How does refinancing work?

Question

Quick question.

I'm trying to wrap my head around cash out refinancing. Can someone quickly walk through how this works? I hear a lot about refinancing a rental property to pull your initial investment out (in order to use it to purchase another rental property). So, hypothetically, I put $50,000 down on a 5 unit building, and got a loan for $150,000. Then say I wanted to refinance to get my initial $50,000 out, what exactly happens? The bank would be giving me the $50,000 (assuming it appraised enough to get that amount). Would my loan now be $200,000 instead of $150,000? And if that's the case, my monthly mortgage payment would be higher right? (If interest rate stayed the same).

Thanks!

Lance H. · Answer

Nik Parks,

As mentioned, for 1-4 unit properties value will most likely be based on comparables, not NOI.

As for paying back investors or hard money, Sam W. touched on it but I'll try to detail.  Refinancing can be used but you need to increase the value significantly more than the example you mentioned.

The biggest confusion I see when talking to people about refinancing is that they don't realize that when you refinance you are taking out an entirely new loan, and the original loans need to be paid back before anything else in the order of position.  So your first position mortgage needs to be paid back first, second position (investor) second and so on.

So putting it in numbers, you pay 100k, you get 80k (first position) from the bank and 20k (second position) from an investor or hard money.  For example purposes we'll say you have a lender who will do 80% LTV, although this may be difficult to find.

For the first 12 months they will base a refi on the original purchase price and the max a bank will loan is 80k.  Keep in mind you still owe the bank 80k (first position) which would need to be paid back before anything else.  So the only reason to do this is for a lower rate.

After 12 months, if you want to pay back the investor, you need to get a loan large enough to cover the 80k owed to the bank plus the 20k owed to the investor so a total of 100k.  Since the max LTV is 80% you need it to appraise for 125k (125*80%=100).  The bank will give you a brand new loan for 100k, 80k will pay back the bank (first position), 20k will pay back the investor (second position).  You will not receive any extra cash in this case.

If the appraisal comes in even higher, say 150k.  The bank will loan 120k (150*80%=120)  The 80k owed to the bank (first position) gets paid back.  The 20k to the investor (second position) gets paid next, you get a check for the leftovers!

Hope that helps,

Sam W. · Answer

Remember Nik Parks - in your example you have an $80K mortgage on the property that will consume most of the $82.5K you'll get when you refinance.

In your example, you will need to have the appraisal come in at about $133,000 to be able to pay the investor back his/her $20,000.

As an aside, borrowing your down payment from an investor may cause problems with your lenders.

Lance H. · Answer

Bill Gulley, I 100% agree, the example I was using is most likely not actually possible.  I got the impression the OP was really looking for the absolute basics of what a refinance is.  I didn't want to clutter the explanation with the details of what banks are actually willing to do.

Corbin Jones · Answer

Hi Lance,

Silly question, but refinancing will change the loan payment, correct? So I have to make sure that I get a place that can still cash flow based on the new value?

Steve Babiak · Answer

I believe that what @Lance H just posted isn't quite 100% correct.  It is possible for a refinance of a junior position mortgage to be made, without paying off all senior position mortgages (so you can refi a second and leave the first alone).  I often see public records where somebody facing foreclosure has taken out a second mortgage, and then a third mortgage to get even more "cash out', and then refi'd the second and third into a new second; all the while not changing anything with respect to the first position mortgage.

And there is also the possibility of subordination - but that usually doesn't happen in a refi scenario.

Sam W. · Answer

Nik Parks

That's why I said in my post (above) that your appraisal will need to come in at about $133,000.......($133K x 75% LTV) = $100K refinance amount.

$100K - $80K (original mortgage) = $20K for your investor

Bill Gulley · Answer

A little more info, an income approach alone is not used to set value, as there are 3 approaches and one is selected which is given the most weight, but all 3 are used to establish value. A 200 unit complex will certainly be considered and more weight given to the income approach, as there are likely no recent sales of such complexes. There is also a construction/repacement approach that will consider depreciation and condition. The value is never simply based 100% on any one approach, but weighted to the most appropriate even if the estimated market value reached is the same number as any the approach selected. It is not simply selecting one approach as the only approach considered. A triplex will usually have comparable sale as Kyle mentioned and will most likely be the heavier weighted approach, but the income will also be cnsidered along with replacement. When you have units that are in need of alot of rehab or say a building that is a failed construction project and requires completion, that approach may be given the greatest weight in assessing value. The three approaches are justifications to show how the appraiser reached the estimated value. A large commercial appraisal may not even be done in the form most investors here are familiar with, they are usually done as a narrative report of value. A narrative report is more descriptive of the factors effecting value. :)

William D. · Answer

@Corbin Jones Seems like it. Living in NYC you'd be hard pressed to find a property where the rental income would cover the mortgage with a correctly appraised value. Need to check the sticks for those properties.

David Janash · Answer

Well said, I was just thinking out loud. Truth is it's likely that you have to be at the right place and the right time to find the best deals. Cotinuously looking and having cash, guts and a vision is key.

Bill Gulley · Answer

The article may be an actual property, the 1 in a hundred or it may just be an example as to the therory.

By the time we get to year two, unless it was an actual deal, it is then loaded with assumptions, but again, to show the therory.

You might get 3% appriciation, might get 4%, could well get 2% or nothing, depends on the market. Adding $10,000 in repairs will usually never increase the value of a property dollar for dollar, but could it happen....sure, in fact, if you know what you're doing it could be more. A house without a roof isn't that marketable, a house with a roof can sell.

Another issues is saying you made money on a good deal, while you can get good deals, no one can say they bought a property at $20k under the market value and thereby made $20K, that's guru accounting, and I don't think I saw that in that article, but is an incorrect assumption often made.

With more reading, you'll see how repairs and improvements might impact value, in reality it's never a one, two, three step issue where all anticipated numbers will fall in place. If you could do that, you'd make millions and never have to buy any property.

I believe Brandon mentions that it's a therory and not an expectation or guaranteed method, but a means to a plan.

Any time you are dealing with projections of value or income, pro forma statements, your guess is only as good as the data it's based on, usually the more conservative the closer you'll be to actual performance.

Folks get stuck, especially in seller financed deals, where they rely on apprceiation at a given rate for future financing requirements. You should really keep an eye on the market, adjsut your path quarterly and plan ahead to establish any targeted equity amount over time. :)

How does refinancing work?

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