When purchasing a commercial real estate asset, there are a number of options that can be used to finance the transaction. In the most traditional option, a borrower would obtain a fixed rate, commercial real estate loan with a term that matches their anticipated investment holding period and would continue to make the required payments until the property is sold. There is nothing wrong with this strategy, but it may not always be the best option. In some cases, investors may benefit from a short term loan that will allow them to purchase and stabilize a property before refinancing into a longer term, permanent loan. These short term loans are sometimes referred to as “bridge loans” and can be very effective in the right circumstances.
What is a Bridge Loan?
Simply, a bridge loan is a short term credit facility that can be used to “bridge” the gap between a purchase and a long term, permanent loan. Generally, there are two features that set bridge loans apart from their more traditional counterparts, term and cost.
As their name suggests, a bridge loan tends to have a short term that can range from weeks to a few years. These are not meant to be permanent facilities, they have a very specific purpose meant to get a borrower from one point to another, at which time the borrower may need to seek a more permanent financing option.
Because they tend to have relatively short terms and are usually used in transactions with an elevated risk profile, bridge loans are more expensive than permanent loans on two fronts, fees and rates. The origination fees are higher due to the increased risk for a lender and the interest rate is higher both because of the increased risk and the relatively short time frame in which the lender can collect interest.
Again, a bridge loan is not meant to be a permanent solution, which means that there are only a handful of situations in which they are appropriate given their higher interest rates and closing costs.
When Does a Bridge Loan Make Sense?
Bridge loans are occasionally used in a residential real estate, where homeowners can use them to bridge the gap between the sale of their current home and the purchase of or down payment on a new home. But, for the purposes of this article, they are considered in a commercial real estate context. With this use case, there are two specific situations where a bridge loan can make sense:
- Time: On occasion, there may be a gap between a required closing date for a purchase and the date in which a permanent lender is ready to close on a loan. Such situations are unusual, but when they occur, a borrower could obtain a bridge loan, which would allow them to close on the purchase and then quickly refinance into a permanent loan when the lender is ready to close.
- Renovations: The more common use case is when an investor purchases a property that may have high vacancy rates and/or is in need of significant renovations. In these cases, a permanent lender may view the property as too risky so it can make sense for the investor to obtain a bridge loan to purchase the property and fund improvements. When they are complete and the property has been leased up and stabilized, the bridge loan can be refinanced for a permanent loan.
Bridge loans may be offered by any type of lender from a traditional retail bank to non-bank lenders. Generally, they can be made in any amount with repayment terms of interest only monthly and principal due at maturity. Borrowers can expect to pay between 1% and 2% of the loan amount in origination fees and higher interest rates than a permanent loan.
Benefits of Bridge Loans
Even though they only make sense in a limited number of situations, there are a number of benefits that can be realized from using a bridge loan to finance a transaction:
- Speed: Bridge loans can be closed relatively quickly, allowing investors to move quickly to secure the best deals.
- Access: Knowing that they can access bridge financing can allow investors to pursue a wide variety of deals that they may not normally consider.
- Documentation: Because they tend to close relatively quickly, bridge loans require less approval documentation than their permanent counterparts.
- Recourse: Bridge loans tend to be non-recourse vs recourse loans, which means that they do not require the personal guarantee of the loan/transaction sponsors.
- Prepayment Penalty: By definition, bridge loans are designed to be paid off in the short term. As such, most do not have prepayment penalties.
While the benefits can be significant, bridge loans are not without risk.
Bridge Loan Risks
The entire concept of a bridge loan is predicated on the belief that the borrower will be able to obtain a new mortgage to replace the current mortgage at some point in the future. But this isn’t always the case and it is the primary risk of obtaining a bridge loan. To illustrate this point, consider the renovation example above. In it, an investor uses a bridge loan to purchase a property and fund high dollar renovations with the belief that they will attract new tenants who will sign leases with high monthly payments that produce strong cash flow for the property. The investor will leverage these strengths to obtain long term financing. But, what if they can’t? What if the investor spends a significant amount of money and the tenants do not come? What if the property’s fundamentals do not improve enough to support a new first mortgage? This is an adverse scenario in which the investor would be required to continue making the high interest rate payments on the bridge loan while searching for other short term financing options or some permanent solution. In a worst case scenario, the bridge loan lender would foreclose on the property, which could certainly result in a financial loss for the investor.
The other major bridge loan risk is that they are expensive. As mentioned above, they tend to come with high interest rates and high closing costs. This can increase the overall cost of the purchase and force the investor to generate more Net Operating Income from the property to compensate. If they are unable to do so, it can result in lower overall returns.
The bottom line is that bridge loans and their expedited funding process and relaxed underwriting criteria can be a very effective way to purchase a new property quickly and make improvements before obtaining a more traditional loan that has a lower mortgage payment. But, they are expensive and can elevate the risk profile of a transaction so they should be used sparingly and only in certain circumstances.
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