Help me understand refinancing at higher valuation after renovating (slightly long post)
Hi CRE amigos-

Fairly seasoned residential (moderate sized portfolio, all &lt;5 units, all fannie/freddie loans) investor here, finally moved into commercial space. Purchased a place, have driven rents up a bit, curious how this affects valuation of the building and potential refinance. I'm not a COMPLETE mouth-breather on CRE, just need some direct answers on some of the finer points of valuation/refinancing.

Here are the specs; please note that this was NOT a great deal at purchase; the rents were low, some of the units needed renovation to get up to market rent, etc etc. We've already started renovating as tenants leave and I'm confident we'll be able to drive rents up quite a bit per the below calculations:

**At purchase**

6-unit in large-sized, non-coastal market, in an 'up-and-coming submarket' with a cap rate for commercial multi-family in the 5-6 range; 650k-ish purchase price, 

Gross rents: 5500 (again, these were at-purchase and could be driven up with some better management/renovation)

\- PM fees 500/mo

\- water 250/mo

\- waste 150/mo

\- vacancy at 6%, or call it +/- 350/mo

\- maintenance + capex at approximately $700/month

\- insurance 200/mo

\- taxes 400/mo

This gives me a NOI around 3k/mo, 36k/year, or approximately 5.5 cap rate at purchase. 

&amp;#x200B;

**After renovation**:

We are already renovating units one-by-one as tenants leave, and I'm confident with an outlay of probably 50-80k we can drive gross rents up to 6500 as a floor, potentially a little higher.

None of the other expenses increase materially, giving an NOI of approximately 50k/ year, or approximately 7.1 cap (50 NOI / 700 value of building; this is all rough, back-of-the-envelope numbers).

**HERE IS WHERE I NEED HELP UNDERSTANDING:**

We aggressively paid down the loan to get our original DSCR numbers low enough for the commercial lender. Currently owe about 410k or something on this loan, have a 25 year amortization, rate at 4.5%.

How will the lender value the building so that we can eventually take out money for other projects? Will they use the prevailing cap rate in the area (5.5-6 seems to be what other comparable buildings are trading at), and say 'aha, you have a NOI of 50k, at a 5.5-6 cap this imputes a valuation of 800-900k, so we will loan you 70% of that valuation, or 550k ish' (which would put 150k back into my pocket for our next project). Am I understanding this correctly in general terms?

(Obviously, this is contingent on rates dropping down to a less astronomical level, since I am not keen on refinancing away a 4.5% rate for a... IDK, 7%-8% rate right now).

If I am understanding this portion correctly, that would necessitate a refinancing of the loan, correct, which would cost like... I don't know, ballpark 10k in just loan closing costs?? So off the bat, I'd be losing 10k of the 150k we take out just to access the dough? 

Sorry for the (fairly basic) CRE questions here, liek I said I'm new to the commercial game. We are confident in this particular project and being able to drive rents up to the stated level, just curious how to access all of the equity created after that fact, and especially interested in getting some back-of-the-envelope calculations on how much the building will be worth afterwards (e.g., making sure I am calculating correctly) and also calculations on how much to expect a refinance to cost on a commercial building. All of my refis in the past have been small-time multifamily deals, which trade based on comps and not NOI.

