Real estate investors use two primary forms of financing: equity (i.e. contributed capital) and senior debt (i.e. a long-term permanent mortgage). However, a variety of other financing options exist. Each of these financing sources has its unique advantages and disadvantages, depending on the particular deal. We’ll use this article to provide an overview of one such additional financing option: commercial real estate bridge loans.
Specifically, we’ll cover the following topics:
- What is a Commercial Real Estate Bridge Loan?
- Common Bridge Loan Scenarios
- Final Thoughts
What is a Commercial Real Estate Bridge Loan?
Overview
Bridge loans serve as a short-term financing tool until commercial real estate investors can secure permanent financing (i.e. a long-term mortgage). While individual terms vary, bridge loans in commercial real estate typically have terms from three months up to three years. And, unlike more permanent financing sources – which can take a long time to close – investors normally can close on a bridge loan far more quickly.
Advantages
This final point covers the primary advantage to bridge loans: speed. When a real estate investor applies for a permanent mortgage on a commercial property, the closing period could last as long as 90 days (or more). On the other hand, borrowers can secure bridge loans in as short a time as two weeks. For a time-sensitive deal, this speed can prove crucial to success.
Furthermore, when reviewing permanent mortgage applications, lenders impose strict requirements on borrowers and the associated properties. For instance, before closing, most lenders will require that a property meet a certain stabilized lease-up threshold – often as high as 95% in the case of multifamily properties. With a bridge loan, you can avoid these requirements, close on a deal quickly – regardless of current occupancy – and use the funds to put the property into service.
Disadvantages
However, with speed and flexibility come some inherent drawbacks to bridge loans – namely, cost. In return for the above advantages, bridge loans charge higher interest rates than permanent mortgages. Depending on the deal and individual borrower, a bridge loan may have rates anywhere from 3% to 10% above market rates for permanent ones. Additionally, these loans often include high closing fees – another cost to consider in an underwriting model.
Commercial real estate bridge loans can be an outstanding financing tool, but real estate investors should weigh these pros and cons before applying for one.
Common Bridge Loan Scenarios in Commercial Real Estate
Commercial real estate investors can use bridge loans in a variety of situations. While not an exhaustive list, here are three of the more common bridge loan scenarios.
Scenario 1: Bridge Loans to Acquire Properties in Time-Sensitive Deals
As stated, bridge loans generally close far more quickly than permanent mortgage applications. With time-sensitive deals, this speed can be a tremendous asset.
For example, say a broker lists a $10,000,000 commercial property in a competitive market. You’re confident in your ability to raise at least 30% of that as a down-payment for a permanent mortgage, but it will take some time. You may need to sell a couple properties in your portfolio, or you may need to pitch the deal to a variety of investors. Regardless of reason, a commercial real estate bridge loan could give you the flexibility to A) quickly purchase this property, while B) raising the capital necessary to secure permanent financing.
Scenario 2: Bridge Loans for Value-Add Deals
Many investors use a value-add commercial real estate strategy. With this approach, you purchase a property, renovate/improve the units and common areas, and increase the rents. Due to the income-based valuation approach in commercial real estate, these increased rents and net operating income lead to increased property values.
Unfortunately, some lenders will approve a mortgage to acquire a stabilized multifamily property but not renovate it. For instance, say you secure permanent financing to purchase a fully leased apartment building. Analyzing the rent roll, you determine that, with an additional $500,000 you can renovate each unit over a two-year period, which will lead to a 20% increase in rents.
Rather than pay that $500,000 in cash, you can secure a two-year bridge loan to finance the value-add improvements. Then, once complete, you can have the property appraised and refinance your permanent mortgage based on the increased value, paying off your bridge loan in the process.
Scenario 3: Bridge Loan to Cover Delayed Capital Contributions
Many commercial real estate deals include some sort of delayed capital contribution. For instance, an investor may agree to contribute money – but only after the property has completed a cost audit and associated certification. This is a common situation in historic tax credit (HTC) deals.
With federal HTC deals, developers can secure federal tax credits up to 20% of a project’s qualified rehabilitation expenses, or QREs. So, a $5,000,000 renovation could potentially lead to $1,000,000 in credits, which an investor may acquire for 80 cents on the dollar – $800,000 (NOTE: HTC investors cannot technically “buy” these credits, and the transfer rate fluctuates with the market).
But, prior to making the full capital contribution, this same investor will want to confirm that the developer can, in fact, complete the renovation process and have it approved by the National Park Service, which administers the federal HTC program. This approval includes a QRE cost audit by a CPA firm. Accordingly, a developer may not see this $800,000 for over a year (or more), that is, through the development, construction, and cost audit periods.
As a result, many HTC developers turn to bridge loans. In this example, a bridge loan could cover all or a portion of the $800,000 federal HTC investor’s contribution until actually made. The developer then uses the eventual HTC investor contribution to curtail the bridge loan.
Final Thoughts
Every commercial real estate financing source has advantages and disadvantages, to include bridge loans. For investors prioritizing speed and willing to potentially pay a premium, bridge loans can be an outstanding solution. A word of caution, though: due to the higher interest rates and shorter terms, investors using bridge loans should always have an exit plan. That is, a clear path to curtailing or refinancing that loan should exist before securing it.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities.