What is a Bridge Loan?

If you’re a business owner or an individual homeowner wondering, ‘what is a bridge loan?’ you’ve come to the right place. Bridge loans are short-term loans that can help provide the financing to keep plans on track. Bridge financing is used in a variety of different industries. But, in this article, we’ll focus on real estate bridge loans.

What is a real estate bridge loan?

Real estate bridge loans are short-term loans. Their typical duration is between six months and three years. Bridge loans are typically secured by the real estate asset. They allow Borrowers to fast track access to capital but at a higher interest rate.

Bridge loans are different from traditional bank loans. Traditional bank loans typically provide Borrowers with longer-term financing options  at lower interest rates. In fact, bridge loans are often refinanced with traditional bank loans once the real estate asset achieves its business objective.

Individuals and businesses can both benefit from bridge loans, though these processes differ.

Why do Borrowers choose bridge loans for real estate?

Borrowers choose real estate bridge financing for a variety of reasons including:

1. Acquisition: They might have come across an opportunity that is time-sensitive. Getting a bridge loan can allow them to act on it quickly.
2. Renovations: They may want to modernize an apartment or building’s vacant units to attract upscale tenants at higher rents.
3. Construction: They might be trying to get the capital needed to support a condominium development and begin the sale of units.
4. Unrelated Need: They might want to buy out an investing partner by leveraging the value of the real estate property.

How does a bridge loan work?

Real estate bridge loans for homeowners

Bridge loans can be useful to homeowners who have their eyes on a new piece of property. In an ideal world, the sale of their existing home and closing on the purchase of the new home would happen at the same time. But often, there is a gap between these two events. Bridge loans let homeowners access equity from their existing home before selling it to finance the purchase of a new property.

Bridge loans can provide homeowners with more time and breathing room. But, bridge loans usually have higher interest rates compared to other options such as a home equity line of credit (HELOC). Homeowners also run the risk of having to pay both their new mortgage and their bridge loan installments until their existing home sells.

Real estate bridge loans for businesses

Businesses can find themselves in need of interim financing between loans. That’s where bridge loans come in. They can bridge the gap by providing a quick source of cash flow as a company secures permanent financing or the removal of an existing obligation. If a business has to complete a deal within a certain timeframe and cannot wait for a loan from a bank, the business  could seek a bridge loan instead. Bridge loans can be a good solution for businesses because they have a shorter application and approval process.

Example of how a real estate bridge loan works:

Biscayne Bay Partners is a prominent real estate company. They own and operate commercial and residential properties in downtown Miami. A rival real estate company has erected a beautiful 50-story apartment building with a cycling studio and a juice bar on the ground floor. But, before the new building is set to open, the rival real estate company announces that they have run out of money and will have to sell the new building.

Previously appraised at over $800M, the distressed sellers put the building on the market for $500M. Biscayne Bay Partners, ready to pounce on the opportunity, can only come up with $50M of cash to buy the asset. They know that once they own the property they can refinance their existing loan, but in the meantime, they need to come up with the $450M difference.

Rather than miss out on the opportunity, they seek a bridge loan from an originator, Hurricane Capital. Hurricane Capital can provide the $450M loan in time to close the acquisition of the property.

Hurricane Capital offers to loan Biscayne Bay Partners the $450M at a 10% interest rate, to be repaid within 10 months.

Biscayne Bay Partners accepts the terms of the loan and uses the funds to complete the acquisition of the apartment building and makes monthly interest payments to Hurricane Capital over the duration of the loan. At the end of the loan, they repay the principal. Biscayne Bay Partners then refinances the property with a bank at a lower interest rate than the original bridge loan.

Construction bridge loans

Bridge loans related to construction are structured differently than other types of bridge loans. This is due to how the underlying project or property is valued. Construction bridge loans are often structured with delayed draws. This means that the Borrower can only draw on its loan after certain criteria or milestones for construction have been met. This can be done in two ways:

1. Expense reimbursement: This is when the Borrower provides receipts and invoices to the Lender as proof that the work is complete. The Lender then provides loan funds to the Borrower on a periodic basis after verifying the receipts and invoices that have been submitted. 
2. Drawdown schedule:  The Lender provides loan funds based on milestones in the construction process. A third-party oversees the construction process to help ensure the milestones are reached before the funds are provided.

A construction bridge loan’s draw method varies based on the project. The reason for employing this structure is risk mitigation. The Lender wants to ensure that the value created during the construction process matches the loan outstanding. It is important that collateral coverage remains in place at all times during the loan’s term. The delayed draw structure helps achieve that.

Value add lending

‘Value add’ is a subset of bridge lending. It also often employs the delayed draw concept and works as follows:

1. A real estate property that is distressed or in need of capital improvements is purchased.
2. The property undergoes renovation and/or construction within a defined budget and timeframe.
3. The property is sold at a profit above acquisition, renovation, and financing costs.

This description of the value-add process is simplified but conveys the general goal of buying at a discount and selling at a premium. 

For example, the premium may be the result of purchasing, holding, and then selling a property without any renovation. As such, the types of strategies may vary but the goal of generating profit in a defined timeframe remains the same.

Bridge loans related to construction are also often valued differently than other types of bridge loans. This is due to the possibility that significant changes may be made to the property. The changes to the property can be summarized by three valuation phases:

1. As-is: The value of the property at the time of the appraisal, which is often before construction.
2. As-complete: The value of the property once completed according to the Borrower’s plans.
3. As-stabilized: The value of the property when completed and occupied by tenants as expected.The loan amount is often a percentage of the ‘as-complete’ or ‘as-stabilized’ value. Combining the delayed draw structure and the three valuation phases help the Lender maintain coverage during the loan’s term. 

