What it Takes to Cash-Out Refi

Many investors, beginner and experienced, are enamored with the strategy of buying a value-add deal, raising the value of the property, then doing a cash-out refinance to return 100% of the originally invested equity. While this is a tremendous strategy which is not only a great way to generate outsized returns and build a growing portfolio, but also extremely tax-efficient, since a refinance is not a taxable event.

However, 100% cash-out refinances are not a common occurrence today even on a heavy value-add deal, since prices are high and takeout leverage is constrained to around 75% (except HUD 223(f) loans which can be levered up to 83%). Stabilized core-plus or value-add deals are nearly impossible to pull off a 100% cash-out refi, not only because prices are high, but also because this deal strategy and financing strategy are a mismatch.

The reality is value must be increased so substantially through the business plan and potentially through appreciation (which can come in the form of rent increases or cap rate compression) that the total capitalization of the deal must be 75% or less of the new appraised value on a refinance. This math makes logical sense since you would have to get a 75% LTV loan based on the new value of the property and use those new loan proceeds to pay off the old debt as well as return all of the original equity (making up the deals acquisition total capitalization). 

Let’s take a deeper dive into these numbers and really look at the metrics of a deal that would produce this level of value increase, such that a 100% cash-out refinance is a potential reality. 

Here we have an example 150-unit multifamily deal we will use to draw conclusions about the qualities of a deal which make it more likely to achieve a full cash-out refi:

As you can see, this is a very prototypical value-add deal. The property is being purchased at a 5% cap rate and the capex budget is $8k/u for both interior and exterior upgrades in order to achieve a $100 rent premium, resulting in a 12.5% revenue increase. For this hypothetical deal, we are keeping expenses the same from in-place to pro forma. 

We are assuming 80% going-in leverage on a Freddie Mac floating rate loan which only has a 1% prepayment penalty, allowing for an economical refinance. The projected returns are 14.2% gross IRR over a 3-year hold which is in-line with market averages for a value-add deal of this profile today. The stabilized yield on cost is 5.95%.

Now if we project a refinance after 24 months of ownership after the value-add business plan is complete (assuming an 18-month stabilization period to raise rents on all 150 units), the cash-out would be about 35%. This is assuming 75% LTV on the new loan and a refi cap rate of 5.5%.

A 35% cash-out is certainly a major success, but still nowhere near the 100% target. Furthermore, this is assuming there is no cap rate expansion in the refinance valuation and no interest rate increases which may hurt leverage through debt service coverage ratio constraints. 

So, how much more value would need to be created from a revenue growth and return on cost perspective to pull off a 100% cash-out? If we increase the rent increase from $100 to $150, that raises the total revenue increase to 18.3% which results in an impressive return on cost of 6.64%. if you’re not familiar with the return on cost metric or its significance, check out this article here. 

Now this hypothetical deal is achieving a terrific 24.4% project IRR over a 3-year hold, assuming a 5.75% exit cap rate. However, a 24-month refi at a 5.5% cap rate valuation still only gets us to 62% cash-out. Still a long way to go to 100%! The metrics on the deal look great now but still not good enough for every investor’s favorite 100% cash-out refinance. 

Lastly, let’s try raising rents by $225 through our $8k/unit capital expenditures program. This is a far cry from our original $100 increase scenario and experienced investors know that finding any deal where you can raise rents $225 is very difficult. Furthermore, it is not just about how much you raise rents since you’re going in valuation matters and, even more important, is your return on cost. For example, you could find a deal where you can raise the rents by $225 but you may have to pay a 3% going-in cap rate for the deal, since the market is pricing in the upside.

With $225 rent increases, the resulting revenue increase is a whopping 27.1% and a stabilized return on cost of 7.68%. These deal metrics result in an unbelievable 37.3% gross IRR over a 3-year hold. Finally, we are also able to achieve a 103% cash-out refi. This goes to show you just how difficult it is to achieve a 100% cash-out refi and therefore should not be relied upon as a viable strategy in most circumstances. Nevertheless, supplemental loans and refinancing are powerful tools even if they only result in a small cash-out. 

In conclusion, investors should generally have more realistic expectations in regard to cash-out refinances in today’s market. Furthermore, investors should not expect that a cash-out refi is a good short-term strategy for cash flow deals which are better suited for long-term holds. We continue to seek deals at both ends of the spectrum; deep value-add opportunities which may deliver high-teens returns and approach the 100% cash-out refi threshold (but we won’t base our assumptions on that), and core-plus deals characterized by quality assets in quality locations, which exhibit a strong and growing cash flow opportunity.

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About Lone Star Capital

Lone Star Capital is a real estate investment firm focused on underperforming multifamily properties in Texas and surrounding states. Lone Star creates core-plus and value-add opportunities that deliver superior risk-adjusted returns by implementing moderate to extensive renovations, improving management, and designing creative capital solutions. Lone Star owns over 1,500 units worth nearly $100M. Click through to view our company presentation here.

About the Author 

Robert Beardsley oversees acquisitions and capital markets for the firm and has acquired over $100M of multifamily real estate. He has evaluated thousands of opportunities using proprietary underwriting models and published the number one book on multifamily underwriting, The Definitive Guide to Underwriting Multifamily Acquisitions. He has written over 50 articles about underwriting, deal structures, and capital markets and hosts the Capital Spotlight podcast, which is focused on interviewing institutional investors. Robert also helps run Greenoaks Capital, his family's real estate investment and advisory firm. Robert grew up in Silicon Valley and currently lives in New York City, where he enjoys reading nonfiction, traveling, working out, meditating, playing golf and piano.