Generally, a bridge loan is a form of short-term financing used to cover a time period before establishing long-term financing on an asset. It’s also a term commonly used in the real estate space to describe loans to used by developers for the acquisition of single family properties renovation and redevelopment (fix-and-flip loans).
Some common features of bridge loans include:
- Maturity between 3-24 months
The transaction of purchasing an undervalued property, renovating/rebuilding it, and then selling it is short-term. These types of loans are usually written with a 12-month loan term to give enough time to do all the necessary work. If the work and sale occur sooner, the borrower will usually always pay the loan off early. The reason a developer wants to do this as quickly as possible is:
- Interest rates between 7%-12% + fees
Why would a developer pay such a high cost for this type of loan when banks tend to charge between 3-5% for a mortgage? One of the biggest factors the borrower is paying for is speed. Most bridge loan lenders are able to release initial funds and follow-up construction draws within a week of requesting funding, whereas a bank will take 30-90 days to approve a loan and potentially the same amount of time for a construction draw.
- Loan-to-value ratio between 20-100% of the purchase cost of the property
For first time developers, lenders tend to want to lend less money. This keeps the Loan-To-Value (LTV) lower, protecting their investment (the loan) with a larger portion of equity that the developer would have to put in (skin in the game). For experienced borrowers who have done many deals with a lender, that lender may be more comfortable lending them more funds in comparison to the purchase price of the asset.
- Loan broken up into ‘draws’
The lender will break the loan up into multiple pieces, called ‘draws’, which they release to the developer as the project reaches certain milestones. The first draw is released for the purchase of the property. Additional construction draws are released as the lender confirms work is being completed according to the statement of work, allowing the developer to fund subsequent portions of the project. Verification is usually done through a combination of on-site verification done by a third party, submitted purchase receipts, and pictures.
- Late payment penalties
If a developer is late on an interest payment there is usually some form of penalty payment assessed. Since it is not uncommon to have late payments, penalties are usually assessed if developer is more than 30-days late. Depending on the terms of the loan, there could also be ‘default interest’ charged if the developer misses enough payments and thereby goes into default, causing the lender to foreclose on the property.