My first foray into real estate investing was not what I would call well-financed or well-organized. I had a rough idea of how much the property I was eyeing would be worth after fixing it up, but I didn’t have a clue about how much the repairs would cost. Plus, I didn’t have the faintest idea that I needed to account for the price of renovations when seeking financing. Still, I managed to get control of the property without incident.
It shouldn’t be too surprising to hear that I ran out of money about halfway through the renovations. I was in trouble because I needed money quickly, and I didn’t have any credit left to draw on. Enter my first gap funding experience with hard money. After a quick chat with a lender and a skim of the contract, I signed on the dotted line and the money hit my account days later.
A few months later, the renovations were finished, and I sold the home. Per the terms I’d agreed on with the gap funding lender, my profits from the deal were minimal. I was lucky. If things had gone slightly differently, I could have lost the entire property and still been on the hook for the debt. If that scares you, it should! But, to avoid this outcome yourself, it’s critical to appreciate the entire hard money gap funding process, so let me share it with you.
Understanding Hard Money Loans
Unlike a non-collateralized loan or a loan provided by a financial institution, hard money loans hold the borrower’s future property as collateral, and they can be administered by individuals or private businesses that aren’t banks. Hard money loans are very common in real estate investing for gap loans as well as other purposes, so it’s important for you to understand them.
Hard money loans tend to be for periods as short as a year. Typically, the terms of a hard money loan are worse than the terms of financing options intended for owner-occupancy like mortgages, though they carry the advantage of not needing much creditworthiness for the borrower. So, even if your business is already heavily leveraged or behind on meeting its debt obligations, hard money loans will still be an option.
In a nutshell, hard money loans for gap funding have a few downsides that you should be aware of, including:
- Very high interest rates
- The risk of losing control of the property in the event of a default
- Conflicting financial incentives between the borrower and the lender
- Very short repayment schedule
And, because there’s real estate held in collateral rather than an unsecured line of credit, the approval process is generally quite fast. After all, what lender wouldn’t want to potentially pick up a new property for peanuts relative to its actual value?
Therein lies the problem, of course. Because the funding from a hard money loan will typically be for a much smaller amount than the value of the house held as collateral, lenders have an incentive for borrowers to default. That means lenders are likely to drive punishing terms that extract a lot of money in a short period. These terms may even include a cut of the profits from the sale of the property, assuming that you are able to renovate it and find a buyer.
At the same time, borrowers have minimal bargaining power, as there will rarely be the time or the creditworthiness to shop around for lenders with better terms. Plus, some of the typical legal protections for borrowers may not apply, which makes the transaction all the riskier.
I especially suggest that you avoid hard money loans for gap funding.
Gap Funding With Hard Money Is Risky and Can Be Pricey
When you seek gap funding, it’s because you need cash to bridge your operations between today and the day when you secure another, longer-term financing solution. The funding fills the gap in cash flow so that you can stay liquid through the entire real estate investing process.
Let’s walk through an example so that you will understand how gap funding with hard money is a tempting but highly dangerous trap.
Assume that you’ve put a home under contract. You eventually get private funding for 50% of the purchase price, take out a loan worth 30%, and pony up the last 20% in cash. Now, the purchase is covered. But, you haven’t figured out how you’re going to finance the costly renovations and future resale, and you still need to find the money for keeping your lights on while you do it.
Without additional funding, you won’t be able to satisfy the terms you negotiated with your existing creditors, and the entire transaction is at risk of falling through. You need money fast, which is to say that you need gap funding. Gap funding with hard money is the obvious option, as lenders generally won’t mind that your credit lines and cash on hand are both tapped out. You need to be sure that the first lien lender’s loan documents allow for a second lien to be added.
So, you start reaching out to potential sources of hard money gap funding. Eventually, you find a private lender to finance the renovations using the property as collateral, and you proceed with the deal. Mere months later, your expensive payments on the gap loan are starting to come due, and the property is nowhere close to being ready to hit the market again.
Now, you’ve got a big problem. With no cash flowing, your gap funding lender may soon be entitled to seize the equity you invested when you purchased the property. If that won’t be enough to make them whole, they could even take the entire property, leaving you on the hook with your other creditors. And even if you stay current somehow, they put a clause in the lending terms which entitles them to a hearty helping of your profit margin.
And that’s why you need to be extremely wary of hard money gap funding.
Budgeting for Success
There are a couple of ways to avoid hard money gap funding. Aside from simply having enough cash or other financing to cover your costs, budgeting is a powerful tool that many real estate investors simply don’t use enough. Remember, if you can plan your transactions and renovations well enough such that your deals don’t need any additional financing to get off the ground, you won’t need any gap loans.
In addition to a full accounting of your sources of financing, your budget should include entries for:
- The property’s sticker price
- Transaction costs
- Estimated renovation costs
- Debt servicing costs and when they will incur
Especially if you’re just getting started with real estate investing, estimating renovation or repair expenditures can be very difficult. Therefore, it helps to have a sophisticated tool like the HomeVestors® ValueChek® software that incorporates data from countless purchases of fixer-uppers to provide an objective prediction of the expected costs.
With ValueChek, HomeVestors independently owned and operated franchisees can build their budgets with the confidence of the years of real estate investing experience baked into the application. That means they’ll be less likely to need hard money loans in their general real estate practice, never mind hard money for gap funding. And, HomeVestors® franchisees get the benefit of rapid access to financing for qualifying purchases and repairs on properties, so they don’t need to rely on shady or exploitative private lenders.
In sum, HomeVestors franchisees have a lot more of the toolset that investors need to succeed. If you’re considering starting a real estate investing business, request information about becoming a franchisee today.
Each franchise office is independently owned and operated.
HomeVestors of America® is the nation’s only real estate investing franchise, providing business opportunities to real estate and investment professionals across the nation.