What Is Gap Funding?

Gap Funding can make all the difference with your successes in real estate.  When people say you can make money in real estate without using any of your own money, it’s almost true.  Yes, I’ve made money in real estate utilizing none of my own money, many times.*

There are 3 views to analyze when considering gap funding: The Rehabber, The Gap Funder, and the Hard Money Lender

Entering into a Gap Funding agreement can be very rewarding for all, and can be devastating to all.  My personal experiences are as a rehabber, yet I’ve seen what happens as from the viewpoint of the gap funder.  I will outline the benefits and the risks from both perspectives.  But first, a quick definition:

The Gap Funder provides funds required for a renovation project that the Hard Money Lender doesn’t cover.  This allows for rehabbers to complete a project without using any of their own funds, yet enjoy profits from the project.  It allows for cash investors to make much higher returns on their funds.

The Rehabber

The concept of gap-funding was introduced to me in my early days as a real estate investor.  The intricacies of financing real estate projects for a profit can be somewhat unclear, especially for a new investor.  The concept “gap funding” is the critical component for the term “other people’s money” – or “OPM”.  This is the vehicle that allows YOU, the real estate investor/rehabber to do your job without making a personal financial sacrifice.  The concept works, with some exceptions.  I’ve done several projects without using any of my own money.  However, you must know this is the most expensive money available (OK, well the extension fees on hard money lender contracts are arguably as expensive, but that’s another story.)

As a Rehabber I will either use a joint venture partner (where there is an agreed upon profit split) or a Hard Money Lender.  Sometimes I use a gap funder, but I personally try to avoid it at this point in my investing career.  However, with all of my cash currently deployed in other projects, I’m facing using gap funders for my futures deals.

As a rehabber, the person that identifies the opportunity, understand the profit potential, manages the construction project, manages the paperwork and sales effort, I have 2 more responsibilities.  That is to my Hard Money Lender and to my Gap Funder.

***Failure to understand this critical concept will result in a very short career as a real estate investor.***

Most gap funding contracts include a second lien position on the property.  You, the rehabber have no lien holder rights to the property.  You, or your entity, may be the owner of record, but the liens usually cover any profitable interest.  You are vulnerable and must prove worthy to your cash investors.

Once the project is finished, the Hard Money Lender is paid in full, the Gap Funder is paid back their original investment plus a share of the profits, and you, the rehabber get the other share of the profits.

I have never been in default with a gap funder, but you must be prepared to deal with that situation should it occur.  That means, you will have to pay them back even if it means selling some of your personal assets.

The Gap Funder

The riskiest investment with the greatest returns can easily get you very excited.  Viewing a pro-forma spreadsheet, trusting in another’s competencies, and the thought of the easy money can lull you into a sense of giddiness that you willingly pull out your checkbook with excitement.  This is when the Gap Funder has lost any level of intelligence that may have previously existed.  Smiles, money, new beginnings over rule common sense.

I hear of more people that have significant losses in the role of a Gap Funder than any other role.  They aren’t thinking when they loan the money.  These are some of the biggest mistakes made by Gap Funders:

• Fail to secure the loan (second deed of trust or second mortgage)
• Place too much trust on an inexperienced investor
• Fail to monitor the project
• Not seeking help once they realize the deal has problems

Of all of the investment loss stories I hear, it’s the Gap Funders that have lost the most.

The Hard Money Lender

Most hard money lenders are either people with a lot of cash wanting to act as a hard money lender, or have other peoples funds available to them for hard money loans.

Hard money lenders insist on have the first level of security in the property – a first lien position.  Smart hard money lenders make YOU, the rehabber come to closing with cash. They want YOU to have “skin in the game” as you are more motivated to save your own money than you will to save the Hard Money Lender’s money.

The Hard Money Lender is usually in a good position.  They make sure there is equity in the deal should they have to foreclose.  Most don’t really care if you have a gap funder involved, yet some do.  Since they have the first position any subsequent position is usually extinguished upon foreclosure.  They owe no duty to the gap funder or to the renovator.

Most hard money lenders was their loan to be paid in a timely manner.  It is costly to foreclose on properties, and don’t really want to have to deal with the properties once foreclosed on.  However, I have heard there are many that have intentions of legally stealing properties for their own benefit.  Luckily I have not come across any.

In Summary

Should you want to invest as a gap funder, treat it as a business decision.  This world of real estate investing is based a lot on trust.  Writing checks to rehabbers like me is not the same as showing up at your local Fidelity office and having them invest your funds for you. The risks may be similar, but you must know how to protect yourself more than anything.

On the other side, don’t get bogged down with analysis paralysis.  If there is a good opportunity with a person that has a track record of managing profitable projects, then you must be prepared to take action.  Gap Funders CAN make a lot of money with the right team.  You merely need to understand your role and how to protect yourself.

*Where you can make money in real estate using all other people’s money, there are times you will need use of your own funds due to timing issues, for example you may have to put up an earnest money deposit while you search for cash investors.