Why do so many real estate sponsors use bridge debt?
I don’t know exactly when the moment happened, but at some point, bridge debt became the financing vehicle of choice for many apartment syndicators. Syndicators are people or companies who get a property under contract to buy, and then raise the acquisition money from individual investors. Usually this is done on a one-off deal basis. Bridge debt traditionally is originated from a private lender that can typically provide a loan of 75% or more of the purchase price and then finance 100% of the planned capital expenditures. On an investor’s basis (purchase price + fees/costs + capital expenditures), the debt could be 80% or more of cost, all-in. This makes me nervous, but plenty of syndicators saw no problem with this much leverage.
At the peak of apartment excess in late 2021, the cost of bridge debt was less than 4%. In many respects, it wasn’t any more expensive than traditional agency (Fannie Mae or Freddie Mac) financing. The big difference was that you could get 75% of your purchase price from the bridge lender, but with Fannie or Freddie you’d be lucky to get 60%. As long as you didn’t need to refinance the bridge loan in a rising rate environment and/or you could sell the property to the next investor at a similarly low 3% cap rate, there was no issue with bridge debt—at least for those groups drawn to it. Now that we’re in a higher rate environment (new bridge debt is around 9% and agency is about 6%) and cap rates are 6% in many markets, those with bridge debt originated from 2020 to 2022 are in the most trouble.
Why are people still extolling the virtues of bridge debt today? You won’t hear it from me, but here’s their argument: 1) the Fed is going to stop raising rates and you don’t want to be locked into fixed rate debt; 2) you can buy an “in-the-money” cap to bring the interest rate down from 9% to 7% or lower; and 3) a value-add business plan is going to raise net operating income, therefore allowing an investor the option of refinancing or selling during their three-ish year business plan. Never once do I hear any of these groups discuss that they’re taking on more leverage than the property can adequately sustain today. They fall back to argument number three and say their business plan will increase net operating income such that the loan is sufficiently margined. No doubt there are some instances where this is true, but the run of the mill unit renovation and exterior paint program of the past 5 years won’t cut it. Especially not in a declining rent and NOI environment.
We have never taken on this type of debt for two main reasons. First, we believe that the property should be able to service its debt based on current cash flow. This is how banks and agency lenders evaluate loans. It is frustratingly not forward-looking, but it’s a prudent way of determining the amount of leverage. Second, debt funds (those who originate bridge loans) may not necessarily care if they foreclose on your property and keep the real estate. Unlike banks with significant regulatory oversight and generally no interest in owning distressed properties, a private investment fund could easily find a way to monetize a distressed asset. At Calvera, we have been able to generate high investment returns despite not maximizing debt available in the marketplace. To me, that speaks more to our ability to operate and truly add value than just the momentum of a lower cap rate trend.
Today, we share in the frustration of the current lending environment. With rates high, choosing a fixed rate for a long term (i.e., 10 years) doesn’t feel great, especially because the prepayment penalty will be high if you attempt to sell or refinance if or when rates fall. Banks traditionally had the best prepayment options for loans, and they’re not active right now. Floating rate agency loans were also a good option, but loan proceeds currently suffer because of the math behind how those loans are sized. That leaves fixed rate agency loans or floating rate bridge debt as the two best options today.
Bridge debt is always the siren song of more leverage. Less equity in a deal and more leverage inflates both the IRR and multiple in an investment. Putting less equity in an investment also allows one to buy a larger property, thereby increasing the potential size of incentive compensation for a sponsor. More leverage comes with a higher interest rate and more fees. Unless a property can unlock significant value quickly (i.e., within 1-2 years) it will be difficult to refinance the bridge loan. This risk of having to sell or add additional equity to an investment isn’t worth it to us on the deals we’re seeing.
With increasing cap rates and somewhat steady interest rates (at least for the past week), it is possible to generate neutral-to-positive leverage on a new acquisition using 5-year agency financing. The stability of that type of loan, lower all-in rate, interest-only options, and generally short term (5 years) is our loan of choice right now. We can always refinance around the 5-year mark or even stomach a prepayment penalty in year 4. To us, this is the more prudent way of financing an asset during the current period of uncertainty. It is always best to focus on cash flow.
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