Paper on The Opportunity in Bridge Lending

[client work; to note: I do not endorse the ‘language’ of this piece as it was heavily edited by the client. Rather, I wanted to show the intersection of my research and market narrative capabilities.]

Private credit secured by commercial real estate has long provided investors a compelling risk return profile, one characterized by short durations, high current income, and downside protection. And today, emerging from COVID-19’s unique market impacts, the investment opportunity is more attractive than ever.

When the pandemic hit, commercial real estate (CRE) finance suffered a shock as property sales, lending, and the network of CRE partner functions (appraisers, title, escrow etc.) halted operations overnight. While in the short-term this disruption limited the amount of capital available to borrowers looking to finance properties, it also created an opportunity for lenders to meet pent-up borrowing demand as the commercial real estate finance market bounced back.

While murky waters lie ahead for the broader investment markets – stocks are highly valued and public fixed income yields remain abysmally low – a bright spot exists in commercial real estate bridge lending. CRE bridge lending offers an excellent opportunity for investors looking for stable recurring income, reliable returns in the high single-digits and the downside protection of real asset-backed collateral.  

Commercial Bridge Lending Primer

It is worth briefly explaining the difference between lending types within commercial real estate finance. Permanent lending, which is the financing most are familiar with, is provided by banks to customers with multiple banking relationships, on stabilized assets, with a loan term of seven to ten years.  

Bridge lending, on the other hand, provides short-term (one to three year) loans for properties in a transition or seasoning phase (working toward 18-24 months of stable operating performance) prior to obtaining permanent bank financing. For example, a bridge borrower might be a property owner looking to lease up a newly built asset or reposition an existing property to improve net operating income.

Bridge, or transitional, loans are offered by private, non-bank lenders rather than traditional banks. These assets allow bridge lenders to charge higher interest rates while managing risk with lower loan-to-values and shorter durations and by financing value add projects from strong, highly experienced borrowers.


Post-Pandemic Opportunity for Investors Seeking Current Income and Capital Preservation 

COVID-19 paused commercial lending activity and severely limited liquidity as new real estate sales and refinancings paused. All the while, commercial loans continued to mature, creating a backlog of borrowers needing short-term bridge financing. These dynamics, along with a real estate finance market better equipped to withstand economic shocks (the result of changes made in the years following the global financial crisis), lay the foundation for an exciting period of growth in the private lending market.

The Pandemic’s Liquidity Impact – and Commercial Real Estate Market Resiliency

There are two primary reasons that CRE lending dried up in 2020. One, most lenders slowed down lending activity and some lenders stopped their bridge lending programs altogether.  And two, loans did not pay off at the same rate as they did prior to the pandemic. With slower and fewer loan payoffs, private lenders had to prioritize liquidity for meeting future funding requirements before creating additional commitments. Lenders also wanted time to reassess the new risk environment and better understand the impact of the shutdown on borrowers. This shrunk the supply of credit available from lenders.

We see the effects of the lending halt and lack of loan payoffs borne out in CRE issuance and securitization data. New issuance within CMBS fell nearly 50% in 2020 while CRE CLO issuance, which had seen impressive growth since 2012, dropped roughly 60% compared to issuance in 2019. This drop in issuance is comparable to the impact we saw during the global financial crisis in 2008 and 2009. Unlike the 2008 crisis where issuance took 2-3 years to recover, initial data in 2021 suggests that issuance across both CMBS conduit and CRE CLOs have already bounced back quickly over the first half of 2021 and should return or even surpass 2019 issuance by year end.

CRE CLOs have been an increasingly popular financing vehicle for transitional lenders over the last several years, enabling lenders to source less expensive cost of capital. Figure 1 shows the growth of CRE CLO issuance since 2012, when these securitizations started becoming more popular among bridge lenders. COVID stunted this growth in 2020 as CRE CLO issuance fell to $8.7 billion from $19.7 billion in 2019, a drop of roughly 55% in deal activity. But similar to CMBS issuance, CRE CLO deal flow has rebounded sharply to start the year. New securitizations have totaled $9 billion in Q1, already outpacing total CRE CLO deal activity in 2020. And most CRE CLO forecasts call for total issuance to surpass 2019 volume signaling a strong rebounded for commercial real estate lending.                                                     

Figure 1: Annual CRE CLO Issuance Volume (Trepp)

The impact of the pandemic was also reflected in CMBS delinquency rates. Delinquency rates quickly spiked to 10% in 2020, their highest level since the aftermath of the financial crisis, as liquidity quickly dried up and borrowers grappled with cash flow issues. Figure 2 shows how delinquency rates have trended from 2008 through 2020 – they remained elevated for several years following the 2008 financial crisis as recovery was gradual. Initial data coming out of COVID suggests delinquency rates are already making a quick retreat to lower levels.

