With cap rates compressing to new cyclical lows, multifamily investors often struggle to find opportunity in—and attractive returns for—stabilized apartment communities. As the hurdles for finding success in stabilized assets grow, many owners are turning to value-add acquisitions. Before we examine how to execute a bridge-to-permanent financing solution that does not compromise long-term ROI, let us examine a few reasons why market participants are turning to value-add and bridge strategies.
THE STATE OF LATE CYCLE MULTIFAMILY
First, there is the issue of plateauing rent growth. Down from a cycle high of 5.8% in 2015, rent growth is projected to be 4.1% for 2018 (Reis, Inc.). Apartment operators are starting to realize that they can no longer rely on organic rent growth alone to increase NOI. Second, it has become clear that we are operating in a rising interest rate environment, at least for the short term. After the four (expected) rate hikes in 2018, the Federal Reserve is expected to issue three more interest rate hikes in 2019, and at least one in 2020. While spreads between multifamily cap rates and the 10-year Treasury yield remains wide in the grand scheme of things, margins are now at late-2005/early-2006 levels (Nareit).
Over the past few years, tightening of the stabilized multifamily market has triggered a flurry of activity in the value-add sector, where opportunities remain attractive. Experienced operators continue to find success in identifying underperforming properties (often in off-market transactions) and unlocking upside through both physical and operational overhauls. As the recession faded, this trend appeared first in the gateway markets but has been in full swing in the in secondary and tertiary cities over the past few years. This strategic shift can be quantified by looking at how the value-add component of the average commercial lender’s loan profile has shifted from 15% to 18% between 2015 and 2017 (CRE Finance Council).
The value-add strategy creates attractive returns for investors in the medium term through a boost to NOI from the execution of a property business plan. Furthermore, returns are enhanced because this strategy pairs nicely with attractive financing options through the bridge loan market where spreads on transitional floating-rate loans continue to be very low. These floating rate loan spreads are in turn supported by a robust capital markets environment for CRE CLO floating-rate bonds that continue to be bid very aggressively, thus allowing borrowers to obtain attractive leverage to finance a property’s capital improvements. That said, short-term floating-rate bridge loans are not just for acquisitions’
BENEFITS OF A BRIDGE-TO-PERMANENT SOLUTION
No matter what the purpose of your bridge loan, it is imperative that your permanent financing needs drive the loan structure. Your bridge loan’s structure will influence what your permanent take-out financing will look like. Many borrowers realize that working with a ‘one-stop shop’ – that is, a single lender who can provide both the bridge and permanent loan – provides several strategic and financial benefits. By streamlining the due diligence process and underwriting the bridge loan with a permanent agency takeout, a one-stop shop lender can provide more speed and transparency than two separate lenders and loan processes. Financial incentives usually come in the form of reduced fees. Hunt Real Estate Capital’s (“Hunt”) proprietary bridge loan program, for example, typically waives the bridge loan exit fee when Hunt is also the source of the permanent takeout financing.
That waiver, in addition to the flexible yield maintenance and non-recourse debt, is what attracted a Southeast investment group to a Hunt bridge solution when it came time to acquire and renovate a garden-style community in Greensboro, NC. The $10.3 million bridge loan was structured as a 36-month floating rate, interest-only note with $1.2 million earmarked for property renovations and improvements. With a value-add repositioning well underway, the borrowers are currently looking to transition to a long-term, fixed-rate solution.
In another recent transaction, albeit on the other side of the country, Hunt provided a Seattle-area developer with a $15.3 million floating-rate interest-only bridge loan to refinance the construction loan on a 2017-built mid-rise community in Seattle’s Central District. That solution allowed the borrower to focus on the lease up, moving from roughly 50% occupancy to a well-stabilized 92% before Hunt submitted an application for a fixed-rate, permanent Agency takeout less than nine months after closing the bridge loan.
In summary, a bridge solution can provide the speed and flexibility needed to capitalize on the unique opportunities that arise late in the multifamily cycle. To be in the best position for a smooth transition into a long-term, fixed-rate solution that takes advantage of today’s low—by historical standards—interest rates, consider working with an experienced ‘one-stop’ lender.
This article was originally published in the Fall 2018 issue of California Mortgage Finance News, a California Mortgage Banker’s Association publication.