Bridge loans are short-term loans used to meet current funding obligations. You may also hear them referred to as hard money loans. A bridge loan usually has a term between 12 and 24 months and is more expensive than traditional lender financing. Borrowers seek bridge loans when they do not qualify for bank financing. There are various reasons why a loan wouldn’t qualify for bank financing. Here are some common reasons:
- The property lacks sufficient cash flow.
- Example: the borrower is purchasing a high-vacancy property. They have a business plan to reposition and lease up the property. Once complete, they can seek permanent financing.
- The property is out of favor with lenders.
- Example: hospitality during COVID and office buildings post-COVID.
- The Guarantor is questionable.
- Example: the Guarantor has poor credit and/or a recent foreclosure/bankruptcy. Traditional lenders refuse to extend credit regardless of the quality of the deal.
- Land Acquisition and Development
- Example: traditional lenders do not like to lend on vacant/raw land. Real estate developers seek low-leverage financing to acquire and then entitle the land for development.
- Current loan matures
- Example: the borrower’s existing loan matures, and their lender does not want to extend it. Their business plan is not complete. They need additional time to finish.
There are many other reasons a borrower would seek a bridge loan, but these are the most frequent. Since most bridge lenders are private and not regulated like banks, the loan structure and deal terms can be much more creative.
Funding Sources
Bridge loans tend to be available from debt funds or private investors. A debt fund likely employs a team of loan originators (LO) who source deals directly for the company (fund). They will also utilize mortgage brokers (MB) who are retained by their clients and tasked with finding capital for their deals. Private investors tend to be high net worth (HNW) or ultra-high net worth (UHNW). They want to deploy their capital and like the risk/reward of short-term, collateralized lending. MB relationships are critical as the private investor’s team tends to be small and nimble. Bridge lending is not their sole focus but one piece of their capital allocation strategy.
Deal Participants
The following are involved in a typical bridge lending transaction:
- Borrower: LLC seeking the funding
- Lender: company or person structuring and funding the loan (i.e., debt fund or private investor)
- Loan Originator (LO): works for the Lender and sources the opportunities. They help structure the deal and get it closed. The Lender has an agreed-upon compensation structure with their LOs.
- Mortgage Broker (MB): direct relationship with the borrower. They are tasked with finding the best deal possible for their client. The Lender usually compensates them at loan closing (but ultimately, the Borrower pays for it, as I’ll explain later).
- Attorney: the Lender always has an attorney handle the loan documents and closing. The Borrower should have an attorney represent them, but that is only sometimes the case.
- Title Agent: provides title insurance to the Borrower and Lender. Also, they handle the closing and settlement statement.
Rates and Fees
Bridge lending rates are significantly higher than bank rates. They can be fixed or floating; it depends on the lender. As of Q1 2024, rates were generally in the low to mid-double digits. Floating rates may start at SOFR + 5%, which equates to ~10.50% today. Depending on the quality of the deal and Sponsor, the rate may go as low as SOFR + 3% to as high as SOFR + 9+%. Fixed rates are generally at least 10% today.
Rates are only a portion of the costs. Bridge loans have very high fees. Lenders charge an origination fee. It is quoted as a percentage of the loan amount. 2% is typical for the Lender. It is deducted from the loan proceeds at closing. If an MB is involved, they will also charge a fee. 1-2% is typical on top of the lender’s fee. As mentioned previously, the Borrower ultimately pays for it as it is deducted from their loan proceeds and remitted to the MB at closing. Lenders may also charge an exit fee which is quoted as a percentage of the loan amount. This is due at loan payoff.
LTV/LTC
Loan-to-Value or Loan-to-Cost. This is a key aspect of bridge lending. The lender wants i) a low LTV/LTC so their capital is well protected by the collateral in case of a default and ii) the borrower has significant “skin in the game.” Let’s think about this logically. You purchase a property for $1,000,000. We give you a loan for $950,000 (95% LTC), so you invested $50,000. The project starts to go sideways for one reason or another. How hard are you going to fight for it? You only have $50,000 on the line.
