In commercial real estate, there are many scenarios where conventional long-term financing is not an economically viable or advantageous option for investors. This is where bridge loans are ideal. So, what are bridge loans, how do they function, and what are their pros and cons?
Bridge loans are an interim form of financing that lenders provide to commercial real estate (CRE) investors who require short-term funding for a specific strategic purpose. Investors typically use the loans to stabilize a property, for example, by rehabilitating it or sustaining its cash flow.
Making commercially successful investments in the CRE sector involves a robust understanding of the most common and effective financing options, such as bridging loans. If you want to develop your knowledge of bridge financing, you might find the following information and insights helpful.
Bridge Loans In Commercial Real Estate: An Overview
Bridging loans are a crucial option to consider in CRE when investors need interim funding for a specific, short-term purpose while long-term (permanent) financing is secured (or if such financing is not available or strategically advantageous for the project).
The defining features of bridging loans (also called bridge, interim, gap, or swing financing) are:
- Short-term – the duration of the loan repayment is rarely more than two years
- Quick to secure – these loans get processed rapidly
- High interest – the interest rate is higher than conventional loans
- Non-recourse – the borrower provides collateral (typically property) but is not personally liable
Bridge financing is generally used to stabilize a commercial property. Borrowers use bridge loans to ensure a property has a secure income stream and favorable debt-to-equity ratio. A principal measure of stability is that properties have occupancy rates of 80% or more (usually with one-year leases).
As part of the stabilization process, investors may need to meet ongoing financial obligations while applying for a long-term loan. With a bridging loan, borrowers can sustain a positive cash flow, which enables them to pay for operating expenses and debt repayments.
Borrowers might also seek bridge financing to rehabilitate a piece of CRE. The interim loan provides the funding to pay for renovations so they can sell the property or reposition it in the market.
Another crucial reason CRE investors apply for bridge financing is to pursue time-sensitive investment opportunities like purchasing a valuable property in a high-demand market.
Bridge Loans: Application Process And Contractual Terms
Bridging loans are flexible and tailored to the borrowers’ project, so there is some variability, but the application process and contractual terms share some common elements.
The financing period is relatively short compared with permanent loans (like mortgages). On average, bridge loans have a duration of one to two years.
Obtaining interim financing is also significantly quicker than conventional real estate loans. In some instances, the application, approval, and release of funds take place in less than two weeks!
Borrowersmust offer collateral, which is generally in the form of property. The collateral is typically included in the loan agreement on a non-recourse basis, meaning borrowers do not have personal liability. In addition, borrowers need a high credit score if they hope to apply successfully for bridge loans.
Most gap financing has a relatively high degree of leverage. Providers typically provide bridge loans at loan-to-value (LTV) ratios of 65% to 80%, and loan-to-cost (LTC) ratios of up to 75% (sometimes as high as 85% to 90%). This amount of leverage involves a relatively high risk for the lenders, but can be advantageous for borrowers.
Due to the rapid access, short repayment duration, and high LTC ratio, lenders charge higher than average interest rates for bridge loans, typically anything from 4.75% to 10% (or more)!
Factors That Influence Bridging Loan Repayments And Terms
Lenders determine the loan amount based on the overall project cost (whether purchasing a new property, paying for operating costs, or funding renovation work).
The status of the property’s income-generating capacity is another critical factor affecting the terms of interim loans. Borrowers are more likely to receive bridge financing with favorable terms for projects relating to properties with established, stable net operating incomes.
The size of the loan and its degree of leverage also influence the terms of the funding arrangement (specifically, the interest rate and collateral provisions). Bridging loans up to $10 million or with high leverage ratios of more than 65% (LTC) are usually offered with full recourse.
Non-recourse loan provisions usually apply if the bridge funding is more than $10 million at low leverage ratios. Borrowers can access non-recourse bridge financing for smaller amounts or at higher leverage ratios. In these instances, lenders generally charge considerably higher than average interest rates of 10% or more.
Lenders also charge higher interest rates if the purpose of the bridging loan is to pay for outstanding debts or problematic litigation processes.
In addition, the urgency of the funding application significantly influences the terms of bridge financing. CRE investors pay higher interest rates on bridging loans when they need to access funds within a short time (7 to 14 days), compared with situations where their financial needs are less urgent.
Pros And Cons Of Bridging Loans For CRE
CRE investors to consider the specific advantages and disadvantages of bridging loans so they can evaluate whether this type of financing might advance or undermine their strategic objectives.
Pros
Here is a summary of the primary advantages of bridge loans in the CRE context:
- Speed – borrowers can access funding significantly quicker than long-term financing
- Flexibility – investors can tailor the loan to their unique requirements
- An alternative source of financing – investors can obtain funding for real estate that is not eligible for permanent funding
- Typically no prepayment penalties – borrowers can settle the loan immediately after selling the subject property (without incurring penalty fees)
Cons
It is also essential for CRE investors to consider the disadvantages of bridge loans, such as:
- Temporary – the short-term duration of the loans means they are less secure and stable than permanent financing
- High rates of interest – the strategic advantages of bridge financing come at the cost of higher than average interest rate charges
- Strong credit history – borrowers must have excellent credit histories to obtain a bridge loan
- Costly application process – lenders generally charge higher origination fees to process bridging loans than conventional forms of real estate financing
Conclusion
Bridge financing serves a vital strategic function in CRE investment, providing investors with rapid access to temporary financing when permanent funds are unavailable or pending approval.
Though interest rates for bridging loans are high, they allow CRE investors to make short-term moves that advance their long-term strategic objectives. Bridge financing allows borrowers to purchase real estate quickly, meet ongoing financial obligations, or rehabilitate a property despite lacking conventional long-term loans.