With the downturn in the real estate markets we’ve seen an increase in real estate investors, especially in the fix and flip business. In this business model there is a great deal of gap financing for real estate investors. While there is a lot of information about more traditional loans, there is not a lot out there with regards to gap financing, so we’re going to take this post to go over what to expect when working with a gap lender.

Gap financing typically refers to financing to cover the gap between what is available and what is needed. Most often it is used in conjunction with another type of loan. In my case, it is used in conjunction with a hard money loan where the gap money is financing the difference between the hard money loan I put together and the cash needed to close on a purchase.

The upside to using this type of financing is the leverage you can obtain. Many people use gap money to allow them to purchase homes with little or no money of their own into the deal. They borrow money from a hard money lender, cover the gap with a private gap loan and maybe they put up earnest money, fees, or even no cash at all.

The trade off to this type of financing is the cost. Hard money loans are expensive, but gap financing is typically more expensive. Depending on who you are working with, there are a few different structures to this financing.

With a flat rate of return, the gap lender is guaranteed a percentage return regardless of time. So for example, someone lending $100,000 with a 30% guaranteed flat return would be paid back $130,000. This is true whether the funds are out for one month or twenty months, it is a flat return.

With an annualized return, the money is accruing interest as time goes on. So with the same $100,000 and a 30% annualized return, the amount needed to be paid back would differ with time. At the 12 month mark it would require $130,000 to be paid back. It would cost less if the money was out for less time and more if it is out for longer.

Finally, with a participation return, the gap lender is actually participating in the profits of the project. In the same example above, with $100,000 in gap money and a 50% participation return, the gap lender would simply make 50% of the profit, regardless of how long the money is out. So if there is $60,000 in profit on a property, with a 50% participation the gap lender would be paid back $130,000 ($100,000 principal plus 50% of the profit).

Many times you end up with some kind of combination of the returns mentioned above, maybe a flat rate of return plus some participation or a flat rate of return plus an annualized return. Each transaction is different, and each gap lender is different. Often you are working with the individuals who will be writing the check for you as partners, so discussing terms upfront and being clear about what you agree upon is important.

For more information on financing your rehab properties, please see our rehab loans page.