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What You Should Know About Investing in Commercial Bridge Loans

Coryanne Hicks

Short-term commercial mortgage bridge loans give investors fixed returns of 6 percent to 10 percent per year. Junk bonds of similar duration only provide about 1.77 percent.

With no fees and no loads taken from the investor's share, this can translate into a straight 6 percent annual return paid monthly to investors, says Lynnette Robbins, owner and founder of Knowles Systems, a financial firm in Providence, Rhode Island, that helps clients invest in commercial bridge loans.

How can bridge loans yield nearly six times as much as the riskiest bonds on the market? The answer, direct lenders say, is in the nature of the loans. Commercial mortgage bridge loans are short term (usually six to 18 months), high-interest-rate loans businesses use to "bridge the gap" when long-term financing is needed to buy a property but not yet available. When longer-term financing comes through, the borrower uses those funds to pay off the bridge loan.

Not long ago, only high-net-worth investors with millions of dollars to invest had access to these investments, but thanks to crowdfunding, hundreds of people can have a first lien claim on a property, Robbins says. Instead of one investor needing to put down millions of dollars for a loan on a commercial property, hundreds of people can pool their money to accumulate the necessary funds. This makes it possible for individual investors to become direct lenders.

[See: 16 Things Investors Should Know About Crowdfunding.]

If you're thinking these investments must have a catch somewhere, you aren't alone. Terry Savage, a nationally syndicated personal finance columnist in Chicago and author of "The Savage Truth on Money," says these loans carry significant risks. "The basic idea is that you are making a temporary loan to someone who cannot get a loan from a typical financial institution for some reason or other, and is willing to pay a higher rate. Right there, it tells you that there is more risk in the products," she says. It's OK to take this risk if you understand that it is there and are being compensated fairly for it, but she says for most average investors in bridge loans, neither is true.

You may be a lender for longer than you'd like. The first risk with bridge loans is that they are not as liquid as they are portrayed, she says. Investors in bridge loans face the risk that when the loan matures, the borrower is unable to repay it and asks for an extension. "The borrower has the right to extend per their agreement," says Greg Herlean, an executive at CapSource, a real estate investment and mortgage-lending company in Las Vegas.

At this point, if you're an investor, what you thought was a one-year note may turn into a much longer loan, Savage says. "The fact of the matter is the person who is offering these loans to you is making a profit in all of this. And that profit comes right out of the spread between what the borrower pays and what you're getting as the investor," she says.

At CapSource, each loan comes with an upfront sales charge and a rate spread that the borrower pays, both of which vary on a per-loan basis. Knowles Systems also takes a spread from the borrower's rate. A portion of these charges are used to cover the costs of crowdfunding as well as evaluating and underwriting the loans.

These are research-intensive investments. The trouble is "most retail investors are not well-equipped to evaluate the risks and investment merits of a commercial real estate loan, or they don't have the time, or both," says Evan Gentry, CEO and founder of Money360, a direct lender of commercial real estate loans in Ladera Ranch, California.

[See: The 10 Best Ways to Buy Real Estate.]

Instead, investors rely on the expertise of the companies that provide the loans to determine their risks and merits. To evaluate the loans, the companies employ third-party appraisers. These third parties determine the value of the real estate and perform a detailed analysis of the borrower. If the appraiser says everything checks out, the company underwrites the loan.

At CapSource, the appraisals are condensed into a three- to four-page summary. Investors can review this summary to determine if the loan is the right investment for them, Herlean says, adding that investors choose which loans their money funds, not CapSource.

In Gentry's experience, even this is more research than most investors are willing to do. "Let's be honest, most retail investors don't have the time to pick individual stocks on E-Trade, not to mention research complicated commercial real estate loans."

To this end, his company's wholly owned subsidiary, M360 Advisors, offers accredited retail investors (as defined by individual investors with a net worth of more than $1 million excluding their primary residence or an annual income of more than $200,000) a commingled commercial bridge loan fund. Investors are charged a 0.75 percent annual management fee, paid monthly, plus a yearly incentive fee, which allows the fund to participate in 10 percent of the annual returns above an 8 percent hurdle rate. In exchange, investors gain access to a more diversified fund of commercial bridge loans underwritten by Money360. According to Gentry, the fund's diversification helps mitigate "the risk of principal loss from any individual loan in the portfolio."

Savage says a commingled fund may help cut the risk that one bad loan in your portfolio takes your entire investment with it, but what happens when multiple loans are hurt all at once? What if it is "some kind of economic event that makes it impossible for the borrowers to get permanent financing at the end of the bridge loan," she asks.

Defaults are rare until they're not. Herlean says default rarely happens. Except during the 2008 crash, "in general, less than 1 or 2 percent of loans have issues."

Gentry adds that the 2008 economic crisis happened in part because banks loaned up to 100 percent of the loan's value. Most bridge loans have loan-to-value ratios of only 65 to 70 percent, so "property values would need to drop over 30 percent on average before our principal would be at risk," he says

Savage says it's only a matter of time before defaults occur. For the average retail investor, investing in bridge loans "is not going to end well," she says. "These are products that have worked and will work until they don't." It's easy for bridge lenders to be successful when the economy is growing and liquidity is high, she says. As long as borrowers are able to obtain more traditional financing at the end of the bridge loan, everything runs smoothly.

[See: 8 Strategies for Investing in Real Estate.]

But what happens in a credit crunch or a slow economy when end financiers are unwilling to provide long-term loans, or the real estate market tanks, taking property values with it? "At that point, these bridge loans could become a bridge to nowhere," Savage says.

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