of their money back and keep the asset and that's kind of the ultimate when I think for us, you know, if you would buy that asset again and again and again, like today, if you ask yourself, hey, do I still want to own this? If it's not Like 100,000 square foot colds or something like you want to keep it, it's a great investment. You like the asset class. Your investors like it. Um, you know, the idea of refinancing it and pulling your money out, letting the property continue to pay down that debt and keep it in perpetuity and, and give your investors monthly or quarterly cash flow. That's a win. That's a massive win. So it might be that you refinance your debt amount, your monthly debt, um, might go up, but you're pulling all that money out. And so now it's basically, it's whatever the cash flow is that's left over. Even though your debt payments higher that it's free money basically.

I mean you don't have anything in the, in the deal. Is that what you're saying? Exactly, possibly. Exactly. So you know, if you raised a million dollars from your investors and you know that it was 10 investors and they each had $100,000 and you gave them the option of, hey, You know, we can keep this 12% cash on cash return. We're giving you 12% every year. We can keep that going or we can give you all of your money back. But we'll give you a return that would equate to 8% on your investment. So They would say Wow, I get all my money back so I can invest that somewhere else and you're still going to give me 8% as if you had my money and we get to keep the asset and pay down the debt and let it appreciate some more. They're gonna be like, yes, sign me up, do it because the property is paying for the debt and, and even more, it's, it's not income that is not income because you're paying it back. It's alone right now. That's, that's a couple of beautiful points there that I don't wanna skip over is a refinance allows you to take uh depending on the situation allows you to take profit tax free and go invest it again. So most, most of our deals when I see money, I don't see, you know, cars or, or stuff, I, I see a, you know, a little thing that can generate more of itself.

And so I think of money, it's, it's like, hey, a dollar can earn, I can earn 15% a year on that dollar. So any time there's an opportunity for me to borrow at 4% or 5% And go and invest that and make 15 to me. That's, that's the game of real estate that people need to be thinking about it. It's a leverage game and so refinance is a powerful tool to get tax free money. You say it's tax free because you put that money in and you're just getting that money back so you haven't made a profit on it. Is that why it's tax free or it's tax free because loan dollars borrowing money is not a taxable event. Okay. Uh not income, it's not income, income is something totally different. Um but getting getting borrowing money from a bank no matter how much you borrow, even if it's four times the amount you put in originally, it's not income, its loan dollars and so loan dollars are not tax so you can get that profit without paying tax and that's nice. Yeah. So a really good point we had in our last episode is, is the difference in evaluating debt and debt you can put on a property and versus when you have it in contract and you're trying to buy it versus owning it in all cash and then putting debt on and afterwards it's the same thing that you're doing in a value add project if you buy something and it's making, you know, a little bit of money or however much money and you double the amount of income it makes, you can take that to a new lender and they're looking at it as a brand new property that they've never seen before and they just evaluated on the merits, as long as you've got trailing cash flows or You know, a 12 months worth of historic canals or sometimes they can even annualized, you know, trailing three months or six months or whatever.

Um they'll evaluate that and not only potentially give you all of your cash back but potentially millions of dollars more because the property can afford to make the monthly debt payments and it's a good investment for them as a lender because that's all they're doing. They're taking our money and they're giving it back to us and loans, right? So so I want to give, I'll try to give an example just so people that listening, they can kind of go through it in their mind and maybe this is a big example, but they can pare it down to even a single family home that this can work on all of that. But you know, you buy something that's uh, you know, struggling with occupancy, it's, it's run down and it's been through foreclosure and so you know, we, we bought a deal in in Indianapolis, it was just like that Uh, you know, as a lender owned it and they're going to sell it for cheap. We we take a risk on it. It had a lot of problems, but let's say we bought it for $2 million bucks and then we, we go to to spend money on fixing it up new roof and new parking lot and new paint and some new windows and all that and maybe maybe that's $500,000.

So now, you know, we're kind of in at 2.5 million. But now we filled it up and the income is way higher than we bought it. So we go, we, we took it to a new lender And and they said, Hey this this is worth $6 million dollars now and I know it's a drastic increase, but it's a true example of what happened with the with the rising economy and the work that we did. So They said, Hey, we'll loan you $5 million dollars on this property. And so I've got, you know, I got to, you know, basically 0 2.5 million my loan is for less than that. But with the cash I have in But they're gonna give me five And it was like at 3.8% interest on a 30 year am so the income of the property more than covered the payment on that $5 million. And so I got to take that, you know, we my my business partner and we got to take that 2.5 million, No tax tax free and we didn't sell the asset, there's no taxable event. We still own the asset and so now we're paying down that $5 million 10 or 15% on that 2.5 million.

