FEATURE ARTICLE, JUNE 2007
BRIDGING THE GAP
How to save 100 basis points (1 percent) or more on your next bridge loan.
Many developers are accustomed to using floating-rate debt for their acquisition/reposition financing. These bridge debt borrowers typically have business plans ranging from 18 months to 5 years for any given asset. Traditionally, developers have elected to use floating-rate debt because of its low interest rates, open prepayment and interest-only amortization. Once their business plan was complete, the developers would refinance or sell the asset almost immediately.
Recent shifts in yields have made this floating-rate financing structure less attractive. Short-term rates are based on floating-rate indices (e.g., Libor, Prime) that are meaningfully higher than current fixed-rate indices (e.g., treasuries). Furthermore, credit spreads on fixed-rate loans are generally tighter than floating-rate spreads. The result is that fixed-rate loans have significantly lower interest rates than floating rate loans today.
Because of this dynamic, an increasing number of borrowers are choosing fixed-rate financing options for bridge debt, at rates that are very attractive on a relative basis. This is particularly true for borrowers whose business plans exceed 18 to 24 months and for properties with at least some in-place cash flow during the reposition. These borrowers often find that they can achieve similar or even greater leverage with fixed-rate financing because it yields a more favorable debt service coverage ratio on the cash flow in place.
In evaluating fixed- or floating-rate bridge options, it is worth comparing several key aspects of the financing, including amortization, prepayment, pricing and leverage.
• Amortization: Floating-rate loans are almost exclusively interest-only (I/O). Fixed-rate loans traditionally had 25- or 30-year amortization schedules. Today, however, a wide cross-section of lenders offers 3- and 5-year fixed-rate loans that are I/O for the full term. Because these fixed-rate loans do not include any principal paydown, the monthly payment is meaningfully lower than it would be with amortization.
• Pricing: For a good borrower in a moderate to strong market, non-recourse, floating-rate bridge debt prices in a range from about 1.65 to 2.35 percent over Libor. With Libor hovering around 5.30 percent, a quote at Libor + 1.75 percent translates roughly to a 7.05 percent interest rate. Note that this pricing applies generally to CDOs, credit companies or select commercial banks.
Non-recourse, fixed-rate bridge debt (e.g., CMBS) prices over a fixed-rate index, typically U.S. Treasuries. The 5-year treasury was recently 4.50 percent. At this level, the fixed-rate index is 80+ basis points inside of 30-day Libor. Fixed-rate bridge loan spreads are generally in the 1.20 to 1.60 percent range. If a 1.40 percent spread is assumed, a fixed-rate borrower starts out with an interest rate that is less than 6.00 percent.
See the following table for a brief overview of typical fixed- and floating-rate pricing:
• Pricing Variables: Pricing for fixed- and floating-rate bridge loans is often impacted by cap costs or prepayment windows. Floating-rate borrowers typically have to purchase interest rate caps for their loans. Lenders require the interest-rate caps in order to limit the potential upward movement in the index and the resulting pressure on the loan’s debt service coverage ratio. Interest rate cap requirements vary, depending on term (2-year caps are much cheaper than 3-year caps) and how far above the index the cap is set. Caps are often priced as additional spread over the primary term of the loan, and may cost 10 to 40 basis points. Fixed-rate borrowers do not have to purchase caps because those loans have no potential exposure to interest rate fluctuation.
Prepayment: Historically, the biggest drawback to fixed-rate interim debt has been inflexible prepayment. Defeasance and yield maintenance have been unacceptable trade-offs for most bridge borrowers. However, the capital markets have recently begun offering a variety of prepayment options. For instance, borrowers can purchase a longer prepayment window at the end of their loan terms. The borrower might structure the loan to allow prepayment at par in the last 6, 12 or even 18 months of the loan. The price of this flexibility is an add-on to the spread, depending on the size of the prepayment window. Another option is to structure prepayment flexibility in the form of fixed prepayment penalties in the final year(s) of the loan or through a “make-whole” calculation.
Non-recourse, fixed-rate bridge loans are generally locked to prepayment for 12 to 24 months. Lenders want to guarantee that they are getting a minimum amount of yield on their loan. Floating-rate bridge loans typically have a 12 month lock-out period, after which they are open to prepayment at par. Commercial banks commonly structure floating-rate bridge loans with no prepayment penalty at all. The bank loans often have a recourse component, however.
• Reserve Structures: The other major drawback to fixed-rate bridge debt is the treatment of reserves. Traditionally, floating-rate bridge loans are sized on a loan-to-cost basis. Lenders generally fund 75 to 90 percent of total capitalization. Total capitalization includes not only purchase price and closing costs, but also deferred maintenance, rehabilitation dollars, tenant improvements, leasing commissions, and even acquisition and disposition fees. Portfolio bridge lenders only charge interest on loan proceeds that have actually been advanced to the borrower.
Fixed-rate bridge loans vary in their treatment of reserves. Portfolio lenders will fund reserves only as needed. For securitized lenders, however, loan proceeds that are not supported by in-place cash flow at closing will typically be funded to an escrow account. These escrowed funds are released to the borrower once the incremental cash flow is realized. If the TI/LC/CapEx escrow is sizeable, though, and if the rehab project takes more than a few months, the borrower can end up paying significant negative arbitrage on this escrowed amount. The reason is that the escrowed funds accrue interest as soon as they are funded, before they are released to the borrower.
An increasing number of developers are using fixed-rate bridge debt for properties in transition. The interest rate savings realized by these developers can exceed 1 percent per year when compared to floating-rate options. Fixed-rate bridge debt is typically non-recourse, and it avoids any need for an interest rate cap. Floating-rate bridge debt remains compelling for borrowers with development timeframes less than about 18 months. Also, for projects with very significant anticipated TI/LC/CapEx expenditures, it is important to work with a portfolio lender in order to avoid negative arbitrage on reserve funds.
Larry Wilemon is a senior vice president at George Smith Partners in Los Angeles.
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