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How Do Transactional Funding Lenders Work?
How to Avoid the Confusion about Transactional Funding and who are the Best Transactional Funding lenders for Real Estate.
There is a great deal of confusion about transactional funding in real estate transactions and exactly how it works. Following is a review of what transactional funding is and what it is not to get a better understanding of this unique method of closing real estate deals with no money of your own.
Transactional funding is the process of using money borrowed from a lender to finance 100% of the purchase price of a property to close the first half of a double closing. A double closing is where a property is bought and sold preferably on the same day or the next day by all the parties involved in the transaction.
The parties to the transaction are designated by the letters as follows:
the seller of the property (“A”),
the investor buyer (“B”) who also becomes the seller in the second half (leg) of the two closings and
the end-buyer (“C”).
The total of the two closings is referred to as an A – B and B – C double or simultaneous closing. Each of the two transactions is often referred to as individual “legs”.
In some instances, a number of investors sell and resell a particular property over and over in a series of transactions that ultimately close as transactional fundings. These can be referred to as A – B, B – C, C – D, D – E and so on with the end-buyer as the last designated letter. This “series” of closings is what is casually referred to as a “Daisy Chain” closing. Unfortunately, if any of the buyers or sellers in the chain doesn’t perform the entire closing won’t take place. This is why many of the best transactional funding lenders will not do the fund these deals.
By far more popular for real estate investors is what is called Contract Assignments. In these real estate closings, the Investor “B” has gotten a contract from the original seller “A” but has also contractually agreed with an end-buyer “C” to step into his shoes and close the transaction on his behalf. This process saves the investor “B” closing costs on the two legs of what would have been a double closing and is referred as an A – C closing.
The biggest potential problem with assigning the investor’s contract is that the original seller “A” and the end-buyer “C” know what profit the investor “B” is making on the transaction. The seller and the buyer are suddenly exposed to the investor’s profit and this “profit shock” can cause either the seller “A” or the end-buyer ‘C” to suddenly decide to not close. Their reason is that the investor’s profit is too large, but what is too large?
Too large a profit is dependent on the mindset of the seller “A” and the end-buyer “C” and can be vastly different. As a guideline, the expected profit is often akin to what a Realtor® might make in the same transaction of about 3% to 6%. For a $100,000 purchase, this would mean the investor “B” would be assigning his contract for a $3,000 to $6,000 profit.
But too often the Assignment Fee is much smaller as the investor “B” is dependent on the profit being dictated by the end-buyer “C” who is another and often more savvy investor. Most often these assignment fees result in smaller profits in the $1,000 to $2,000 range. It is difficult or impossible to make a living as a real estate investor making small profits of this size on every deal.
In the above transaction, if a Double Closing had been used instead of an Assignment of Contract, the profit spread could have been virtually unlimited. This is because the original seller “A” and the end-buyer “C” would not have known the investor’s profit for days or weeks after the closing. Actually, the only way they would have known is by the two sale prices being posted in the public record. Generally, this is too late for either party to contest the transaction. In some states, the sale prices of properties are not even listed in the public record.
In some situations, investors use what are called Joint Venture Agreements (“JV”) to get paid for their profit in a real estate transaction. Typically in JV transactions, the closing takes place between the “A” seller and the “C” buyer but the profit is shown on the closing statement as a JV Fee and there may be two or more investors receiving compensation for bringing the “C” buyer to closing. If the seller “A” or the end-buyer “C” asks what the JV Fee is they should be told that it is actually the profit on the transaction to the investor. This fee, or profit more correctly, could once again run the risk that one or the other party to the transaction decides not to close.
When is transactional funding most often required? Simply put, whenever an investor gets a deal that is so profitable that the original seller or end-buyer may object and decide not to close. But what is the additional cost of a double closing? While the cost of a real estate closing varies greatly from state to state, generally speaking, you can assume the first closing will be about 2% of the purchase price and slightly less for the sale side. These costs can easily be offset by having the original seller and/or the end-buyer pay for some or all of the investor’s closing costs.
How does an investor get the “opposing party”, the original seller or the end-buyer, to pay these costs? The easiest way is to simply add them to the contracts for the seller and the end-buyer. Don’t worry what you may be told that you can’t do that as you can by simply adding a clause to your contracts that seller and/or buyer pay for part or all of your closing costs.
If your original seller and/or end-buyer is motivated to sell or purchase the property they may object but will relent in most cases. If they object, tell them that “typically” that’s what you do it but in this case, you will split the costs with them. This “split” of your closing costs will result in a substantial saving and actually a larger profit to you.
