Is an early cash-out refinance strategy really a no-brainer?
The early return of your money looks great on paper. But it may decrease your portfolio return, and increase risk.
August 13, 2017 BY IAN IPPOLITO
that if you don't hav(Usual disclaimer: I’m just an investor expressing my own personal opinion and not a financial advisor. Consult your own financial advisor before making any investment decisions).
In general, equity investments hold your cash for a long time (5 to 7 years for a typical value-added investment). That's because your money is used to purchase property during the holding period. And only when it's sold (for hopefully a higher value) do you get it back (plus any profit). Obviously this tie-up of your money, is a major hassle for real estate investors. (And this illiquidity recognized as one of the major drawbacks of investing in real estate).
So some enterprising sponsors have figured out a way to "solve" this problem for investors with a technique called a cash-out refi (refinance). At some point in the middle of the investment (perhaps year 3), the sponsor plans to refinance the property based on its (hopefully) much higher value. Then they use the proceeds to return some or all of your principal early.
It sounds like an automatic win-win and many sponsors tout the strategy that way. But is it always?
"Everything is Awesome!"
The advantage of a refi is obviously the early return of your money. This has the effect of taking your chips off the table (assuming there are no clawback provisions in the PPM, which we'll talk about in a minute). And doing this often makes your investment ROI skyrocket (because you have less money invested after the cash out).
So what's not to like? Well, perhaps a few things.
When ROI up equals ROI down
First, while this does make your investment ROI go up, it can actually decrease your portfolio ROI. That's because once it's returned, your money is now sitting in cash, earning nothing until you can successfully deploy it. And if you can't deploy it into an investment that is returning a higher rate then you would have on the refi investment, your overall portfolio return will be reduced.
At this stage in cycle where margins and returns are shrinking and great deals can be very difficult to find, this can be an issue. It's very possible that the great deal you found 3 to 4 years ago is difficult to duplicate today.
Watching Your Debt
Second, the refinancing is done by adding debt. This increases the debt burden of the property, meaning the amount it has to perform to avoid a catastrophic default, and loss of your remaining investment.
And the money you cashed out early may still be at risk. If the PPM in the investment includes what's called a clawback-provision, you would have to return the money that was previously given to you from the refi. (Which
Also, if the price of the property hasn't appreciated substantially enough, this will increase the amount of debt in relationship to the value of the property (loan-to-value or LTV). The higher the LTV, the more expensive the debt is to acquire and the more fragile the overall investment becomes if things go badly.
So ironically, by making the investment "safer" the refi may actually make it riskier.
"To refi or not to refi?"
So when is it a good thing and when is it not? In my opinion, it depends on the riskiness of the deal, it's terms and the alternatives you find available in the market.
If it's a very risky deal, and there is no clawback, it might very well be worth it to take some of your chips off the table.
Or if you need the money for noninvestment purposes earlier than 5 to 7 years, it can make sense.
(Although I should point out that there's no guarantee that any refinance will actually occur, because it can only happen if the property appraises that a much higher value. If the market turns against you, the refi will never happen. So you should never invest money into an equity investment that you can't comfortably hold for the entire holding period + the lengths of any extensions in the PPM, in case it takes that long for prices to recover).
On the other hand, at this stage of the cycle, I personally feel the quality of the deals are getting worse by the year, rather than better. If you feel the same way, and you're in a low-risk deal that you feel would weather a downturn well (and you want to keep your money deployed in something productive) then a refinance probably is a bad idea.
A selection of other advanced tutorials
Hard Money Loan Roulette. Part 1: What's a hard money loan and what are the hidden costs
Black-Belt Real-Estate Strategies from Investment Author Paul Kaseburg: Part 1: Why your sponsor’s performance-based compensation isn’t as aligned with you as they claim.
Black-Belt Real-Estate Strategies from Investment Author Paul Kaseburg. Part 2: How to evaluate a sponsor
What's your opinion?
About Ian Ippolito
Ian Ippolito is an investor and serial entrepreneur. He has been interviewed by the Wall Street Journal, Business Week, Forbes, TIME, Fast Company, TechCrunch, CBS News, FOX News and more.
Ian was impressed by the potential of real estate crowdfunding, but frustrated by the lack of quality site reviews and investment analysis. He created The Real Estate Crowdfunding Review to fill that gap.