Gap Lending

[Jordan Geiman]

First time poster, long time reader. I find the information here amazing. I am completely new to this business, but feel I have studied a good amount about real estate investing.

A friend of mine has been doing real estate investing for about 18 months and has been moderately successful. I approached him with my interest in the topic and he shared some info and also asked if I may want to be a gap lender (or other avenue of lending) for some of his deals.

I thought it all sounded good and am now preparing for my first deal with him.

I am primarily concerned with my risk in this deal. He has a hard money lender that will be in first position and I will be the 2nd lien on the home, my total investment into the property is $25k.

The terms are that I receive 8% on my 25k if he pays me back within 90 days, 10% within 120 days, and 12% within 150 days. Is this fairly standard? I thought they were pretty good terms compared to my other investments outside of real estate.

But back to my main focus of this post, what are the necessary risks of this deal? I am going to have my lawyer look over the contract that my friend and I will sign. I will have a 2nd position lien on the house. I know my friend has rental homes and a few other properties of equity. So bottom line... is this a fairly secure investment to test the waters for me into this space?

Is there anything in particular I should make sure is in the contract?

The house itself seems like a great deal to me, the numbers check out, the comps all made sense, and the DOM for the comps were relatively quick.

Thanks!

[Jon Holdman]

1) Give us the numbers. You say you think the make sense, but you don't actually provide them.

2) Second position? For 8%? No way. Not even for 18% paid in weekly installments.

Standard is on the order of 15% plus some points for up to 70% of the ARV or (purchase plus rehab) for a more conservative lender.

[Jordan Geiman]

Thanks for the feedback Jon.

Specs on home:
purchase for: 415k
closing costs: 8.3k
rehab: 16k
holding: 3.5k
total project cost: 442.8k

closing on sell: 11.5k
realtor costs: 29k

ARV: 575k (comps provided in his summary)

potential profit: 92k

Can you elaborate on your point #2? :)

[Joel Owens]

Hi Jordan,

John rates are typical but NOT if this property is located in California. In those areas the rates you quoted are normal. HML lenders there are clamoring to lend money at low rates because they view that market as really hot and if the rehabber can't sell it or make mistakes they still get their money back in a rising market and limited inventory.

How a lender views the asset would also depend on the price range. For instance from the people I have talked to in many areas of California anything sub 400k in a decent area it flying off the shelves with tons of offers. You get up into the higher priced flips of regular sales and things take much longer.

This is why I do not like all the stories about the markets recovering. A CERTAIN price point and product 3 bed 2 bath under 200k or whatever might be moving fast in a certain market but others are still selling at 2009 levels.

Houses I am looking at locally in a certain subdivision anything 250k and under has about a 90% sell rate and moves fast. Anything say close to 300k and up is moving at 2009 levels with maybe 20% selling and the rest stagnating. The subdivision goes from 150k to 1 million in price.

If your friend owns other properties that are trophies I would definitely cross-collateralize some or all of his other properties and get a personal guarantee. If your friend feels confident about the deal for the flip he should have no problem providing this.

[Jordan Geiman]

Thanks for the reply Joel. That makes me feel a bit better about the rates my buddy was telling me. I wouldn't think of him to give me a worse rate than market value. But since we are in CA, I guess it does seem reasonable.

And I agree with your other assessment of what I have been seeing. It is a little alarming. I live in the bay area and bought in Nov 2011. By the market rates in our area a conservative present value for our place already has it appreciating over $200k. Which is great from my perspective, but worries me that it is going too high too fast. But I'm new to all of this, so what do I know :)

Can I ask briefly about rates for other states? As an investor why wouldn't I want to invest outside of CA as a gap lender to gain these rates that are much better? is there that much more risk associated to the properties or does it just remain on the shelves for a few more months?

I'll ask about that cross-collateral at all, great suggestion!

[Joel Owens]

Rates depend on what you are lending on in what areas determines the risk and reward factor.

Generally the down side to outside your area is you do not know the area like the local HML's do. When a buyer is competing against others to land a property they have to act fast. The local HML can usually pull the trigger much faster than an outside person does because more research has to be completed to asses risk in lending for that area.

This is why local HML lenders rates might be lower than a national HML lender that prices a few percentage point higher and one to two points more to price in the unknown factor of the area.

[Steve Babiak]

When you say "8%" - is that annualized, or a straight 8%? So in your example of $25K, 8% of 25K is 2000, so do you get back 27K (return of 8% of investment plus the original investment) or just 25.5K (return of your investment plus 8% annualized)?

