The traditional role of bridge financing has been to cover a temporary gap in a business’s liquidity until longer-term funding can be secured. In the commercial real estate sector, such finance has often been used when a manager needed to close a deal on a property quickly or execute a stage of its business plan to de-risk an asset, for example by securing planning consent.
Tickets were typically modest in size, and terms were short. Pricing was high, but borrowers were prepared to swallow the cost because it would often be only six to 24 months before the bridging debt would be refinanced using a traditional bank loan.
Today, following rapid base rate increases, which have caused turmoil in European real estate markets, the resulting dislocation in the lending market has transformed what lenders and borrowers mean when they talk about bridge finance. To begin with, there are fewer traditional bridge loans for acquisitions for the simple reason that there are fewer investment deals being done. The price expectations of buyers and sellers are often still far apart, and finance is more expensive and harder to secure.
In a liquidity-constrained market, sponsors are wary of taking out short-term loans they may find difficult to refinance a few months hence, says Ben Eppley, partner in charge of the European commercial real estate debt business at asset manager Apollo Global Management. “This market has caused prolongations of business plans, and there hasn’t been the acquisition and sales activity that we’ve seen in the past. So, over the last 18 months, bridges have tended to serve a different purpose. Primarily, they are financings that help sponsors find more time to execute a strategy.”
In a market where the phrase ‘stay alive till 2025’ has been used to describe businesses’ efforts to ride out the current turbulence, historically small bridge loans with a short time frame of six months to two years have evolved to become larger in amount and longer in duration, says Patrick Züchner, chief investment officer of German-headquartered debt fund manager Aukera Real Estate.
“The volumes for these transactions can now be very large. We have been involved in several situations of €100 million or more”
Aukera Real Estate
“The volumes for these transactions can now be very large. We have been involved in several situations of €100 million or more. And the terms are much longer – more than two years, and often three or four years, close to the lower end of what we might have considered a normal financing term in the past,” he says.
The transformation of the bridge loan market has happened over the course of this year, he argues. “The reason for that is clear: it is because of constrained liquidity across the wider real estate market, not because of the underlying real estate.”
Züchner uses the term ‘bridge-to-exit’ to describe the type of deal that is becoming more prevalent in the bridging market.
Bridge-to-exit is the most significant opportunity for short-term lending in the current market circumstances, he believes. In situations where a developer is nearing completion of a scheme that has been substantially pre-let, with development and letting risk minimised, standard practice would be to either sell or refinance to take out its equity and realise the development margin.
However, without active core equity buyers or access to cheap finance, both those avenues have effectively closed, unless the developer is prepared to accept a severe reduction in its anticipated return. For some, the answer is to take out a bridge-to-exit loan that will preserve liquidity in the capital structure while the developer waits for a better market environment in which to sell or refinance.
Eppley says Apollo is active in refinancing assets that are close to completion, or have recently completed, to give them time to stabilise. “The construction risk is gone. The assets are often open and operating, but they need more time to bring in residents or guests or tenants. We provide a three or four-year loan to allow that property to mature and then we will eventually be taken out by core financing from a traditional senior lender.”
Züchner identifies a second bridging scenario, which he calls ‘bridge-to-practical completion’. In this case, liquidity is lacking at an earlier stage of the development process, so the lender must be prepared to take on development risk to finish the project. In such situations a lender may have the option to not only refinance the existing development loan, but also the sponsor’s equity, so that the developer is retained and paid a development management fee, while the lender receives an equity-like preferred return.
Deals of this kind are only possible where the profit margin of the development, while reduced, is still sufficient to allow both lender and developer to fulfil their return expectations, says Züchner. “No institutional debt player would touch projects with a very thin margin left, say 10 percent or even less, between total construction costs and exit value today. That is more a game for the value-add opportunistic equity players.”
A third bridging situation is ‘bridge-to transformation’ where the collateral is an existing asset, such as an outdated office building, which will be refurbished to modern sustainability standards. A bridge lender can step in to plug the liquidity gap in a similar way to bridge-to-PC, again potentially capturing a preferred equity return. “In all these cases it is not a question of a bad-performing asset, but a lack of liquidity,” says Züchner.
