The total amount of debt needed for purchase is not usually covered by primary mortgages in commercial real estate. In other words, a discrepancy might arise between the money you invest in a project and the senior debt financing that is readily accessible. Thankfully, bridge loans provide an answer in these circumstances. So, in this post, we’ll talk about how to include bridging loans in the underwriting process for multifamily buying.
We’ll discuss the following subjects in further detail:
- Overview of Bridge Loans
- Example: Multifamily Acquisition Underwriting for Bridge Loans
- Final Thoughts
- Overview of Bridge Loans
Owner-contributed capital, or your own money invested in a venture, and senior debt are the two main financing options for commercial real estate deals (i.e. a permanent mortgage). When these major funding sources fall short of meeting the capital needs of a business, the capital stack model offers many other financing choices.
Bridge loans in particular provide a temporary source of funding while investors search for a long-term mortgage. Although every loan is unique, commercial real estate bridge loans usually have maturities ranging from three months to three years. Additionally, a bridge loan can typically be closed quickly, unlike more long-term financing options, which might take a while to conclude.
We’ll give a thorough illustration of how investors might take bridge loans into account when evaluating a multifamily transaction in the next section.
Example: Multifamily Acquisition Underwriting for Bridge Loans
Scenario
Consider the scenario where you wish to purchase an apartment complex, renovate the public spaces and individual flats, and then raise the property’s worth. After carefully examining the offer, you decide that you can have the house for $1.25 million plus an extra $230,000 for renovations.
You have $250,000 in the capital, so you can get a loan for the property with an interest-only acquisition rate, but you don’t have the extra $230,000 to pay for the improvements. As a result, the purchase appears as follows:
Initial Purchase Financing
| Cap Rate | 5% |
| NOI | $62,500.00 |
| Income-Derived Value | $1,250,000.00 |
| Contributed Capital* | $250,000.00 |
| Acquisition Debt (Interest Only) | $1,000,000.00 |
| Acquisition Debt Interest Rate | 4% |
| Acquisition Term | 1 |
| Total Acquisition Debt Interest | $40,000.00 |
*For simplicity’s sake this amount ignores closing costs.
Notably, the present net operating income (NOI) of $62,500 and the $40,000 per year of interest-only debt payment result in a debt-service coverage ratio (DSCR) of 1.56, which is more than enough to qualify for the purchase loan. (NOTE: A DSCR of between 1.20 and 1.25 is often required by lenders.)
You choose to take out a bridging loan to pay for the refurbishment. However, you must first do the calculations, which we’ll do in the next part.
Bridge Loans in Your Underwriting Model
An offer for a $250,000 bridge loan is made by a lender after you submit your renovation designs, construction estimates, and post-renovation pro forma. The $230,000 in remodeling expenses as well as the $20,000 interest reserve are included in this sum.
Your updated underwriting figures are as follows:
Value-Add Period Financing
| Bridge Loan (Interest Only) | $250,000.00 |
| Bridge Loan Interest Rate | 8% |
| Term | 1 |
| Total Bridge Loan Interest | $20,000.00 |
| Value-Add Increase in NOI | 25% |
| New NOI | $78,125.00 |
| New Income-Derived Value | $1,562,500.00 |
| Perm. LTV | 80% |
| Perm. Mortgage* | $1,250,000.00 |
*New loan pays off acquisition and bridge loan.
The conditions of the loan are described in the first four lines. Bridge loans are classified as unsecured debt, thus their interest rates are often higher than those of secured loans. This is why the rate is 8%. Your anticipated remodeling timetable lines up with the one-year term. Final point: By paying the loan’s interest with withdrawals from its principle, you can manage your cash flow thanks to the $20,000 interest reserve.
Then, after doing market research, you find that, after the refurbishment, you can boost the property’s NOI by 25% by combining higher rentals with lower running costs. With a market cap rate of 5%, the higher NOI results in a new, income-derived valuation of $1,562,500.
Following that, you provide these figures to a lender in a formal mortgage application. The home is eligible for a $1.25 million permanent mortgage at an 80 percent loan-to-value (LTV) ratio. Your $1 million acquisition loan and your $250,000 bridging loan will both be repaid by the permanent financing after this loan closes, which will happen after the refurbishment and subsequent lease-up.
In exchange for your $250,000 contributed money (ignoring closing fees for simplicity), you will have control over an asset with a value of $1,562,500 after the transaction is complete. Alternatively, looking at it from a different perspective, you will now have $312,500 in equity in this home ($1,562,500 worth minus the $1.25 million mortgage).
Final Thoughts
Yes, the example presented in the aforementioned article was simplified. The most crucial lesson learned, however, is how useful bridge loans may be in the underwriting process of a multifamily transaction. Even if the interest rate is greater, these loans provide quickness and flexibility that are uncommon in many traditional lending products.
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