Investors and developers generally use bridge loans until they can secure long-term financing. As with any form of financing, there are advantages and disadvantages.
What’s a bridge loan?
Investopedia defines a bridge loan as a “short-term loan that is used until a person or company secures permanent financing or removes an existing obligation.” Generally, commercial bridge loans are interim financing that’s secured by commercial real estate and used to “bridge” gaps for borrowers between property transactions.
Typical bridge loans involving commercial property are for a term of six months to one year. However, for a fee, many commercial lenders will give the bridge loan borrowers the option to extend for an additional six months to one year. A bridge loan is typically paid off when the owner places permanent financing on the property.
Because of their short term nature, bridge loans usually don’t have any prepayment penalties. And they’re versatile: Bridge loans can be used to purchase or refinance many different types of projects, including apartment complexes, retail property, office buildings and hotels.
For example, suppose you plan to renovate 50% of the units in a multifamily property by installing new kitchen appliances, granite countertops and new flooring. You might apply for a bridge loan at the start of the renovation project. Once you complete the renovations, you plan to raise rental rates given the units’ new, high quality finishes. Moreover, you hope that your improvements will stabilize the property’s income stream by lowering the vacancy rate and tenant turnover.
Are there benefits?
Bridge loans are particularly attractive these days for investors in underperforming multifamily properties. Traditional lenders generally prefer more stabilized properties, making it difficult to obtain financing to increase occupancy, make improvements or retain smarter management. A bridge loan can give investors the opportunity to address the issues necessary to stabilize a property to the satisfaction of traditional lenders.
Bridge loans are also appealing because of the borrower’s ability to choose repayment options. A borrower can opt to repay the loan before or after long-term financing is found. A borrower can improve its credit rating by making the payments on time, thereby improving its odds of qualifying for long-term loans with favorable terms. If the bridge loan is to be paid off after long-term financing is secured, part of that financing can be applied to repay the loan.
Additionally, bridge loans tend to require less income documentation than conventional loans and typically close quickly. So, bridge financing allows investors to jump on market opportunities before competitors who are using traditional financing. Bridge loans also can be nonrecourse, which helps protect the borrower’s other assets.
What’s the downside?
Not surprisingly, bridge loans usually feature higher interest rates, fees and penalties, and require a large balloon payment at the end of the term. Similar to other property loans, fees for these types of loans can include:
Your closing costs will usually be high with a bridge loan; and, like other loans, you can’t recover them if you find long-term financing sooner than expected. Generally, if you choose not to pay off the bridge loan after obtaining long-term financing, you’ll incur greater interest expense, because you’ll have two loans simultaneously on the same property. If your long-term financing falls through, and you have to make the balloon payment out of your own pocket but you’re unable, the bank may ultimately decide to foreclose on the property.
Time to decide
So, is a bridge loan what you need? In the right situation, a bridge loan may be the best way to proceed. Ask your financial advisor about whether this type of financing is right for you.