Now, it's an additional 250 300 400,000 in cash flow a year that we're making. Uh and that's how valuable refinance can be. And we still kept that S and we have we have the new asset and all without paying any tax. And so you get to invest that money tax free and you get to rolled over and then that new assets producing cash flow and I'm investing that cash flow. And then the next deal. So you just think about this guys, you're compounding interest in returns over and over all before it gets taxed, Right? But what happens with your job income or any type of tax income is they take 40%, 40% 7% from Medicare. Uh and then you spend whatever. Then you have this thing left over. And then if you go and and make uh some money on on a different type event, you're not real estate. You you may have to pay tax on that income that you make. And you're just, it's cutting it's cutting the income each time in the cycle where real estate allows you to roll it and and and make those returns and then invest those returns tax free. And then invest those returns tax free all from that initial investment of that building, which was probably several $100,000.

You parlay it into millions over the years. So that's that's the power of of real estate and refinancing. I'll bet if you looked at that compounding of the example you just gave versus income where you're paying all these taxes. I'll bet I'll bet if you came up with an example like that, it just be incredible how much more money you can make it that way. Um Other reasons to refinance um What maybe you can get a locked in rate longer period of time, maybe you can get a non recourse, change it from recourse to non recourse. Maybe you get a longer amortization schedule. Those are all possible. All possibilities first. It's just drop, you can drop your interest rate if interest rates have lowered uh and you think they're as low as they're going to go, I would take advantage of that. Um And the costs are gonna be minimal to to the to the savings. You might pay a point, you might pay half a point of origination fees or whatever real quick. I was gonna ask about that. What what what are the costs real quick? Just um a new um it's like you're doing a new loan, a new appraisal and and just closing fees.

Okay. Just just like a new loan. Okay, lets Lets you know some people when they're doing a refinance on $125,000 mortgage the closing costs are gonna be, there can be four or 5 $6000. Um And so man it takes a little while to pay that back but on a $5 million commercial mortgage, let's say I'm going to save a point uh an interest a year that well I don't know, I don't even think you pay appoint an origination most of the time. Uh You may if you're using a mortgage broker to get a Fannie Freddie loan but just a bank loan you may pay a quarter of a point but you're saving $50,000 a year for that one point. And it may cost you with appraisals and title work and all that. It may cost you 15 or 20,000. So your payback is in five months uh Where that's not the case in a typical, I'm gonna refinance my house kind of way. Right, okay, good point anyway and I cut you off on the reasons you started with lowering your interest rate. Okay. You can you do dropping off guarantee, you're going from recourse to non recourse that's really common.

You can go in asking for that up front if you're going in with the bank debt. Um a lot of lenders, especially local bank that lenders um you know the loan kind of 10 years in once they see the financials on it for several years. Once you know they're a partner in in the asset with you. Like like I said there are the majority of the money um in the deal typically. So you know once they have it on the books for a few years and get to know you and get to know the deal 10 years in and it's reasonable at that point to start dropping guarantee, you know, maybe you go from 100% guarantee to 75% and then maybe a few years later goes to 50% maybe it goes down to nothing eventually. Right? I mean you can you can step it down, it can go from 100% to 0, but just knowing you can ask for it, knowing it's possibility is a big win. That's a question you need to know and you know, I have some thoughts on, we we do a lot of non recourse and recourse and a lot of people are just so averse to any type of recourse and I would say my advice would be make, make the decision more about the deal and about the cash flow and the interest rate and then just getting rid of any recourse that you can because we've done, we've converted some to non recourse.

Uh and I wish I wouldn't have done that because the typical non recourse is going to limit your ability to be flexible in the market. Uh it can, it can be harder to sell uh if you have a good opportunity to sell to somebody, it can limit your ability to take advantage of moving interest rates real quick brian and I were trying to buy a retail deal who here locally probably a year ago. And the only reason we couldn't buy it, I believe, um, it's because his loan payoff, he had to pay off his loan early and we had to assume it and we didn't want to assume his crappy alone was non recourse was put on a long time ago and he had to pay off over half a million dollars in pre payment penalties before we could even come to the table. So that half a million killed the deal potentially. Yeah. So the, so just to circle back, that's a great point. So when I'm making a decision on going to a non recourse loan typically is because the terms are better not because I'm just trying to get rid of my exposure and I guarantee, you know, Fannie Freddie loan, they may just, those loans are just better than bank loans on multi family, for example.

So anyway, we, we, we do need to have a whole show on just debt, but we won't get into all that today. Uh, you know, one deal we're doing right now. We're refinancing. I'm, I'm on a 20 year m, and I'm taking it to 25 I'm lowering the interest rate a quarter a quarter point already had a really good interest rate. So you're, you're hitting it from both ends on the debt and it's gonna help, uh, increase cash flow and there, there wasn't a prepaid penalty on it. And so it's just something that we can do pretty easy. Yeah. So when, when you look at it, you have things that are above the net operating income line. You know, you have your profit, you have your expenses, and then you typically have net operating income below that. You have, you know, your debt service and then you're free cash flow to distribute to your investors. And really what matters is the free cash flow you're distributing to your investors. So if you spend it all in debt, then there's no free cash. But I forget where I was going with this. Well, you're just saying, well, I lengthen the immunization and I lowered the interest rate is gonna allow me more money to distribute to the investors. Right. Right, right. But you didn't make the property produce any more money.

