Commercial real estate is bought and sold primarily based on a stream of income. There are plenty of subjective factors that make a good deal, but price is based on cash flow. We have seen valuations on multifamily rise dramatically in the last 2 years. Bridge lending or short-term financing with the intention to get to permanent financing is what is inflating price.
Permanent Financing
Agency debt or permanent financing is handcuffed to a 1.25 Debt Service Coverage Ratio (DSCR). This means that the Net Operating Income (NOI) must be 1.25 times the debt service or your loan payment.
A typical example would be your property generates $1,000,000 per year in income and your expenses are $500,000 per year to operate. Expenses typically include payroll, management fees, general administration, marketing, repairs and maintenance, taxes, and insurance. NOI is what is left to cover your debt service or loan payment.
Your NOI is $1,000,000 (income) minus $500,000 (expenses) which equals $500,000. To have a DSCR of 1.25 your loan amount will have to be $400,000 per year— $500,000(NOI)/$400,000(Total Debt Service) = 1.25.
It is important to note that this is on an amortizing basis over 30 years. Using amortization tables and spreadsheets you can work backwards to get a loan amount. For this example, a $7,000,000 loan at a 4% fixed interest rate gets you pretty close to $400,000 per year in debt service.
This means no matter what the price is, the agency or permanent financing is limited to loaning you $7,000,000 in max proceeds. This amount also adjusts down as interest rates rise.
A lot of deals have been sizing to 50% agency leverage meaning that this deal would likely be listed and sold around $14,000,000. The cap rate for this deal would be $500,000 (NOI)/$14,000,000(Price) = approximately 3.6%. Not uncommon for the last year.
Enter Bridge Loans
Bridge lenders lend to bridge the gap from what is to what can be. They are looking at a pro forma or what the property will look like in 2 to 3 years from now. They are good loans to use for value-add deals that do not qualify for agency or permanent financing. To get permanent financing the property needs to be stabilized which is considered 90% occupied or greater for 90 days.
Instead of using bridge loans on deals that need bridge loans, buyers have been using them on stabilized deals to pay more for a deal. The $14 million deal listed that can only get 50% agency leverage could get 80% leverage or $11,200,000 in 2021 with a bridge loan.
This offers great returns for investors and wins deals for the buyer group. The prices only keep inflating as long as high leverage, low interest debt is readily available all other things being equal.
The leverage works because when the lender looks at year 3 when the initial term is up, the NOI is such that the DSCR is 1.25 and qualifies for permanent financing. They also provide interest only payments so the borrower can meet the debt obligation.
What is happening now is lenders look at year 3 pro forma with a higher interest rate and see that current trends cannot meet the higher interest rate.
An example would be that your NOI growth is strong at 20% per year. Your $500,000 NOI is now $864,000 in year 3 when the bridge loan term is up. The agency will size up your NOI to a 1.25 DSCR and yield $691,000 per year in loan payment based on a 30-year amortization.
All things remaining equal, i.e., interest rates, you can get roughly a $12 million agency loan at 4% to replace your $11.2 million bridge loan. If you raise the interest rate 1% up to 5% then you only qualify for approximately $10.7 million loan which does not get you back to your original loan amount. You would have to sell or do a cash in refinance if you did not have any extensions. The loan proceeds get lower with every rise in interest rates.
Conclusion
Bridge lenders have inflated the multifamily market valuations. If things kept on as they were the next buyer could keep paying it forward. I like to think of agency debt or using a 1.25 DSCR as buying in place cash flows whereas bridge debt is buying pro forma cash flows when using it to buy a stabilized deal.
The bridge lenders must drop the leverage down to where a year 3 take out on agency or permanent financing makes sense otherwise, they could be left holding the bag. I believe this is the primary reason there is a lot of turmoil in the multifamily debt market right now.
