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Price Discrepancy Between Bridge Vs Perm Debt
October 27, 2020
Since the onset of the COVID-19 pandemic, the real estate capital markets have experienced significant headwinds and changes. Focusing on multifamily finance, the three main products are agency (Fannie Mae and Freddie Mac), CMBS (commercial mortgage backed securities), and bridge (shorter term, transitional financing). CMBS loans are used to finance stabilized assets, typically on a longer-term basis. Due to the securitization process and the reliance on the secondary market for bond sales, CMBS loans nearly disappeared when the economic uncertainty associated with COVID-19 hit the market. Similarly, a large portion of bridge loans are securitized in CRE CLOs (collateralized loan obligation) which also rely on bond purchasers to maintain a stable flow and low cost of capital. Even bridge lenders who utilize their own balance sheet to make loans saw the cost of their credit lines and A notes increase causing upward pressure on all-in rates for borrowers. Meanwhile, Fannie Mae and Freddie Mac, backed by the government, have been able to continue to provide much needed liquidity to the multifamily market with even cheaper pricing than pre-COVID due to index rates (US 10-year treasury yield) going substantially lower. This new reality has caused a dichotomy of pricing, leverage, and underwriting standards between agency debt and bridge financing.
In simple terms, bridge loans have gotten more expensive and permanent debt has become cheaper. This is not just true due to the difference in interest rates. Bridge lenders have also generally reduced their leverage more than the agencies, resulting in a wider gap in WACC (weighted average cost of capital). For example, pre-COVID, an 80% LTC (loan to cost) bridge loan was easy to obtain while agencies max out around 80% LTV (loan to value). On a $9,000,000 purchase with a $1,000,000 capital expenditures budget, that would equal to a $800,000 difference in leverage ($8,000,000 versus $7,200,000). This $800,000 of additional proceeds from the bridge loan would help offset the higher cost of the bridge loan, essentially making it more worth it.
However, today, bridge lenders are more likely to be at 75% LTC, which in our previous scenario is now only $300,000 more leverage than the cheaper agency option. The reason for bridge lenders pulling back their proceeds is because of the uncertainty associated with business plan execution. Borrowers of bridge debt are borrowing based on pro forma cash flows, not in-place, and therefore the lender is betting on the borrower’s ability to increase occupancy or raise rents, both of which are much more scrutinized today than pre-COVID. This makes the decision between a bridge and permanent loan easy today: only take the bridge if you have too. For those who are unfamiliar, permanent debt and agency loans are only available for properties which are stabilized (typically defined as 90% occupancy for 90 days).
Unfortunately, just because a property is un-stabilized, doesn’t mean it supports the cost and risk of a bridge loan. In spite of the potential headwinds in the market, sellers are holding firm on their prices, even for properties which have low occupancy and are in rough condition. High prices and lack of certainty makes the proposition of a more expensive, shorter term bridge loan an uncompelling proposition. It was even rare pre-COVID (2017-2019) to find a deal with enough upside to justify bridge loan risk; today it is worse. Your best bet in today’s market is to find a stabilized property which you wouldn’t mind owning for five to ten years, which produces enough cash flow to support a low-cost agency loan at 80% LTV. These types of investments carry low risk because the debt is cheap and long-term, and the business plan entails little execution risk.
One unique way to still capitalize on underperforming/un-stabilized opportunities in today’s market is to acquire such properties subject to an assumption of the property’s existing debt. While these opportunities are similarly uncommon, they do exist and can provide the best of both worlds by way of assuming cheaper, longer-term debt than bridge while still having the opportunity to approach a transitional asset with a “buy it, fix it, sell it” strategy.