Gap Funding For Real Estate Investors – Pros & Cons

Gap funding—also known as a bridge loan—can be an invaluable tool for real estate investors needing extra cash to cover expenses and obligations. It often makes the difference between closing on a great investment opportunity and letting it slip away to another investor. 

While gap funding comes with costs and risks, understanding its benefits and drawbacks is crucial. Let’s explore what gap funding is, why it is sometimes necessary, its pros and cons, and who stands to gain the most from utilizing gap funding. 

What is Gap Funding? 

Gap funding is a private loan that bridges the financial gap between a hard money loan and the total project cost, covering expenses like rehabbing, renovating, marketing, carrying costs, and selling the finished home. 

Despite having higher interest rates due to increased risk, gap loans provide essential support. The hard money lender holds the first lien on the property, guaranteeing their payment first, while the gap lender holds the second position. In rare foreclosure cases, the gap lender might face a loss, and some may even seek a share of the profits. 

Gap funding can be transformative for both smaller and experienced investors. It allows those with capital that is tied up in multiple projects to maintain their investment cycles without waiting for a current project sale to free up funds. 

How To Get a Gap Funding Loan 

Receiving a gap loan offers investors flexibility in choosing between traditional or alternative funding sources. Gap loans are available from both institutionalized banks and private money lenders. Opting for a traditional bank involves a standard loan application process, while working with private or hard money lenders requires attracting interested investors. Given that gap lending carries higher risk, investors need to demonstrate the value of their investment to secure funding. Like hard money loans, gap loans are primarily asset-based, so the stronger the deal, the greater the likelihood of obtaining the funds. 

Gap Financing in Real Estate – Advantages and Disadvantages 

A gap loan closes the cash gap between what a real estate investor needs to complete their project and what finances they have available. Gap funding lenders can make up for the limitations of most hard money lenders. More importantly, gap funding can cover the difference between the original hard money loan and the remaining cost requirements. For an investor, this means the funding can possibly cover the rest of the acquisition costs, along with the expenses incurred during marketing, advertising, and selling of the property. 

Why is Gap Funding Necessary? 

When real estate investors discover a lucrative investment opportunity — such as a house that can be quickly renovated and sold for a substantial profit — they often bypass traditional bank mortgages. The time and expense involved with a traditional mortgage make it impractical. This is especially true when coupled with the need for a quick turnaround and selling the property with a mortgage attached. Traditional mortgages can take months to secure, and banks have stringent approval criteria. Investors need to act swiftly and might not meet the financial requirements for a conventional bank loan. 

Instead, house flippers typically use hard money loans for their investments. These are private loans for investment properties, usually provided by wealthy investors. Since they are private loans, they involve minimal paperwork, and the funds can be available in as little as a week. 

However, hard money loans come with high interest rates — up to 20%, which is significantly above average. Additionally, they rarely cover the entire cost of acquisition and renovation. Hard money lenders require investors to contribute some of their own funds to ensure they have “skin in the game” (like banks asking residential buyers for a 20% down payment). Consequently, hard money loans generally cover about 70% of the total project cost. 

Many investors may not have readily available cash to invest in the project, or they may prefer not to use their own money. This is where gap funding becomes essential. 

Gap Funding Pros 

This type of real estate investment funding is best suited for investors who flip a high volume of properties. Some advantages of securing a gap funding are: 

• Since this real estate funding covers the gap between hard money loans and the actual acquisition costs, it makes it possible for investors to acquire the properties they otherwise wouldn’t have thought possible. 
• Gap money can be used for more than just acquiring the property; it can be used to cover rehab costs and any other incidental expenses. 
• Unlike traditional bank mortgages that require a lot of paperwork and take months to close, gap funding can be acquired within a matter of days. 
• Gap funding for real estate investors is tailored for those who plan to undertake several property projects at once. In this scenario, a gap funding alleviates the risks you may encounter from a delayed sale or any other unexpected situation that can slow down the rehab process. 
• This funding enables a real estate investor to put down the deposit on a huge investment while they are waiting for a long-term financing to come through. 
• Gap funding gives investors a leeway to remain in a more liquid position. 

Gap Funding Cons 

• Since gap funding lenders face an increased risk, they often levy a larger interest rate as compared to banks. Their interest rates are typically 1% higher than traditional mortgages. 
• Gap funding for real estate investors is not ideal for those who want to flip a single deal. 

• Although not a standard practice, some gap funding lenders request a percentage of the proceeds from the sale of your investment properties. 
• Borrowers can also expect to incur additional costs such as appraisal fees, notary fees, loan origination fees, administration fees, title policy fees, etc. 

When Should You Use Gap Funding? 

Real estate gap funding has been proven invaluable to countless investors. The quick and easy access to cash is a significant advantage, especially in today’s competitive market. While gap funding may not be necessary for every deal, it is highly effective when used appropriately. Specifically, gap funding is ideal in situations such as: 

• High-end projects with the potential for sizable returns 
• Investors seeking to maintain more liquidity 
• Insufficient cash on hand to close a deal 
• Transitioning to a bridge loan to reduce interest payments from the initial loan 
• Needing cash reserves to complete unfinished construction projects 
• Accumulating interest payments due to a deal taking longer to close 
• Keeping enough cash on hand for future investment opportunities 

Gap Financing Costs 

Gap funding emerges as a valuable resource for those seeking short-term financing solutions. However, while gap financing offers flexibility, it often accompanies a higher cost compared to conventional alternatives. Interest rates on gap loans, for instance, may vary between 3.25% to 10.5% based on creditworthiness. Alongside elevated interest rates, borrowers should anticipate additional expenses such as: 

• Administration fees 
• Appraisal fees 
• Escrow fees 
• Loan origination fees  
• Notary fees 
• Title policy fees

The Bottom Line 

Gap funding has gained a reputation for providing borrowers with immediate access to capital. Gap funding isn’t just about getting money; it’s a valuable tool that helps countless investors close deals they might have otherwise missed out on. However, it’s important to recognize that there are optimal times to use it.  

We at BFPMInc. strongly advise you to learn everything there is about gap funding before you take the plunge; you should ideally explore the various other lending options before committing to a gap fund.