Instead, let’s say we only give you $600,000 (60% LTC), so you must invest $400,000 of your hard-earned cash. We are willing to bet you are going to fight much harder now. As the lender, we want to be confident in assessing the value and know our borrower has a lot at stake personally.
Interest Reserve
Lenders will often structure bridge loans with an interest reserve which can be sinking or non-sinking. An interest reserve is the interest due on the loan over a certain period, which is held back from the loan proceeds by the lender. For example, a 12-month interest reserve on a $5,000,000 loan at 12% interest will be $600,000*. At closing, the lender would advance $4,400,000 (before other fees are deducted). Under a sinking interest reserve, the lender takes the interest due each month from the interest reserve as payment. Over time the interest reserve is depleted. Under a non-sinking interest reserve, the borrower makes their monthly interest payment out of pocket. If the borrower fails to pay, the interest reserve is tapped (the lender would consider this a default).
The purpose of the interest reserve is to provide the lender with additional protection against nonpayment.
*Technically, the interest reserve would be $608,333.33 on a 365/360 interest calculation.
Lender Leverage
Lenders may or may not leverage their positions. If debt funds utilize leverage, it will be in their prospectus. If private investors are using leverage, then they likely have a decent size lending business that justifies the time and cost of establishing a warehouse facility. A bank typically provides a warehouse facility or a line of credit (LOC). The bank will fund a portion of the loan made by the lender. In return, the lender pays interest to the bank. The key is that the interest on the loan the lender originated is higher than the interest they are paying on the bank’s loan. This helps amplify the returns. As I will always note, leverage adds risk. If your borrower defaults, you must still service the bank’s loan. If you don’t, you are in default, and they have the right to foreclosure (the bank gets a collateral assignment at closing).
Returns
The interest rate environment will dictate your pricing and, therefore, your returns. The origination and brokerage fees stay consistent regardless of the environment. Somewhere between 1% and 3% should be expected. The interest rate you can win deals at will fluctuate over time. In 2024, bridge lenders should be charging at least 10%, and even that is low. Of course, this is a generalization. The more risk you are willing to take, the higher rate you can charge.
Let’s quickly run through who makes money on a bridge lending transaction:
- The LO and MB will receive a portion of the origination fee. The payout structure will be specific to each company. If you’re an independent MB, you will keep your entire fee. However, you have to build your client base, which takes time. The LO works for the lender, so their compensation structure is negotiated before joining the firm. Your experience and book of business will dictate the commission split. For example, you may get 80% of the origination fee if you are a great producer. It can be a lucrative career if you’re good.
- Private investors are deploying their capital. They keep all the interest and the balance of the fees after paying the LO and MB.
- Fund managers have to pay their employees and investors. They are paid in two ways: 1) origination fees and 2) a promote or return incentive. The fund manager retains the origination fee balance after paying out the commission to their LOs. The fund may also service the loans and charge a fee, but it’s not typically a profit center. The real return for the fund manager is via the promote. It can be structured in various ways. I know one fund manager who offers his investors an 8% preferred return on committed capital (the fund was raised in 2019) and then earns a 30% promote thereafter. If he has a $50,000,000 fund, he has to pay his investors $4,000,000 annually, so he better have a ton of deal flow. Without deals, he can’t invest the capital and earn a return. The fund manager’s objective is to lend at a rate higher than 8% and earn a promote on the "spread".
- Example: The fund manager charges the borrowers 12%. He has to pay his investors 8%. The spread is 4%. With a fully invested $50,000,000 fund, the manager can earn a $600,000 promote [($50,000,000 x 4%) x 30%].
- It seems like a great business, but this all goes back to risk and return. He must consistently find quality deals since he is paying on committed capital. Other fund managers may only pay on invested capital (i.e., funds deployed into a deal), but their promote won’t be as lucrative.
Read more here:
