Interest Rates Don’t Matter
Well, they are important in the long run, but their significance pales to other terms in certain scenarios. I need to make this point clear:
Interest rates on a construction or short-term repositioning loan matter very little.
In fact, increasing the interest rate a competitive bank will charge (4.5%) to that of a typical bridge lender (7.5%) only moves the IRR needle by about ~2% on a successful office repositioning over a 7 year hold.
Context is important. Let’s dive in today’s example.
Example: Office repositioning, 7 year hold
In this example, the deal is an acquisition and repositioning of an under-performing office building, current NOI of $400k, listed at $8,000,000 (5% cap rate). The sponsor believes that over the course of a 7-year hold, they can slowly stabilize the property to an NOI of $750k before selling. They assume an exit cap rate at 6.5% just to be safe.
4.5% bank financing with 2 year I/O period
7.5% I/O bridge loan for 24 months, then 4.5% bank financing
Here the higher rate of the bridge loan over 24 months reduces our IRR by 2.16%, from 24.9% to 22.74%. Investors all have a threshold for the IRR they want to see on a deal in order to “pull the trigger”, but I don’t see anyone making that cut-off at 23% IRR. If you’re confident in your ability to reposition an office asset as described above, you should take it all day, regardless of whether you can get bank financing on day 1.
Every project has its own situation, as does every borrower. Yours may be completely inapplicable to any of the above. But the idea that analysis over the full course of a project should determine the financing strategy is always applicable.
Here’s where that leaves us: getting construction or bridge financing at a low rate from a bank is great, but getting a short-term loan from a debt fund/private lender at higher rates can be great as well, particularly if they offer higher leverage, less recourse, and a faster close, or in instances where bank financing is impossible. Private money/debt funds also typically have less red tape in the origination, servicing, and construction draw process than banks.
Money can be made in any market and with a wide array of financing options by delivering quality projects. If you can deliver more projects, bigger projects, or the same projects more quickly, there’s your financial return ticking back up. Shying away from a deal because you can’t attract bank financing yet may not be the right decision — if you can execute!
If this example proves helpful, we will follow up with additional examples, including IRR analysis for a ground-up multifamily project.
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