The Refinance Assumption Trap

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The Refinance Assumption Trap

I am often asked what assumptions LPs should look out for when looking at a deal. I am very hesitant to give specific guidance on these matters, because what tends to happen is that LPs will check whether those 1-3 “red flags” are present … and then invest on them not being in the deal.

I think this strategy (if you can call it that?) is deeply shortsighted, because all investments need to be looked at through the perspective of balancing the pros and cons of the transaction. The closest I’ve gone to giving such guidance so far is writing the Top 15 Syndication Mistakes article, and mentioning on several podcasts that many of the deals that are having challenges today assumed some degree of cap rate compression at the time of investment.

I have also seen many instances of cash out refinances today, a term that wasn't widely known until the past two years - more on that towards the bottom because it’s very related to today’s topic.

I keep seeing refinance assumptions appear in decks that have very material impact on IRRs. Although exit cap rates are the biggest place to slip up in most LP investments, it feels like refinance assumptions are a fairly close second.

Although exit cap rates are the biggest place to slip up in LP investments, it feels like refinance assumptions are a fairly close second.

Let’s dive in.

First, let's address why refinance assumptions matter.

Most investment decks will have an IRR, which is a measure of returns to you as an LP. This number is very sensitive to timing - if you get dollars sooner, it’s materially better for the calculation. Therefore, having a large “pop” (cash out to investors) early on in a 5 year horizon deal is very material to your IRR.

Refinances tend to occur upon stabilization and it’s common to see them in years 2-3 of a project.

It is also common to see decks that do not talk about refinance assumptions at all, but rather simply include the refinance impact in dollar terms. This is precisely why I wanted to write about this topic, as I feel it is often a hidden aspect of the deck that has a material impact on analyzing the risk/reward of the transaction in front of you.

There are four variables to consider at the time of a refinance:

• NOI

• It’s important to note here that NOI in a future year will have a lot of assumptions on both the income and the expense side

• For the avoidance of doubt, the NOI at the time of the refi is an assumption, because it depends on the GPs ability to execute on the plan that’s put into a summarized financial model.

• It’s your job (as LP) to vet the NOI to ensure that the assumptions are valid.. and if you feel that the assumptions are a bit aggressive, consider doing a sensitivity table (or simply discounting the NOI a bit) to see what would occur if the NOI goals aren’t reached

• Cap Rate

• The property’s valuation at the time of the refinance is typically determined by NOI/Cap Rate

• This cap rate assumption is critical due to the same reason it’s critical at exit value - the cap rate needs to make sense relative to where cap rates are today!

• Assuming cap rate compression at a refi is risky for the same reason it’s risky to assume cap rate compression at an exit - this is a macro (rather than property) bet and isn’t in the control of the GP

• Regardless of what number you come to, this valuation determines your property value at the refi… which you then apply an LTV assumption to

• LTV

• Once we got to the property’s value (NOI/Cap Rate above) it’s normal for the GP to apply an LTV assumption to this number to determine the loan amount they’ll receive to take out the existing lender

• Sometimes the LTV assumption is more aggressive than entry, and you need to ensure that this is realistic because lender preferences/sentiment do change even within the same asset class (during more difficult/uncertain economic times, LTVs tend to get more conservative, thereby decreasing)

• Sometimes loan proceeds will be capped due to debt yield (NOI /Proposed Mortgage Balance) or DSCR (NOI / Debt Service) requirements by the lender, but I don’t usually see this level of analysis

• Terms

• In order to build out the proforma debt service and exit valuation for the business plan, the GP will also assume basic terms about the loan:

• Interest Rate (and sometimes an interest only, IO, period)

• This is an important one again, because it’s not uncommon to assume interest rate drops as part of the refi. As I always say, there’s no issue with this as long as you go into the investment understanding that the GP (and you) are expecting rates to drop by x%.

• Maturity

• Amortization Period

• Note that this can be (and often is) far longer than the maturity date

• Prepayment penalties

• This is important to think about in terms of exit, since you might have a fee to pay at closing

As we have outlined above, you can now see why these assumptions are so tricky. I think 4/5 decks that I review contain refinance assumptions that aren't clearly explained. Of the 4 decks that contains such assumptions, ~2 tend to have assumptions that are aggressive based on one (or more) of the four variables I discussed above.

As a quick note, both valuation and changes in lender sentiment (willingness to lend, LTV, interest rate, etc.) are a big reason for the cash in refinances that are occurring today. Simply said, these are scenarios where the refinance loan is less (in terms of principal balance) than the existing loan.. and the GP/LP partnership needs to come up with additional cash for the cash in (hence the name) refinance.

I think many would agree that it would have been hard to predict the rate increases that we saw in the past two years, but I also hope everyone can agree that running a sensitivity table on such outcomes would have been quite easy before investing.

I hope this helps you be a bit more cautious as you look at your next deal! See you next week :D

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