The Risk Of Gap Funding

What does the second position lender risk when lending behind the first? Possibly everything.

None of us like to think about a deal going bad, but deals have risk, and it is a possibility. To recover their funds, the lenders can foreclose on a property, and sell it...the proceeds from the sale then going to pay back the money the lenders are owed.

The problem is that the first position lender only really cares about their own money, not the second position lender's. They only need to sell the property for enough to cover their principal, whatever interest is unpaid (although that's not vital), and whatever costs they incur when foreclosing on and liquidating the property. If anything remains, it goes to the second position lender; the GAP.

For example a property is being purchased for $100,000, rehabbed for $50,000, and sold for $250,000. The first position lender lending 80% of Purchase Price and 100% of Rehab Costs, lends $80,000 and $50,000, leaving a GAP of $20,000 (we're not counting all the other costs involved). If the deal goes bad, they only need to recover $130,000, even though the total amount with the GAP is $150,000. Is the property worth enough to cover both the first and the second? Possibly, but that doesn't matter, if it only sells for $130,000 all of it goes to them...that is why they are first.

In case of a deal going bad it is unlikely that the first position will lose everything (the property will always be worth something), and they will recover most if not all of their funds, but the second position lender can lose EVERYTHING. This is the risk faced by every second position/GAP lender.

*Disclaimer: This post is not to say that people shouldn't lend in second position. This post is to explain why second position/GAP lending carries significantly higher risk.