Before diving into the details, we generally analyze four key deal points to determine i) if we are interested in the opportunity and ii) how to structure the loan.   

The existing 90,000 SF of retail was built in the 1960s. The property was run down and only ~35% occupied. When the property was built, this area of the City was bustling with economic activity. Unfortunately, many key employers relocated their operations to other parts of the country or world. When the jobs left, so did the people and their spending power. It hurt the neighborhood and impacted the value of the real estate.

After nearly three decades of decline, a new City government decided it was time to incentivize redevelopment. They unanimously passed a Development-Redevelopment Agreement (DRA), which rezoned the neighborhood. For those lucky enough to own property or land in the neighborhood, the value of their assets increased overnight. Our borrower found a willing seller and moved quickly to put the subject property under contract.

The DRA allowed multifamily development and increased the density to 30 units per acre. With a 6-acre site, 180 multifamily units were now possible to build. The benefit of a covered land play is that the property owner can collect rent from the existing real estate while they work through the site plan and permitting process. This process can take months to years, depending on the municipality and the project's complexity.

From a lender’s standpoint, we also like covered land plays. Like the property owner, it gives us optionality. Our loan documents will forbid the borrower from demolishing the existing building. If the loan stops performing and we must take the property back via foreclosure, we want the ability to collect rent. Remember, after the foreclosure (assuming no one bids over our final judgment amount), we take title to the property and become the owner. Property taxes, insurance, and operating expenses are our responsibility. Rental income will help offset those expenses.

Another benefit to the lender is the potential value your borrower is creating. Developing real estate is expensive. You incur substantial costs before construction even begins. You must hire attorneys, architects, engineers, consultants, etc. The costs add up quickly. We always require the borrower to provide us with their development files. It goes back to the worst-case scenario of having to foreclose and take the property back. Having all the development information allows us to step into their shoes or provide a potential buyer with a detailed analysis of where things stand. Please note that this is not the outcome any lender wants, including us. Jumping into a development project is difficult, costly, and time-consuming.

Our borrower went under contract at a purchase price of $5,400,000 or $30,000 per buildable unit. After studying the market, we thought this was an attractive price point. However, our borrower would be the first mover in this neighborhood. There were not any direct comps. Luckily, we knew a great appraiser in the City. Although this was not her area of expertise, she could refer us to another appraiser specializing in land and development. This appraiser determined the as-is value to be $33,000 per buildable unit or $5,940,000. After analyzing the report, we were comfortable with the valuation.   

As a bridge lender, one of our key criteria is “skin in the game,” or how much cash the borrower has invested in the deal. The more cash a borrower has in the deal, the more likely they are to perform. Think about it: if you buy a property for $1,000,000 and a lender gives you a loan for $950,000, then you are only required to invest $50,000. If the deal starts to go sideways, it may be in your best economic interest to return the keys to the lender (especially if the deal is bleeding cash and there is no personal guaranty). If the lender only gives you a $500,000 loan, you must invest $500,000. It is going to be a much tougher decision to walk away. You are much more likely to stay in the fight and find a way to get the project back on track.

We offered to lend the lesser of 50% of the purchase price or appraised value. In this case, the purchase price was $5,400,000, and the appraised value was $5,940,000. Therefore, our loan amount would be $2,700,000 or 50% loan-to-cost (LTC). This would make our cost basis $15,000 per buildable unit or $30/SF on the existing retail building. At this basis, the risk of capital loss was low.

As previously mentioned, the existing retail property was only ~35% occupied. The 2021 NOI was $81,000, and 2022 was trending in the same direction. We were surprised the NOI was even positive. The seller benefited from low operating expenses, however. First, the seller had owned the property for decades, so the property taxes were very low. Second, the seller didn’t take care of the property. This is part of the reason why it was 35% occupied. The seller was lucky the area was rezoned, or it would have been worth a fraction of what our borrower paid.

Why do we even care if the site is going to be redeveloped? Well, we need to understand how the borrower will pay the interest. Let’s do some quick math. If the in-place NOI is $81,000 and our loan amount is $2,700,000, the property can service a ~3% interest rate ($81,000 divided by $2,700,000). We aren’t lending at 3%. Our interest rate will be at least 10%, so there is a significant shortfall between the in-place NOI and the total debt service. This is common in bridge lending. If there were sufficient cash flow to service the debt, the borrower would go to a bank and pay a much lower interest rate.

We have two options at this point. Option 1, the borrower pays the shortfall out of pocket. Option 2, we hold back an interest reserve at closing. There is no hard and fast rule regarding when to require an interest reserve. You must look at the entire deal, including the property’s financial performance, business plan, and the borrower’s liquidity situation. In this case, we decided to utilize an interest reserve. While this would result in the borrower bringing more funds to the closing table, it would allow them to concentrate on the redevelopment process post-closing.

This brings us to their business plan, which was straightforward. The borrowers would build a 180-unit mid-rise multifamily property on the site. They had already assembled the development team, and the initial site plan was underway. They planned to repay our loan with a construction loan. This is typical in bridge lending. Construction lenders want to finance construction, not land acquisition and soft costs. While the borrowers pursued site plan approval and building permits, they would manage and collect rent from the existing property.

This sounds like a great plan, but lenders don’t just hand out large construction loans. Like us, they want to know the borrower’s background and track record.    

The operator may also be called the sponsor. This person (or persons) is responsible for executing the business plan. They likely found the opportunity, negotiated the purchase contract, created a business plan, and raised the capital to close the transaction. As a lender, we want an operator with experience and a successful track record. The operator is arguably as important as the property. A bad operator can destroy a great property.

In this case, we had an experienced operator with a history of successful projects. He had previously developed numerous multifamily projects. Even better, he had experience developing in this City. So far, so good.

The next step was a review of his finances. We always request a Personal Financial Statement (PFS) and liquidity verification. A PFS is your personal balance sheet. It shows your assets and liabilities. The difference is your net worth (assuming assets > liabilities). The liquidity verification shows how much cash and cash equivalents the borrower has access to. The higher the net worth and the more liquidity, the better.

In this case, our borrower had a high net worth but minimal liquidity. This tends to be common for real estate investors, especially developers. We were unconcerned with his liquidity position as his investors would contribute most of the equity (cash) to the deal. However, it was unlikely they would agree to guarantee the loan. This would ultimately fall on the operator. We were comfortable enough with his PFS and experience to proceed with the deal. 

Note that we always require a personal guaranty (PG) from the operator/sponsor. This can be controversial in the bridge lending community. Some borrowers (and lenders) believe paying a high-interest rate with lower leverage should be enough to make the loan. However, if you are unwilling to provide a PG, we question your confidence in the deal. This goes back to skin in the game. We want borrowers who are all in. As a lender, if we do our job and value the collateral correctly and structure the loan properly, then it should be rare that we must pursue the guarantor personally.

The timing of this origination was interesting. The Fed had just started its rate hiking cycle. The cost of debt was going to increase. No one knew how fast or how high the Fed would hike. We had to price the loan to reflect the uncertainty and be competitive enough to win the deal. After all, we aren’t the only bridge lenders in town. Our offer would have been a floating (variable) interest rate if we were. The borrower wasn’t dumb, however. They knew rates would increase and wanted to lock in a fixed rate.

We eventually offered them the following:

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