More Than Double Your Returns with This Strategy – Bridge Loan vs. Perm Loan Case StudyPaul Winterowd
Everyone wants the best rate and terms when financing a multifamily deal. It goes without saying. We naturally seek quotes and rate sheets with the lowest possible published rates.
Rate is the simplest “common” denominator used to compare different loan options. It is easy to understand, but not always the best gauge of overall returns. There are several other variables to consider.
We want that low rate, but we also want leverage. Leverage is how we juice our returns. It’s not that it doesn’t come with some risk, but the laws of mathematics don’t lie. Greater leverage will mathematically produce higher returns given everything else being equal.
As cap rates continue to compress and property values increase in today’s markets, it is getting harder to maximize leverage – especially on an acquisition – because the in-place income from the property can’t support the maximum allowable leverage.
The expansionary cycle we’re in doesn’t seem to be going anywhere right away. These increased values put more and more pressure on the debt coverage ratio as the limiting factor on leverage. Common permanent financing will have a 75-80% LTV cap with a 1.25 debt coverage ratio minimum as well.
Because values are high right now, and the low in-place income on multifamily acquisitions doesn’t meet the debt coverage requirement at the maximum allowable leverage. That simply means your loan amount must be reduced to a point where it meets the 1.25 requirement.
Before you know it, you could be looking at 65% loan to value. Likely not what you’re wanting.
Let’s look at how different financing options affect both the overall returns on the deal and the equity required to do a deal.
On a $5 million multifamily deal, at 65% leverage it requires $500,000 more equity than at 75% leverage.
Let’s assume that $5 million deal has a nice value-add component that will require $1 million of capex. So, you’re looking at $6 million all in.
At a 65% LTV plus the rehab budget of $1 million, the equity required is $2.75 million with this loan structure.
With a bridge loan, we look at costs (purchase price + rehab budget) and the after-repair value. All in we are looking at $6 million in costs. With a bridge loan we can get a loan for 85% of total costs. That means the down payment would only be $900,000.
As we continue this example, and admittedly there are dozens of variables that can influence the ultimate outcome, I’ve simplified things to include the pertinent information and will note all the assumptions.
The results are really interesting so hang in there…
- Renovation Budget: $1,000,000
- Number of Units: 50
- NOI Increase per Unit after Rehab: $250 / month
- Cost of Equity: 12% per year
- Hold Period: 5 Years
- Cap Rate: Steady through 5 years at 5.5%
- Exit Costs: 5% of sales price
- No annual rent increases, Purchase NOI in place for 2 years, Rehab NOI in place for final 3 years
- Reversion Value: $7,727,273
- Bridge loan payments are Interest Only for 2 years
- Permanent loans are amortizing payments on 30-year amortization schedule
- Permanent Loans Interest Rate: 4%
- Bridge Loan Interest Rate: 8%
- Total Loan Origination Costs for Perm Loan: $47,500
- Total Loan Origination Costs for Bridge Scenario: $248,000
- No cash out with Bridge Loan refinance to permanent loan, transaction costs added to loan balance
There’s quite a large difference in the equity required between the two scenarios. $900K vs. $2.75 million. Basically, triple with the perm loan option. Whether it is your money, or you are raising that equity from investors, there is an opportunity cost associated with those additional funds.
If the deal only requires $900K and you have $2.75 available, you have the necessary equity to do 2 more similar deals. That alone could triple your returns!
Often overlooked is the cost of equity. The assumed cost of equity in this case study is 12%. Investors look very closely at their cost of debt, but may not even know what their cost of equity it. A common argument I hear about bridge loans is the debt payment is so much higher given the higher interest rate. But what if you combine the cost of equity with the payment?
Permanent Financing: Annual payment is $186,192 on the debt. 12% on $2.75 million is $330,000 for the equity. Combined the capital stack (total cost of capital) is $516,192 per year.
Bridge Financing: Annual payment is $408,000 on the debt. 12% of $900K is $108K for the equity. Combined the capital stack (total cost of capital) is $516,000 per year.
Your total cost of capital is lower with a bridge loan, than with “cheap” permanent financing. If you’re cost of equity is 16%, you’d lose $74,192 per year in the additional cost of the equity by not going with the bridge loan strategy!
The IRR on the 5-year hold with the bridge loan strategy is 21.9%, and the equity multiple is 3.34x.
The IRR on the deal with only the permanent loan scenario is 14.7%, with an equity multiple of 1.90x.
Candidly there are a lot of investors that can’t get past the higher interest rate and fees associated with a bridge loan strategy. They focus on costs rather than loan structure and big picture of overall investment returns. When only looking at the cost of the bridge loan strategy looks, it appears absolutely absurd when compared to the perm loan strategy.
Even more absurd though, is the difference in total returns, especially when equal amounts of capital are deployed in both strategies.
I have used the bridge loan strategy personally, and I’ve had clients use this strategy with great success. As we continue to move forward in a tighter market, a strategic and “big picture” perspective will make a great difference for those who adopt it.