Term sheets headline the debt yield test. The loan agreement usually adds an LTV test on a fresh appraisal, and on most cap rates that is the one that binds.
A bridge loan earn-out releases held-back loan proceeds once the property's income supports a larger loan, and the amount released is the lower of what the debt yield test and the loan-to-value test allow, less the loan already funded. On an illustrative $40.0M loan with $32.5M funded at closing and a $7.5M earn-out, released at an 8.0 per cent debt yield and 70 per cent LTV on an appraisal at a 6.00 per cent cap rate, full release needs $3,428,571 of NOI, not the $3,200,000 the debt yield test alone suggests. At $3,200,000 the borrower draws $4,833,333 and leaves $2,666,667 behind.
Worked in full in The Real Estate Debt Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Value-add bridge loans are often structured with a performance holdback, usually called an earn-out: part of the commitment is funded at closing, and the rest only when the business plan has produced the income to support it. For the lender it caps the day-one exposure; for the borrower it is cheaper than raising equity for the gap. Both sides tend to model the release from the debt yield, because that is the test in the term sheet's headline. The loan agreement usually adds a second one.
| Input | Value |
|---|---|
| Purchase price | $50,000,000 |
| Initial advance (65% of price) | $32,500,000 |
| Earn-out | $7,500,000 |
| Total commitment | $40,000,000 |
| Release test 1: debt yield on the total loan after release | ≥ 8.0% |
| Release test 2: LTV on an updated appraisal | ≤ 70% |
| Appraisal basis | In-place NOI at a 6.00% cap rate |
| Minimum release | $1,000,000 |
| NOI at closing | $2,400,000 (7.38% debt yield) |
The buyer paid $50,000,000 for the lease-up, a 4.8 per cent going-in yield. Capitalised at 6.00 per cent, the in-place NOI supports a value of only $40,000,000. That gap is why the earn-out exists.
Max loan by debt yield = NOI ÷ 8.0% = 12.50 × NOI
Max loan by LTV = 70% × NOI ÷ 6.00% = 11.67 × NOI
Release = MIN(earn-out, MAX(0, MIN(both tests) − funded loan)), and nothing if below the minimum. In Excel, with NOI in B1 and the funded loan in B2: =LET(r,MIN(7500000,MAX(0,MIN(B1/8%,70%*B1/6%)-B2)),IF(r<1000000,0,r))
At a 6.00 per cent cap rate the LTV test always binds, because 70 per cent of value lends 11.67 times NOI while the debt yield allows 12.50 times. The two tests give the same answer only at a cap rate of 5.60 per cent, 70 per cent times 8.0 per cent.
| NOI, $ | Debt yield test, $ | LTV test, $ | Release, $ | If only debt yield applied, $ |
|---|---|---|---|---|
| 2,400,000 | 30,000,000 | 28,000,000 | 0 | 0 |
| 2,800,000 | 35,000,000 | 32,666,667 | 0 | 2,500,000 |
| 3,000,000 | 37,500,000 | 35,000,000 | 2,500,000 | 5,000,000 |
| 3,200,000 | 40,000,000 | 37,333,333 | 4,833,333 | 7,500,000 |
| 3,500,000 | 43,750,000 | 40,833,333 | 7,500,000 | 7,500,000 |
At $2,800,000 of NOI the LTV test allows $32,666,667, only $166,667 above the funded loan, which is below the $1,000,000 minimum: nothing is released. The first draw needs $2,871,429 of NOI. The full $7.5M needs $3,428,571, 42.9 per cent above closing NOI, against 33.3 per cent if only the debt yield test applied. On a lease-up that adds NOI steadily, that difference can be the last year of the business plan.
| Appraisal cap rate | NOI for full release, $ | Binding test | Release at $3,200,000 NOI, $ |
|---|---|---|---|
| 5.50% | 3,200,000 | Debt yield | 7,500,000 |
| 6.00% | 3,428,571 | LTV | 4,833,333 |
| 6.50% | 3,714,286 | LTV | 1,961,538 |
| 7.00% | 4,000,000 | LTV | 0 |
The earn-out is a bet on two things, not one: that the borrower delivers the income, and that cap rates do not widen before the appraisal. A 100 bp widening, from 6.00 to 7.00 per cent, takes the release at $3,200,000 of NOI from $4,833,333 to nothing. The lender is protected either way: every dollar it releases stays at or below 70 per cent of the appraised value and at or above an 8.0 per cent debt yield.
For the debt investor the earn-out is a way to lend against a business plan without lending against it on day one. The funded loan of $32,500,000 is 65 per cent of the price but 81 per cent of the $40,000,000 the in-place income supports at a 6.00 per cent cap rate, so the initial exposure already relies on part of the plan. Each release, by contrast, is underwritten on income that exists: at full release the loan is 70 per cent of an appraised $57,142,857 and yields 8.57 per cent on $3,428,571 of NOI. The fee and pricing should reflect the larger commitment, since unfunded earn-out capacity ties up the lender's capital or its facility headroom until it is drawn or cancelled.
Budgeting the earn-out off the debt yield in the term sheet and ignoring the LTV test, the appraisal basis and the minimum release in the loan agreement. A borrower who reaches $3,200,000 of NOI and expects $7.5M gets $4,833,333 and has $2,666,667 of capital expenditure or leasing costs to fund from equity. Check also the expiry date of the earn-out, after which unreleased amounts are cancelled, and whether the NOI is trailing or annualised, which on a lease-up can move the release by several quarters.
The loan, tests and cap rates are illustrative and not a statement of market terms. Not advice on any financing.
The structuring of value-add loans, from sizing to workout, is the subject of the book's companion page. The loan's value tested before and after the business plan is worked in as-is vs as-stabilised LTV, and the income it needs at maturity in what NOI a bridge loan needs to refinance.
A part of the loan commitment held back at closing and released when the property's income meets set tests. In the illustrative case $32.5M of a $40.0M loan is funded at closing and the $7.5M balance is released as NOI grows, subject to an 8.0 per cent debt yield and 70 per cent LTV on an updated appraisal.
The LTV test binds whenever the appraisal cap rate is above the LTV limit times the debt yield, here 70 per cent times 8.0 per cent, 5.60 per cent. At a 6.00 per cent cap rate the LTV test lends 11.67 times NOI against 12.50 for the debt yield, so full release needs $3,428,571 of NOI instead of $3,200,000.
Because of a minimum release amount or a wider appraisal cap rate. At $2,800,000 of NOI the LTV test allows only $166,667 more than the funded loan, below a $1,000,000 minimum, and at a 7.00 per cent cap rate even $3,200,000 of NOI releases nothing.
This article is one calculation from The Real Estate Debt Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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