If you bought a multifamily property with a bridge loan in the last year, then you have a Debt Yield or Debt Service Coverage Ratio (DSCR) test upcoming.
This test can be considered a “Cash Management Trigger Event”. A trigger event happens when you fail to meet the lenders minimum requirements after a certain date.
Cash Management
A normal bridge loan takes about 60 days to close. During this time the borrower is required to setup a lockbox. Typically, it is a “soft” lockbox that the borrower deposits all rents. The borrower is entitled to the lockbox funds unless a cash management trigger event occurs.
This cash management trigger event can occur at 6 months, 1 year, or 18 months usually. It depends on the contract language of your loan documents. Cash management will “spring” upon triggers that include events of default, insolvency, and property failing to meet a certain Debt Yield or DSCR by a certain date.
If the property fails to meet the test, then the lockbox will spring, and the lender will take control of the cash. This can hamstring operators. Not having access to the operating cash flows does not allow for any cash distributions to investors. You might also have to come out of pocket for repairs and capex.
This situation will prompt a lot of borrowers to want to sell the property or try to refinance out of the bridge loan. It is important to know what the trigger events of your bridge loan are to avoid a cash management situation.
Trigger Events
The two main trigger events are Debt Yield test and Debt Service Coverage Ratio or DSCR test. It could be an either-or situation, or it could be both.
Debt Yield Test
Debt Yield is a function of Net Operating Income or NOI divided by the total loan amount. At closing, only the initial funding of the purchase price is the current loan amount unless an advance is taken. In 2021, for example, 80% of the purchase price was the initial funding and there was future funding of 100% of rehab.
As an example, let’s say you bought a $20MM property and you got a bridge loan for $16MM and $2MM of future capex funding. Let’s also say you bought it at a 4% cap rate, so the NOI is $800,000.
Debt Yield = NOI/Loan Amount = $800,000/$16,000,000 = 5%
The going in Debt Yield is 5%. To stay out of cash management the Debt Yield must be a certain percent by a certain date. For illustrative purposes we can use 6% after 12 months. Now, if you were fast to execute your business plan and used up all the capex then your loan amount is now $18MM.
Working backwards to get 6% we can see that $18,000,000 x 6% = $1,080,000 in NOI. This is a 35% increase in NOI for year 1. You can see that some borrowers might be in trouble. Even if you did push rents over 30% there is still some vacancy and an increase in expenses.
Also, it is not uncommon for groups to really reach to win a deal. In this example, 5% going in Debt Yield is strong. A lot of deals had a 4-handle going in at 80% which means it might be increasingly difficult to pass the test.
DSCR Test
The other side of this equation is the DSCR test. Hopefully, the bridge loan requires a Debt Yield test and not a DSCR test because the rise in interest rates makes this test more difficult.
DSCR = NOI/Total Debt Service
Agency lenders require the NOI to be 1.25 times the Total Debt Service or the amount of loan payment for the year. This makes sense because the cash flow should cover the debt payments. However, bridge lenders got creative and pushed the envelope. They value properties by using potential cash flow.
Read More: How Bridge Lenders Inflated the Multifamily Market
Therefore, they also use cash management incase the cash flow potential is not realized. They want to be paid first. They are in 1st lien position also known as the senior loan.
Using the previous example, the debt service obligation is on $16,000,000 plus any capex completed and funded. The floating rate loan likely started with a spread around 350 to 400 basis points and the floating index is Secured Overnight Financing Rate or SOFR.
Initially using interest-only or IO, your payment was likely 4.00% on $16,000,000 or $640,000 per year. Now that SOFR is approximately 2.30% and some capex is completed, you are paying 6.30% on $18,000,000 or $1,134,000 per year.
Rate Cap
This depends on how prophetic you were about the rate cap you purchased. Some borrowers bought low strikes and other borrowers thought it was a waste of money and did not purchase the extra insurance. If we use the 35% increase in NOI and compare it to the total debt service in this example, we can see this borrower might also be in trouble:
DSCR = NOI/Total Debt Service = $1,080,000/$1,134,000 = 0.95
They may have passed the Debt Yield test, but the NOI is not enough to make the debt payment and could trigger a cash management event. A typical DSCR test is greater than 1.10 by 6 months or 12 months. In this example, the borrower does not meet the DSCR test.
It is important to note in this example that the DSCR test is using interest-only. Agency lenders will require the DSCR to be 1.25 on a 30- or 35-year amortizing basis. This means the payment will include interest payments plus principal payments so the total debt service will be higher even if the actual payment is lower during the interest-only period.
Conclusion
As you can see there are a lot of variables at play here. The loan amount, how well the property is performing, and rate cap all play important factors. Some borrowers will have all 3 working against them. It is important to understand what the cash management triggers are for each bridge loan. Being aware of this situation that is going to be playing out over this last quarter and Q1 of 2023 can help you strategize.
It might not be a bad idea to start thinking about a refinance into permanent debt to avoid any further rising interest rates or cash management situations.
