If you have been looking at the products available for commercial and residential real estate loans, you have probably encountered the term bridge loan before. Unless you’ve had to apply for one, though, you might not realize what bridge loans are or how they are used. These are short-term loans designed to allow borrowers to:
Buy time to line up long-term funding
Close on a property quickly
Purchase a property, improve it, and resell it in a short time period
In the case of investing in bridge loans, the third reason is the most common. These are the loans mostly used by “house flippers”; real estate investors who purchase and rehabilitate properties before reselling them. They represent a great investment opportunity too, and if you are interested in getting into real estate lending as an investment, you need to know how investing in a bridge loan – or portfolios of bridge loans – can provide you with a great return in a relatively short amount of time.
Bridge Loan Features
Before deciding to take the plunge and starting to invest in bridge loans, it’s important to understand the pros and cons, and exactly how these products work for the lender, and by extension, the investor who is investing in the loans.
They have short maturity terms. Loans of this type have terms of 3-24 months, though the usual term for a fix and flip bridge loan is 12 months, with extensions for consideration of extra time required to complete the renovation and sale of a property In other cases, the loans are paid off early if the developer completes the work and sells it before the loan maturity date.
They cover a large percentage of the property value at the time of purchase. Bridge loans are sometimes available to borrowers for up to the full purchase price of the property, namely because the property is generally undervalued at the time of purchase. This puts the borrower in a position to use funds to make improvements and increase the value of the property for resale. Similar to putting a down payment on your home mortgage, borrowers are required to put personal funds into the purchase, to show skin in the game. Borrowers are required to put a deposit of at least 10% of the property value. Common LTV (loan-to-value) values range from 50 to 80%..
Late payment penalties are in place for most bridge loans. If the borrower does not make a regularly scheduled interest payment, then the penalties ensure the investor is well compensated for the tardiness of the payment.
The loan is broken into multiple ‘draws.’ There will likely be milestones set that allow access to portions of the funds as work completes. The first draw is for the purchase of the property itself. Subsequent draws are based on completion of stated renovation work and must be proven with receipts and invoices.
Interest rates are high. In fact, while many consumer home mortgages charge four to six percent, these loans regularly charge seven to twelve percent, in addition to the loan fees levied by the lender. This provides much more opportunity for investors purchasing the interest-paying note. Coupled with the short loan terms, it means you stand to make a high return quickly.
Other Types Of Bridge Debt
If you are looking for bridge loan investment opportunities, it’s important to understand the diversity of the investment opportunities available. Residential bridge debt is one major category of these loans readily available to individual investors. However, there are other types of bridge loans. Some are used by real estate investors operating in the multifamily and commercial space, and others are used by companies buying and developing new facilities for their own use, or as a stopgap while other financing is sought.
Multifamily: Landlords and property investors often take out bridge loans to cover renovations that will allow them to raise rental rates. This provides them with the initial funds they need, and their strategy allows them to realize a return quickly enough to pay the loan back when it matures.
Retail: Investors that plan to hold retail spaces for a short period of time to develop them before resale often use bridge debt to close on the property. They can then make the interest payments for a year or two before selling the property again to cover the final payment.
Industrial: When industrial spaces do not meet tenant needs, owners often use bridge loans to cover the renovations that bring in new entrepreneurial ventures. This allows them to succeed at interesting new industries and start-ups in tenancy.
Office: Similar to industrial uses, office uses can fund renovations. They can also be used to finance the property while it is being filled before it is sold as a fully mature business to another investor.
Hospitality: The last major use of these loans is to stabilize the cash flows of hospitality businesses as they prepare to refinance into permanent debt.
Each of these types of bridge debt brings with it unique risks and opportunities, so it is important to understand the specific types you invest in and to balance your investments.
The Future Of Bridge Debt
These loans have been powerful instruments allowing for economic development to a wide variety of businesses for many years. It’s not likely that will change anytime soon, but what is likely is that there will be fluctuation in the demand for basic residential bridge loans in various states, cities, and neighborhoods. That’s because residential property investment is its own business with its own very local cycles. By diversifying into a range of bridge debt, though, investors can reap the rewards of the high-interest rates while opening themselves up to more investment opportunities in any market.Advance your investing knowledge by understanding the tax implications around another investment avenue: real estate crowdfunding.
Real estate syndication has been around for decades. But the syndication process has evolved in recent years with new crowdfunding options. Real estate crowdfunding deals are generally classified as either “equity” deals or “debt” deals and each can have different tax implications. Let’s take a closer look at the differences.
When it comes to real estate crowdfunding, much of the tax discussion has revolved around equity deals. I would define an equity deal as one where the investor typically owns shares in a limited liability company (“LLC”) that invests into another LLC that holds title to real property. The investor holds essentially an indirect equitable interest and will participate in the financial upside (or possibly downside) of the property. As such, the investor is a partner in a partnership structure.
Since equity investors are actually partners to the deal they would receive a Form K-1 at the end of the tax year which would report their share of the partnership’s income or loss. Since they are not actively involved in the day to day management of the property, they are typically classified as “passive” partners. Passive partners have special tax rules. A passive partner is taxed at the partner’s marginal tax rate on any profit that is generated. However, if the activity generates a loss the deduction typically will be limited to any income derived from other passive activities (subject to certain exceptions). But if the activity generates income it may also be used to offset any passive losses generated from other activities.
But more and more deals on real estate crowdfunding platforms are considered debt deals. Essentially the investor owns an interest in a promissory note that is often issued by a flipper or developer (the “sponsor”) who is looking for short-term financing for a project. Aside from being collateralized by real estate, the note will typically provide for monthly interest payments and have a personal guarantee from the sponsor. These investors do not have an equitable interest in the property. They are merely acting like a lender in which they are providing the funds for a specific transaction and are receiving interest payments according to the agreement. This type of transaction is different from an equity deal and, accordingly, the tax implications can differ.
Taxpayers investing in debt deals are typically not partners to an operating trade or business and are merely acting as just investors. They do not get to participate in any financial upside of the property. Accordingly, the payments they receive are typically classified as interest income. They will often receive a 1099-INT at the end of the year that reflects the interest income they received, but also may receive a Form K-1 depending on the deal structure. Interest income is considered portfolio income (not passive income) and is also subject to marginal tax rates. However, portfolio income is not considered passive income and is not subject to the same restrictions.
Understanding the tax differences between equity and debt deals can be difficult. We have discussed some of the differences herein, but we need to acknowledge that close consideration of tax issues should be made when structuring any real estate crowdfunding transaction. At the outset of any deal, consultation with experienced tax and legal professionals should be made along with proper investor communications.
Ultimately investors need to carefully review any crowdfunding deal and make sure that they understand the tax ramifications. In addition, they should make sure to engage a qualified CPA or other tax professional to assist them with their tax return.