A six-year value-add hold run with and without a year-three cash-out refinance, and the cost of the extra debt that decides the result.
A cash-out refinance raises the IRR and lowers the equity multiple: it returns equity early, which the IRR rewards, but the extra debt costs interest and fees, which come out of profit. On an illustrative $50,000,000 value-add deal with $20,000,000 of equity, a year-three refinance at 60 per cent LTV returns $7,620,000 and lifts the levered IRR from 17.74 to 18.87 per cent, while the multiple falls from 2.41x to 2.30x and profit by $2,105,000.
Worked in full in Private Equity Real Estate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The refinance is the moment a value-add business plan turns into cash. Sponsors like it because it returns capital to investors, resets the clock on the equity still in the deal and improves the headline IRR. Investors should ask what it costs. The answer depends on one comparison: the cost of the incremental debt against the return the equity is earning.
| Input | Value |
|---|---|
| Total cost | $50,000,000 |
| Acquisition loan, interest-only | $30,000,000 at 6.00% |
| Equity | $20,000,000 |
| NOI, years 1 to 7 | 3.0, 3.3, 3.6, 3.8, 3.9, 4.0, 4.1 ($M) |
| Cap rate, for the refinance and the exit | 6.00% |
| Refinance at end of year 3 | 60% LTV at 6.25%, 1% fee |
| Sale at end of year 6, costs | 1.5% |
Both the refinance and the sale value the property on the next year's NOI. The sale at a 6.00 per cent cap on year-7 NOI of $4,100,000 gives $68,333,333, or $67,308,333 net of costs.
Cash out = new loan − old loan − refinance costs
Value at end of year 3 = 3,800,000 / 6.00% = 63,333,333. New loan = 60% × 63,333,333 = 38,000,000. Cash out = 38,000,000 − 30,000,000 − 380,000 = 7,620,000, 38.1 per cent of the equity invested.
The price is in the interest line: $2,375,000 a year on the new loan against $1,800,000 on the old one, $575,000 more, because the balance is $8,000,000 larger and the whole of it now pays 6.25 per cent.
| Year | No refinance | With refinance | Difference |
|---|---|---|---|
| 0 | −20,000,000 | −20,000,000 | 0 |
| 1 | 1,200,000 | 1,200,000 | 0 |
| 2 | 1,500,000 | 1,500,000 | 0 |
| 3 | 1,800,000 | 9,420,000 | 7,620,000 |
| 4 | 2,000,000 | 1,425,000 | −575,000 |
| 5 | 2,100,000 | 1,525,000 | −575,000 |
| 6 | 39,508,333 | 30,933,333 | −8,575,000 |
| Profit | 28,108,333 | 26,003,333 | −2,105,000 |
| Levered IRR | 17.74% | 18.87% | +113 bp |
| Equity multiple | 2.41x | 2.30x |
In Excel, =IRR(B2:B8) and =SUM(B3:B8)/-B2 on each column. The difference column is the refinance seen on its own: $7,620,000 received, then $575,000 a year and $8,575,000 at the sale paid back. Its IRR, taken as a borrowing, is the cost of the cash-out: 9.07 per cent, well above the 6.25 per cent coupon because the fee and the repricing of the original $30,000,000 are charged to the $8,000,000 of new money.
The equity was earning 17.74 per cent. Replacing $7,620,000 of it with money that costs 9.07 per cent raises the return on what is left, so the IRR goes up. But every dollar of that money is repaid at the sale with interest, so the dollars of profit go down. The multiple cannot see timing; the IRR cannot see the size of the cheque. That is why the equity multiple should always be read beside the IRR. After the refinance, year-4 cash flow is $1,425,000: 11.5 per cent on the $12,380,000 still invested, but only 7.1 per cent on the original equity, against 10.0 per cent without the refinance. The same trade in a leveraged buyout, sized on EBITDA rather than LTV and with no loan to reprice, is worked in how a dividend recap affects IRR and MOIC; what is specific to property is that the refinance resets the rate on the whole balance, which is what makes a small cash-out expensive.
| Refi LTV | New loan | Cash out | Levered IRR | Multiple | Profit |
|---|---|---|---|---|---|
| No refi | 30,000,000 | 0 | 17.74% | 2.41x | 28,108,333 |
| 50% | 31,666,667 | 1,350,000 | 17.70% | 2.36x | 27,254,167 |
| 55% | 34,833,333 | 4,485,000 | 18.26% | 2.33x | 26,628,750 |
| 60% | 38,000,000 | 7,620,000 | 18.87% | 2.30x | 26,003,333 |
| 65% | 41,166,667 | 10,755,000 | 19.53% | 2.27x | 25,377,917 |
| 70% | 44,333,333 | 13,890,000 | 20.26% | 2.24x | 24,752,500 |
At 50 per cent LTV the refinance lowers the IRR: only $1,350,000 comes out, but the whole balance reprices and pays the fee, so the incremental money is too expensive. Above that, each step adds IRR and removes profit, and the higher leverage carries into the last three years, when the deal is most exposed to the exit cap rate.
A refinance moves IRR and multiple in opposite directions; the cost of the incremental debt against the deal's return decides whether it creates anything. Here it adds 113 basis points of IRR and costs $2,105,000 of profit. Private Equity Real Estate computes IRR, TVPI, DPI and RVPI from one cash-flow schedule so that what each one hides becomes visible on the same page, and the free workbooks for the book include that schedule; the leverage arithmetic behind the result is in levered vs unlevered IRR.
Because it returns equity earlier and the IRR rewards timing. The trade only works if the extra debt costs less than the return the equity is earning. In the example, the incremental borrowing, fee and repricing included, costs 9.07 per cent against a 17.74 per cent deal IRR, so returning $7,620,000 in year three lifts the IRR to 18.87 per cent.
The multiple counts dollars, not timing. The cash-out is not profit: it is borrowed money repaid from the sale, and the extra interest and fees come out of profit. In the example the refinance costs $575,000 a year more in interest plus a $380,000 fee, so total profit falls by $2,105,000 and the multiple from 2.41x to 2.30x.
Yes, when it reprices the whole loan for a small amount of cash. At a 50 per cent refinance LTV in the example, only $1,350,000 comes out while the full balance moves from 6.00 to 6.25 per cent and pays a 1 per cent fee, and the IRR slips to 17.70 per cent from 17.74. Compare the cost of the incremental money with the deal IRR before refinancing.
This article is one calculation from Private Equity Real Estate. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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