Interest rates have risen 150 basis points in 2022 and are poised to increase by another 75 to 100 basis points by the end of July. These hikes are meant to curb inflation, which hit 9.1% in May 2022. However, for commercial real estate investors looking to acquire properties, it has become the number-one concern.
Recently, I spoke at two multifamily conferences and listened to my peers describe how they are navigating the new landscape. Some are using only fixed interest rate loans, seeing bridge loans as too risky. Others plan to continue using bridge loans while making other adjustments to reduce risk.
Whether or not you should use bridge or fixed debt depends on many circumstances. Your business plan, experience, exit strategy, etc., will all play a key role in selecting the right loan for your investment. Interest rates get the headlines, but other key loan factors are terms, leverage, DSCR requirements, recourse, and pre-payment penalties.
Pros and Cons of Fixed and Bridge Loans
Fixed loans offer predictability since the rate will not change. However, they often have stringent requirements for operations upon acquisition, making them less available for value-add deals. In addition, they often have considerable pre-payment penalties that deter an early exit. We learned the importance of this on our first syndication. We used a seven-year, fixed loan with a 4.15% rate. We had great offers to buy from us in Year 3, but the steep pre-payment penalty forced us to hold on to it for almost five years.
Bridge loans provide greater flexibility, making them a popular choice for value-add investors. These loans prioritize the business plan over in-place operations and usually omit a pre-payment penalty. The downside to bridge loans is the shorter term and floating interest rate.
Some expect the Fed rate hikes to increase by 2.5% or more. This type of increase can certainly crush a deal's cash flow and operations. To limit this risk, many investors opt for interest rate caps. These caps serve as insurance against interest rates rising. However, costs for these rate caps have increased dramatically. Investors are now paying two to five times more than they would have paid prior to the rate hikes. I spoke with an investor who expected to pay $150,000 for a rate cap and was quoted closer to $500,000.
When you put it all together, it’s understandable that some have decided to wait on the sideline. However, this uncertainty and hesitation are what create opportunities, and those who are actively involved in the market will be uniquely positioned to solve problems and grow their portfolio. Instead of sitting on the sideline, consider how you navigate this landscape.
Mortgage brokers spend all day talking to lenders and investors and serve as a vessel of information when it comes to loan products. They work with experienced operators to stay creative and deliver solutions in this changing market. And they are well-positioned to help you answer the question of what type of loan you should use for your projects. We spoke to a couple of mortgage brokers, and this is generally how they look at the loan options.
The Best Loan Type for Today
Fixed loans are a strong option if you plan to hold a property long-term. With a fixed loan, you want to understand the pre-payment penalty and lock in a step-down structure. This means the penalty for an early exit decreases each year. Freddie Mac and Fannie Mae have tightened their requirements, so regional banks are the best bet for fixed loans at the moment.
Bridge debt is intended to be temporary, so your projections for exiting the bridge loan are critical. If you have a reposition opportunity to create significant value and mitigate risk, these loans are still attractive. You want to stress test these assumptions and limit your exposure to rate hikes.
Many economists believe that rates are being hiked now to slow inflation but will ultimately be cut again in the next 18–36 months. However, speculating that future interest rates will be lower is a dangerous game. Savvy investors plan for the market to be worse in the future and position themselves to navigate any changes in the landscape.
Selecting the right loan comes down to a thorough understanding of your options and the implications of each. The risk is more a function of the assumptions that go into loan selection. While there are fewer factors to consider on a fixed rate loan, bridge debt still serves a key role for investors looking to add significant value to a property. Now is an excellent time to work with experienced operators and mortgage brokers to navigate the changing landscape, no matter what happens with rate hikes.
About the Author:
John Casmon has helped families invest passively in over $100 million worth of apartments. He is also the host of the #1 rated multifamily podcast, Multifamily Insights. Prior to multifamily, John was a marketing executive overseeing campaigns for Buick, Nike, Coors Light, and Mtn Dew: casmoncapital.com