New real estate investors frequently ask me different financing-related questions. And one that comes up often involves bridge loans. In particular, Ryan, how do bridge loans work when buying a house?
Bridge loans provide borrowers short-term financing until they can secure a long-term loan. Fix & flip investors use them to finance the purchase and repair of a home until they can sell. BRRR investors use bridge loans for the same reason, but they pay them off with a long-term refinance instead.
I’ll use this article to provide some more details about bridge loans. Specifically, I’ll dive into the following topics:
- What is a Bridge Loan?
- Traditional Mortgages for Residential Real Estate Investors
- Bridge Loans for Residential Real Estate Investors
- What Investors Should Use Bridge Loans?
- Bridge Loans vs Gap Financing
- Strategies for Buying a House with a Bridge Loan
- Final Thoughts
What is a Bridge Loan?
In simple terms, a bridge loan takes investors from where they are to where they need to be. More precisely, bridge loans provide borrowers a short-term financing solution until they can secure long-term—or “take-out”—financing. For example, investors may use bridge financing to purchase and rehab a property before they can A) sell it, or B) refinance into a long-term mortgage.
Typically, commercial real estate investors use the term “bridge loan” more than residential investors, but the funding mechanism exists in both areas. However, investors should note that, with commercial real estate, a bridge loan differs from an acquisition/construction loan. In commercial real estate, new developments pose tremendous risk to lenders, so they structure acquisition/construction loans for a new development differently than they would a bridge loan, which is more generally used for existing properties.
Traditional Mortgages for Residential Real Estate Investors
Residential real estate investors absolutely use bridge loans, but they refer to them as hard money loans. They use these loans for the same purpose—to provide a short-term financing solution until they can secure a long-term mortgage. To understand how this process works, investors first need to understand how traditional, long-term mortgages work.
With a traditional, long-term mortgage, a lender uses two lending criteria:
The Borrower’s “Soft” Assets
These include the borrower’s general financial picture. Lenders will want to ensure that credit scores, income, debt-to-income ratios, and cash reserves all meet certain minimum standards. Basically, lenders want as much assurance as possible that the borrower has the ability to continue making payments. If you’ve applied for a home loan before, you understand how in-depth a process this can be.
The Actual Property
If a borrower defaults on a loan, the bank still wants its money. As such, lenders require formal home appraisals during the mortgage loan closing process. They want to make sure that they’re not lending you more than the house is actually worth. That way, if you stop paying, they know that they can foreclose on and sell the property, with the proceeds paying off the loan balance. In this vein, most conventional lenders will not provide mortgages for homes in need of major repairs. These homes just pose too much risk for lenders, as they can’t guarantee that they’ll be able to recoup a loan balance in case of default.
Bridge Loans for Residential Real Estate Investors
Here’s the key takeaway about residential long-term financing: lenders will not issue traditional mortgages for properties in need of repair. This brings us back to the idea of using a bridge loan to take us from where we are to where we need to go. Simply put, a bridge loan, enables investors to purchase and rehab a distressed property to a level that will qualify for traditional, long-term financing. Even if the investors don’t plan on refinancing the property, they’ll likely need to sell to a buyer who will use a traditional mortgage.
As a result, if an investor can’t pay cash for a purchase and rehab, he or she will need to use a hard money loan. Many people incorrectly believe that these loans are so named because they are hard to get. In reality, hard money lenders base their lending criteria on the “hard asset,” or the property. They don’t concern themselves with the borrower’s overall financial picture (as long as no bankruptcies or judgements exist).
Whereas traditional lenders look at a property in terms of its current value, hard money lenders don’t concern themselves with this present status. Instead, they look at a property and ask, what will this property become? They base their decision to lend on the projected after-repair value (ARV) of a property.
In other words, hard money lenders issue loans based on what they believe the property will be worth in the future. While each hard money lender offers its own terms, at Do Hard Money we’ll lend up to 70% of a property’s ARV.
But, how can you tell what a property will be worth in the future?
