Despite a popular misconception, bridge lenders are not miscreant loan sharks looking to take advantage of desperate borrowers.
Yes, the cost of money for a bridge loan is higher than what is offered by a conventional lender. After all, the higher the risk for a lender the higher the associated cost of money. Nevertheless, bridge lenders fill a very important niche role within the commercial real estate industry. Bridge lenders provide loans to borrowers and projects that don’t fit within the conventional lending box. Without this alternative financing option, there are many real estate projects that would not have the opportunity to develop and reach their potential.
That being said, here are three (3) common mistakes a borrower should avoid when seeking out a bridge loan.
Common Mistakes and How to Avoid Them
Focusing on the Interest Rate
Getting the lowest interest rate is, of course, important to a borrower. But two variables, which a borrower should also consider important, are time and loan fees. Too often, borrowers who are looking for a bridge loan, attempt to move forward with a private lender simply because they claim the lowest interest rate. Besides rate, a borrower should also be asking questions like, “Can this private lender, actually fund my loan request?” and “What are the fees associated with this bridge loan?”
It would be important to note here that one bridge lender is not like another. Most sources of bridge loans are private companies or individuals who are looking for better returns on their money. These private funding sources have their own lending requirements, favorite property/project types, and risk aversions. If a borrower takes the time up front to vet a bridge lender, they can find out if their loan request and real estate collateral truly matches a lenders appetite. One lender may like providing financing for multi-family properties. Another may like funding development projects. The more a bridge lender is comfortable with a particular asset class, the better the chance of them ultimately funding the loan. However, if interest rate is a borrower’s primary focus, a lot of time might be spent with a bridge lender who wants to appear busy but will ultimately cherry pick the deals they are most comfortable with.
In regards to fees, a borrower needs to find out the true cost of a bridge loan by adding up the total fees that are being charged. A bridge lender may be quoting a higher interest rate, but charge minimal fees and require less third party reports to close the loan. Depending on the length of time a borrower holds the loan, a borrower could miss out on a good lending option by focusing too much on the interest rate.
Not providing the Bridge Lender with a Story
Conventional lenders are pretty straight forward in their loan process. A loan application, tax returns, recent bank statements, and a credit report are usually all that is needed to pre-approve or deny a loan.
In contrast, when applying for a bridge loan, a borrower’s story can influence a lender’s decision to move forward with providing financing. Unfortunately, too often borrowers spend little time to explain the story behind their financing request. Low credit scores, tax liens, pending foreclosures, a development project, and a need for a quick close are all circumstances that a bridge lender might consider – with the right story.
Short answers like, “because I need money to keep my property”, or “I’ve got a great development project that is sure to be a success”, are not likely to affect a bridge lenders interest level. If a borrower needs money to keep a property, they should talk about what led them to be in that situation and what plans will be in place to avoid that situation in the future. If a developer needs financing for a development project, they should talk about their background and experience. They should also discuss their market study analysis and forecast predictions.
Maybe the story is that there is plenty of equity in the underlying real estate collateral and in a scenario where the borrower does not pay the loan back, the lender is in a safe position to recoup their loan after a sale of the property. There are asset based bridge lenders who would be willing to take this high level of risk, with the right collateral.
Not Having an Exit Strategy
In parallel with having a story, a mistake a borrower needs to avoid is entering into a bridge loan without having an exit strategy.
A borrower should be cognizant of how much loan they are able to realistically afford. They should also consider how much time they have to pay back the loan and plan accordingly. Bridge loans are short term loans that have a balloon payment feature at the end of the loan period. These two factors are very important to consider because if a borrower falls behind on their payments or defaults on their loan, a steep default interest rate increase is usually triggered. This increase in rate can be substantial and can make loan payments difficult to maintain.
The best exist strategy advice is for a borrower to only borrow what is absolutely necessary and to have a solid plan to pay off or replace the bridge loan before the end of the term.
If a borrower is looking for fast and expedient method of financing commercial real estate, a bridge loan may be the right option. By avoiding the mistakes outlined above, a borrower will be able to utilize bridge financing to their advantage.