Gap Financing: What you didn’t know
Gap Financing, it’s something most real estate investors don’t know about. I’m going to tell you about You’ve got a property you’re looking to purchase and you’ve got a hard money lender that’s willing to give you the majority of the money that you need for your deal. But you’re short on cash. You’ve gone to family and friends, people in your network, possible business partners, and you’re asking all of them for money to fund the “gap” you need to buy this property.
I am going to tell you how to get a lower cost of capital from these people that you’re asking to “fund the gap” on your deal. By structuring the funding the way I am going to tell you to do it, you are going to give your gap lenders a better feeling of security so you have a higher likelihood of actually getting that money from them!
Most people, when they go to family members or friends for capital to invest in their real estate deals, they approach them as a possible partner or as a joint venture (JV). Don’t do it!
Why not partner or JV? Because you’re going to be giving away a larger percentage of your final profit to that person if you partner with them on a deal!! You’re also going to have to deal with the hassle of having a partner.
If you’ve had partners or family and friends get involved with your real estate deals, you know it can cause you a lot of anguish and stress. Don’t do it!! What do you do instead? Approach these people for a “loan” or debt, instead of a partnership or a JV. You’re going to approach them for what’s called a “gap loan.”
What is Gap Financing?
Now, what exactly is a gap loan? A gap loan is a debt, like a mortgage, and it’s going to be the amount you are short to purchase or rehab a property.
For example, let’s say I’m a hard money lender and I’m going to give you a loan for ninety percent (90%) of the purchase price. You’ve got to come up with a 10 percent (10%) down payment and your repair money. So in this example you are short on the 10% down plus the funds you need for repairs. This means you will need a “gap loan” for that 10% down and the repairs money.
If you’re going to go to a family member, a friend, to ask for these funds you are lacking, now you’re going to say, “Make me a loan on this property, and in exchange for that, I’m going to give you a secured lien on this property.” That sounds a lot better than saying, “Give me the money to invest in this fix and flip property.”
And how is the gap loan structured? Well, the hard money lender is going to do a loan in a first position on that property. And your gap lender is going to do a loan in a second position on that property. Both the hard money lender and the gap lender are going to have secure lien on the property.
And why is a gap loan better for them than partnering with you? Well, rather than them wiring you the money and hoping and praying that your deal is going to work out as it should, they actually get a lien on that property. And if things don’t go as planned they have a secured interest in the real estate.
Real-World Example of a Gap Loan
Let me give you a real-world example of how a gap loan works. We were going to give Nicole a hard money loan to buy a fix and flip. She was short by $30,000 for the amount of money she needed to bring into the deal.
She goes to her uncle and she asks her uncle for a loan. Her uncle checks out the property. He likes what she’s doing. He’s willing to give her the $30,000.
Rather than do a partnership or a joint venture agreement with her uncle, Nicole has structured it as a gap loan, whereby her uncle is going to give her the $30,000 and in exchange for that $30,000 she is going to give him a flat fee of $2,850 when the house sells rather than paying interest. Not only that, but she is going to sign a promissory note with him and give him a lien on the property behind our first lien in the form of a deed of trust or 2nd mortgage.
We had a hard money loan in a first position on that property, and her uncle was going to loan that $30,000 in a second position behind us on that property, in exchange for a flat fee of $2,850 for loaning Nicole that money for a term of 6 months.
And whether the house sells in two months, three months, six months, the uncle was still guaranteed to get that $2,850. And he was going to get a lien on the property. Sounds like a great deal for the uncle! Why? Because rather than him just wiring the money into Nicole’s account and hoping and praying that the deal was going to work out, he was going to make a loan to Nicole. He was going to get a guaranteed $2,850 in 6 months whether she kept the loan for 2 months or 6 months. And he was going to get a lien on the property.
But why not partner with her uncle? Rather than having to split her final profits with her uncle, and deal with the hassle of having him as a partner, Nicole made him a lender and got a gap loan from him instead. If Nicole’s final profit on the deal is $15,000 and she agrees to make her uncle and partner and give him 30% of her profit. That would be $4,500. That’s a lot more than a flat fee of $2,850. Nicole is much better off if she makes her uncle a gap lender than a partner because Nicole walks away with more money.
But there’s one thing that you definitely need to know before you go out and get gap lenders to lend you money. There are licensing requirements. Some states require any lender that is lending on a residential property, whether it’s owner-occupied or non owner-occupied, whether it’s investment or consumer, to have a license to lend their money.
So don’t go out soliciting money from people to lend on residential property in a state where they may need to be licensed unless you understand the lending laws in that state. Why? Because you could expose them to liability and possibly very stiff fines. And you don’t want to put them in that liability.
How do you solve that problem? Lend your money through a licensed broker, like us! We can arrange for that on your behalf. You don’t have to worry about the licensing requirements because we are already licensed.
If you have any questions about how to structure this, leave him in the comments section below and we will answer those for you. Or reach out to us on our contact page. If you think that someone you know could benefit from reading this article, please share it with them!