To determine a property’s future value, hard money lenders need to commission a specific type of home appraisal. With a standard residential appraisal, appraisers analyze a property based on nearby comparable properties, or comps. Essentially, they try to find homes in the same market as similar as possible to the target property that have recently sold, which provides a good estimate of market value.
With an ARV appraisal, appraisers do this, too. But, they also need to look at comps relative to the future property. An appraiser will request a detailed contractor bid for all of the proposed rehab work. Then the appraiser will find renovated homes in the local area that have had similar scopes of work completed during the rehab process. This provides them insight into what a home will be worth following the rehab.
Armed with this ARV appraisal information, hard money lenders can determine the amount of a hard money loan—or bridge loan—they’ll issue. For example, assume an appraiser estimates a property’s ARV at $250,000. With our model, we would then provide a $175,000 loan ($250,000 ARV x 70% LTV). Investors would use these funds as a short-term financing solution. And, they would pay it off either after A) selling the property, or B) refinancing it into a long-term mortgage.
What Investors Should Use Bridge Loans?
After providing an overview of bridge loans for residential investors, which ones should actually use them? I’ll start with who shouldn’t use them.
Due to their short-term nature and the increased risk of a distressed underlying property, hard money loans generally have far higher interest rates than long-term mortgages. As such, you absolutely shouldn’t take out one of these loans if you can qualify for traditional financing. Long-term buy & hold investors often fall into this category.
These investors have much longer-term profit horizons than fix & flip investors. Accordingly, many of them don’t mind buying a property for retail value. They view profit partially through the lens of cash flow. But, they’re much more interested in A) having tenants pay down their amortizing loans, and B) holding a property for a long enough period that it’ll significantly appreciate. With this approach, many buy & hold investors don’t want the hassle of a rehab process. Instead, they’ll buy MLS-listed properties that already qualify for traditional financing. A hard money loan provides a bridge to permanent financing. If you don’t need that bridge in the first place, don’t use it.
Fix & Flip Investors
These investors buy distressed properties, renovate them to a standard that will qualify for traditional mortgages, and sell them—usually to people buying a primary residence. But as discussed, traditional lenders will not provide loans for properties in need of significant repairs. Therefore, fix & flip investors have one of two options: pay cash or use a hard money loan.
Realistically, most investors don’t have enough cash on hand to self-finance a deal—or just don’t want to tie that much money up in a single deal. Hard money loans provide the bridge between the deal’s initial plan and the sold property. And, even though these investors don’t personally secure permanent financing, they need to bring properties to that sort of standard for buyers to actually secure financing for a purchase. If not, they’ll struggle to sell the renovated property, which they’ll need to do to pay off the hard money loan.
These investors take a similar initial approach to fix & flip investors, but they have a different exit strategy from their bridge loans. BRRR stands for buy, rehab, rent, and refinance, and here’s how those steps work:
- Buy: BRRR investors look for the same sort of properties as fix & flip investors. They want to find distressed properties at a deep discount. This discount is critical to building profit into a deal’s budget—spend too much on the purchase and you won’t net any profit on the sale. And like fix & flip investors, BRRR investors will not qualify for traditional financing due to the distressed state of these properties. As such, they also need to secure short-term financing with hard money loans.
- Rehab: The rehab process for a BRRR investor also looks largely the same as a fix & flip deal. However, BRRR investors conduct their rehabs with a goal to rent, not sell, their properties. This means that many of these investors make decisions about materials with an eye towards the wear and tear that tenants can put on a property. Basically, they want to use materials that A) look good to prospective tenants, B) aren’t prohibitively expensive, and C) will last for a long time.
- Rent: This is the step where the BRRR strategy diverges from the fix & flip one. Once renovated, investors list their properties for rent to long-term, high-quality tenants. A signed lease proves critical to the next step in the process.
