Real Estate Investor Financing 101 Series: Cash-Out Refinance

[Robin Simon]

Adapted from twitter thread

📗📗📗Real Estate Investor Financing 101 Series: Cash-Out Refinance

Cash-Out refinances are a valuable and oft-used tool by real estate investors to build wealth - but important to understand from your DSCR lender's perspective to know how to utilize them optimally!

Definition = a cash-out refi is typically defined as a refinance loan (i.e. taking a loan on a property already owned - either w/o debt or concurrently paying off old debt) where after closing costs, cash goes into the borrower's pocket.

Typically above a threshold like $2,000

A refinance loan where the borrower doesn't get any cash or is under the threshold (Example new $510,000 loan pays off $500,000 loan and $10k closing costs = net zero to borrower) is called a: Rate-Term Refinance

Why are cash-out refinances such a powerful tool for real estate investors?

Most importantly, is the money is tax-free. Since it is still a loan, if the property appreciates, the money goes into your pocket but its just a loan, not "income"

An example would be you take a 75% LTV loan of $750k on a $1M property, five years later it appreciates to $1.6M, you take a new loan still at 75% LTV for $1.2M.

Ignoring closing costs, thats $450k in the pocket of the investor, tax-free!

So what are the downsides?

Primarily that you will now cut your monthly cash flow since debt service will increase with a higher principal (unless you refinanced into a much lower rate environment)

However, Cash-Out Refinances are riskier for your Lender for a few reasons, so they will typically charge a higher rate / points for the privilege (versus an otherwise identical loan thats a rate-term refi or acquisition)

Why are Cash-Out Refinances priced higher by the lender?

1) Valuation

The key risk mitigant for lenders is to foreclose on a property upon default, and its important value of the property is accurate, because if the value is inaccurate, the property could be worth less than the mortgage loan amount, and thats when lenders lose money. Almost all lenders will rely on a third-party appraisal providing a valuation of the "market price" of the real estate - but how trustworthy is that value? Definition of Market Value - is highest price it will earn if up for sale. So acquisition loans the value is typically very clear, by definition, the value is the highest bidder, which is most likely the purchaser in the deal. Purchase Price = literal value but refinance loans based on an appraiser's opinion at the end of the day are an opinion. Appraiser quality can be varied and almost all comps are not identical so there is a lot of subjectivity. There is also big opportunity for fraud in any area with subjectivity and opportunity for big gains.

Bottom line - valuations on cash-out refis are less reliable

Additionally, lenders like to see "skin in the game" in terms of properties - psychologically, a borrower that is putting down cold hard cash on an acquisition means they have real $ to lose if things go wrong. If they are cashing out more than they put in, much easier to walk. Finally, when considering a borrower's financial situation as a whole - its safer for the lender where their net worth is "in" the property vs. in cash and used elsewhere - potentially spreading themselves more thinly. In summary - cash-out refis are a great tool for real estate investors - just remember, they're riskier from the lender's perspective, so you'll have to stomach a bit higher in rate (though not huge) and maybe some LTV restrictions.

If you made it this far, now you know why!

[Robin Simon]

Quote from @Joseph Coleman:

@Robin Simon Thanks for the info Robin! 

Out of curiosity, 
-Do you have any tools or resources you recommend for evaluating a cashout refi to calculate how return on equity is impacted for different financing scenarios ?
-Under what situations are you finding that investors are doing cash-out refi's even when the rate today is higher than their current mortgage?
-In the DSCR world how common are pre-payment penalties or situations where a loan can be called due early by the lender for any reason? How does this factor into choosing whether or not to refi?

Thanks! 

 Thank you @Joseph Coleman

Do you have any tools or resources you recommend for evaluating a cashout refi to calculate how return on equity is impacted for different financing scenarios ?

We don't have any proprietary tools - but in general in my mind running the numbers in excel is always the best choice.  Would be a pretty straightforward "scenario analysis" I would advise, Scenario 1 = status quo if you don't refi, what 10 year or so cash flow looks like and calc the return, then Scenario 2 = run the same cash flows with the new loan and then add that to the cash flows of what you would do with the cash-proceeds (another property, etc.)

Under what situations are you finding that investors are doing cash-out refi's even when the rate today is higher than their current mortgage?

There is almost zero cash-out refinance activity right now refinancing another DSCR or conventional 30-year loan since the rate would be much higher, a lot of investors are just keeping status quo or utilizing HELOCs instead. However, still seeing a good number of DSCR Cash-Outs coming out of hard money where the terms are short and the rates are much higher - i.e. the BRRRR method.

In the DSCR world how common are pre-payment penalties or situations where a loan can be called due early by the lender for any reason? How does this factor into choosing whether or not to refi?

DSCR loans are not callable by the lender without a default for any reason (an advantage over HELOC or other types of loans that might have that provision). Prepayment penalties are very common in DSCR and are a big tool used to get DSCR rates competitive with conventional rates but even the harshest penalties last for a max 5 years on a thirty-year loan, so if you are a long-term time horizon investor building a portfolio (generally what DSCR loans are targeted to), it doesn't really hurt