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Gap Funding (also known as mezzanine finance) is a way of bridging the gap when all of your finance options have been exhausted.
Most lenders active in the short term lending sector will offer either a straightforward bridging loan or development finance or both.
However, even offering both of these lending products isn’t always enough to get the deal done and at the end of the day, getting a deal completed and paid out is all that matters.
That’s where Gap Funding comes in and we will explain how and where it is used in the property development process.
Unfortunately, lenders use jargon in nearly every case and this does confuse matters and makes it harder for people new to property development to gain a full understanding of the whole process, so we will do our best to explain the differences.
There are 3 parts to a bridging loan or a development finance loan, they are;
Debt (the loan or finance)
This is the typical loan that you would take out from a lender. Usually a 1st charge meaning that whatever happens on the deal, the 1st charge lender will get ‘first dibs’ on getting their money back should it all go wrong. For example, if a property is being bought for £1m (and also values at £1m) then most lenders will offer 65% of the purchase price, in other words, £650,000 of £1m.
Equity (usually the borrowers cash contribution)
Using the above example and to make the deal work, the borrower will have to put down a deposit of £350,000. That is the equity injection.
Gap Funding (or Mezzanine Finance)
This comes in when there is a gap between the loan being offered by a lender and the cash contribution. Again, using the example above, the borrower has had to find a deposit of 35% of the property value and purchase price (being the same in this case) as the main 1st charge lender can only provide 65% LTV/LTC.
35% is a large deposit for anyone to find, let alone a newbie, so is there a better way for potential borrowers to get their foot on the property development ladder? We think so.
Fund the gap
Gap Funding is where an investor or lender will provide funding for that missing part of the property transaction. Let’s use the example above once more but this time we will work on the basis that the borrower only has a 10% deposit.
A short term lender provides a commercial mortgage of 65% of the lower of the property purchase price or valuation. This equates to £650,000 against the £1m purchase price.
The borrower has a 10% deposit which equates to £100,000. Not an insignificant amount of money but on this deal, they remain £250,000 short. To summarise:
- Purchase Price/ Valuation: £1m
- Commercial mortgage/bridging loan: £650,000 (65%)
- Borrower deposit: £100,000
- Shortfall between the amount the 1st charge lender will lend and the borrowers maximum deposit: £250,000 (£650,000 loan + £100,000 deposit = £750,000 total funds available)
So in this instance, this project will not happen unless the borrower can find another £250,000.
Gap Funding is the answer.
Our investors will look to provide the ‘top-up’ finance to ensure the project proceeds and reaches completion.
You will still get your 1st charge commercial mortgage from the lender you have been working with.
You will still need to put your full deposit into the deal as most lenders, gap funders and Mezzanine finance providers insist that borrowers have significant monetary investment in the deal.
In English, this is called having ‘skin in the game’ and lenders like it because it shows that the borrower is as motivated as the lender(s) to ensure the deal completes on time and on budget.
The other thing about borrower cash input is that with significant sums of their own money invested into a particular deal, they are less likely to be able to look at another deal which would mean taking their eyes off the ball.
How does Gap Funding work?
The investor (not the 1st charge lender) will provide the difference between the commercial mortgage being offered by the lender and the total amount of deposit available from the borrower. In this case, £250,000.
They will charge an interest rate on the money lent and will also share a % of the net profit on the deal after all of the units are built, marketed and sold (or refinanced).
As an indication, and again using the above as an example, our investors will provide the funding of £250,000:
Interest rate of 0.85% per month. This can be rolled up which means that it will only be paid back at the end of the project.
Arrangement Fee: 2%
Exit Fee: None
Share of the profit: This will depend on the project, financials, viability, experience of the developer, etc but typically, it will be a share of either 50/50 or more commonly, 70/30 in favour of the borrower.
In terms of the other significant figures, the investor will usually require a minimum net profit of £1m on the deal, regardless of the GDV. They will be able to provide funding of up to £12m in one transaction with the average gap funding coming in at £2.5m.
What types of security can benefit from Gap Funding?
Commercial property and residential investments. Gap funding doesn’t work on pure land purchases unless there is an element of development involved because the borrower has to be looking at adding value on a project, not simply sitting on a land purchase.
The most common question we get asked is “why should I give up a significant % of the profits just for an extra bit of funding?”
The answer to that is simple. In most cases, the deal will fall down without this extra funding and our advice is simple; 50% of something (actually doing the deal) is far better than 100% of nothing (not enough funding for the deal to go ahead). It’s almost a case of cutting your nose off to spite your face and we understand why people would think this way, however, it’s a narrow minded view.
The % profit share that you make from this Joint Venture (JV) deal could be enough for you to develop your next project without the need for any mezzanine finance or gap funding, so often, people do a JV deal just once.
If you are looking to get a start in property development and you need a helping (financial) hand, then gap funding could be for you.