Have you ever wondered what average commercial real estate (“CRE”) bridge loan interest rates are or why the rates are what they are? I’ll give you the spoiler: the average interest rate is 6.5%. Just kidding. Actually, the answer is: it depends. Boring, right? But it does depend. It depends on things like risk profile, lender appetite, and interest rate trends. We’ll dig a bit deeper and see if we can provide some helpful information on why lenders do what they do and what to expect in a rate.
Interest Rate Basics
Let’s start at the very beginning (a very good place to start). Interest is what’s paid by a borrower to a lender as compensation for the risk that the lender is taking that he or she might not get paid back as promised. The higher the perceived risk, the higher the interest rate. The lowest interest rate in a given market is called the “risk-free” rate. The proxy for this rate is whatever federal debt is yielding, with the assumption that the U.S. federal government is the strongest credit in the land, with the lowest chance of generating losses for lenders. 10-Year Treasurys are currently yielding around 3%, but as you can see in the chart below, that rate fluctuates constantly. You can view risk-free rates as the starting rate for pricing other loans. So, in this environment, you aren’t going to see bridge loans, or any other non-government debt, yield less than the risk-free rate of 3%. Since bridge loans are not “risk free,” lenders price in a premium over the risk-free rate when determining the interest rate.
So how much over 3% will a bridge loan cost? That is by and large answered by what investors in the market will bear. Investors that back bridge lenders have a lot of fixed income options, be it corporate debt, Treasurys, municipal bonds, residential mortgages, securitized consumer debt, etc. In the end, investors need to feel like CRE bridge loans are getting them the right return for the risk they are willing to take, and that affects how much a borrower ends up paying.
Bridge Loan Risks
Let’s talk about a few of the structural risks that lenders consider when pricing CRE bridge loans. One of them is lack of liquidity. Liquidity basically measures how easy it is to trade in and out of an investment without causing a large change in the price of that investment. For example, stocks that trade on the NYSE are very liquid in that you can buy and sell almost instantly without moving market pricing. Getting out of real estate investments by contrast can take months of marketing, negotiating, and closing before the asset changes hands. And if you need to exit more quickly than this, you have to take a discount, or what’s called a “fire sale” price. This lack of liquidity is seen as an increased risk, so investors add rate in order to be compensated.
Another reason that bridge loans aren’t trading at the risk-free rate is that, while CRE bridge borrowers tend to be pretty good credit, they are not risk free. If something goes wrong with the market or business plan and it seems like things aren’t really working out with the loan, borrowers might choose to walk away or fight the lender. This can result in the lender losing some income and/or principal.
Lastly, bridge loans can be riskier than stabilized CRE loans because they tend to have low or inconsistent cash flow early in the loan term. And while the borrowers always have plans to remedy this, there is a risk that things might not go as planned.
Bridge Loan Benefits
On the flip side, CRE bridge loans also have benefits relative to other fixed income options that keep rates low. Most importantly, real estate loans are secured by assets, called collateral. This makes them safer than unsecured loans, because lenders are not just relying on someone’s word that they’ll pay them back. On a secured loan, if they don’t pay you back, the lender is allowed to foreclose on the collateral and take it over. The goal is for the collateral to be worth more than the loan, so that you can liquidate the collateral and be made whole on the loan.
Another strength is that CRE borrowers are relatively creditworthy. CRE bridge loans are typically multi-million-dollar loans, and people who are able to raise and invest millions of dollars of other people’s money tend to be sophisticated and financially savvy (although there are several notable exceptions).
A final benefit for lenders (though not so much for borrowers) is that most U.S. CRE bridge lending is short term and based on the 30-day London Inter-Bank Offered Rate, or LIBOR, plus an additional spread. This means that the loan has a “floating” rate that tends to rise as macro interest rates rise. In rising rate environments, such as the current one, this helps keep loans at or above market rates and preserves the value of the loan. Note that LIBOR is currently approximately 2.3%, but for years after the crisis, it was less than 1.0%. As LIBOR rises, expect bridge loans to get pricier. By the way, LIBOR is supposedly the average interest rate that several banks in London would charge to borrow from each other. But…in the wake of some of the shenanigans of these banks during the financial crisis, LIBOR is going away, likely to be replaced by something called the Secured Overnight Funding Rate (“SOFR”) by 2021.