The same tenants were in there. But you increased your free cash flow, that you're distributing your investors. And that was important. I mentioned, uh, locking in for a longer period of time. What are your thoughts on that? I mean, to me, it would be a great as good as interest rates right now. If I could go find a alone where I could lock in for, say, 10 years. I'd love that. I think, yeah, I I agree now is a great time to be able to lock in. There's some people that get floating rates and they don't mind, they get a lower rate today and they don't mind taking that risk For me. I really do appreciate having that fixed interest rate piece of yeah, the peace of mind that comes along with getting a ten-year fixed rate when when you know your cash flow because rents over time will go up and so if you can get a good interest rate and you know your payment isn't gonna go up for 10 years, you know that you're going to be you know in a really good cash position in the future. Now if you get a five year fixed which we have to do on some of the retail deals, It's still good. Um but you know as you approach five years if rates are up 30% and you haven't increased your rents very much in your casual could be taken a hit.

So the longer is always is always better. But especially when there's not a pre pay heavy pre pay no longer may not always be better if you're locking yourself in with a huge prepaid because it will reduce your ability to be flexible to the market. Yeah. Yeah, I would agree with that. What else? I don't know. I'll tell you one thing that struck me when you guys were talking about this is you know you said always be looking at refinancing. I mean almost from day one because when you think about it, we worked really hard on getting the best that we can, and if we get another 10th of a percent, we think, oh man, that's great, that that's another tens of thousands of dollars a year in free cash flow. But then I think people's tendency is okay. I got that done. The whole deal is done now. I'm just, I'm just gonna kind of operate this property and let it go. I mean, I think you need to be thinking about it all the time. You might refinance, you know, within six months or something. I suppose if there's a drop in interest rates or whatever, some of these things we talked about could occur. So I think what you guys said about, I always think about refinancing because it's the biggest part of the deal. Yeah, we, uh, you know, just when you're looking at a time perspective, you know, the amount of lenders you and I are meeting with is almost comparable, or more than the amount of investors were meeting with because, again, the lenders, you know, we've, we've gotten way more money from lenders that we have from investors and that's typically the scenario with most people buying real estate.

So when you focus on the money and where it's coming from, you know, it's, it's a relationship and it's something to be monitored and, you know, they're, they're doing it to make money and when you respect all of these things and know them for what they are then, Yeah, I mean it makes sense to look at it every day, it makes sense to look at it all the time. Because if you can get your investors their money back, if you can save money, if you can lower your risk by going from recourse the non recourse, you know, there's there's so many things, why wouldn't you want to look at that every day? That's that's your job? Just wait, that's mine in your business, you have to be doing that. Um What I would say is in order to take advantage of always be looking for the next refinance is uh I want to give people a tip, is push back on your lenders on pre pay. I have I have allowed lenders to put pre pays on deals uh that we were doing purely because I thought, oh at the time this is a great rate, I'm not gonna I'm not gonna want to refinance and I I got soft and I let them put the fee on there and I just paid uh two points, 2% of the whole deal to refine one of our deals.

Now, I still think it was the right business decision, but it was really painful. And and I just wanna encourage you, the banks will bend on some of that, push back really, really hard on prepayment penalties uh when you're getting your loans, that will help you have flexibility to take advantage of situations in the future, that's a really good point because just like you said, I'll bet most people are thinking, oh well I'm, I'm not gonna refinance and they're gonna give me this great deal. And all I do have is a few years is a pre payment. I think a lot of people are thinking just what you said that, that's not going to come into play and when it really does. Yeah. And you know, you're not gonna get it all on every deal. And some deals need, you know, lower rates. Some deals can afford a higher rate because they've got more cash flow. But you know, you maybe wanna longer am schedule or this, you know, multi family, you can, you can typically always get 25 30 year and retail and some other classes you maybe 15 or 20 sometimes and that's a major difference on free cash flow that you're able to distribute. So, I mean, it's just, it's a massive deal anyway. It was a good episode. Um, you got to focus on the debt.

You got to focus on the majority of capping stack. Um, it's mitigating risk for you. The investors and the idea of, hey, we're gonna give you all of your money back and we're still going to send you money and we're having, we're going to keep this upset asset, We're gonna pay down the debt. That's, that's the best case scenario, Then you become a real estate collector anyway, checks out on the Internet how to invest in syria dot tv and we'll see in a few days. Mm hmm. Yeah.

Episode #030 - Evaluating HOW and WHEN to Refinance in Commercial Real Estate Investing!
Episode #030 - Evaluating HOW and WHEN to Refinance in Commercial Real Estate Investing!
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