[Jordan Geiman]

It is a set return, not annualized. If he can pay me back within 90 days I would receive 27k back. Within 90-120 days, I would receive 27.5k, and so on.

[Bill Gulley]

A few important clarifications, it is usually ILLEGAL for a private person to charge points and lending fees, especially if your state has usuary laws. Do so and you can be seen "being in the business of" which then may carrying financing compliance issues.

Rates of interest should be in line with the risks assumed. Your attorney will have a better idea as to what is cutomary in your area, generally acceptable for private money. There is a world of difference between private loans and a hard money lender as well as rates charged. Assuming a private lender should compete or charge at the same level as a conventional lender or a HML is an incorrect assumption. I suggest you see what customary rates toprivate lenders are in your area.

Next, your security means nothing if you can't take out those liens ahead of you. You should first be concerned about the return of your investment before the return on your investment.

Part of that includes being added as an additional insured as a lien holder. In the event of an insured loss, minor issues will generally be disbursed to the borrower, major losses can end up going to the first mortgage lender leaving the borrower with a property and a second note holder with a damaged property as collateral. So, ask your attorney about insured losses and claims. This becomes an issue of cocern in higher priced properties with larger seconds, but if your loan is less than the lot value, you're probably in a much better position.

Another issue that could apply to you is the recent CA investor requirements and being a qualified investor.

I would not suggest you start lending out of state without a mortgage originator/broker. Having money doesn't make you a lender. Just because you have the ability to do something doesn't mean you should. I assume you don't have so much money that it can't be lent out in your area. If you have some constraint to lending in CA, I suggest you get with a mortgage broker for any out of state deals.

There is alot to read here on lending issues, you need to understand that as a lender your interest in the collateral will always be as a lender and not an owner unless your borrower gives you the deed to cancel the debt

The best place for a new lender to start, IMO, is not in making seconds as gap financing but as a transactional lender, funding closings and getting your money immediately in compliance with any usuary law that may apply. :)

[Steve Babiak]

So that puts you into second position at more than 32% annualized interest. Maybe Jon Holdman would consider that!

[Jon Holdman]

Originally posted by Steve Babiak:
So that puts you into second position at more than 32% annualized interest. Maybe Jon Holdman would consider that!

It is a more interesting rate. But, as Bill Gulley points out usury laws come into play. That's probably too high a rate in most places.

The heartburn I would still have is being in second position. If the project goes bad and the first position lender forecloses, you will almost certainly get wiped out. How much is the first position lien? The total up front costs are 77% of ARV. Your $25K is about 4%. If you have the slice from 73% to 77%, you're really in a weak position.

The rehabber will have more costs that you list. In particular, interest on the first position loan. This may be less than I would budget if HML's are really only getting 8% in CA. But I still don't see it accounted for in the numbers. I don't see getting $92K out of this deal.

[Will Barnard]

Originally posted by Jon Holdman:
1) Give us the numbers. You say you think the make sense, but you don't actually provide them.

2) Second position? For 8%? No way. Not even for 18% paid in weekly installments.

Standard is on the order of 15% plus some points for up to 70% of the ARV or (purchase plus rehab) for a more conservative lender.

Jon, I would respectfully disagree with you here. Making such a blanket statement on item #2 is not reasonable (Im sure you will agree once reading my explanation) as the combined LTV plays a hudge role. if the first was $100k, and the second was $25k and the value was $300k, would you say no way to a $25k loan at risk in second position with $175k equity spread and a combined LTV of 41.6%? I say, that is a great deal for a second.

Now, in this real example, the purchase price of $415k and rehab of $16k (that seems terribly low, so red flag for me on this portion), places this at an all-in deal (acquisition plus rehab) of 75%. At an exit value below $600k, that is a decent deal (an easy single looking to round to second base).

Also, Jordan has stated that he will receive a flat rate of 8% in 90 days (not 8% annulized) which comes out to a 32% annual return.

Jordan, word to the wise, any loan contract you have with your borrower here in CA that exceeds an annual interest rate (including any points, fees, etc) in escess of 10% would constitute a CA usury violation. Therefore, I suggest you speak with your attorney and have an attorney or broker underwrite this loan, make sure it is labeled as a NOO loan, and make sure to comply with all the local state laws. Having a broker underwite your loan to your borower will allow you to legally charge above the usury limit just as banks, credit card companies, etc. are allowed to do.

