Gap Funding For Real Estate Investors: Why It’s Not A Good Idea

When it comes to real estate investing, finding the right financing options can be a challenge. There are many different types of financing that I wholeheartedly recommend. However, before any real estate investor uses a new kind of financing tool they need to know both the pros and cons of that option.

Gap funding has become a popular strategy for financing real estate deals. In a nutshell, a gap loan is a temporary, short-term solution. It’s used to “bridge the gap” between the purchase price of a property and the amount of traditional financing that the borrower can obtain.

Gap loans can be a helpful tool in certain situations. However, there are several drawbacks that I believe make them a risky proposition for borrowers.

What Is Gap Funding?

Gap funding is a type of financing that allows borrowers to cover immediate expenses. It is typically used by investors who are trying to purchase a property but do not have the finances available for the full amount of the down payment.

Essentially, the borrower takes out two loans to finance the purchase of a property – one loan for the down payment and one loan for the remaining balance of the purchase price.

For example, let’s say you find a property that you want to purchase for $100,000. You have been pre-approved for a traditional loan for $80,000. In order to complete the purchase, you would need to obtain a gap loan for the additional $20,000.

The advantage of gap funding is that it allows borrowers to access financing that they would not otherwise be able to obtain. The downside of gap funding is that it can be very expensive – the interest rates on these types of loans are typically higher than on traditional loans.

How Real Estate Investors Qualify For A Gap Loan

Not everybody is going to be able to qualify for gap funding. There are a few things that you will need in order to qualify. Besides having a good credit score, you will also need the following:

  • Collateral: Down payments are meant to help offset some of the risks that the lender is taking on. If you need a gap loan because you can’t cover the down payment, lenders will require you to put up an asset as collateral. This could be in the form of a deed to a property, a vehicle, or even stocks and bonds.
  • Convince lenders that the investment is secure: I know that every investor wants to believe that the investment they are making is secure. But a lender is going to want to see some form of proof. This could be in the form of a business plan, pro forma statements, or even market research.

If you can’t provide some type of objective assurance that the investment you’re making is secure, you’re going to have a tough time qualifying for gap funding.

Why Investors Seek Out Funding Through Gap Loans

Many investors use gap loans to secure the funding they need and the following are a few of the reasons why some real estate investors like to use gap loans:

  • Quick flipping: One of the biggest advantages of gap loans is that they can be used to finance a quick flip. If an investor finds a property that they think they can turn around and sell quickly, they may not have time to get traditional financing in place.

For instance, they could use a more traditional loan to buy the property, then use a gap loan to cover the cost of renovations so that they can turn around and sell it quickly.

  • Saving an investor’s property from foreclosure: In some cases, an investor may find themselves in a position where they are about to lose their property.

If the investor has equity in the property, they may be able to take out a gap loan to cover the expenses. This can help the investor keep their property and avoid having to go through foreclosure.

  • Helps cash-poor investors make pre-listing improvements: In some cases, an investor may find a property that needs significant repairs to bring it up to code before it can be listed on the market. If the investor does not have the cash on hand to make the repairs, they may be able to take out a gap loan to finance the work.
  • Other unforeseen circumstances: There are always going to be unforeseen circumstances that crop up when you’re investing in real estate. If an investor needs funding for a situation that they didn’t plan for, a gap loan can provide the financing you need.

Why This Type Of Funding Isn’t Recommended For Everyone

I think that the drawbacks far outweigh the benefits of a gap loan. In fact, I believe that gap loans should only be used as a last resort. The following are a few significant reasons why gap loans are not only a bad idea for borrowers, but for lenders as well:

For Borrowers

The following are some of the reasons why borrowers are better off looking at alternative financing options instead of trying to get a gap loan:

  • Must look for a lender who is willing to lend: Most traditional lenders are not going to be willing to lend money for this type of loan. This means that borrowers are going to have a tough time finding a lender who is willing to work with them.
  • The slim margin for profitability: The profit margins on flipping houses are already slim. When you factor in the interest rate on a gap loan, it can eat into your profits significantly.
  • Increases costs: Not only does the interest rate on a gap loan add to the costs of flipping a house, but there are also other fees associated with this type of loan. These fees can include origination fees, points, and appraisal fees.
  • Eats up time and energy: The process of finding a lender and getting approved for a gap loan can take up a lot of time and energy. This is time that could be spent finding a different type of loan that will meet your needs more effectively.
  • Can affect your reputation: Borrowing money through a gap loan can actually damage your reputation. This is because many lenders see this type of loan as a sign that you are desperate for money and are willing to take on more risk than you may be able to handle. This can make it difficult to get approved for other types of loans in the future. 