Such situations, where a loan provides a bridge from one stage of an asset’s life cycle to another, are often called transitional lending by mid-market and large lenders, says Daniel Austin, chief executive officer at specialist UK property lender ASK Partners. “The lender is bridging that period when the buyer of an asset is implementing a business plan, so that at the end of that phase of asset management, they can either refinance it onto much cheaper long-term debt or sell it.”
He adds that another common bridging scenario has been created by higher interest rates dampening the UK residential market. Consequently, some residential developers need bridge finance when an existing development loan is coming to an end, and the housebuilder is taking longer than expected to dispose of its remaining unsold units. Taking out transitional finance provides the developer with more time to sell off properties so that it does not have to drop the price to encourage quick sales.
Austin says another emerging trend is for the owners of income-producing portfolios to seek short-term finance because falling values have undermined their interest coverage ratios. The sponsor’s existing lender may demand an equity injection or expect it to repay the loan via a sale or refinancing. “If they don’t have equity to put in, they need someone like us to lend them the money until they are able to drive higher income off the portfolio,” he says.
“If they are struggling to service us with the net income they are receiving, they might have to chip in a bit of equity along the line to keep us current. But that is a better option than having to sell and put all their equity at risk.”
Enter the equity funds
Rob Jones, principal at adviser Moorhall Capital, says there are a broad range of lenders prepared to provide bridge-type debt, usually debt funds and challenger banks, but also equity funds moving into the space because they are struggling to deploy capital and see debt as a good alternative. Jones also sees family offices, high-net-worth individuals, and property companies which see it as an attractive opportunistic play.
“Securing a loan of this type is about finding a lender that is prepared to buy into the strategy that you have for the asset,” he notes. “Just because a situation might not work for the current incumbent lender, doesn’t mean it won’t work for someone else. Every lender has a different risk appetite and cost parameters.”
In some bridging situations, the “unspoken truth” is that the lender is not overly concerned about the prospect of a default, he adds. “It isn’t necessarily the sales pitch, but the implication is that if you really need it, we will lend you this money on our terms, and if you don’t deliver then we would be happy to own the asset at that price.”
“Just because a situation might not work for the current incumbent lender, doesn’t mean it won’t work for someone else”
For investors placing capital with debt funds doing bridge deals, the opportunity to make equity-like returns in a debt situation where the risk is reduced because of the high quality of the assets is appealing, says Züchner. “It is all about very good projects, ESG-perfect and in strong locations, institutional on every point of the checklist, where liquidity is constrained not because of the asset, but by external effects.”
He argues relatively few potential lenders are well-equipped to step into complex bridge-to-exit transactions, however. “It is not just about receiving cashflow from a standing asset. It requires a manager with the skills and track record to solve these situations at different points in the market cycle.”
The manager needs to be able to take a quick decision to advance large sums, he adds, which requires a fully discretionary fund or a managed account with very short lines of decision-making.
Lenders can take a variety of steps to reduce risk by the way they structure bridge loans, suggests Austin. “We take a first charge on the asset. If there is a shortfall in the income the asset can produce to keep our loan current, we might take an interest guarantee or an equity commitment letter. We might have an interest reserve so that we know we can always dip into that to top up any shortfalls. And ultimately, we are taking a view on the asset value as well as the cashflow.”
ASK offers bridge-type loans of up to 60 or 65 percent loan-to-value. Eppley says Apollo’s bridge loans are typically around 60 percent LTV, and the lender also likes sponsors to commit to investing equity capital in the asset. The ability to identify more than one clear route to exit is another crucial consideration, he adds.
For Züchner, the LTV is less important than the overall value of the project margin, because that determines the sum that can be divided up between the sponsor and lender and distributed on exit. “Just to look at LTV in respect of exit value, or loan-to-cost in respect of total construction costs is a bit too simplistic thinking in these complex scenarios,” he argues.
Eppley says that while the drivers may change or shift over time, there will always be a need for bridge financing. However, the duration of the window of opportunity for new-style bridge lending will depend on how long current market conditions persist. “At some point there will be more acquisition activity as valuations settle. And that will mean that the need for bridge-to-exit financing will probably diminish.”
He believes that higher financing costs will make it expensive to carry underperforming assets, catalysing more transactional activity in 2024.
Austin is less optimistic about the likely trajectory of the market. “The maxim is ‘stay alive until 2025’, but it could be 2026,” he says. “Most sponsors seeking short-term finance want to be borrowing until at least the middle or end of 2025.”