As a private lender, I get the following scenario presented to me almost daily. Let’s set the stage. Someone in your network wants to buy an investment property. Their loan provider requires them to bring a down payment and the closing costs to closing, so they come looking to you for the extra money.
You have the extra $20,000, so you can loan your cousin’s best friend the money as gap funding. After this conversation, people usually begin to reach out and ask how to do this, and usually, my answer instead asks why you want to do this.
Why Gap Funding is Too Risky
First, let’s get a few lending terms out of the way. The first mortgage (or deed of trust, depending on your state) will provide some percentage of this investment property’s purchase price (and potentially some money for renovations). To keep things simple, we will assume this is a $100,000 single-family home that the borrower wants to turn into a rental. Their lender requires them to bring 20% to the closing table, plus pay for closing costs. The borrower is now asking you to bring that 20% ($20,000) to the closing table as a loan to them.
Does this sound familiar? In this scenario, under the best of terms, the borrower would end up with an $80,000 first lien (mortgage/deed of trust) and then a $20,000 second lien on a $100,000 home. Usually, someone gives the borrower $20,000 with a very simple promissory note, and nothing is ever recorded. Likely, the document isn’t even legal because it doesn’t have the required language and may be outside the legal limits for a loan. This scenario is commonly called “gap funding”, but other configurations can also use this moniker as well.
Now that we have a lending scenario built let’s discuss why this loan is outside my personal risk tolerance. I won’t tell someone not to give a loan, as everyone will have different risk tolerances.
From where I stand, this loan is extremely risky. From the borrower’s standpoint, they have little to no money tied up in the deal. This could be out of necessity if they don’t have the capital to close, or choice if they want to remain liquid for some other reason. Either way, it could mean a capital shortage should something go wrong with the property. If a major mechanical system breaks and the borrower doesn’t have the cash reserves to address it, it could very easily tilt this loan into default for nonpayment. A month or more of not having a paying tenant could also tax the borrower’s cash reserves, as we saw in the early stages of the pandemic.
What Happens When The Borrower Can’t Pay the Loan
So what happens when a cash-strapped borrower can’t cover the first mortgage on a property or do the necessary repairs on the property? Well, they are likely to pull the “ostrich maneuver” and put their head in the sand hoping everything will work out.
Depending on the situation and the borrower, they may choose to walk away from the property because they do not have that much tied up in it and they don’t have the money to fix it or continue to pay the mortgage for a property that isn’t generating any income. From the lender’s standpoint on the loan, this would be a big reason this type of loan could be very risky.
If the first lien holder starts foreclosure proceedings, chances are very high that the second lien holder will get wiped out with default interest and legal fees. The $20,000 you put into the deal as a second lien would likely get wiped out unless the property has appreciated considerably in value and sells at auction for an amount well over the $100,000 original value.
The property itself can also be a deterrent for this type of loan scenario as well. In the example, the property did not need any renovation. The borrower was purchasing a single-family home as a turnkey rental. They likely bought it near the value of the home (as it has been a strong seller’s market, and the property has already been stabilized with renovations completed and possibly a tenant in place).
Residential property like this gets its value from other comparable properties in the local area. The value of this home is dictated by someone else other than the borrower or the lender. If the market bobbles or softens, that 20% down payment you supplied is now going to be underwater when compared to the value of the home.
For example, the $100,000 home goes down in value to $90,000 due to higher interest rates and a lack of demand from buyers. The total outstanding debt on the home is $100,000. If the owner tries to sell the home, they would need to bring cash to closing just to get rid of the property. The borrower was likely cash-strapped to begin with, which is why they wanted the 20% down payment in the first place, so this isn’t an appealing situation as a lender in the second lien position. Also, similar to what was mentioned before, if the home defaults, the $20,000 is even more underwater because the default interest and legal fees from the first lien holder will wipe out any money left after the auction, especially if that property has lost value from the $100,000 starting value.
