By the income-generating business activities of occupants, commercial real estate makes it an entirely different investment option. The funding and how the funds are raised are different from real estate for residential purposes. Developers of commercial real estate and investors have a different set of considerations when it comes to the raising of funds.
Most lending for a commercial real estate typically covers a significant portion of the total project cost. However, the full cost of the project is not covered by lenders. This makes it necessary for developers and investors to rely on bridge loans and gap financing to meet the gap between available funding and required costs. Here is a closer look at gap financing in CRE.
What is the purpose of gap funding, and whom does it suit the interests of investors and developers?
Commercial real estate developers and investors typically manage multiple projects simultaneously. Consequently, the demand for funds is higher and often forces investors/developers to raise funds from various sources. For instance, hard money lending and loans from financial institutions cover only a particular portion of the requirement.
The investor is expected to foot the remaining requirement, as this gives the institution the ability to recover the extended loan in the event of a default. The value of the lien is considered good when the loan is not the full amount.
For instance, if the loan amount is extended for the project’s full costs and the beneficiary defaults, the proceeds from cashing in on the lien will not cover the extended loan amount. However, if the loan amount extended is lesser than the project’s full value, the cashing in on the lien will fetch an amount that is as close or equal to the loan amount extended.
It is precise because lenders typically cover most of the costs of a project but not the whole cost. Consequently, investors and developers are left with a gap in financing needs. Gap financing and bridge loans help meet this shortfall of funds.
Standout benefits of gap financing for investors
Gap financing offers multiple benefits to investors, in addition to being a source of funding. Most commercial real estate stakeholders have interests in multiple projects. In addition to the need for funds for multiple projects, it is the timing of the requirements that matter the most.
For instance, the requirement for funds may come at the same time for multiple projects. As a result, stakeholders have very little space to juggle finances and manage funds from existing liquidity. With gap financing, it is possible to raise funds and keep multiple projects going at the same time.
Investors and stakeholders may be in possession of funds for managing requirements, but investors are forever in need of liquidity to make a sift investment in any new commercially viable project. Liquidity is often the best reserve that investors can use quickly to take advantage of an offer to invest in a property or deal.
As a result of this need to maintain a reserve corps, investors find funding to manage projects. Access to such funding helps investors take on projects that may not have been possible in the absence of adequate bridge funding. For instance, a deal or a new project may be a great opportunity for an investor, but the absence of funds to bridge the gap of ongoing projects may prevent the investor from taking up new projects. With bridge loans, investors can take on new projects without jeopardizing existing projects.
Completion of projects may often go haywire due to one or many reasons. Consequently, the ability to sell or rent out properties are likely to be delayed. In such eventualities, the cash flows of projects are affected. This makes it necessary for raising funds to meet the shortfall in other projects. It is a cyclical requirement.
For instance, the proceeds from the sale of a property may have been the intended source of funds for completion of another project. As one project gets delayed, access to funds is limited, which affects investors’ ability to manage all projects. Gap financing helps meet this shortfall, helping maintain all projects.
Cost overruns are another eventuality that projects are likely to face. For instance, a project may have been initially planned within a specific budget but may have resulted in cost overruns. For instance, the project may have changed midway, or the costs of materials, labor, or other unexpected rises in costs may have affected the project.
This makes it necessary for investors to look at additional options to raise funds. Gap financing offers investors an avenue to quickly raise funds and manage the requirements with out affecting the project’s lifecycle.
Downsides of gap financing
Despite the appeal of gap financing, there are downsides to the option, and it is necessary that investors take careful, considered look to work out if it suits needs. For instance, by becoming the second position in lending, gap financing is considered riskier than hard money loans—consequently, lenders who advance gap financing attempt to make up for the risks with higher interest rates. Most gap financing/bridge loans are typically 1% higher than that of hard money loans.
Gap financing is a short term loan and is not suitable for longer terms of financing. This makes it suitable only to meet the needs of projects that are nearing completion and insight of closure. For instance, a promising project and is expected to fetch a good return in a very short period is a strong potential for a bridge loan. This is because the project will help the investor to make money in a short period and this can, in turn, help repay the bridge loan quickly. The investor gets to make a reasonable profit, while the bridge loan’s lender will receive better interest rates and faster turnaround.
In a limited number of cases, commercial real estate bridge loan have additional terms. This does not apply to all the projects. However, it depends entirely or the project, or the circumstances surrounding the bridge loan. This could be the urgency with which liquidity is required, it could be the size of the loan, or it could also be the project’s risks.
Under the additional terms of such bridge loans, the investor/developer needs to part with a small percentage of the lender’s profits. This is typical as per the mutual understanding between the lender and the investor. This is only for projects that involve an outright sale and a part of the proceeds are given to the lender. It works for the investor as the project completion may hinge on the bridge gap, without which the sale may not have been possible.
Gap financing is suitable only when the commercial real estate investor is into multiple projects. The need to return the loan quickly accompanied by the higher interest rates makes this most suitable only when multiple projects are being handled.
A viable option when exercise with diligence
Gap financing for commercial real estate is a sound option that works when the investor makes a calculated decision to raise additional funds. This works best when the individual or the institution is into multiple projects with a need for raising liquidity fast to meet project expenses. With bridge financing for commercial real estate, investors can spread their assets and interests in a planned way and manage finances effectively without jeopardizing projects’ status.
Understanding How Lenders Are Considering Deals
Gap finance bridges a funding gap. It covers the gap between the cost of a property and the amount that a traditional lender is willing to grant. This gap happens because a lender’s willingness to lend money is based on the property’s value. They express this as a loan-to-value (LTV) ratio. The ratio isn’t high enough to cover everything.
Things to Think About
Gap financing has many benefits. But, it’s important to be aware of any downsides.
Higher Costs
Gap financing is riskier for the lender than standard loans. It usually has higher interest rates and other costs.
Investor Scrutiny
Getting gap funding often needs a more thorough assessment. Both the investor and the enterprise must do it.
How Deals Are Being Considered by Lenders
Experts like Private Capital Investors have interacted with their database of verified second-position and mezzanine lenders, who are currently making loans. They have learned much about how lenders handle transactions needing gap funding.
Transaction Size
Many second position lenders only consider larger transactions. These lenders deal with mezzanine debt and need about $5 million in financing. Some have a $2 million floor.
Debt Ratio
Many lenders are asking for an 8% minimum. This is for deals that need gap financing due to underwriting considerations. One of the most crucial things that lenders are thinking about is this.
DSCR Conditions
A 1.05 to 1.15 DSCR serves as the foundation for the underwriting of many second position and mezzanine lenders.
Stability of Properties
They are very strict about property stability. They have high stability requirements. Lenders providing gap financing also take Pro-Formas into account.