- Refinance: Instead of paying off their bridge loans by selling properties, BRRR investors refinance their properties into a long-term mortgage, using these proceeds to pay off the hard money loan and, potentially, take some cash out of the deal. But, traditional lenders have income requirements for long-term mortgages on investment properties. Many investors don’t have the income to qualify without rental income, and banks generally consider a percentage a property’s rent towards the owner’s income requirements. Accordingly, BRRR investors generally need a tenant in place before they can secure a long-term financing solution and pay off their bridge loans in the process.
Bridge Loans vs Gap Financing
Investors often throw around the term “gap financing” interchangeably with bridge loans. These two are similar in that they both represent short-term financing solutions. But, gap financing serves a different purpose than bridge loans.
With gap financing, investors look for a way to get from what they have to what they need to make a deal happen. For example, assume you can get a $100,000 hard money loan for a property, but you need $120,000 to make the deal happen. If you have $10,000 of your own cash, that still leaves you $10,000 short on the deal. Enter gap financing. In this example, these short-term financing solutions provide investors a way to cover that last $10,000 (or whatever that funding gap totals).
Residential real estate investors have plenty of gap financing options, but here are a few of the more common ones:
- Credit card financing: Credit card companies want your money. As such, if you’re a responsible borrower, they’ll provide you pretty good personal loan options. Say you have a $25,000 limit on your credit card, but you only use $2,000 of it every month, always paying it off on time. There’s a good chance the card company will offer you a relatively low interest personal loan for the difference between the credit you regularly tap and your limit. This can be an outstanding gap financing strategy.
- Business partner: Alternatively, you can seek a business partner. Plenty of people A) want to invest in real estate, but B) don’t have the time or experience to do so. If someone has money to invest, you can potentially bring them on as a limited—or “money”—partner. These individuals provide funds, have no role in the day-to-day operations, and receive a return on their investment. Yes, you’ll need to sacrifice a portion of your returns. But if it makes the difference between funding a deal or not, bringing on a partner can be a great option.
- HELOC: Home equity lines of credit, or HELOCs, are another great gap financing strategy. Typically, investors tap the equity in their primary residences. So, assume you have $50,000 in equity in your property. A lender may not extend a HELOC for that entire amount, but even if you secure a $25,000 HELOC, this gives you a tremendous amount of gap financing flexibility. And with HELOCs, you only pay interest on the money you draw. Once you repay the outstanding balance, you don’t need to pay interest.
- Business LOC: Functionally, a business line of credit (LOC) acts the same as a HELOC. However, rather than secure the credit against your primary residence, banks use your business’s operations to secure a business LOC. Obviously, this option only exists for investors with a business. But, if you have a successful business, a LOC secured by its operations can be an outstanding gap financing option.
Strategies for Buying a House with a Bridge Loan
After explaining how bridge loans work, the question remains—how can you find good deals to actually use a bridge loan as a real estate investor? Really, this question means, how can I find good fix & flip / BRRR properties?
Investors can look for properties on the MLS. But, I consider this a fool’s errand for two reasons. First, with MLS properties, you’re competing against everyone—other investors and primary home buyers. Second, these properties tend to qualify for traditional financing, meaning it wouldn’t make sense to seek a hard money loan to purchase and renovate them.
Instead, we highly recommend looking for off-market properties. As they’re not listed, these properties inherently have less competition. Many motivated buyers A) want to sell, but B) haven’t listed their homes due to major renovation needs. For these potential sellers, fix & flip and BRRR investors act as problem solvers. They use hard money loans to purchase the homes, which represents a win-win. The seller gets cash out of the property without needing to do any repairs, and the investor gets a great deal on the property.
As an investor, bridge loans take you from where you are to where you need to go. For most investors, they open up a world of possibilities. Most people realistically do not have the money sitting in their accounts to self-finance deals—especially new investors. Bridge loans offer investors a means to access deals that would otherwise be out of reach. Yes, they charge a higher interest rate than long-term financing, but this is a small price to pay relative to the potential returns of a properly analyzed fix & flip or BRRR deal.