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Can I Refinance My 1031 Property?

It may be possible to refinance a 1031 property – but there are several important
considerations and trade-offs that we will cover in this blog post.

Based on our 17+ year history at First Guardian managing many properties on behalf of many investors, we have seen that the use of debt can be both a blessing and curse. Like adding seasoning to a nice meal, the right amount can be good – and too much can not only ruin the meal – but be downright unhealthy.

The Downsides of Debt

The biggest fear in considering using any debt is that, if your property fails to produce sufficient income to cover debt service and you lack reserves to cover mortgage obligations, the lender can take your property from you leaving you with not only a loss of your original investment – but possibly further obligations to repay the debt. This situation can lead to a forced liquidation of your other assets or even bankruptcy to protect your remaining assets.

Debt is inherently risky because payments must be made regardless of whether your asset
continues to produce income or not. What happens if, for example, you lose a tenant and no longer have sufficient income to pay the mortgage? That does not matter to the lender. To avoid a loan default, you may need draw funds from other sources until you are able to re-tenant your property and restore your income.

If you have debt on your investment property, it is prudent to maintain a large enough cash reserve that would allow you to continue to make mortgage payments and pay expenses until you can restore adequate occupancy. Many of our clients who own single family rentals tend to set aside reserves to cover about 6 months of total principal, interest, taxes, and insurance payments sitting in cash. Larger multi-tenant properties such as apartments may be OK with fewer months of reserves if it can be assumed that the loss of some tenants may not impact the property’s overall ability to cover expenses.

Debt can also be especially risky when you have a large lump sum payment (balloon payment) due at the end of the loan term. During the 2008-2010 financial crisis we saw that some real estate investors were unable pay off their balloon debts and experienced financial hardships.

The Benefits of Debt

The prudent use of debt can provide several important potential benefits:

- Ability to purchase higher valued real estate assets which may provide greater income
and appreciation relative to assets with no debt.

- The ability to deduct depreciation and interest expenses may result in greater after-tax
income even after payment of debt service.

- Today’s historically low interest rates can increase the potential benefits of using debt.
Guidelines for Using Debt

Here are guidelines that we and many of our clients use when considering the use of debt in their real estate investments.

1. Stable predictable assets: Limit borrowing only to those assets that are likely to continue to produce sufficient income to cover debt service plus expenses.

2. Reserves: Set aside sufficient reserves to cover reasonably anticipated shortfalls in
income.

3. Fixed payments: Obtain longer term loans having debt service payments that do not
fluctuate over time. Avoid Adjustable Rate Mortgages (ARM) whose payments may
increase during inflationary periods.

4. Avoid personal guarantees: If possible, seek loans that are guaranteed solely by the
property and not personally by you. This may be difficult for smaller residential
properties e.g., single family rentals – but may be an option on larger commercial and
multifamily properties.

5. Minimize debt: Going back to my analogy of thinking of debt like seasoning on a meal,
don’t overdo it. Even if lenders are willing to give you a large loan e.g., 70% to 80% of
your property value – be conservative and limit your indebtedness to be well within
your risk tolerance and your property’s ability to generate steady income to cover the
mortgage payments and other expenses.

6. Friendly lenders: Use well known lenders who have a track record of offering flexibility if
unexpected events occur. Start with lenders that you may be working with now and
consider even paying a higher rate of interest to obtain a new loan with a lender that is
more likely to work with you rather than against you. Be cautious in using private money lenders or lenders who cannot provide solid references from other clients.

It is OK if you can’t achieve 100% of these rules for each investment. But being aware of these guidelines will provide a good framework for knowing when you are compromising so you can compensate through reducing risk in other areas and still achieve an acceptable overall balance.

For more information feel free to schedule some time on my calendar to talk! 

Paul Getty

Paul Getty is a licensed real estate broker in the state of California and Texas and has been directly involved in commercial transactions totaling over $3 billion on assets throughout the United States. His experience spans all major asset classes including retail, office, multifamily, and student, and senior housing. Paul’s transaction experience includes buy and sell side representation, sourcing and structuring of debt and equity, workouts, and asset and property management. He has worked closely with nationally prominent real estate brokerage and investment organizations including Marcus Millichap, CB Richard Ellis, JP Morgan, and Morgan Stanley among others on the firm’s numerous transactions. Paul also maintains a broad network of active buyers and sellers of commercial real estate including lenders, institutions, family office managers, and high net worth individuals. Prior to founding First Guardian Group/FGG1031, Paul was a founder and CEO of Venture Navigation, a boutique investment banking firm specializing in structuring equity investments made by institutions and high net worth individuals. He possesses over 35 years of comprehensive worldwide business management experience in environments ranging from early phase start-ups to multi-billion-dollar corporations. His track record includes participation in IPOs and successful M&A activity that has resulted in investor returns of over $700M. Paul holds an MBA in Finance from the University of Michigan, graduating with honors, and a Bachelor’s Degree in Chemistry from Wayne State University. Paul Getty holds Series 22, 62, and 63 securities licenses and is a registered financial representative with LightPath Capital Inc, member FINRA /SIPC. Paul is a noted speaker, author, and actively lectures on investments, sales, and management related topics. He is author of The 12 Magic Slides, Regulation A+: How the JOBS Act Creates Opportunities for Entrepreneurs and Investors, and Tax Deferral Strategies Utilizing the Delaware Statutory Trust (DST), available on Amazon and other retail outlets.

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