When you embark upon a real estate project, lenders will require you to put up some of your own capital, the down payment, before you can receive a loan. For example, if you want to fix-and-flip a $500K house, your typical hard money loan would require you to put down 40% ( $200K) in cash. Now suppose you want to reclaim the $200K before you’ve completed the project? You can use gap funding to, well, plug the gap.
Gap funding reduces or eliminates the cash you tie up in the down payment for a real estate loan. In other words, you can use gap funding to achieve 100% loan-to-value financing. The gap funder lends you an amount equal to some, or all, of your down payment. In return, the funder receives a cut (up to 50%) of the profit that you make on the project.
Advantages of Gap Funding
Here are some reasons to accept gap funding:
- By freeing up your cash, you can participate in more projects at the same time. This can bulk up your profits and boost your company’s growth.
- You can wrap the interest on the gap loan into the primary loan. For example, suppose you take a nine-month, interest-only fix-and-flip loan with an end-of-term balloon payment. If you get a gap loan, you can use some of it to prepay the first six months of interest on the original loan. If you arrange this in advance you might be able to score a lower interest rate on the original loan. In any event, this arrangement saves you from servicing the original loan for a period of time.
- You and your gap funder share the risk. If you don’t make a profit on the project, the funder doesn’t get a profit kicker.
Disadvantages of Gap Funding
Here are some reasons to eschew gap funding:
- You give up a portion of your profit. That might be OK, depending on the economics of the project.
- Gap funding interest rates are higher than hard money loan rates. That’s to be expected, since the gap lender is in a junior lien position.
When to Accept Gap Funding
The following situations are examples of situations where you might consider gap funding:
- Projects with a high potential profit margin.
- You need to conserve your cash.
- You want to wrap out-of-pocket interest payments into the gap loan.
- You need extra money to finish the project.
- It’s taking longer than anticipated to sell the property and you are still paying interest on the primary loan.
- You want maximum cash on cash return.