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Gap Funding: A Great Way to Lose Money in Real Estate

Published Friday, February 14, 2014
By admin

Mind the Gap

One of the large mentorship programs – and star of a reality TV house flipping show – preaches debt stacking your real estate deals to reduce or eliminate your out of pocket requirements.  Potential real estate flippers are sold on this because they hear that they will get infinite returns with little or no risk.  On paper this sounds great but there are several fundamental problems with this, especially in the markets in which Pine Financial does business.   The sad thing about this is that people pay $44,000 or more to learn this information. What’s worse is that people buy in to this so much that they try to teach people how to do it or brag about how they do it on social networking sites like Facebook and at offline networking meetings.  The purpose of this article is simply to share my experience with this way of operating and to try to protect you from falling into this trap.

We are in the middle of a foreclosure with one of our clients in Colorado Springs.  We are probably about half way through the process but our client has the house under contract to sell.  The problem is that there is not going to be enough money to pay us back and pay back all her “gap” funders.  I would define a gap funder as a private lender willing to lend on a piece of real estate in a junior position to cover the gap between what the primary lender is willing to lend and what the borrower wants or needs to get the deal done.  The numbers on this deal look like this:

 

  • Purchase – $115,000
  • Repairs – $73,000
  • Our appraised value – $280,000
  • Our Loan – $196,000 (notice this is enough to buy and fix the house)
  • Gap funder Loans – $80,000 (3 different individuals)
  • Contract price – $225,000 (they will need to subtract costs to sell to get a net figure of available cash for all the lenders)

 

We were off on our value because the client made some fatal mistakes: she originally listed in the mid-$300s and it was not complete (that was way too high to list this house); there were very few price adjustments; the work that was done did not properly adjust the floor plan; and it just recently received an appliance package.  How can you expect to get top dollar when the house is not staged and it does not have appliances? It was on the market for over a year.  The biggest problem was the floor plan but the fact that it sat on the market so long really hurt its true market value.  Properties get a stigma if they have too much MLS exposure.  Buyers automatically think there is either something wrong with it or think they can get a bargain because the seller should be motivated.  Had the house been listed closer to the true value of $270-$280k and listed after it was complete and staged, I am confident it would have sold for much closer to our original estimate of its value.

 

The reason she had to borrow $80,000 above our loan was mostly because of holding costs, so a lot of that would have been eliminated had the property sold.  I am not sure where the rest of the money went but it makes you wonder.

 

I have had conversations with two of the three gap funders and they all paid $44,000 to learn how to lose $80,000.  They all have their sad story and to be honest it breaks my heart.  One of the three spent all of their savings on this deal and will likely get none of it back.  I am not sure what our client told these people to get them to invest with her but if any of it was misleading, there could be a fraud case here as well.   You might have noticed that the total loan to value based on our original value is 100% which means that these lenders would likely take a loss even if the house sold for its full value.

 

With as bad as this deal turned out, we are still going to get our money back.  This is why hard money lenders loan at 70% of the value.  That leaves room for mistakes.  In Colorado and Minnesota, there are hard money lenders that loan up to 70%.  If the deal is too much higher than that, the flipper probably should look at doing a different deal or consider cheaper funding source like cash or a bank.  The worst thing flippers can do is borrow hard money and then use gap funders, thus increasing costs and risk in the deal.  It is my strong opinion that if a flipper needs gap funders they should not be doing the deal.

 

I have also heard of real estate investors who use gap funding to fund a portion of the profits up front. (Is this what happened in my example?)  I guess this is to help them with their lack of cash flow.  Why in the world would they borrow their profit and pay interest and possibly fees on that money unless they really could not wait until they got the deal done? If the client is not liquid enough to wait for their money, my guess is they are not liquid enough to handle a problem with their deal if there is one – unless, of course, they are borrowing more money.  That is exactly what happened to our client in the above example.

 

I can go on and on but as sad is my story is, I have heard even worse.  We get calls a few times a month from “gap” funders that need to foreclose but do not have the money to buy out the senior debtors.  They are asking us for money to either buy out the senior lenders or redeem from their junior position.  If you don’t have the funds available to protect your loan you are really making an unsecured loan and could possibly be making the loan to an investor that does not have the ability or wherewithal to pay it back.

 

If you have money and have considered “gap” funding some deals please call me first.  I would love to share some more stories and maybe some ideas on safer ways to invest.