Value-add product is becoming harder and harder for investors to find in the current market.
Our nation’s continued economic health has driven fundamentals forward, while high investment transaction volume, an influx of hungry capital and a healthy dose of foreign investment have driven up property prices in major metros throughout the United States.
While the overall result is net positive for the nation, the challenge for commercial real estate professionals is that projects are becoming increasingly difficult to pencil.
As capital markets shift and cap rates tighten, investors are seeking new ways to find value—and they may be surprised to find that the right financing strategy is likely the key.
Bridge loan is no longer a bad word
Bridge loans have historically (and often unfairly) received a bad rap. Because they are sometimes perceived as hard money loans—which they are not—many investors look at these finance vehicles as overly expensive or volatile.
Perhaps surprisingly, today’s market is actually poised for many investors to create value using bridge loan structures.
When pricing rises and cap rates compress, it becomes more difficult to achieve high leverage loans. Lenders become more conservative, and commercial property owners find themselves needing more and more equity to complete their capital stack or implement on-site improvements.
A bridge loan can be an economical solution for a borrower who typically syndicates equity or brings in an equity partner. In this case, a bridge loan serves as inexpensive equity—the borrower can finance up to 85 percent of total costs, often at a rate that is similar to or just above the cost of permanent financing.
Permanent lenders in the current market have loan programs that will go up to 75 to 80 percent of the purchase price, but it’s virtually impossible to reach those levels via a permanent lender based on current market conditions and the compression of cap rates.
While some investors are narrowly focused on rate, those who look at the big picture will see that there can be tremendous value created by locking in a slightly higher rate bridge loan product that can fund more of the acquisition and operational expenses.
For example, George Smith Partners recently arranged financing for an investor acquiring a multifamily property in Hollywood. The client bought the property at a relatively low cap rate—around 3.0 percent—and is planning to invest approximately $10,000 per unit into property upgrades to stimulate rent growth. Had we secured a permanent loan, the buyer would have received approximately 40 percent of the purchase price and would have had to pay out-of-pocket for the capital improvements.
Instead, we brought the investor a bridge loan structure, through which the borrower was able to finance 70 percent of the property’s value, providing flexibility and cash flow to implement the upgrades needed from the start.
Less in, more out
Bridge loans can be especially lucrative for commercial property investors who are able to invest minimal equity and bring a property full-cycle within the typical three-year term of these loan types.
George Smith Partners recently worked with a client who acquired a multifamily property where the majority of the rents were below market. The buyer’s total cost basis was $25 million, and they only put in about $4 million of their own equity. We were able to secure financing for 85 percent of the total cost via a bridge loan. Two years later, we helped the owner refinance the asset with another bridge loan, freeing up capital from the existing loan, which the owner then used to acquire an adjacent property with no outlay of cash.
The borrower is about to sell the two-property portfolio and make over a four multiple on their original cash investment.
What’s the catch?
This bridge loan value-add strategy only works for owners with a clear plan for how they will increase income at their property.
The loan product itself is centered on risk tolerance. Some borrowers are only comfortable with a 10-year fixed rate—they want the security of a low leverage loan. Those products are valuable in certain situations as well, and we would never recommend a bridge loan to these borrowers.
In bridge products, the lender determines the stress rate, which is anywhere from 5.5 to 6.5 percent in the current market. Most are floating-rate, thus there is an inherent risk to the borrower when they wanted to refinance or sell the property if rates were to go higher.
The key is that most borrowers don’t realize how aggressive lenders have become on this loan type. We have seen new fixed-rate bridge loan products emerge from both banks and debt funds in the past year. This speaks to the competition in the capital markets and gives borrowers an excellent position from which to negotiate.
How long will this strategy be viable?
Like every other facet of commercial real estate, the financing strategy that is most lucrative is likely to change at different points in the cycle.
While property pricing is high and Treasury rates remain around 3.0 percent, bridge loans are a viable strategy for investors seeking value-add opportunities without having to put in more of their own money. Naturally, an investor planning a long hold should seek a different strategy—likely a 10-year fixed-rate product that locks in today’s low interest rates for the long term.
That said, investors who a) find themselves frustrated by the limited availability of value-add properties in the market, and b) can clearly demonstrate a plan to increase income are very likely to benefit from a bridge loan financing strategy throughout the remainder of this cycle.