What is Commercial Cash-Out Refinance & How Does It Work?

Commercial cash-out refinances grant property investors access to the equity that would likely otherwise be illiquid. Selling and cash-out refinancing are two main ways to realize equity and reallocate capital, and refinancing has several advantages.

What Exactly is a Commercial Cash-Out Refinance?

A commercial cash-out refinance is a process in which property is refinanced, and equity is withdrawn; hence the term “cash-out refinance.”

The property is refinanced with less equity tied up, and all realized equity is paid to the investor. What the investor receives can be used for improvements to the property, new property acquisitions, distributions to investor(s), or almost any other purpose.

How Does a Commercial Cash-Out Refinance Work?

A commercial cash-out refinance works by securing a new loan against an investment property. The new loan is then used to pay off the existing loan, and the investor receives the remainder of the new loan. The process works step by step as follows:

1. The existing property has substantial equity that the investor would like to access
2. A new loan is secured for much of the existing property’s value
3. The new loan is used to pay off the existing mortgage
4. The remaining balance of the new loan is disbursed to the investor
5. The disbursed funds can be used for any purpose

Features of Commercial Cash-Out Refinancing

The loan requirements and terms for cash-out refinancing are lender-specific. Most lenders use terms similar to the following general features, though:

• Equity Required: Cash-out refinances normally only make sense if investors have at least 30-40% equity. New loans typically require investors to retain 20-25% equity, which would give investors between 5-15% with these numbers.
• Loan to Value: The maximum LTV ratio is typically 80%. This is where the ~20% equity requirement for new loans comes from, as does the guideline to have 30-50% equity before executing a cash-out refinance.
• Debt Service Coverage Ratio: The minimum required DSCR is normally 1.2-1.5, which is fairly in line with most mortgage programs for commercial real estate.
• Fees: Lender fees typically range between 1-3% of the new loan’s value, and closing costs are normally 2-5% of the loan. Investors should be aware that there may also be a prepayment penalty that must be paid on the current loan.
• Term: The loans underwritten for cash-out refinances are primary mortgages, and, thus, usually last between 15 and 30 years.
• Processing: Refinancing normally takes between 30-45 days to complete once signed up with a lender, although issues can arise that delay underwriting.

Example of a Commercial Cash-Out Refinance

For an example of a commercial cash-out refinance, assume a building purchased three years ago for $1 million is now worth $1.3 million. The original $800,000 loan has been paid down to $700,000, so there’s $600,000 in equity.

A new loan for $1 million is taken out. The first $700,000 of this loan is used to pay off the current loan, and another $35,000 is needed for a prepayment penalty. Another $40,000 is needed to pay the new loan’s associated fees of 4%.

The investor then receives $225,000. They intend to spend $25,000 on new storage units, which will boost NOI and cash flow. The other $200,000 is earmarked for purchasing another $1 million property, which requires a 20% downpayment.

The investor has added revenue to their existing property and financed the purchase of a second property.

5 Benefits of Cash-Out Refinancing

Commercial cash-out refinancing can be used to make improvements, purchase additional properties, distribute returns, or for many other purposes. There are several benefits of refinancing commercial property:

• Lessen tax obligations compared to using profits generated from selling
• Pay investors back more quickly than they otherwise could be
• Avoid balloon payments when adjustable-rate mortgages come due
• Secure lower commercial cash-out refinances rates if interest rates have decreased
• Gain liquidity, and reallocate capital for any purpose

4 Disadvantages of Cash-Out Refinancing

Despite the benefits, commercial cash-out refinancing isn’t right for every situation. There are several disadvantages to consider:

• New loans come with hefty lender fees and closing costs that must be paid upfront
• Current loans may have large outstanding prepayment penalties
• Not all commercial property loans qualify for cash-out refinancing
• Can end up with worse loan terms if interest rates have increased

Is There a Limit on Cash-Out Refinances?

There’s no strict dollar amount that can’t be extracted via cash-out refinance. Instead, the limit on how much can be extracted is usually based on the new loan’s LTV requirement. The maximum that can be withdrawn is usually 80% of a property’s current value.

Commercial Cash-Out Refinance vs. Selling

The two main ways to realize equity in commercial real estate are cash-out refinances and property sales.

Selling is a straightforward process that frees an investor of all obligations related to the sold property. The maximum amount of equity is realized, as the equity and fee requirements of a new loan don’t have to be met. Any applicable prepayment penalty also can be avoided if the buyer assumes the current loan.

Cash-out refinancing allows investors to retain their building ownership, potentially gaining from future appreciation or rent increases. Refinancing is also faster since investors don’t have to wait for a qualified and interested buyer to purchase the property.

In many cases, cash-out refinancing minimizes tax obligations. Whereas taxes must be paid when a property is sold, simply extracting equity doesn’t invoke a tax. The taxes assessed on a cash-out refinance can be null if the equity is used for improvements and/or acquisitions. The tax savings often outweigh the added fees that selling avoids.

Whether a property should be sold or refinanced depends on the specifics of the property and the investor’s situation. This is a decision that investors must make for themselves.

Wrapping Things Up: Is Cash-Out Refinancing Right for You?

If you have equity in commercial real estate, you don’t necessarily have to wait until selling to realize that equity. Consider a cash-out refinance, and how you might deploy the equity trapped in your property. The other uses make executing a commercial real estate refinance worthwhile.