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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   May 2017

Close the Deal With a Little Help

Small-balance loans can make a big difference in bridging the financing gap

Close the Deal With a Little Help

Small-balance bridge lending in the commercial real estate market exists in a sort of parallel universe to the world of large institutional real estate finance. “Small-balance” is generally defined as a loan under $10 million — with the cutoff often going as low as $5 million or less.

Such loans are the bread and butter of many regional and local lenders, including hard money lenders. These smaller lenders may be like little fish compared to their much larger financing cousins, but they can play a pivotal role in providing a short-term financing bridge to getting the deal done.

Institutional bridge lenders — those working with loans of $10 million to $100 million — have typically operated nationally, with a focus on the largest metro areas. The landscape is changing, however. Increasingly, investors and lenders are discovering the beauty of small-balance bridge loans and the deal opportunities in midsize cities that these smaller loans open up. They particularly value the higher interest rates available to lenders making small, short-term bridge loans.

The process for underwriting small-balance bridge loans, however, differs from that used with larger loans. As a starting point, think of the company funding your loan as a manufacturer. The process for making Boeing Dreamliner commercial jets is very different from the process for making Cessna single-engine propeller planes, for example. The assembly line making the small Cessna aircraft has some things in common with Boeing’s assembly line, but many things are different, and they need to be different in order to run the smaller business profitably.

A main similarity is that both assembly lines need to produce planes that can take off, get their passengers from point A to point B, and then land safely. Keeping this analogy in mind will help commercial mortgage brokers better understand the small-balance lender’s perspective and how to work effectively with them.

Loan review

First, small-balance lenders need to right-size their process in order to make loans free from overwhelming costs to the borrower. Second, originators need to be aware that the level of professionalism in small-balance lending is different — both on the borrower and the lender’s end — than it is with larger institutional loans.

Finally, keep in mind the benefits of working with a local or regional lender whose decisionmakers can personally inspect a property and may have made many similar loans nearby. The less “plain vanilla” the loan request, the more important this becomes.

Use the right tool for the job. For obvious reasons, a $3 million loan cannot use the same amount and types of resources as a $30 million loan. Even if the origination fees on the smaller loan are worth two points while the larger loan might command only one point, the total fees on that larger loan will be many times greater than they will be for the smaller one.

How can lenders afford to do these smaller loans at all? The answer is that they must be very efficient, putting underwriting resources into only the most essential items.

The lender must know how to “triage” the loan request, only proceeding with each step after asking the most critical questions and determining that the loan is likely to work. There is real skill involved for a lender to know which questions to ask, and in which order, to make sure all parties aren’t wasting their time on a loan that won’t ultimately be approved by the lender’s credit committee.

For example, a lender should find out up front about the timeline for funding a particular loan. If the deadline is many months away, the lender may be wise to hold off on detailed underwriting because there are so many things that could change in that amount of time. Many bridge lenders prefer to focus their resources on loans that are closing within 30 days or less.

Small-balance lenders need to right-size their process in order to make loans free from overwhelming costs to the borrower. 

Furthermore, many smaller bridge lenders do not ask for deposits from borrowers. If this is the case, the lender must be careful not to sink excessive resources into loans that get approved but, ultimately, aren’t funded because the borrower decides late in the game to choose a different lender or backs out for some reason.

In short, successful small-balance bridge lenders tend to have very seasoned professionals making the ultimate lending decisions, and these professionals need to possess an instinct for proceeding with or delaying the loan-underwriting process. A lender that lacks this instinctive approach will likely fall back on extensive due-diligence processes instead. That results in a lot of pain during the loan-review process, and an 11th-hour adverse decision still remains a possibility.

Rough edges

The levels of professionalism are uneven in the world of small-balance lending. With large-balance bridge lending, most of the people involved in a transaction consciously pursued finance as a career, and many may have started with traditional financial analyst jobs. In many cases, they have received formal training at larger institutions.

In small-balance lending, many players may have become involved in real estate more organically, frequently starting at the bottom and learning the business over time. The best small-balance lenders turn this difference in professional experience into an advantage by creating a team-oriented environment where serving borrowers and mortgage brokers is paramount.

For those who have been there, think of a fast-food restaurant like In-N-Out Burger that deals in high volume but also delivers excellent, authentic customer service the vast majority of the time. In contrast, some large lenders and their teams may be highly professional, but less friendly — and more focused on their year-end bonuses.

The point is that few small-balance lenders have worked as private bankers, investment bankers or private-equity real estate professionals. A small-balance lender’s business model generally cannot support the kinds of across-the-board salaries that large-balance lenders are able to pay, nor do they have large training budgets. Only a small percentage of small-balance lenders can afford to provide the necessary training to create a high level of professionalism throughout their organizations.

Local decisions

It is true that internet-enabled business models are providing more options for brokers seeking to source small-balance bridge loans for their clients. Also, a handful of companies are trying to build national small-balance platforms to lend in almost any state.

If you can deal with a local or regional lender, however, it is far more likely that one of the lender’s key people can visit your property and meet you in person. That may be a better solution for you. By definition, properties that need a bridge loan are not plain-vanilla, fully stabilized properties.

There is a story to tell about each property — which may explain why it isn’t fully leased, what kind of work needs to be done to the property, or why the borrower is not quite bankable via a traditional lender. Regardless of the story, it is easier to provide these details in-person to someone who has the authority to green light the loan.

The big takeaway

One virtue of small-balance bridge loans is the sheer quantity of opportunities that exist in the market. Even in a large market like Los Angeles, the vast majority of properties are small. Millions of people live and work in small buildings. Only a small fraction live and work in institutional-sized buildings.

As a broker, it pays to serve this huge smaller-property market. That’s because small-balance bridge lending will continue to be an expanding financing niche for local and regional lenders as big banks remain hobbled by regulations and, frequently, a “can’t-do it” culture.

Following are some key takeaway messages for mortgage brokers who advise their clients on small-balance bridge-loan requests:

  • Pick a lender with a proven ability to get small transactions done. Ask for a record of recent, similar transactions. Contact a borrower or loan originator who recently dealt with the organization to get a reference. Don’t use only the two or three references the lender volunteers. Those are his or her closest relationships. Select a loan at random and ask to speak with the broker or borrower for that particular transaction.
  • Ask about all transaction costs, including legal fees as well as third-party reports. Don’t find out at the very end that the borrower must bear all the costs, which are far higher than anyone expected. Many of the costs, like legal fees, don’t scale down proportionately as the transaction gets smaller, so these fees must be managed vigilantly to avoid being excessive.
    Be particularly wary of scenarios in which a senior and junior lender are partnering on a particular loan. The costs to structure and negotiate such an arrangement between lenders can easily run into the tens of thousands of dollars. Ask for a cap on every category of transaction costs.
  • Get to know a variety of lenders. Different lenders have different criteria, strengths and weaknesses. A great way to meet lenders is attending events in your region related to the types of properties and loans that are in your comfort zone. Frequently, lenders will attend and speak at such events. Ask them about their strengths and weaknesses.

Each lender looks at leverage a little differently. What are their maximum allowable loan-to-value and loan-to-cost ratios? Some lenders, for example, will allow multiple draws on a particular loan as renovations are completed and paid for. Other lenders only allow a single funding per loan. This one difference can translate into a particular project requiring vastly different amounts of cash reserves for the borrower.


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