How is real estate valued in a bridge loan?

The valuation of a real estate property requires a combination of available data sources and assumptions. There are various situational based approaches to valuing real estate, including:

Income capitalization approach

This is based on the real estate property’s net operating income (NOI) and capitalization rate. The real estate property’s value is the NOI divided by the capitalization rate.

A real estate property’s NOI can be derived using either historical or projected performance figures.

Projected performance is used when the property undergoes a change during the bridge loan’s term. This includes changes such as renovation, construction, or rent increases.

The capitalization rate is a way to compare the performance of properties similar in size and location. It also represents a property’s annualized return based on its value. Various data points are considered to determine the capitalization rate. These are factors like property location,  property type, cash flow stability, interest rate environment, and market competition.

For example, say the capitalization rate of multi-family properties in a given area is determined to be between 5.0% and 5.5% after considering relevant data points. A specific multifamily property in the same area would have to be compared to others in that same range to establish a capitalization rate. If the property was assigned a capitalization rate of 5.0% and generated $250K of NOI, then the resulting estimated value of the property would be $5.0M.

Sales Comparison Approach

This is based on the sale price of similar real estate properties in a defined set of comparable assets. The accuracy of this approach depends on how similar the properties are, how many similar properties can be used, and how recently those sales occurred.

The use of comparable sales can be a reliable valuation approach after taking into account the quality of the dataset being used. For this reason, the sales comparison approach is not reliable without a number of quality data points to reference. If this information is available, the sales comparison approach can provide an accurate valuation. It can then be validated by an actual market-based outcome.

Why are exit strategies important in bridge financing?

Bridge loans are temporary in nature and not intended as a long-term financing solution. As such, the validity of the Borrower’s exit strategy is often evaluated by the Lender. The most common exit strategies involve the sale or refinancing of the underlying property:

1. Sale: The analysis is focused on the property value, marketability, and time to sale.
2. Refinance: The analysis is focused on the target Lender metrics and prospective Lenders.

Target Lender metrics are the criteria by which prospective Lenders will assess the attractiveness of a given loan. The target Lender metrics are based on the loan and property assumptions at maturity. 

Prospective Lenders have their own defined credit standards. These can be compared to the target Lender metrics to determine the prospective Lenders most likely to refinance the loan. The fewer prospective Lenders likely to refinance the loan, the less viable a refinance exit strategy is. Some of the common prospective Lender categories include:

1. National Banks
2. Regional Banks
3. Bank Agencies
4. Community Banks
5. Bridge Lenders

How does a company qualify for a bridge loan?

Three primary factors are examined by prospective Lenders to qualify for a real estate bridge loan:

1. Debt-to-Income (DTI) Ratio: This requirement is generally the same as that for a mortgage. When calculating the debt-to-income ratio, you take the total amount of monthly debt payments and divide it by gross monthly income.
2. Loan-to-Value (LTV) Ratio: LTV represents the value of a loan relative to the value of the property. The lower the LTV, the less risky a loan is. In the example above, Biscayne is seeking a $450M loan over the $500M property value, which has 90% LTV.
3. Current Equity: Most Lenders offer a maximum bridge loan of an 80% LTV. Thus, Borrowers generally need at least 20% equity in their current home or business to qualify for a bridge loan.

How are bridge loans repaid?

A bridge loan is typically repaid after the sale of the asset or a refinancing of the loan once the business objective has been successfully completed.  Most bridge loans also are interest-only. This provides the Borrower with more flexibility to complete its business plan and cut down on out-of-pocket equity contributions.

Bridge loans vs. traditional loans

Real estate bridge loans are different from traditional bank loans. Typically, they have faster application, approval, and funding processes. Bridge loans are also different than traditional bank loans because bridge loans are not meant to be a long-term financing option. Rather, bridge loans are a short-term solution for a short-term need. For this reason, once the timely need or obligation is fulfilled, bridge loans are often refinanced. Alternative Lenders that provide bridge loans look for a low LTV ratio for the requested loan. They also look for other credit or collateral support like an interest reserve, a first lien on the property, or a personal guarantee.

Pros and cons of a real estate bridge loan

As mentioned, real estate bridge loans can be beneficial, but they aren’t for everyone. The process will also be different whether you are an individual or a company looking for a bridge loan. It is important to note the following attributes and terms when assessing the pros and cons of a real estate bridge loan:

Benefits of a real estate bridge loan

1. Short-term financial flexibility: Borrowers are able to proceed with their plan, whether it be purchasing a new home or real estate investment, before the sale of an existing property.
2. Quick access to funds: The application and funding process is usually faster with a bridge loan.
3. Purchase without contingencies: Homeowners looking to buy a new home may increase their odds of having their offer accepted by removing the contingencies of sale.

Drawbacks of a real estate bridge loan

1. Higher interest rate: Bridge loans typically feature a higher interest rate than a normal bank loan. This compensates the Lender for the flexibility they provide.
2. Restrictions: Lenders typically only offer a maximum loan of 80% of the combined value of the existing property and the purchased property. Both individuals and real estate investors should have ample savings and/or equity in their existing property.
3. Backed by collateral: The primary source of security for a bridge loan is the property involved in the transaction. A Borrower can also be required to provide a personal guarantee based on their net worth or existing assets.

Bridge finance can be a viable option for Borrowers that need quick access to capital or are not eligible for traditional bank loans. However, they must have the right collateral and be able to qualify based on the Lender’s criteria.

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