Getting ready to refinance – planning in advance

Broken down to its simplest form, refinancing is replacing existing debt with new debt.

Whilst this doesn’t sound particularly adventurous or interesting, it is a common practice for both businesses and individuals and is often a cornerstone of a considered business model.

The reasons for refinancing vary but can include that the existing debt may be coming due, a preferable interest rate is available for the borrower or strategic lending is preferable to increase available capital for a business to redeploy elsewhere. The results of refinancing therefore can be both adventurous and interesting.

Risks:

The main risk of refinancing is that you are not paying off debt, instead simply moving your liability into the future. In such circumstances refinancing can lead to a borrower taking on more debt, which naturally places more of a potential future liability on their shoulders.

Taking on further borrowing means the borrower is more reliant on the value of their asset to eventually pay the debt off. Take the example of a buy-to let investor who takes a 2-year fixed rate, 75% loan to value mortgage out over their property. This is indicative of the maximum loan to value over a residential buy-to-let property in Scotland. Say, in the intervening 2-year period there is a dip in the housing market and the property has been tenanted by a tenant who has not looked after the property. Cumulatively, this has decreased the value of the property by 10%.

At the end of the 2-year fixed period the borrower has two options – move to a variable (and likely, much higher) rate of payment or refinance the asset.

The trouble with the refinancing option is, if the property was valued at £200,000,00, and the value has now decreased 10% to £180,000.00, the borrower will have to raise another £20,000.00 in order to move on to a new, lower rate loan at the new value.

If they don’t have the money to do this, or don’t wish to tie up more money – there are 2 options:

1. Pay the variable mortgage payment which is likely to outpace the market rent (therefore making the property not profitable); or
2. Sell the property.

Neither option is a good one. Option 2 also may well not be tax efficient, or easy if there is a sitting tenant which reduces the buyer pool, and the property is not in a good condition.

The only other option is to shop around for a lender who may value the property at a higher level, however success is not guaranteed, and this may be both costly and time consuming.

Rewards:

If executed correctly refinancing can be incredibly powerful.

Take the example of the investor who buys a vacant, rundown commercial unit for a knock down price of £100,000.00. Existing business funds are used to purchase this unit, meaning there is no borrowing at the point of purchase.

A renovation is undertaken, and a lease is prepared for a commercial occupier. The cost of the works and legal costs to place the tenant is £50,000.00.

Between the valuation of the building in ‘bricks and mortar’ terms and the commercial valuation based on the lease, the property is valued at £200,000.00.

The borrower is able to get a loan to the value of 75% of the new £200,000.00 value, meaning that £150,000.00 is released to the borrower as a loan advance.

This means that the borrower’s initial investment of £100,000.00 (purchase price) and £50,000.00 (renovation and legal costs) are in effect re-released to them after the property is brought up to its potential.

Should they choose to do so, the borrower can use the released funds to continue to invest and begin to build a portfolio.

They also have the benefits of owning the property and receiving the market rent. They do of course have to cover the monthly payments of the loan they have taken out – however the rent covers the cost of the loan and allows an additional £500 per month to build up for the borrower. The loan is fixed for a period of five years, meaning that the borrower has a regular, reliable cash-flowing asset, which has fixed finance costs for an extended period meaning the cash flow is protected.

It is also worth noting the longer-term, fixed rate loan also gives the property a better chance to continue to grow in value and outpace what the existing value of the loan is by the time the fixed rate period is over. In our instance, let’s say that after the initial 5-year fixed loan period, the borrower wishes to re-mortgage the property on to a new fixed rate mortgage. The property has now been valued at £250,000.00 – as its value has grown over time.

In such circumstances, the borrower has two options:

1. Keeping the same loan to value and releasing more equity from the property. If a loan at 75% of the new value (of £250,000.00) was taken out, then the borrower could now release £187,500.00. This could pay off the initial £150,000.00 loan (assuming only interest was paid on this in the five preceding years) and pocket the borrower another £37,500.00 released to them to fund their business.
2. Keeping the same level of loan (£150,000.00 – assuming only interest had been paid in the five year’s previous) and moving on to a loan where they are borrowing less of a % value of the property (in this case around 60% of the new value £250,000.00), the borrower will become less of a risk to the lender and have room to negotiate both a more favourable rate and a longer fixed rate period. The result of this is that they can end up with both a smaller monthly payment and longer-term certainty of what that payment will be if the lender is willing to commit to a longer-term fixed rate.

Hasn’t that worked out nicely?

Process and conditions:

The power of a well-executed refinance is evident, but the I’s must be dotted and the T’s need to be crossed. That’s where the solicitors come in – we ensure the process is managed and do what we can to ensure the desired result is achieved. This process is done very much on a case-by-case, lender-by-lender basis. An indicative checklist of what is usually required is as follows:

• A good, independent mortgage broker, to get the borrower the best rate and provide all necessary company details to the lender
• The title deeds
• Legal due diligence reports to include – legal report, property enquiry certificate, charges searches etc.
• Building paperwork from the local council which would be required in relation to any alterations/change of use
• Tenancy/lease documentations
• Buildings insurance to cover the insurance reinstatement value
• Signed security documents in favour of the lender, to usually also include a personal guarantee against the director of a corporate borrower and a floating charge over the assets of a corporate entity.

Due diligence can be extensive and if all necessary information is not to hand, a refinance can quickly not become as simple as expected.

At Gilson Gray we routinely act for both sides of a refinance – the borrower and the lender – so we are aware of the requirements of each side, can pre-empt issues and ensure that refinances are carried out as efficiently as possible. We help give you the best chance of reward after your business has taken the risk.

Find out more about our Real Estate services here.

The information and opinions contained in this blog are for information only.  They are not intended to constitute advice and should not be relied upon or considered as a replacement for advice.  Before acting on any information contained in this blog, please seek solicitor’s advice from Gilson Gray.