The multifamily real estate space has seen a lot of new bridge lenders enter the market over the last year. Non-recourse bridge lenders finance multifamily assets up to 80% of the purchase price. The terms are usually 3 years with Interest Only (IO) with the option to extend the term twice for a year each time. The test for these loans is a minimum Debt Yield (DY) going in and a DY test at year 3 based on the Pro Forma.
Bridge lenders dominated the market at the end of 2021. At Old Capital, over 80% of the volume we did at the end of last year was non-recourse bridge loans. The trend continues at the start of 2022. However, some of the bridge lenders are starting to get weary.
Agency Debt
A main driver for non-recourse bridge loans is leverage. The government agencies Fannie Mae and Freddie Mac are beholden to the Debt Service Coverage Ratio (DSCR) of 1.25 and up to 1.35 in some secondary markets. This test implies that the Net Operating Income (NOI) is 1.25 times the debt service. It is a good test because it says you can pay your mortgage after expenses. The problem is that in a lot of markets right now price and competition is high. We see a lot of properties only qualify for 50% leverage with agency debt when meeting the 1.25 DSCR test.
Leverage is what makes real estate a powerful investing vehicle. If you can get 100% leverage, meaning the loan is 100% of purchase price, then you do not have to put any money down. If the property appreciates $1MM then you just made an infinite return because you put $0 down. Leverage at 80% still provides an attractive return in most cases. However, 50% leverage and 50% down payment starts to really limit investment returns.
If you buy a $10MM property and put $5MM down, that $1MM gain is only a 20% total return. If you get 80% leverage and put 20% down or $2MM instead of $5MM, then a $1MM gain is a 50% return. The amount of agency debt you can get right now is lower in leverage, but also less risky.
Multifamily Bridge Lenders
The higher prices and lower leverage available from the agencies are what makes non-recourse bridge loans attractive. They are not constrained by the 1.25 DSCR. They use a DY test based on the current financial situation at the property. This is usually around 4.5% but can be lower depending on the story. They look at the DY pro forma in year 3 to be at a minimum of 7.25%.
If the sponsorship team, property condition, and business plan make sense, bridge lenders will finance up to 80% of the purchase price and fund 100% of the future capital expenditures needed to complete the project. This is a good way to increase the NOI of the property to then qualify for a cash-out refinance into more long-term financing with the agencies.
While prices continue to rise and agency debt leverage drops, some bridge lenders are getting a little weary. They financed a lot of properties last year and are concerned about their exposure. We are now seeing leverage starting to come down to 75% of purchase price. Interest rates are also rising. If you try to get 80% leverage it will likely come with a higher interest rate.
The bridge loans typically have a floating rate and require a rate cap. The rate caps have gotten increasingly more expensive as well. Volatility is what is driving higher rate caps and lower leverage. There is noise in the market that there might be a 50bps rate hike in March and five to six hikes in 2022.
Conclusion
After listening to the Old Capital Podcast episode recapping the National Multifamily Housing Council event last month, everyone is still bullish on Multifamily. Afterall, the risk-free rate is zero percent, and you are losing money to inflation keeping it in the bank. You can even make the case we have negative interest rates.
When using bridge financing it is important to implement your business plan expeditiously and increase the NOI. This will allow you to refinance into long-term fixed rate debt that is less risky.
We are still seeing large amounts of capital flowing into the multifamily space. This is what is driving prices way up and increasing the risk. It appears that leverage on non-recourse bridge loans is dropping. Less leverage will mean less returns. It is important to explain this to your investors. Managing investor expectations is important. You do not want to advertise huge returns then deliver no cash flow.
