Q: Does it make sense to recapitalize a property with greater equity to get interest-only financing?

A: Recapitalizing a property by reducing debt levels and increasing equity can be an effective strategy to boost cash flow. Let's explore two financing scenarios that demonstrate how this works, focusing on amortizing vs. interest-only loans and the impact of adding more equity. The sample property has an NOI of $1 million and is valued at a 6.5 cap rate.

Scenario 1: 65% Amortizing Loan, 5.25% Rate

In the first scenario, the property has:

• Loan amount: $10,000,000 (65% of the property value)

• Equity: $5,384,615 (35% of the property value)

• Interest rate: 5.25%

• Amortization period: 25 years

The annual loan payment is $727,406, which reduces the available cash flow. After covering the debt service, the net cash flow amounts to $272,593 per year, resulting in a cash-on-cash return of 5.06%.

Scenario 2: 50% Interest-Only Loan, 5.25% Rate

In the second scenario, we reduce the loan-to-value (LTV) ratio to 50%, resulting in:

• Loan amount: $7,692,308 (50% of the property value)

• Equity: $7,692,308 (50% of the property value)

• Interest rate: 5.25%

• Interest-only payment: No principal is paid down, resulting in lower annual payments.

The annual loan payment is reduced to $403,846 because we are only paying interest. This leaves a much larger net cash flow of $596,154 per year, increasing the cash-on-cash return to 7.75%.

Key Take-aways

• Increased Cash Flow: By shifting to a lower debt level and opting for interest-only payments, the net cash flow nearly doubles—from $272,593 to $596,154.

• Higher Cash-on-Cash Return: Despite requiring more equity, the cash-on-cash return increases from 5.06% to 7.75%, meaning investors earn a higher return on their invested capital.

• Lower Debt Service: The lower loan amount and interest-only structure reduce the financial burden, leaving more cash available for distribution.

The Role of a REIT in Recapitalization

One common challenge with this strategy is the increased equity requirement. However, partnering with a Real Estate Investment Trust (REIT) offers a viable solution. A REIT can provide the necessary equity infusion, enabling recapitalization without more cash from the original property owners. This partnership can help unlock the benefits of increased cash flow and distribution while allowing the property owners to maintain an interest in the property.

REITs are often looking for stable cash-flowing assets, making them ideal partners for this type of recapitalization strategy. By sharing the equity burden with a REIT, property owners can enjoy the benefits of reduced debt service and higher cash distributions without needing to raise all the capital on their own.

It is important to also note that this reduces downside risk for all parties and also provides a path to liquidity for the original property owner. 

Most importantly, this transaction, if structured correctly, can be accomplished tax-free.

Executive Summary

Recapitalizing a property by using more equity and interest-only financing can significantly increase cash flow and investor returns. While this approach requires more equity, the benefits of higher cash-on-cash returns and greater liquidity often outweigh the costs. Partnering with a REIT is a practical solution to meet the equity needs while maintaining the property’s financial strength.

By carefully structuring financing and leveraging partnerships, real estate investors can optimize their returns while managing risk and taxes.