In commercial real estate, primary mortgages don’t always cover all of a deal’s debt requirements. That is, a gap may exist between the cash you put into a deal and the senior debt financing available. Fortunately, bridge loans offer a solution in these situations. As such, we’ll use this article to discuss including bridge loans in multifamily acquisition underwriting.
Specifically, we’ll cover the following topics:
- Bridge Loan Overview
- Example: Bridge Loans in Multifamily Acquisition Underwriting
- Final Thoughts
Bridge Loan Overview
Commercial real estate deals include two primary sources of financing: 1) owner contributed capital (i.e. the cash you put into a deal), and 2) senior debt (i.e. a permanent mortgage). However, the capital stack model includes a variety of other financing options when these primary sources do not cover a deal’s capital requirements.
In particular, bridge loans serve as a short-term financing tool until investors can secure a permanent 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 – you can normally close on a bridge loan in a relatively brief period of time.
In the next section, we’ll provide a comprehensive example of how investors can include bridge loans when underwriting a multifamily acquisition.
Example: Bridge Loans in Multifamily Acquisition Underwriting
Scenario
Assume you want to buy an apartment building, renovate the common areas and individual units, and increase the value of the property – a standard value-add model. Reviewing the deal, you determine that you can purchase the property for $1.25 million and renovate it for an additional $230,000.
With $250,000 in capital, you can qualify for an interest-only acquisition loan to purchase the property, but you don’t have the additional $230,000 cash on hand to complete the renovations. Accordingly, the purchase looks like this:
Initial Purchase Financing | |
Cap Rate | 5% |
NOI | $62,500.00 |
Income-Derived Value | $1,250,000.00 |
Contributed Capital* | $250,000.00 |
Acquisition Debt (Interest Only) | $1,000,000.00 |
Acquisition Debt Interest Rate | 4% |
Acquisition Term | 1 |
Total Acquisition Debt Interest | $40,000.00 |
*For simplicity’s sake this amount ignores closing costs. |
Of note, the current net operating income (NOI) of $62,500 and interest-only debt service of $40,000/year translates to a debt-service coverage ratio (DSCR) of 1.56 – more than sufficient to qualify for the acquisition loan. (NOTE: Most lenders require a DSCR of between 1.20 and 1.25).
To finance the renovation, you decide to use a bridge loan. But, you first need to run the numbers, which we’ll complete in the next section.
Including a Bridge Loan in Your Underwriting Model
After submitting your renovation plans, construction bids, and post-renovation pro forma, a lender offers you a $250,000 bridge loan. This amount includes the $230,000 in renovation costs plus $20,000 in interest reserve.
Your new underwriting numbers look like this:
Value-Add Period Financing | |
Bridge Loan (Interest Only) | $250,000.00 |
Bridge Loan Interest Rate | 8% |
Term | 1 |
Total Bridge Loan Interest | $20,000.00 |
Value-Add Increase in NOI | 25% |
New NOI | $78,125.00 |
New Income-Derived Value | $1,562,500.00 |
Perm. LTV | 80% |
Perm. Mortgage* | $1,250,000.00 |
*New loan pays off acquisition and bridge loan. |
The first four lines outline the terms of the loan. As unsecured debt, bridge loans generally have higher interest rates than secured loans, which explains the 8% rate. The one-year term corresponds with your projected renovation schedule. Lastly, the $20,000 in interest reserve allows you to control your cash flow by paying the interest on the loan with draws against its principal.
Next, after conducting a market analysis, you determine that, following the renovation, you can increase the property’s NOI by 25% through a combination of increased rents and decreased operating expenses. Using the market cap rate of 5%, this increased NOI translates to a new, income-derived valuation of $1,562,500.
You then submit these numbers to a lender in a permanent mortgage application. At a loan-to-value (LTV) of 80%, the property qualifies for a $1.25 million permanent mortgage. When you close on this loan following the renovation and subsequent lease-up, the permanent financing will pay off 1) your $1 million acquisition loan, and 2) the $250,000 bridge loan.
Once you close, you will control an asset valued at $1,562,500 for $250,000 in contributed capital (ignoring closing costs for simplicity’s sake). Or, viewed from a different angle, you will now have $312,500 in equity in this property ($1,562,500 value minus the $1.25 million mortgage).
Final Thoughts
Yes, we used a simplified example in the above article. But, the important takeaway is the valuable role bridge loans can play when underwriting a multifamily acquisition. While you pay a higher interest rate, these loans offer a speed and flexibility not available in many conventional loan products.
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 multifamily real estate investment opportunities.