In the dynamic landscape of commercial real estate (CRE), financial products evolve as the industry grapples with emerging challenges and opportunities. The mounting uncertainties of the market, combined with the accelerating need for quick and effective financial solutions, have put bridge/rescue financing under the spotlight.
What is Bridge/Rescue Financing?
Bridge financing, or interim financing, refers to a short-term loan extended by a lender to a borrower meant to “bridge” the gap in the capital stack until the borrower secures permanent financing. This interim loan often comes with a higher interest rate and is usually expected to be repaid within a year or two. Examples of these types of loans include floating-rate bridge loans, mezzanine/secondary debt, and preferred equity.
Note that we use bridge and rescue financing interchangeably. We do this because we are referring to a bridge loan that is being used in a situation where the borrower is under some stress. There are other situations where bridge loans are used in the ordinary course of business, when a borrower is not under stress (i.e. a transitional lease-up project), but this is not what we are referring to here.
The Growing Importance of Bridge/Rescue Financing
The mounting relevance of bridge/rescue financing today is a direct result of the recent significant increase in interest rates in 2022-23. Some deals that were purchased or developed in 2019 through 2021 with the expectation of low interest rates are now facing a dramatically different interest rate environment. This puts pressure on both property values and also loan sizes, which are limited by DSCR and LTV constraints.
Given its short-term nature, bridge financing offers a cushion against market volatility, providing borrowers the flexibility to secure permanent financing at a later date, once things have stabilized. This is particularly relevant for property owners and developers facing a near-term loan maturity.
Example
Let’s consider an example:
Suppose a developer broke ground on a multifamily development project in a secondary real estate market in 2021, with a total project cost of $60 million. The developer financed the project with a $43 million floating-rate construction loan (72% loan-to-cost or LTC). Two years later, in 2023, the project was leased up and had a stabilized cash flow of $3.3 million, or a 5.5% yield on cost ($3.3M cash flow / $60M project cost).
While a 5.5% yield on cost is decent in a low interest rate environment, it is too low for a higher interest rate environment in 2023. The developer now needs to pay off the construction loan which matures in 2024. Cap rates on secondary multifamily assets have moved up since the developer broke ground on the project, from about 4.5% to 5.5%. Since the yield on cost is also 5.5%, the developer is roughly breakeven on the project.
In terms of securing a new loan, lenders are now looking for 1.25x debt service coverage on a 30-year amortizing loan, which implies a loan size of about $38 million, relative to the construction loan of $43 million, resulting in a $5 million funding shortfall. The developer has two options at this point: 1) they can come up with an additional $5 million equity in order to fund the shortfall or 2) they can seek bridge financing in order to make up the difference. Bridge financing could be in the form of a subordinate loan with a low double-digit interest rate, preferred equity with a 10% interest rate plus some percentage of the future equity upside in the asset, or some variation of these. While this is not ideal, both of these options will allow the developer to avoid an equity contribution and buy themselves some time until a permanent loan can be obtained.
Other Considerations
While bridge/rescue financing offers a host of benefits, securing such financing requires careful planning and consideration. Below are some major aspects to consider:
1. Lender’s Reputation and Expertise
The lending institution’s reputation and experience in handling bridge/rescue financing should be a primary consideration. A lender with a proven track record in dealing with similar financing arrangements can provide valuable insights and support throughout the process, and provide a certainty of capital and execution.
2. Interest Rates and Fees
Given their short-term nature and the perceived risk by the lender, bridge and rescue loans often carry higher interest rates and fees. It is essential to consider the total cost of the loan, including all fees and charges.
3. Repayment Structure
Bridge/rescue loans usually have a unique repayment structure. The borrower may not make any payments for the first few months, but the loan may then require hefty payments thereafter. There also may be more unique forms of payment structures, including equity kickers granted to the lender for future profits, or a combination of both current and PIK interest.
4. Exit Strategy
Having a clear exit strategy is vital when securing bridge or rescue financing. Whether it’s refinancing the bridge loan with a long-term loan, selling the property, or another avenue, the borrower needs to be prepared for the loan’s repayment. Given the riskier nature of these financing options, lenders will look for additional security on their loan which can lead to foreclosure and the handing over of keys if a clear exit / repayment strategy is not executed.
5. Legal and Regulatory Compliance
Bridge/rescue financing involves complex legal and regulatory aspects. Ensuring the financing arrangement complies with all relevant laws and regulations is vital to avoid future issues. This can include aspects such as distribution rights, positive / negative covenants, subordination rights, prepayment fees, and reporting requirements to name a few.
Final Thoughts
Bridge and rescue financing have emerged as vital instruments in the commercial real estate toolbox, particularly in today’s challenging and rapidly evolving market conditions. By providing a financial bridge to navigate uncertain times, these financial products are highly relevant today. However, they come with their own set of challenges and considerations, making it imperative for borrowers to tread carefully and seek expert advice when securing such financing.
A question to consider: have you seen any deals recently that would be good candidates for bridge/rescue financing?
Thanks for reading!
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