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Why Bridge Loans are Still Potentially Attractive
January 19, 2020
A common theme in the multifamily world over the last few years has been an aversion to bridge loans. As interest rates began to rise quickly in 2018, many investors ran from bridge loans and other floating rate debt instruments because they thought interest rates would continue to rise, which would lower the cash flow of investments as well as potentially cause a recession. In this reality, long-term fixed rate debt would be a strong mitigator of risk. However, in the last few months, the Fed’s interest rate guidance as well as the market’s pricing of future rate hikes has drastically changed. The Fed’s pause on hikes and even discussion of lowering rates has certainly changed the attractiveness of floating rate debt. While I still believe a recession or general slowdown is coming over the next two to three years, I don’t think bridge loans should be considered off the table by most investors.
For at least the next 12 months, the risk of interest rates rising is fairly low. However, the real risk of bridge loans (refinance risk) still remains. Even in our previous environment of rising interest rates which characterized 2018, refinance risk was still the much more important risk involved in taking on bridge debt than the fear of rising debt payments. Refinance risk is the concern that the capital markets will be dislocated when the current loan (bridge loan in this case) matures, forcing an unfavorable sale/refinance/recapitalization of the property. In my opinion, this risk is low, especially for $5MM to $20MM multifamily loans as these are the most liquid segment of the most liquid sector of the real estate debt market. Furthermore, the real estate capital markets are robust and diverse (GSEs, CMBS, debt funds, bank, life insurance), providing the most likelihood of being able to refinance your debts and avoid selling at the worst time. Nevertheless, we are still pricing deals according to the risks of our intended capital structure and demand a risk premium for deals necessitating a bridge loan. For example, if we are proposing to put permanent financing on the property from day one, then we would be okay with a net IRR of ~14%. However, if we are pursuing a deal that requires a substantial capex budget ($7k+ per door) and over 18 months of stabilization time then we would insist on the deal underwriting to a 17%+ IRR net of fees. Of course, for bridge loans we look at the tail risks and the various downside scenarios that would still allow for a cash-neutral refinance. Lastly, we don’t lose sight of unlevered returns to ensure we are buying a fundamentally sound investment, irrespective of debt structure.
Another reason why bridge loans are attractive today is their competitiveness in pricing and leverage. Since there is so much competition in the lending space, bridge lenders have gotten aggressive with their pricing and terms. We still see constraints as far as proceeds, holdbacks, and covenants, which is a good thing as this largely prevents borrowers from getting themselves into very risky situations. While we would love to do a deal using agency debt for acquisition financing, we have yet to find a deal with 90%+ occupancy that pencils for us. However, some deals are struggling with occupancy but all in all are not heavy value-add deals. These deals are perfect for some of the longer-term bridge options out there that have LIBOR+300 or less pricing and modest leverage. Another strategy is to work with the seller prior to contract or while under contract to help him or her lease up units to meet the 90% occupancy requirement. Spending $500 per new lease on marketing is well worth it and benefits the seller in the meantime.