When shopping for commercial mortgages, borrowers tend to gravitate to long-term financing that offers the lowest interest rates. But for many, a long-term loan (aka permanent financing) may not be the best option.
Recent federal funds rate hikes have had a greater and more immediate impact on long-term financing rates. The rate gap between bridge loans and permanent (perm) loans has narrowed. For example, a $1 million loan priced at 7% and amortized over 25 years would have a monthly principal and interest payment of about $7,068. The same loan amount with interest-only payments priced at 8.5% – 1.5% higher — generates a monthly payment of $7,083, only $15 higher.
With the costs of permanent loans and bridge loans being so similar, this affords commercial mortgage brokers a new perspective when comparing products and allows for an evaluation of both options on a more even playing field. Current rate levels allow borrowers and originators to focus on priorities other than interest rates alone.
Today, a bridge loan can offer a borrower some breathing room to grow their commercial real estate investments in the short term while they wait for rates to fall before they lock in a long-term loan. Given the current climate, it is worthwhile for brokers to revisit the unique advantages of both long-term and bridge financing, and to help borrowers navigate these distinctions to find the loans that best suit their needs.
Defining terms
A brief side-by-side comparison can highlight the major differences between bridge and permanent financing. A bridge loan is temporary financing that is most often used until an individual or a company can secure permanent financing or sell the property.
These loans usually mature after one to two years, but they can last up to three years with an extension. Monthly payments are typically interest-only and may be lower than that of a long-term loan. The income and debt-service requirements for these loans are lighter and less document-intensive.
Therefore, a bridge loan can close more quickly than a perm loan. In many cases, a bridge loan can take as little as three weeks while a perm loan can take six to eight weeks. Maybe the greatest distinction of a bridge loan is the ability to fund an underperforming property. This is often a disqualifying factor for a long-term loan.
Although it is possible to switch gears and convert a long-term loan application into a bridge loan request, this can drive up the costs or, in the worst case possible, kill the deal.
Permanent financing includes loans that mature somewhere between five to 30 years. Monthly payments include principal, interest, taxes and insurance amortized over a long term. The interest rates available for permanent loans trend lower than that of bridge financing.
Both types of loans may carry prepayment penalties. The bridge loan, having a shorter term, tends to carry a shorter prepayment penalty (often six months to a year). Conversely, long-term loans may include penalty periods of up to five years.
Bridge loans can be migrated into longer-term loans at maturity or earlier, depending on the prepayment penalty. This allows a borrower to stabilize a property or cure defects that may have initially prevented them from qualifying for the preferred long-term interest rate.
Logistical challenges
Before delving into more specifics, it is important to consider the logistical challenges that can arise from choosing the wrong path. Although it is possible to switch gears and convert a long-term loan application into a bridge loan request, this can drive up the costs or, in the worst case possible, kill the deal.
Consider, for example, a borrower who is under deadline to fund a purchase contract or a maturity default. The borrower assumes the best path is a lower-interest perm loan, so they apply for one. But more rigid underwriting, which undoubtedly will include an appraisal, takes time.
Assuming the borrower has enough lead time and can qualify, a permanent loan is likely the correct path. But if the borrower runs into hurdles in underwriting — e.g., the property is not fully stabilized or has a tax lien; the borrower ran up credit card debt and their scores fall below the lender’s threshold; or they have a spotty mortgage payment history — the long-term loan request may be declined part way through the underwriting process.
With the costs of permanent loans and bridge loans being so similar, this affords commercial mortgage brokers a new perspective when comparing products.
A borrower who was six weeks away from closing the purchase contract is now three weeks away from losing the deal. Switching to a bridge loan at this juncture requires a reboot at a time when the borrower just spent their cash on underwriting an unsuccessful loan. In many cases, the borrower might have to find a new lender if their primary lender does not offer bridge financing.
If a bridge loan was the better option all along, this stress was for nothing. Borrowers will sometimes apply for permanent financing even though it’s unlikely they will qualify. When the request is declined and the deal is in danger, they opt for a bridge loan as a Hail Mary.