For Lenders

Gap loans aren’t just a bad idea for borrowers, they also tend to be a bad idea for lenders. The following are a few reasons why lenders will usually stay away from offering gap loans:

  • Lenders are second in line to recoup costs: In the event that a borrower defaults on their loan, the lender who provided the gap loan is going to be second in line to recoup their losses behind the primary lender. This means that there is a greater risk of the gap loan lender not getting their money back if the borrower defaults.
  • Problems with funding can be passed on to the borrower: If the gap loan lender has trouble getting funding for the loan, this can cause delays for the borrower. In turn, this can put the borrower’s project on hold and cause them to incur additional costs.

An Example Of Funding Gone Wrong

I want to stress that gap funding isn’t always a bad option. However, in my experience, it’s rarely the best solution and can result in all kinds of potential issues. For example, some time ago we were in the middle of foreclosure with one of our clients in Colorado Springs. We were about halfway through the process, but our client put the house under contract to sell.

The numbers on the deal looked like this:

  • Purchase price – $115,000
  • Repairs – $73,000
  • Our appraised value – $280,000
  • Our loan – $196,000 (notice, this was enough to both buy and fix the house)
  • Gap funding loans – $80,000 (from three different gap lending 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)

The problem was that there was not enough money to pay both us back and pay back all the client’s gap funders. This was because our value was off the mark due to a few significant mistakes that the client made.

Firstly, they originally listed the house in the mid-$300,000s even though it was not complete. Secondly, there were very few price adjustments. Thirdly, the work that was done did not properly adjust the floor plan, and it had recently received an appliance package.

If a property has been on the MLS for too long, then buyers automatically think there is either something wrong with the property or they think they can get a bargain because the seller is motivated to sell, which means the offers can end up being substantially lower than expected.

Pricing the property correctly will help prevent it from being on the market for too long, thereby helping to avoid these particular issues.

The reason the owner 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 at the estimated value.

This example is one of the reasons why gap funding is a significant risk to lenders as well as buyers. On paper, the gap funders should’ve been able to get their money back.

However, due to a series of mistakes, the property did not sell at its estimated value, which led to an overall loss. I had conversations with two of the three gap funders and they essentially paid $44,000 to learn how to lose $80,000.

Finally, you might have noticed that the total loan to value based on our original value was 100%, which means that these lenders would likely have taken a loss even if the house sold for its full value.

Can You Recover From Losing Money Like This?

As bad as the previously mentioned deal turned out, we still got our money back because – like most hard money lenders – we cap our loans at 70% of the after-repair-value (ARV), which is the estimate of how much the property will be worth following repairs.

That means that if the ARV of a property is estimated to be $200,000, we will only provide a loan of up to $140,000. If the property only sells at $170,000 due to a miscalculation or mistake on the buyer’s end, the loan will still be covered. Basically, capping hard money loans at 70% of the ARV provides a little bit of wiggle room for potential 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 investor should probably find an alternative deal or consider a cheaper funding source like cash or a bank.

The worst thing flippers can do is borrow hard money and then use gap funding to cover the difference – this increases both the costs and the risks of 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 upfront. I guess this is to help them with their lack of cash flow. If the client is not liquid enough to wait for their money, my guess is they are not liquid enough to handle a problem if there is one – unless, of course, they are borrowing more money. That is exactly what happened to our client in the above example.

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 are a lender and you don’t have the funds available to protect your loan, you are really making an unsecured loan. As a result, you could potentially be making the loan to an investor that does not have the ability or wherewithal to pay it back.

 Consult With The Experts Before You Decide To Go With Gap Funding

I know that financing a real estate investment can be a challenge at times. However, I urge you not to settle for gap funding. Gap loans simply present too great of a risk to be worth it in most situations.

Fortunately, there are lots of other financing options available for you to consider. Here at Pine Financial Group, we can provide you with information and advice on real estate financing.

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.

Consider your financing options before you go into debt. Consult with us today!