Developers and investors operating in today’s commercial real estate and multifamily markets must cope with tight inventories, the risk of rising interest rates and new regulations that are constraining access to traditional bank loans. Multiple bidders chasing limited supplies create additional pressures to quickly execute on transactions.
Bridge and mezzanine loans can serve as useful tools for navigating this changing environment. Bridge loans have shorter terms, less stringent underwriting criteria and can allow for more rapid executions with lower execution risk than longer term traditional financing.
Mezzanine loans are used to fill the “financing gap” in those instances when additional funding is needed and the structure is able to support subordinate financing.
What are bridge loans?
Bridge loans are first-position liens with short terms, typically 1-2 years. Some lenders may also provide extension options that can be used to extend the total term for as long as 48 months.
Bridge loans differ from permanent loans, the latter of which offer longer terms and may include a fixed interest rate. Bridge loans usually carry variable rates that float based upon some margin above the LIBOR index.
Bridge loans may close within 30-45 days, faster than the 90-120 days that are typical of perm loans. Maximum loan-to-value ratios are often similar but are sometimes higher than what is available in the perm loan market.
What are mezzanine loans?
Whereas bridge loans are typically in first position, mezzanine debt (often abbreviated as “mezz”) is second-position gap financing that is subordinated to senior debt.
Mezzanine loans are typically used to reduce the borrower/sponsor’s equity requirements. Mezzanine loans are usually secured with equity, with mezz lenders receiving an assignment of the borrower/sponsor’s ownership interest. This structure allows the mezz lender to take control of the asset in the event of default.
With more than one lender participating in the capital stack, mezzanine loans necessarily include more strings than do their bridge loan cousins. Mezz debt is also complicated by the need to divert substantial amounts of the property’s cash flow to debt service.
Mezz loans that are secured by borrower equity utilize “intercreditor agreements” between the permanent and mezz lenders. The need for intercreditor agreements is a barrier to certain lenders: Conduit (CMBS) lenders typically avoid mezzanine loans altogether, while existing lenders will typically not modify loan agreements that are already in place in order to accommodate mezz debt. However, there are some experienced first-position lenders that will agree to mezz debt arrangements when placing new or refinancing existing debt.
Closings generally coincide with those of the underlying permanent debt, so a period of 90-120 days is often required.
Overall, bridge and mezzanine loans can be advantageous to borrowers who have less equity to deploy. Bridge loans also benefit those borrowers who have shorter timeframes and/or greater concerns about execution risk.
Permanent loans frequently include substantial prepayment penalties. In contrast, bridge and mezzanine loans typically allow prepayment prior to maturity following a short lock-out period, although this benefit may be offset by exit fees and yield maintenance requirements.
Recourse terms of such loans can vary, including non-recourse, partial recourse and full recourse debt. Non-recourse debt typically carries a higher interest rate.
Regulations from the “Great Recession” create a new market for alternative loan vehicles
As of 2017, new High Volatility Commercial Real Estate (HVCRE) regulations require financial institutions to comply with more stringent capital requirements. These rules were instituted as a result of Basel III banking regulations that were adopted as a result of the global financial crisis, and banks have begun responding with stricter lending and higher equity requirements that have been increasing financing costs for developers.
The Dodd-Frank Act is also contributing to new market constraints by requiring commercial mortgage-backed securities (CMBS) issuers to hold a percentage of their own securities. Those rules have contributed to a reduction in CMBS loan originations, creating an impetus for developers and acquisition groups to seek new alternatives.
What are the best uses of bridge and mezzanine loans?
Bridge loans are well suited to funding new acquisitions, including rehabilitation and value-added projects. Bridge loans are also useful for refinancing existing mortgages, particularly those with approaching maturities. Mezzanine loans can play a role in refinancing loans that are maturing and funding existing development, as well as financing new acquisitions.
These are flexible products that can be used for multifamily and senior housing, student housing, office, industrial, retail and hospitality properties. The ability to quickly fund a flexible debt vehicle with modest equity requirements can open doors to new opportunities for investors and developers.
Bridge and mezzanine loans do involve certain tradeoffs. Their flexibility is usually accompanied by interest rates that are higher than what is typical of perm debt, although the cost may seem reasonable when compared to the high returns that are usually required of equity investors. The strength of the borrower/sponsor and property location also play roles in the approval process, with many lenders unwilling to commit to inexperienced borrowers and tertiary metro areas.
Navigating the alternative loan market
Bridge and mezzanine loans are usually non-bank loan products, which makes it necessary to secure the services of a broker/advisor who has relationships with private funding sources and knowledge of the capital markets.
Westmont Advisors may be able to help. Our partner Cantilever Capital enjoys relationships with a variety of bridge and mezzanine lenders that finance both multifamily and commercial properties. Please do not hesitate to contact us to discuss these.
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