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With the Covid-19 pandemic still in view, many investors may harbor concerns or confusion regarding the commercial real estate market. Some sectors – office, hospitality, and retail – will face challenges for some time. Bridge loans are one area where investors are likely to find consistent low-risk and high rewards compared to similar investments offering a fixed income.
Simply put, bridge loans are used for commercial real estate when more traditional institutional financing sources may not be available. Due to temporary illiquidity, many borrowers have capital needs that traditional sources often can’t meet. For example, a borrower purchases property out of bankruptcy or foreclosure and needs to close quickly or needs to take advantage of a short-term opportunity to secure long-term financing.
There is very often a value-add component to bridge lending, with repayment usually occurring when there is a specific improvement or change that allows a permanent or subsequent round of mortgage financing to occur. This value creation is often found at the development or renovation phase of an asset’s life cycle and is usually performed by seasoned bridge lenders who are better equipped than public market firms or traditional banks to pursue those opportunities. These firms benefit from local proximity to their investment properties and flexibility in investment criteria, both of which allow them to be entrepreneurial enough to invest in projects that have the potential to create value.
Historically, the bridge loan business has been dominated by family offices – particularly those that already had real estate portfolios. In recent times, however, there has been a proliferation of companies that have raised institutional capital to invest in bridge loans. Additionally, although before Covid-19 certain companies attempted to utilize crowdfunding – and some still do – the bridge lending business does not lend itself well to these types of funds. I have noticed that being local to the chosen market allows a lender to understand microeconomic trends within these markets neighborhood by neighborhood and block by block. This familiarity provides them with invaluable information that is typically unavailable to nonlocal investors regarding when and where they should invest in growing or improving neighborhoods.
Banks provide another source for bridge loans, but at times it can be difficult and time-consuming to obtain a bridge loan due to internal bureaucracy and other priorities that may take precedence for the bank – such as financial fallout from a pandemic. Typically, bridge loans are offered at a lower loan-to-value ratio but require higher rates than conventional loans backed by banks or the government. You may see terms where a bridge loan is 50% to 65% of the appraised property value, and the rate is between 8% and 12%.
Moreover, I believe that interest rates on bridge loans will continue at levels consistent with current rates as target borrowers for such loans tend to be more sensitive to timing, capital availability and structural flexibility and less sensitive to pricing when seeking such loans. In addition, the relatively short tenor of the bridge loans often mitigates the impact of their higher rates relative to those offered on loans issued by traditional mortgage lenders.
Volatility and correlation exist in every investment, but the amounts vary by investment class, type and market. Generally speaking, the private bridge lending market operates differently than public markets, providing for less correlation and volatility within the market. Portfolios containing investments with little or no correlation to the public markets have less risk of volatility and, ultimately, loss. This also allows investors the potential to earn above-market returns in a way that’s not possible in an efficient market.
I am often asked the question, “What makes bridge lending more attractive than investing in other well-established ETFs or REITs?” It’s a fair question. I have found that the traditional investment marketplace is organized to place individual investors at the end of the value chain so that they earn the lowest return at the greatest cost. Commercial bridge lending, on the other hand, is one way to reorganize the investment structure to give you direct access to better positioning in the chain, resulting in lower costs and potentially better returns.
Consequently, if you conduct due diligence to find a well-disciplined bridge lender, you can find consistent returns above 10%. Further, specific deals with leverage are capable of returns in the high teens. This can be achieved with low-leverage loans that feature less risk than providing equity – which itself often provides similar returns but at a much greater risk.
As has generally occurred in past recessions, I expect that attractive opportunistic investments will begin to present themselves, but this is likely to take time, so patience will be key.