Q: What constitutes an acceptable return on investment when refinancing?

A: The window of opportunity for a refinance rarely occurs at the end of a loan term. This means that investors often find themselves facing a prepayment penalty as they weigh the attributes of a refinance.

Multifamily investors refinance for a variety of reasons. Some of these reasons include:

• to reduce debt service,
• to pull out cash from the refinance to refurbish or purchase property,
• buying out partners,
• estate planning.

For refinances that are not based on a drop in debt service, the return on investment analysis may not be as crucial to the investor. (For example, the cash needed to purchase another property may only be available from a refinance. The opportunity to purchase a property might mitigate the size of the prepayment penalty.)

The return on investment calculation is most germane when the reason for refinancing is mainly motivated by reducing annual debt service. When this is the case, an investor can calculate the return on investment as follows:

1. Determine when the closing of the new loan is expected to occur.
2. Calculate the outstanding loan balance on the anticipated closing date.
3. With the current lender’s assistance, calculate the prepayment penalty on the anticipated closing date of the new loan. If the prepayment penalty is a yield maintenance penalty, the dollar amount of the penalty is likely to change from the date of the original calculation due to changes in interest rates.
4. Calculate the annual debt service on the new loan. Do not include any increase in the loan amount since the cash out represents a return of equity. Make certain that the new loan is amortized on the same schedule as the existing loan.
5. Divide the cost of prepayment by the annual debt service savings to determine the payback period of the refinance. For example, a $100,000 prepayment penalty with an annual debt service savings of $50,000 would result in a two year payback period; the cost of the $100,000 penalty would be recouped in two years.
   NOTE: The refinancing expenses should not be added to the prepayment penalty, since these expenses will occur whenever a property is refinanced, regardless of whether a prepayment penalty exists.

What is an acceptable return on investment? Most investors will proceed with a refinance if the payback period is two years or less. Between two to three years, more than 50% of investors proceed with the refinance. With a payback period of more than three years, most investors do not proceed with the refinance. However, no one rule of thumb is correct. The decision to refinance should be discussed with your mortgage banker, partners and accountant.