We’ve explained a bit why CRE bridge loans generally cost what they do; now we’ll try to get more specific. In the space RRA lends into, we currently see bridge loans priced in the 5-10% interest rate range, with a sweet spot around 5.5% - 7.5%. As stated previously, these ranges change continually based on risk free rates and what other debt investments are yielding. Typically, quotes from various lenders will be in a relatively tight range; however, a borrower might get better pricing on a bridge loan simply because a lender’s allocation in the space recently increased, and they need to get money out. So, it’s important to shop around (read “Tips for Getting the Best Commercial Bridge Loan Financing” for more on this). Let’s now go over specific attributes that can cause a rate to be higher or lower on any individual loan. We ranked the factors below in terms of how much we think they can affect rate.
- Loan to Value Ratio (“LTV”) - Potential rate impact: +/- 3% (e.g. if the base interest rate is 7% at 75% LTV, that same loan at 90% LTV might be 10% (7% + 3%), or at 50% LTV might be 4% (7% - 3%)).
Secured loans are originated at a discount to the value of the collateral. This provides a margin of safety for the lender should the borrower default. The lower the loan amount relative to the value of the collateral, the lower the risk and the lower the interest rate. A low LTV can make up for a host of other loan risks. That’s why LTV can affect rate so much. Loan to values in the 40% - 65% range are dominated by banks and life insurance companies, who have a low cost of capital and can have rates of L+200 – 300 bps (all in around 5%). Loans with LTVs of 65% and up, maybe even up to 100%, are dominated by private lenders and may have rates of 6% - 10%.
- Personal Recourse - Potential rate impact: +/- 2%
Most bridge loans do not have personal recourse. If something goes wrong, the lenders can take the collateral but they can’t go after the borrower’s personal bank account, boat or Rolex. This is not so with full recourse loans and so, loans with recourse have lower rates. Most bank loans have recourse.
- Business Plan Quality - Potential rate impact: +/- 2%
Borrowers on most bridge loans have plans to increase the value of their property, usually by aiming to reduce vacancy and increase rents. They typically achieve this through some combination of capital investments and improved management. The more feasible this plan sounds to a lender, the better the interest rate.
- Borrower Quality - Potential rate impact: +/- 1%
Borrowers who have direct experience with the product type and business plan in question will receive lower rates. At RRA, we We look for track records that span market cycles. We like to see multiple exits through sales or refinances. We don’t like to see bankruptcies or foreclosures. It helps if the borrower has sizable net worth and liquidity.
- Market Quality - Potential rate impact: +/- 1%
Lenders want large markets with low vacancy, high rental rates, high barriers to entry, improving fundamental trends, and lots of willing buyers and lenders waiting to take them out of the loan if desired. Small or stagnating markets add a variety of risks and will contribute to an increased interest rate.
- Property Quality - Potential rate impact: +/- 1%
Lenders want to lend on functional properties that are easily leasable to a wide variety of tenants. A borrower is going to get a better rate with a loan collateralized by an apartment instead of a retail big box, a better rate with a downtown office than a marina.
- Cash Flow - Potential rate impact: +/- 1%
If the property is mostly or totally vacant, this adds risk that the borrower might not be able to pay interest. As such, interest will increase.
- Loan Size - Potential rate impact: +/- 1%
In general, the larger the loan, the better the interest rate. This is mainly because (a) the larger loans typically have more institutional borrowers and (b) larger loans allow lenders to put out a lot of money in one slug, which makes their job easier.
In summary, there are lots of factors that go in to interest rate pricing, from how much the federal government is paying on its debt, to the loan to value ratio, to how much money a lender needs to put to work that month. In today’s market, a borrower is not likely to get quoted a 4% interest rate, but if you’re seeing quotes at or above 10%, lenders are pricing in some significant risk that may or may not be warranted. Average rates will change in time, but most of the fundamental concepts noted here that determine those rates will not.
- Top 10 Things to Avoid When Trying to Secure a CRE Bridge Loan
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- Tips for Getting the Best Commercial Bridge Loan Financing