This strategy is ill-advised — but not only because of the high risk of failure. There’s also a risk that the borrower will succeed. A good example is a borrower who pushes for a perm loan and later is caught off guard by a multiyear prepayment penalty. Bridge and perm financing are two divergent paths. One is going to make more sense than the other when you start to plug in all of the borrower’s priorities.
Bridging the gap
Generally, permanent loans are best for clients with good credit who are purchasing or refinancing high-occupancy and income-producing properties that they intend to keep.
Borrowers who are planning to stabilize a property so they can sell or refinance it in less than three years may do better to avoid the more stringent underwriting requirements and longer prepayment penalty of a perm loan. Once the property is stabilized with steady income, the borrower can look at taking out the bridge financing with a perm loan if they choose to hold the property.
In a typical scenario, a borrower will purchase an underperforming property at an appealing price with the intention of rehabbing and re-leasing it. The borrower may have sufficient credit to qualify for a long-term loan. But the property in question does not qualify for perm financing — not yet.
The profit potential of a deal like this is high. A return-on-investment analysis likely will prove that the costs of bridge financing are easily absorbed. And there are other advantages to a bridge loan in this example.
A bridge lender may be able to offer enough funds to cover some or all of the construction costs. Once the property is stabilized, the borrower can look for a perm loan based on the post-renovation value of the property, allowing them to recoup expenses.
Debt-service factors
The debt-service-coverage ratio (DSCR) is likely the single most important factor for a lender when evaluating a commercial mortgage request. To qualify for a perm loan, this calculation needs to yield a sufficient margin between the debt service and the net income.
Property stabilization issues are likely to disqualify a borrower from a long-term loan due to the impact on net income and the resulting DSCR. Properties that are not fully occupied or are brimming with long-term tenants at below-market rents typically do not generate sufficient projected income to qualify for a perm loan.
In contrast, a bridge lender is willing to consider a low DSCR. To hedge such a bet, the lender can require an interest reserve, typically equal to a year of payments, to shield the borrower from potential default.
The bridge lender can do this because they understand that while today’s income may be insufficient to service the debt, the DSCR will be solid once the rehab is complete and the property is stabilized. An interest reserve can fill this gap. In comparison, a permanent loan is constrained by current income.
Right questions
Because of the importance of the DSCR calculation, if the borrower is contemplating a perm loan, the originator needs to be sure there is evidence of continuing net income. For example, in addition to the current occupancy rate and rents, the term of each tenant’s lease comes into play. Expiring or month-to-month leases can kill the deal because the future income is in jeopardy.
It also is important for originators to pin down where the borrower wants to end up with the project, both long term and short term. What is the client’s ultimate game plan? How long do they intend to hold the property?
Take, for example, a borrower who has a purchase contract deadline on a property that is not fully occupied. His plan is to rehab and sell the property in one to two years. In this case, the interest rate comparison between bridge and permanent financing is largely irrelevant. A bridge loan provides easier qualification, faster underwriting and funding, and a shorter prepayment penalty.
A long-term loan, even if fundable, would not be at a preferred interest rate because the property is not fully stabilized. This loan request requires more documentation and carries a higher risk of default once the lender delves into the details. The borrower and broker will need to weigh the benefits of a perm loan against any risks. Pivoting to a bridge loan at the last minute could blow up the purchase contract.
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Bridge loans and permanent loans have their own advantages. Perm loans can save money over time and offer stability for financial planning. Bridge loans can fund the purchase and rehab of a property that generates future income.
Helping a client choose between these options is a little like buying a new car. If you’re planning to log a lot of miles over the years, you’ll want the reliability of an SUV. But if speed and maneuverability are paramount, you might opt for the sleeker sports car. It can get you where you need to go in a hurry and navigate tight spaces. And just like these loans, when you’re ready to slow down, you can trade it in for something more practical. ●
