When financing commercial real estate, acquisition, construction or rehab, there’s usually a requirement to inject cash into the deal. For example, if you wish to construct and sell a $5 million office building, your typical financing would require you to put up cash. This is typically ranges from 20% to 40% ($1 to $2 million) cash into the deal. The loan would be a first-position construction loan or bridge loan. But, if you’d like to reduce the amount of your own cash down payment, you can supply the cash via gap funding. In other words, gap funding “plugs the gap” arising from the primary loan’s LTC or LTV requirements and your cash on hand.
What Is Gap Funding?
Unlike construction, acquisition and bridge financing, gap funding is a junior-position loan. This means that the lender enforces the gap-funding lien on your property. But only after the primary lienholder receives repayment, should a default occur. Gap funding can reduce your requirement to inject cash into the deal. It does this by providing a way to achieve higher than normal LTC financing. In return, you agree to share some of the profit (sometimes greater than 50%) with the provider of gap financing. Gap funding is appropriate when you plan to sell the property after construction or rehab, so that the gap lender can collect its profit share.
Pros and Cons of Gap Funding
Gap funding can play an important part in your investment strategy. But first, you need to understand its advantages and disadvantages.
Pro: Freeing up Your Cash
Through gap funding, you can increase the number and/or size of your deals, since you avoid cash constraints you’d otherwise face. This can produce an overall increase in your revenues and profits, enabling you to grow your business faster. For sizeable deals, you can make a good profit even after sharing it with the gap lender.
Pro: Reducing Cash Outflow
A nice feature of gap financing is that you can wrap the interest payments from the primary loan into the gap loan. For example, suppose you take a 12-month, interest-only construction loan with a balloon payment at the end of the term. You might be able to prepay, through escrow, the first six interest payments using the proceeds from a gap loan. This arrangement might allow you to obtain a lower interest rate on the primary loan. And, it can relieve you of your immediate debt service obligation on the primary loan.
Pro: Facilitating the Primary Loan
Suppose your primary loan is from a hard money lender willing to fund up to 60% LTV of your rehab project. Gap funding doesn’t threaten your hard money lender, since the lender will maintain its primary lien position. Furthermore, if as suggested above, you can wrap the hard money loan interest charges into the gap loan. The hard money lender has a positive incentive to make the primary loan.
Pro: Sharing the Risk
From time to time, a real estate project might produce less profit than anticipated. If you use gap funding, up to half of the profits go to the gap lender. In other words, you share the risk of a smaller profit or even a loss with the provider of gap financing.
Con: Sharing the Reward
The flip side of risk-sharing is reward-sharing. With gap funding, you must forego up to half of your profit in return for a zero-cash deal. If the deal makes economic sense to you even after sharing the profit, then the benefits of conserving your own cash might easily outweigh the profit haircut you must take.
Con: Higher Cost
Gap funding providers charge higher interest rates and fees than do primary lenders. That’s because they assume the extra risk incurred by a junior lien (a subordinate lien). For example, you might take a primary rehab loan at 10% and 1 point. However, if you were to add on gap funding, you’d might face a 12% interest rate, an upfront fee of 4 points, and an equity share of 50%. Therefore, you must work out the profitability of the deal in light of the incremental costs presented by gap funding.
When Should I Use Gap Funding?
Gap funding makes sense when any or all of the following are true:
- The real estate project is high-end (at least $5 million) and will produce a sizeable profit.
- You don’t have enough cash to bring to the deal, or you simply want to conserve your cash.
- You want to avoid out-of-pocket interest payments on the first loan by wrapping them into the gap loan.
- It’s taking longer than expected to finish constructing or rehabbing a property and you need extra money to complete the job.
- The property is taking longer to sell than anticipated and you need relief from monthly interest payments.
- You are looking to maximize your cash on cash yield.
- You can finance the project without gap funding, but prefer to get a gap loan in order to remain liquid should another opportunity present itself.
Assets America® Rarely Offers Gap Financing
You can rely on Assets America® for primary and secondary financing on your real estate projects. Our funding starts at a bare minimum loan size of $5 million. Our extensive network of institutional and private funding sources can help you achieve your financing goals. Your best deal arises when you obtain all of your primary and sometimes secondary financing from us, as we can offer continuity of funding. Contact Assets America® today for more information about gap funding.