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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   March 2007

Bridging the Gap

Inform clients about how to transition between loans successfully with bridge financing

Bridge loans are a useful capitalization technique for owners of commercial real estate. They tend to be more customized than permanent loans. And lenders that offer bridge loans are often better-equipped to operate in shorter closing times.

Commercial real estate investors can use bridge loans for various short-term situations. Although the fees may be more than those in longer-term debt structures, bridge financing is still advantageous in many scenarios.

Mortgage bankers and brokers should advise their clients about the benefits of bridge financing and the reasons to employ it. In particular, they should focus on:

  • The cost of capital across the full life of asset-ownership;
  • Interest-rate risk and balloon risk; and
  • Post-bridge-period capitalization requirements.

Cost of capital

Borrowers’ goal often is to reduce their overall cost of capital during the entire asset-ownership. The most effective way to achieve that is to segment and price separately the different periods of equity risk that apply during the full course of ownership. Ultimately, investors should investigate the costs of a bridge loan and compare them to costs of a permanent loan.

For example, assume you are working with a group of investors who want to purchase a 75-percent occupied apartment building . Their business plan is to renovate the property, lease the remaining units and increase overall rents.

Completing the business plan alone can be risky. They may run into construction difficulties, or they may be unable to find enough new tenants.

If they take out a permanent loan from the onset, the pricing will carry a premium to reflect the uncertainties of completing the project. Further, if the loan issues at a fixed rate, the higher pricing will apply even after the project’s uncertainties are eliminated. Lender likely will not come back at that time and agree to reduce the rate.

If the borrowers do succeed at their goals, though, they likely will want to reduce their cost of capital. Taking on a bridge loan from the onset will give them more options for doing so. After all, once the property has been stabilized, their loan request will reflect a fully occupied building in good condition and generating market-level returns. The financing they can now obtain should be better.

When trying to decide if a bridge loan is worth it, the question you and your borrowers should ask is: Is the weighted average cost of a bridge plus a lower-cost permanent loan less than the cost of securing a permanent loan from the outset? If the answer is yes, then the borrower has a positive capital strategy.

Risk assessments

Remember that by following this strategy, borrowers could be subjecting themselves to the risks and fees associated with two loan closings instead of just one.

Nevertheless, they may still come out ahead. After all, if they make progress on their property improvements, they can save time and effort in the process of securing the second loan. And again, they could see a net price reduction.

There are interest-rate risks, however. Let’s return to our example of property renovation. Over time, interest rates on the bridge loan may rise, thus increasing balloon risk. Although it is true that interest rates can be hedged, this can prove expensive, as the interest rate will increase by approximately 1.5 to 3 basis points for each month after the rate is locked.

Some borrowers try to shorten the bridge terms in an effort to reduce the risk of increasing rates or to limit prepayment penalties. This strategy may not be wise. If property improvements end up taking longer than expected, the borrowers’ property might be only partly renovated when the loan is due.

The best approach may be to build in a margin of safety — require pro forma cash flow sufficient to service the debt on an amortizing loan at interest rates at least 200 to 300 basis points more than the prevailing rates.

Post bridge-loan conditions

The final consideration in deciding whether to seek a bridge loan applies to the capitalization requirements after the bridge period. At the end of a bridge period, another loan will be needed. So think well ahead. It may be advantageous to obtain the bridge loan from a lender that will also provide the longer-term permanent financing.

Savvy mortgage brokers and bankers will negotiate a longer-term loan, contingent on the completion of the required improvement. They may request that if the bridge rolls into permanent financing, no prepayment penalties should be applied within a reasonable period of time. If the lender approved the loan once, it is more likely to approve it again. Closing costs may well be reduced.

Finally, if the lender is also the loan-servicer, neither party will experience a disruption from an administrative standpoint.

•  •  •

Understanding these considerations can help property-owners achieve their objectives more profitably. Clients will be pleased to reduce their costs of capital over the holding time of the asset. They will benefit from minimizing the costs of the transition from bridge to permanent financing.

Further, they should be relieved to spend their time focusing on property risk, rather than on financing risk, during the bridge period. The last thing they need is to be caught up in project overruns, pending maturity dates and increasing interest rates.

Mortgage brokers and bankers who are versed in these issues will be better prepared to assist their clients.


 


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