Really appreciate the look-over.
[{"id": "ir5tvp4", "text": "Changes in NOI do not change the cap rate it changes the value.  You need to know what the cap rate is from recently closed sales of similar properties.\n\nBut yeah, the basics are V=i/r But the cap rate may change because of the change in mortgage rates mostly depending on the supply and demand.", "replies": [{"id": "ir5uksi", "text": "yep, thanks for the response! I think I understood this - assuming that similarly-placed properties are trading at a 6-cap, would that then impute a value of our building at something around 800-900k, like I guessed in my original post?\n\nIf this is the case, my question is: how does the lender view this, will he say 'based on your new NOI and the prevailing cap rate in the area, even on the low end we assesss the building is now worth 800k'.\n\nWould the lender then loan out 70% of that valuation, or +/- 550? As I mentioned in the original post, that would put a chunk back in our pockets.\n\nSorry if I got some of the terminology wrong in the original post (e.g., personal cap rate on a building as compared to prevailing cap rate in an area for purposes of valuations). Still learning here...!", "replies": [{"id": "ir6487k", "text": "Basically yes.  You are understanding correctly.  All else being equal, when NOI rises, the building value rises and lenders will lend at the higher valuation.  (Another good option instead of refinancing is to get an equity line against that extra equity, by the way.)\n\nThe major caveat in real life right now is that cap rates had gotten historically low.  With interest rates as they are, cap rates certainly must rise.  Which is bad for valuations.\n\n100,000 noi / .06 cap rate = $1,666,667\n\n100,000 noi / .07 cap rate = $1,428,571\n\nThis doesn't mean your property isn't improving if cap rates go up, just that the valuation of what others would be willing to pay for it or lend on it may not rise as much.  Anyway sounds like you're on a great path so far, good luck!", "replies": [{"id": "ir65dmm", "text": "&gt;(Another good option instead of refinancing is to get an equity line against that extra equity, by the way.)\n\nAha, ok this is perfect and just the sort of new info I needed - can you just give me a simple yay/nay to make sure i'm wrapping my noggin around how a commercial equity LOC works?\n\n(All of this is assuming cap rates don't MASSIVELY change, but have to go with the info I have in front of me today - obviously underwriting would change if prevailing cap rates change etc etc).\n\nIn a few years I owe, say, 400 on the original mortgage; the building is worth, say, 800. The lender says \"we'll extend you a LOC on your 400k in equity at whatever-rates-are-at-for-LOCs-today\", and then I just spend against that LOC?\n\nIs that more or less how a commercial equity LOC works? If that IS how it works, that's 100% the route we would take, because I am not keen on refinancing out the (Relatively) cheap 4.5% original mortgage we have, and if I can take a loan on the equity - even at a higher rate - that would still be preferable to losing the 4.5% loan that we currently have. \n\nWhat sort of limits do lenders typically have on commercial equity LOC? I assume up-to-70%-LTV or based on DSCR or something. Is that about right?\n\nAlso, do commercial LOCs typically require the same closing costs / origination costs as a typical mortgage?  \n\n&amp;#x200B;\n\nREALLY appreciate the input here. I've seen your posts around and you've always been v. knowledgeable on this stuff.", "replies": [{"id": "ir68fzu", "text": "Thanks for the kind compliment!  I've had to learn all this the hard way too.\n\nSo yes, as your value increases, the lender (possibly the same lender your main loan is with!) will do an equity line up to 70% LTV.  Or for their own reasons they may only go to 65%, whatever.\n\nClosing costs hopefully can be much cheaper.  You already have a title commitment from when you purchased.  A good commercial lender may just use your original appraisal (as long as it's not too old) plus current leases to qualify your new higher property valuation.\n\nMy loans come from a local 2 branch bank that does lots of community business/real estate lending.  And also we started working with the largest commercial lender in my state.  We got a 10 year rate (on 20yr amortization) this spring at 4.25%.  loving that rate now.\n\nYou could ask your broker from when you bought the place who is the biggest commercial lender in your area.  You need a bank who WANTS this type of loan and is used to it.  But anyway it's totally normal, people do it all the time.  