There are some things in the commercial real estate business that you want. There are some things that you need, and there are some must-haves. The commercial cash out refi is a must-have.
What Exactly is a Commercial Cash Out Refi and How Can it Help You?
The commercial cash out refi is a very common strategy of putting your property into position to refinance the current loan and pull out your original down payment as cash.
It's also a very important skill to have if you want to be a successful syndicator of commercial real estate deals. It's a vital skill. Once you pull the cash out, you can use the cash with various things like renovating the property, You can buy another property, and you can pay back your investors and be very popular amongst them if you do that. You can also have a nice fat savings account. The end-game, with the commercial cash out refi is to build well. The cash out refi equals wealth building when you get down to it.
The Cash Out Refi Concept
Remember the good old days in residential, single family home investing when you could buy a rental home, wait for it to quickly appreciate and then refi, pull the cash out and hold on to the property? Then, you would take that cash, well, hope you did, and buy another rental and another new rental and another and another? Then, you could do this for years as long as the market kept going up.
As you all know, the market has stopped going up like it did back in those good old days and those good old days of residential are gone. The market crashed for a few years and left many residential investors in shambles. I'm sure many of you remember those days. Well, guess what? The cash out refi is alive and well in commercial real estate and it is not so market-driven as residential real estate. It is more income-driven than anything else.
Yes, the market still does have a little say but the net operating income has a bigger say. I will give you an example right now to show you how powerful the net operating income is when considering a cash out refi and how it plays into that. Here's basically how it works. Let's take a 12-unit apartment complex as an example. Let's say you purchase it for $1.4 million and let's say all their rents are $750 a month for each unit. But let's also say that the rents are $125 below the market. The rents can actually go from $750 to $875.
Then let's also stamp the market with a 5% cap rate. I'm out here in California and that's pretty common. Some places on the East Coast and in Southwest, that's pretty common too. We'll use 5% as the market cap rate. We have a 12-unit and the rents can go from $750 to $875 so $125 bump. Let's also say that we can also cut the cost of the water utility by transferring those water cost to the tenants. We'll put in separate meters and we'll charge the tenants the cost of water.
Let's say also, we're going to be really good property managers, so operationally, we're going to be way more on top of things than we were in the past and so we're going to have a total monthly savings of about $1,000 a month which is about $12,000 a year. We get that from the water savings and just better management. A total savings of $1,000 a month or $12,000 a year. You follow me so far? So far, we have a rent bump of $125 across all 12 units and also we're implementing water utilities to the tenants and being a better manager so we're saving $1,000 a month.
Now, let's say that the price is $1.4 million, 25% of that is $350,000. That's the typical down payment on the commercial deal of 25%. So, 25% of $1.4 million is $350,000. Follow me so far? After you put down the down payment of $350,000, you're going to owe $1,050,000. It's just simple math. Remember that number. You owe a $1,050,000 after your down payment. Just remember that number. As I mentioned before, your rents can go from $750 to $875. We're going to do that across the board. We're going to do $875 a month times 12 units times 12 months. That gives me $126,000 a month. Now, we have the income of this 12-unit, the new income of this 12-unit.
Now, we're going to subtract expenses. To make a long story short, we're going to take 35% of the income as expenses. So, 35% of $126,000 is $44,000. I'm going to subtract the $44,000 from $126,000 and I come up with a net operating income of $82,000. Follow me so far? So, $126,000 in income minus $44,000 in expenses gives me a NOI, net operating income of $82,000. The net operating income or the NOI is a very important number in commercial. Hopefully, you follow me so far.
If you recall, I also have a savings of $12,000 because I pass on the water and I tightened the management. That goes to my bottom line to my NOI, so $12,000 for the year. My new NOI is $82,000 plus $12,000. It's $94,000 now. I have a new net operating income of $94,000, new NOI of $94,000. Now, there's an equation I need you to know. Many of you, know the basics of commercial that a cap rate formula, cap rate is equal to the NOI divided by the sales price.
Cap rate is equal to NOI divided by the sales price. I can flip that equation over and say the sales price is equal to the NOI and divided by the cap rate. All I did was flip that equation over. The sales prices is equal to the NOI divided by the market cap. Now, if you recall, I have an NOI of $94,000 and I stamped a cap rate of 5%. Now, I have my new sales price. Remember, sales price is equal to NOI divided by the cap rate so it's $94,000 divided by 5%. My new sales price now is, I do the math there, it's $94,000 divided by 5% equals $1,878,000. So, $1,878,000, follow me so far?
Now that I have increased my NOI, I have a new value. As the NOI goes up and the cap rate stays the same, the property value goes up. You can just use this new equation if you want. New value is equal to your new NOI divided by the cap rate. That's all I did, new value is equal to my new NOI which is $94,000 divided by 5%. I have a new value of $1,878,000. Let's continue.
Commercial real estate lenders allow you to refi 75% of your new value. Once the property is stable, they will look at this new value of [$1,878,000 00:08:07] and they will do a typical 75% refi. What's 75% of $1,878,000? The 75% of $1,878,000, $1,408,500. I'm going to go ahead and get a refi loan in the amount of $1,408,500. Now, do you recall what we owed? We owe from our original loan $1,050,000. I'm getting a refi loan at $1,408,500, my old loan is $1,050,000.
Cash Out Refi
My new loan is going to pay off the $1,050,000. What do I have left? After my new loan of $1,408,500 pays off my old loan, I have $358,500 left. That's cash to you. Do you recall what your initial down payment was? Your initial down payment was $350,000. At the close of your refi loan, you got a check for $358,500, you originally put in $350,000, you have essentially paid yourself back with this refi loan. This is called a cash out refi. It's a very popular thing to do, something you need to learn how to do, very powerful thing.
Basically, all I did was increase my rents. I pass over the utility to the tenants and I tightened my operations all in the spirit of increasing my NOI. Then, I apply for a refi loan with a new value and then I got the cash out and I paid myself back. What do we learn here? We learned here was to always look for ways to increase your net operating income. I discovered that my rents can go up $125. I discovered that I can pass off my water cost to my tenants. I discover that I can be a better operator and better property manager and tightened things up and increase on bottom line which is my NOI.
Always look for ways to do that because as your NOI goes up, your property value also goes up. Now, as your NOI increases, it can come from, as I mentioned, rent increases or expense reduction. This is what we call force appreciation. When you do a force appreciation, you're forcing appreciation by increasing the NOI. You're not relying on the market. Remember what I said, this is not so market-dependent as more NOI, income-dependent so we can force your appreciation by doing those things.
Why Cash Out Refi is Valuable
That's tax-free money that you're taking. Now, again, let me review why is this so valuable to know how to do?
First of all, you can pay back your investors and keep your property 100% to yourself.
Secondly, you will become a very popular investor among your peers and private money investors. Why wouldn't they want to do another deal with you if you can pay back their investment and keep them in an investment? Why wouldn't they want to do another deal with you?
Thirdly, answer this question, what is your cash-on-cash return with zero money left into the deal? The answer is what? Infinity, your cash-on-cash return with no money into the deal is called infinity.