In commercial real estate, financing is king. The quality of the deal doesn’t matter if you can’t finance it. Accordingly, new investors should familiarize themselves with the different options available. In particular, investors should have a solid understanding of short-term financing options, because these tools provide significant flexibility in making a deal happen prior to securing a permanent mortgage. As such, we’ll use this article to provide an overview of short-term financing in commercial real estate.
Specifically, we’ll cover the following topics:
- Why Short-Term Financing Matters in Commercial Real Estate
- Acquisition Loans
- Construction Loans
- Bridge Loans
- Final Thoughts
Why Short-Term Financing Matters in Commercial Real Estate
Permanent Financing in Commercial Real Estate
In commercial real estate, permanent financing refers to a long-term, amortizing mortgage. While residential real estate typically aligns loan terms and amortization, this isn’t necessarily the case in commercial financing. More often, permanent financing includes a shorter loan term than the amortization period. For example, a developer may secure a 10-year term, 25-year amortization mortgage, which would require a refinance or balloon payment at the end of the 10-year term.
Generally speaking, developers can only secure this sort of permanent financing once they have stabilized a property. For multifamily developers, this typically means leasing 90 to 95% of the units, depending on the particular lender. As a result, these developers face a financing challenge: how can we finance the acquisition, construction, and lease-up of a property before that property qualifies for permanent financing?
The Role of Short-term Financing
Enter short-term financing. This umbrella term refers to any form of debt financing besides permanent financing. Broadly speaking, these short-term options allow developers to finance some aspect of a development’s life-cycle prior to securing a permanent mortgage. Or, as the name suggests, they provide short-term solutions to facilitate some sort of capital investment.
Depending on a developer’s unique needs, a variety of short-term financing options can be used. But, each of these options shares some general characteristics:
- Non-amortizing: Unlike permanent mortgages, short-term financing typically is not amortizing. That is, you do not make regular payments divided between principal and interest. Rather, these loans usually have interest-only payments or accrual, with a final lump sum payoff at maturity.
- Shorter terms: As the name suggests, these financing options have far shorter terms than permanent loans. Most short-term solutions have terms ranging from three months to three years, with 12 to 24 months the most common.
- Higher interest rates: Due to the shorter terms, these loans also typically have higher interest rates than permanent mortgages. However, the actual rates will depend on market conditions, the borrower’s profile, and the specific loan type and purpose.
In the remainder of the article, we’ll provide brief overviews of several common short-term financing options. This article will not make you an expert. Rather, our goal is to expose you to potential options you may use in a future deal.
Real estate developers use short-term acquisition loans to purchase a property. As a result, lenders typically provide a lump sum payment that a developer will eventually pay off during the refinance into permanent financing. Normally, these loans are used in place of a permanent mortgage for two reasons.
First, many commercial properties require some level of repair or construction before stabilization. Accordingly, lenders will not approve long-term mortgages until that work has been completed. With an acquisition loan, developers can purchase a property, complete the necessary work, then refinance that short-term loan into a permanent mortgage. And, depending on the specific deal, developers may finance those repairs with cash investments or by pairing the acquisition loan with a construction loan (discussed in the next section).
Second, acquisition loans allow investors to quickly seize opportunities. In the commercial real estate world, tremendous competition can exist for certain properties. Normally, developers can close on a short-term acquisition loan far more quickly than they could a permanent mortgage. This quick turnaround facilitates far faster deal closings in competitive markets.
Next, developers use these loans to finance construction projects. For this reason, lenders generally issue construction loans on a loan-to-cost (LTC) basis. For example, say a developer has firm bids for a $2,000,000 project. At 80% LTC, the lender would issue a $1,600,000 construction loan ($2,000,000 total cost x 80% LTC), with the developer needing to contribute the other $400,000.
But, properties in need of construction come with inherent collateral risk to lenders. That is, lenders base these loans on total costs. If a developer received a lump sum payment and then defaulted before doing any work, the underlying collateral (i.e. the property), would not cover the outstanding loan balance.
Due to this nature, lenders issue construction loans in draws. Rather than provide a single payment, developers complete a certain percentage of work, submit a draw request to the lender, and then receive the funds from that draw request. Continuing the above example, say the developer completes $200,000 of work. At that point in time, they will submit a draw request for that $200,000 – along with the associated verification of work completed – and then receive those funds. At that point, they would have drawn $200,000 on a $1,600,000 construction loan, with $1,400,000 in loan draws remaining. Of note, borrowers only pay interest on the funds drawn to date – not the total loan amount.
In this fashion, construction lenders protect themselves from default. They never lend more than the costs already put into a project.
Bridge loans represent more of an umbrella term than a specific financing product. In particular, these loans exist to “bridge” the gap between a current financing need and a longer-term financing solution. For example, a historic tax credit developer won’t actually receive the tax credit investor funds until the property has been stabilized and a cost audit completed. To access this cash earlier, many tax credit developers secure bridge loans in anticipation of the future cash investment. Then, upon receiving that investment, developers use it to pay off the outstanding bridge loan balance.
Like hard money loans in residential real estate investing, bridge loans have trade offs. On a positive note, they can close extremely quickly, allowing investors to take advantage of deals. Rather than conduct an in-depth underwriting process, bridge loans are typically approved based solely on the asset itself – not the income it generates.
But, this speed comes with higher interest rates. To offset the increased lending risk, bridge lenders charge higher rates than commercial loans with comparable terms (e.g. a fully underwritten acquisition loan). As a result, investors need to factor these higher rates into their own deal underwriting.
As stated, our goal with this article was not to make you an expert in these financing options. Rather, we hope to expose investors and developers to a variety of tools to meet their short-term financing needs.
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 real estate investment opportunities