Figure 2: CMBS Delinquency and Special Servicing Rates (Trepp)

The detail in figure 3 shows monthly delinquency rates averaged across all commercial property types, highlights speedy recovery since the initial shock of COVID. Delinquency rates have fallen each month since March 2020, when they topped at 10.3%. These numbers also include hospitality and retail properties, whose delinquency rates remain elevated at 16% and 11% respectively as of April 2021. Other asset types, like industrial, multifamily, and office, have normalized more quickly.

Figure 3: Monthly CMBS Delinquency Rates since COVID (Trepp)

Expectations for recovery are different today than they were coming out of 2008 and 2009. Lending markets, transaction activity, and loan performance are all poised to rebound much quicker following this market shock. A strong and quick recovery should be fueled by: 

  1. Resilient supply and demand dynamics. The pandemic’s impact created a unique shock to supply and demand factors but left most company-specific fundamentals intact. This should spur a quicker recovery than the 2008 crisis as supply and demand normalizes with the lift on economic shutdown measures.

  2. Accommodative government stimulus programs providing liquidity for struggling companies and supportive monetary policy to keep interest rates low.

  3. A strong market backdrop with solid fundamentals underpinning real estate markets, recovering levels of activity, improving bank and company balance sheets, and better underwriting standards and practices following 2008.

A Backlog of Demand

Most commercial properties are financed, in part, through debt. There is approximately $4.7 trillion of debt financing roughly $8.1 trillion of CRE transaction volume (U.S. Federal Reserve, March 2020), and the pandemic did not cancel the need for new loans or the need to refinance maturing loans. COVID-19 all but halted lending volume during the summer months of 2020, but many private lenders have returned and have scaled up lending activity to meet this backlog of borrower demand, creating an opportunity for investors seeking high current income.

Additionally, there is a large cohort of borrowers who no longer qualify for permanent financing and will need to access non-bank financing sources for capital, expanding the opportunity set for capital providers.

As private lenders pick up activity, those deploying capital post-pandemic will have access to not only a larger pool of borrowers but also a greater share of that opportunity. Bridge lenders will see robust deal flow, allowing them to be even more selective in their credit and underwriting process. This strengthens the risk-return profile for investors by aligning capital with lenders that select only the strongest opportunities. Private lenders will have better access to: 

  • Experienced owners with strong property management teams

  • High quality properties

  • High growth locations, or tenants poised to recover well from the pandemic 

All the qualities that investors tend to like in a fixed income investment strategy – short durations, high current income, senior secured first lien position and capital preservation -an attractive the risk return profile – are abundant in the current environment and expected to last well into 2022.

This is not all to ignore the risks. Worries about uncertainty, choppy performance, and extended COVID-19 impacts linger. However, lenders can combat these concerns with lower loan-to-value (LTV) ratios, and first lien, senior secured positions. Investors should continue to prioritize these attributes as they seek alternative fixed income offerings secured by commercial real estate.

How to Allocate to Commercial Real Estate Secured Debt

Commercial real estate bridge lending is well positioned to enjoy a steady and strong deal flow over the coming years, providing an attractive opportunistic investment while maintaining its solid return profile in the high single-digits.

Short-term bridge lending strategies are versatile and fit into a number of institutional allocations.

  • They can act as a high yielding ballast to public fixed income, an area where yields have remained historically low.

  • As a component within a private credit or general alternatives allocations.

  • As a hedge to inflation in the real asset bucket.   

All the above fit the needs of investors looking for stable returns and high current income from real assets. Each of these strategies have the security offered by an asset backed, inflation protected investment.

This is a unique time to gain exposure to private commercial real estate and bridge lending. Against the backdrop of highly valued equities and low yielding public debt, and with a large pool of borrowers in need of short-term financing, commercial short-term bridge lending provides attractive income secured by real assets in a low yielding environment