Investment Analysis

Bridge Loans Rising

Due to tougher regulations, bridge loans are in high demand as a stop-gap measure.

During the Great Recession, cooling capital markets, greater regulatory scrutiny, and tighter underwriting for commercial mortgage-backed securities caused more challenges for financing transitional assets. Even as the economy has improved, CMBS markets have not adapted.

As a result, bridge lending has stepped in to fill the gaps. Since its comeback, commercial real estate professionals will have more opportunities to use capital from bridge loans to assist with closing deals. It is crucial to understand its nuances.

In recent years, major companies such as Teva Pharmaceutical Industries, Anthem, AbbVie, and Aetna have used bridge loans for initial financing of significant acquisitions. When Teva bought Allergan's generic business in 2015, it lined up $27 billion of debt to finance the $40.5 billion deal. Likewise, health insurer Anthem borrowed $26.5 billion in bridge financing for its $54.2 billion purchase of Cigna Corp. While biopharmaceutical company AbbVie secured an $18 billion bridge loan to finance its $21 billion acquisition of Pharmacyclics, Aetna lined up a $16.2 billion bridge loan to fund its $47 billion purchase of smaller rival Humana.

Total U.S. loan volume reached $2 trillion in 2016, and many of those loans started with bridge financing

Intended as an interim step before securing permanent financing, bridge loans typically range from two weeks to three years. From the commercial real estate perspective, compared to other financial products, bridge loans are monitored at higher levels. In contrast, traditional CMBS loans are static at inception and constrained by limitations from the Internal Revenue Code.

Funding Obligations

For bridge loans, lenders impose hard cash management at origination. These cash management provisions feature cash traps with complex debt-coverage ratio or debt yield tests that commercial real estate professionals have to calculate.

To date, no consensus exists about how to perform these calculations. To the extent that bridge loans feature future funding, commercial real estate professionals should understand that a cash trap's debt yield test may differ from the test related to a future advance.

Reckoning on Libor

Bridge loans are offered at a floating rate. They almost always use the London Interbank Offered Rate to calculate the interest due. Unlike fixed-rate loans, the interest rate will change periodically.

U.K. regulators have proposed phasing out Libor by the end of 2021. Bridge lenders should examine their existing loans and see which deals will be affected by its elimination. Any changes to a borrower's interest rate index will be closely scrutinized.

Understanding Prepayments

Next, bridge loans often feature prepayment very early - in some cases within the first year - and are often interest-only. As a result, commercial real estate professionals should consider pricing carefully.

These loans may not produce the income that longer-term loans may provide. Without assumption fees, asset management fees, defeasance fees, and other assorted lender fees, the mortgage servicers' income may be simply a servicing fee and interest income on deposits similar to a float.

Reserves and Disbursements

Bridge loans often provide options for reserves and disbursements. Their proper administration may be more critical than long-term loans because of their transitional nature.

Mortgage servicers are required to process disbursements, while understanding the requirements for disbursement and what, if any, performance hurdles are required to disburse. Given the need for capital infusions for bridge loan properties, the speed and accuracy of the process determines its success.

Extension Options

Many bridge loans contain extension options. As a result, commercial real estate professionals must ensure that the collateral and the obligors are meeting the performance criteria under the related loan documents. Inevitably, this will involve debt-service coverage ratio maintenance and also may require certain principal curtailments. Commercial real estate professionals should review extension provisions and know these provisions requirements.

Bridge lending's rise will present new challenges for commercial real estate professionals. With diligence and preparation, they can use bridge loans effectively and take advantage of these opportunities.

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Geoffrey R. Maibohm and Robert J. Sullivan

Geoffrey R. Maibohm serves as corporate and finance  attorney and Robert J. Sullivan is a partner in the Finance Group at Alston & Bird in Charlotte, N.C. Contact Maibohm at geoff.maibohm@alston.com and Sullivan at robert.sullivan@alston.com.

CIRE Nov/Dec 2017 Issue Cover

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