Other Issues That Can Arise
The market isn’t the only thing that can affect the value of this property. If the borrower has a major loss or damage done to the property, and there isn’t adequate insurance to cover it, the condition of the property will significantly impact the value of the home. This isn’t as far-fetched a scenario as it sounds.
A tenant leaves a candle burning, someone turns on the stove and walks away, wiring in the attic is old and frays, someone leaves two chemicals close together in the garage and they ignite—all ways that the property could very easily catch fire. Things happen.
There are also natural disasters such as hurricanes, tornados, earthquakes, and hail to contend with as well! If there wasn’t appropriate or adequate insurance coverage, or the damage wasn’t covered by an insurance policy, the borrower could be left holding a property that is worth significantly less than they owe on it, with little financial recourse to get the property back to its previous condition to reinstate the value.
Another common scenario is an investor who wants to purchase a home with a short-term loan, such as a hard money loan. The lender, in this case, may require a certain percentage of the purchase price to be paid as a down payment, and then if there is any equity left over, they will cover the renovation costs as well.
In this loan scenario, the borrower is theoretically buying the property at a discount and will add value through renovations and updates. Lending in the second lien position in this situation may sound less risky, but it can present its own set of challenges. If the borrower runs out of money before the renovation is finished, the property may not reach that expected after repair value and may even lose value from the original purchase price because demolition work was done, but the replacement has not. Also, if the renovations take longer than expected and the borrower has reached the end of his loan term and cannot pay the balloon payment balance, that can also push the first loan into default.
Lastly, the other common scenario seen is that a borrower will ask for the $20,000 to be put into their bank account directly, sometimes even before the property closes! This borrower needs to show the money for the down payment, closing costs, and reserves to close the loan. This loan scenario is not even secured against real estate, so you have essentially done a $20,000 personal loan to another individual or their LLC. When lending on real estate as a private lender, having the collateral of the property makes this a secured loan. A secured loan means there is an asset to cover the capital put out to acquire that asset. In this lending scenario, there isn’t an asset to back the $20,000 lent out. There is no guarantee the borrower won’t take that money to Vegas! You have no guarantee the money will go towards that property, the renovations, or anything else the borrower says they will do with the funds. Sadly, this is the most common scenario I see when people approach me to ask about their first private lending deal. Often they are reaching out after the money has already exchanged hands, with a promissory note from a template they got off the internet.
This brings me to my last point in doing loans like this. Each state will have usury laws. The documentation and required verbiage within that documentation are required by law in order for the loan to be valid and enforceable. In addition, these laws will outline the upper limits for interest rates and fees associated with the loan. These laws will also guide the requirements around licensing and under what situations you may require a license to lend your own money.
For example, in some states, if you are an LLC lending money to another LLC that is a business-purpose loan, you may not need to be licensed. In that same state, if you are an individual lending to another individual, you may be required to have a license. For all states, you must lend only on an investment property! The Federal government has tight guidelines around licensing and lending activities associated with a consumer’s primary residence, so be certain the property is only intended to be an investment property.
The best thing to do is talk to an attorney familiar with lending in the state you are going to be lending in, which may not be the attorney you closed your own home loan with previously. Many real estate attorneys are emailed documents by the lender to have a borrower sign. They are often not the ones generating these documents. If you are sending someone money for a loan, the only thing you get back from that is a piece of paper covering yourself legally to be repaid. Why would you trust a free template you found online?
While this loan may seem easy and straightforward when it is first presented to you, I hope this article makes you take a pause for a moment and realize what you may actually be getting into. If you feel at the end of the day, you could sleep at night having a loan deployed, then feel free to do the loan your way. Everyone’s risk tolerances are different, and as you have seen above, there are many that are above my level of comfort. Unfortunately, this scenario often arises with individuals who are new to private lending, maybe even real estate in general, which makes them blind to the true risk of doing a loan like this, especially in the current economic climate.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.