How to Unlock Trapped Equity in Real Estate
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It used to be easy to pull your equity out of a real estate property via a simple refinance. This was the life blood of a developer. You take down a property with conventional debt and equity, add value and refinance your loan through a traditional lending source allowing you to pull all of your cash out of a deal. You then would repeat the same process on the next project and next project and so on. Well as we all know, this world does not exist in todays financing market and most developers have all of their cash trapped in deals they have done over the past three years.
The banks now days simply will not allow you to cash out equity. For example, if you bought a property for $10 million using 60% conventional debt and 40% equity and have now added value to the property the banks will not allow you to refinance to pull your equity out. Even if you have an appraisal in hand for $15 million, you would think would be able to refinance with the same leverage of 60% Loan to Value (“LTV”) and pull $3 million of your $4 million out of the deal. The answer is no you cannot. The banks simply will not allow you to do this anymore…
In this post we are going to walk you through a strategy that will allow you to get around this.
The Client’s Situation
The client a few years back found an opportunity to buy an Office building REO property through a bank at a significant discount to true value of the asset. The asset had a 90% occupancy with market rate leases in place and the client was able to acquire the asset at a 19 CAP or $5 million. To do so he had to act quickly so we arranged a bridge loan for 70% Loan to Cost (“LTC”) with a 12% coupon. The client was required to bring 30% of the cost to the deal in fresh equity.
The takeout for the bridge loan was a refinance one year later through a conventional lending source. The rate was excellent at 5%, but the issue was they would only refinance the $3.5 million bridge loan and would not allow the client to cash out any of their equity. Even taking into consideration the property was worth $10 million via an appraisal which put them at only a 35% LTV.
So we needed to find a solution or the client’s equity was trapped and effectively put him out of business.
We found a creative way to use a Mezzanine loan to bring his leverage up to an 85% LTV. Our lending source was willing to provide him a Mezzanine loan on the property of $5 million or the GAP between the senior loan of $3.5 million and $8.5 million or 85% of the property’s value. This allowed the developer to cash out all of his original equity and then some. The terms of the loan were a 7% current pay with a 12% IRR “look back” with a 5 year term. You might say that is a bit expensive and was it worth the client pulling the cash out or should he have stayed with just his current senior loan and left his cash in the deal? Obviously this is a good question…
The answer is of course yes… Our objective in this structure was to allow him to pull equity out of the deal, but most importantly put him in a situation that he could refinance the loan with conventional terms at a later date. The Mezzanine lender was willing to allow the client to pay off the loan in two years rather than the full term of 5 years. They of course charged two points to do so, but it gave the client the ability to bring in conventional debt. Remember, because we now have 85% debt on the property and 15% equity, the client is no longer looking to cash out equity on the refinance. He was simply refinancing the existing debt.
The client was able to refinance the entire $8.5 million with conventional terms and was able to get all of his equity out of the transaction. This strategy also works on assets an investor has held for multiple years and has built significant equity in the property.
A Mezzanine loan provides a mechanism to unlock some of the appreciation you may have achieved over the years.
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