Lastly, make damn sure the exit value is real and easily obtainable and that this "rehab estimate of $16k" is accurate. You may want to hold back funds of your loan in escrow and provide draws on the rehab as progress is completed and you may want to ask for cross collateralization. You also want a personal guarantee rider on your loan, a balloon payment rider, and any other riders your attorney deems necessary to keep you and your funds protected.

Of the purchase price, rehab, and holding costs, how much cash is the borrower putting in?
What is the amount of the first trust deed? This makes a big difference in IF you should lend on this deal in second position or not. Your combined LTV (loan to value) should not exceed 70%.

[Jon Holdman]

Will Barnard I do actually agree with you the CLTV is very important. I think we were probably posting at the same time. That's why I asked for the numbers, and then asked again for the amount of the first. If this $25K is at the very top of the CLTV, I continue to think its very risky. If the borrower is putting in $100K of their own cash and the first is about $315K, its probably reasonably secure. If the first forecloses and take it to a sale, it will likely bring enough at the sale to pay off both the first and second. If the first is $415K, a foreclosure sale probably doesn't net enough to cover the first, so the second is a total loss.

[Will Barnard]

I hear ya Jon, we are on the same page as I suspected. I did see after i posted that you did in fact ask for the same thing I did - the amount of the first lien (a very important factor here).

[Bill Gulley]

Okay, let's get a little more creative in the use of our money and stay away from usuaary laws. Ask your rehabber where he gets materials, try to find some lumber yards and suppliers, not lowes of HD as they have credit departments.

Set up a line of credit with suppliers and by the paper at the time of sale. The material supplier subordinates thier rights to you as a lien holder. You build in the profit on the 90 days+ on material financed. As a material lien holder you have priority in most states over any mortgage holder! In the exampels given above, the lender will either pay you off or collect amounts you are due... :) Consider it my tip of the day.... LOL

[Jordan Geiman]

Amazing information you guys are giving, I really appreciate it and I will need to go through and re-read - google your replies to make sure I have a good understanding of my situation. to answer some of the questions asked to me.

I believe the first lien is coming in at 65% ARV, which would be right around 375k. I would be the 2nd lien at 25k, a third person would be behind me at 24k, and the borrower is handling the remainder (roughly 20k). It isn't what he typically does, typically he just has a 1st and 2nd lien, but I won't put down more than 25k for my first go at this in case something does happen.

I am a bit confused on the cltv though, what do i use for the value of the house: his purchase price, the ARV price, the ARV-rehab price? It depends because one of those puts me in the 70% range :)

Regarding the rehab, i agree it seems low, I actually grew up in the area and know it really well. I also have seen a lot of pictures of the inside and know that his rehab team he uses does all of his jobs and they have done about a dozen in the past year and all but one came in within his estimate. So I feel pretty confident in his assessment. Honestly, from the pictures I am unsure where the 16k is going.

The ARV also seemed a bit tricky, but honest, some of the quick sales in the area were across the street on a golf course that I imagine would inflate the price of that sale. But his house is also bigger than those. To some degree I imagine this would balance out a bit. But his assumed profit appears to give me confidence that even if he doesnt get everything he wants, he still has room to gain a profit.

[Steve Babiak]

Originally posted by Jordan Geiman:
...

I am a bit confused on the cltv though, what do i use for the value of the house: his purchase price, the ARV price, the ARV-rehab price? It depends because one of those puts me in the 70% range :)

...

Any and all of the above - seriously. After demo, it will be worth LESS than what was paid to buy it. After some rehab, it will improve in value. After completed rehab, it should be at ARV. You don't know when in the cycle you might have to foreclose due to non-payment, so you use all of the scenarios to determine how bad off you might end up.

[Will Barnard]

Now you have thrown another item into this mix, a third lien. This concerns me as the investor appears to have very little skin in the game. Not sure I would be comfortable with that added scenario.

[Jordan Geiman]

Probably a neutral comment: But he usually doesn't have skin in the game on his flips. He gets a HML for the 1st lien to cover 65% ARV and then a gap lender to pay the additional plus holding costs, etc... so his out of pocket in most deals is extremely minimal.

Not counting his buy and holds though, I believe he finances those himself solely.

[Olena Smaliuk]

Hello! Do you still doing gap funding?

[Chris Seveney]

Quote from @Olena Smaliuk:

Hello! Do you still doing gap funding?

 we have people who do gap funding but its got to have skin in the game. its not 100% financing

[Olena Smaliuk]

Thank you for answer! how can I connect with them to check their terms?

[Olena Smaliuk]

Thank you for answer! how can I connect with them to check their terms?