Good luck!", "replies": [{"id": "ir68s8v", "text": "Perfect, thanks again - to continued success! I'll buy you a beer when we are kazillionaire real estate moguls", "replies": [{"id": "ir6anyz", "text": "Cheers to that!", "replies": [], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "ir5xhe1", "text": "The future rental income and future cap rate for the re-fi are all assumptions you are making that may not be accurate. For example, you might improve the tenant spaces but there still may not be a market for them due to market conditions. So while income-producing properties are valued in part on NOI, that entails lease comps. Even if you manage to have longterm above-market leases in place, the appraiser and lender are going to consider that the tenant might default or threaten to get a renegotiated lease.\n\nAlso, underwriting guidelines are always changing. They may offer at 70% loan-to-value now, but not later, so that\u2019s another assumption. \n\nI don\u2019t have experience with properties your size, but $10k for a refi sounds too low. What was your initial financing cost?\n\nI\u2019m sure this is not news to you, but you realize that a payment based on a 25-year-amortization schedule is not necessarily a 25-year mortgage term, right? Most commercial mortgages are much shorter term. \n\nSorry not to give you more definitive answers. There are just too many assumptions to make that are not within my scope of knowledge, or really any of ours, given the lack of location, use, and time horizon. You\u2019ll just have to lay it all out on a worksheet and decide how likely the assumptions are and run things from worst possible scenario to best possible scenario, and continue to modify them as the time to consider the cash-out refinancing gets closer.", "replies": [{"id": "ir5znxl", "text": "Hi there! Yes, I should have stated, you are correct - it's a 25 year amortization but a 5 year term, if I remember right (no balloon, just a renegotiation at current rates at that time). EDIT: I just checked, it's a 5-year WITH a balloon, but our lender has told us that they never call for a balloon payment and just renegotiate a new 5-year loan with prevailing rates at that time.\n\nIt's possible that 10k for the refi was, indeed, too low - just throwing out a number for the sake of understanding back-of-the-envelope calculations. At some point, clearly, it doesn't make sense to refi... e.g., paying 10-15k to unlock 50k in equity would be a non-starter for me.\n\nAlso, while you are correct that I am making a lot of assumptions, for the sake of my understanding I just want to make sure that IF my assumptions on renovations-driving-rent-upwards are correct (which I think they are! Have done considerable research in this submarket, discussed with realtors, etc), I just want to see what the valuation of the building will be after I am able to drive rents up. I'm aware that I'm \\*assuming\\* that rents will increase, but it's a pretty solid, based-in-fact assumption, if that makes sense.", "replies": [], "depth": 2}], "depth": 1}, {"id": "ir5ydzh", "text": "Yes, lender's will underwrite the in-place numbers (some lenders may want at least a Trailing 3 months proof) and current cap rates of similar properties to determine their underwritten value and will lend on their parameters of LTV/DSCR (usually utilizing an appraisal). However, depending on the timeframe of when you first purchased the property and the refinance, you may be constrained on loan dollars due to LTC (Loan to Cost). The loan to cost will be the total amount you have spent on the project (Purchase Price, Renovation Costs, Purchase Fees, etc.) now this will vary from lender to lender on how high you can push the LTC %. Not every lender utilizes this but it is something to be aware of.\n\nAlso, like you mentioned in your post: rates are much higher than what you currently have and I would advise you to hold on to that rate and less you really need the capital for another project you expect to have great returns.\n\nI am a Commercial Mortgage Broker for $2M+ but would happily answer any additional questions if you want to DM me.", "replies": [{"id": "ir60n11", "text": "this was very helpful, DM incoming", "replies": [], "depth": 2}], "depth": 1}, {"id": "ir6mawu", "text": "Well most commercial loans have massive prepayment penalties.  You didn't mention those but if you have them don't be surprised if you have to pay a few percent of your principal out of pocket to get out of your current loan.   \n\nLenders have a minimum threshold for each of DSCR, LTV, Debt Yield.  (plus LTC for developments).  I think DSCR will be your limiting factor but it's hard to say.  If you made rents higher you should be able to get a loan that's proportional to rent increases less impact of interest rates working against you.  Figure out what your prior lenders DSCR is and then model the amortization schedule for your new loan to get you to the same DSCR on your new income.  I usually use 1.25x NOI for DSCR ratio, could be better and could be worse.", "replies": [], "depth": 1}]