The refinance that was going to return your capital

A business plan frequently contains a moment that shapes the whole return. Around year three the property refinances, the new loan is larger than the old one, and the surplus is distributed to investors. Much of the original investment comes home while the ownership stays intact.

It is an elegant structure and it is genuinely how many deals work. It is also a forecast about a future credit market, presented alongside forecasts about rent and occupancy that are far more within the sponsor's control.

Consider what the event requires. This is an illustration, not a real deal. A property is bought for $10,000,000 with a $6,500,000 loan and $3,500,000 of equity. The plan lifts net operating income from $500,000 to $700,000 by year three. At a five percent cap the property is then worth $14,000,000.

Now refinance. A lender offering seventy percent of value would lend $9,800,000. Repay the existing $6,500,000 and $3,300,000 remains, close to the full original equity. The projection shows almost all capital returned in year three with investors still owning the asset.

Change two inputs and watch it move. Suppose income reaches $640,000 rather than $700,000, a shortfall of under nine percent. Suppose the market now prices at a six percent cap rather than five. Value is $10,666,667. Seventy percent of that is $7,466,667. After repaying $6,500,000, the surplus is $966,667 rather than $3,300,000.

The plan mostly worked. The capital event did not.

There is a further constraint that binds before the loan-to-value test does. The coverage ratio. At a 1.25 requirement and a six percent rate, income of $640,000 supports annual debt service of $512,000 and a loan near $8,533,333. Lenders apply the lower of the two tests, so the binding number here is the value test at $7,466,667.

None of this makes the original projection dishonest. It makes it conditional, and the conditions deserve to be stated as clearly as the outcome.

Questions worth asking. Does the projected return depend on a refinance, and what portion of it does? What value and what income does that refinance assume? What does the return look like with no refinance at all, holding to sale?

That last scenario is the one to study. If a deal is acceptable without the refinance, the refinance is upside. If it is only acceptable with it, you are investing in a credit market forecast.

Capital returned early is a plan. Capital returned at sale is an outcome.

In the projections you have seen, how much of the headline return arrived before the property was sold?