Let’s discuss what Transactional Funding is not. Very often the term “Transactional” is confused with “Transitional” and the two have very different meanings. Transactional funding is specifically designed to provide funding for a double closing transaction that takes place on the same day. In a few cases and for various reasons, the second leg of the transaction may take place the following day. Transitional funding provides funds to move or replace a temporary loan into a more permanent loan on the same property.
With transactional funding, if the second leg (B – C) of the transaction takes place days after the original A – B or first leg funding this could be referred to as “Extended Transactional Funding”. In most cases, this extended time period was not originally planned for by the lender. Had the lender known about the extended payback period they most often would have required the loan to be a hard money loan.
The reason is that too often these extended transactions not only do not close timely or they sometimes do not close at all. This means the transactional funding lender has funded 100% of the purchase price and may have to foreclose if the investor can’t find another buyer to replace the one who didn’t close.
Sometimes a buyer will need to close on the property he wants to buy and then go through the conventional financing process with a bank. This process could take a few weeks to a few months or not at all even after tentative approval by his proposed lender. The concept is one loan “transitions” into a longer-term loan that stays with the property for years.
Transitional funding implies a transition from one type of funding to another and can take from a week to many months to be completed. Examples that are well known are Bridge Loans that finance the purchase of a property and possibly some rehab or construction and later these loans are refinanced into long-term mortgages on the property.
The risk to lenders in any of the above types of loans is very different and defines how the lender charges for the use of his money. Transactional funding same-day loans should carry the least risk if done properly and there is no fraud involved. Hence these lenders charge between one percent (1 point) and 4 points and with minimum fees required. The exception is www.TransactionalFunding1PT.com which only charges one point and a $50 wire fee on any amount less than $500,000 and they also have no minimum purchase amount. The reviews left are always positive and confirm we are one of the best transactional funding lenders in real estate investing.
Extended transactional lenders are faced with the prospect of having to foreclose and take the property back if something goes wrong. They have already loaned 100% of the purchase price so they then face having to sell a property to recover whatever they can from the proceeds of the foreclosure sale. This prospect of getting back less than the amount funded has caused almost every transactional funder to stop doing extended transactional fundings. If the funder is faced with the prospect of the second leg of the closing to be extended, he will usually revise the funding fee to a progressive schedule by charging more interest the longer it takes to close the second leg.
Extended transactional funding is often used when the investor-buyer gets a short sale approved and must close before the Approval Letter expires. About 35% of the time the original lender (bank) has a mortgage on the property and is taking a principal reduction to allow the property to be sold before a foreclosure sale. This mortgage/note holder can make various last-minute demands before a closing. One common demand is that the property may not be resold for a specified time period which is called a Deed Restriction. This time period is usually 30 days but in some cases as much as 180 days.
Suddenly the investor is faced with telling his transactional lender that he can’t close the B – C leg until 30+ days later but he still needs the funds immediately. Of course, the investor has no money of his own to close. This is suddenly crunch time for the transactional lender who has made a decision to say “No” or modify his original transactional loan into Extended Transactional Funding. The lender’s risk has gone from low to very high in an instant. This is why many of the best transactional funding lenders have virtually stopped doing “extended” fundings. If the lender chooses to not fund the loan the investor must find another lender instantly or lose the deal and his Earnest Money Deposit (EMD).
What makes the most sense to a potential lender in these types of extended transactional fundings is to have the buyer put up between 20% and 25% of the purchase price so they have “Skin in the game!” These funds from the investor reduce the potential loss to the lender if there is a default by the investor buyer or his end-buyer never comes to closing. To further reduce the lender’s risk, he may check the credit of the investor, review his real estate transaction history, do an appraisal on the property or even make the investor personally liable for the transaction.
No matter the amount of background screening of all of the participants in the transaction, there is still the possibility of a failed funding. In Transactional Fundings the lender has 100% invested so he has to be sure the property is worth more than the amount he is lending.
With Extended Transactional Funding the lender runs the risk of having to foreclose and then getting back less than he originally funded and the foreclosure process can be very time-consuming. Hard money lenders require a much higher level of due diligence to protect their investment before lending any funds because they have to plan on taking the property back and reselling it and that’s why they are often referred to as “Predatory Lenders”.
In summary, as an investor who must rely on others to fund your real estate transactions, it is critical that you make sure both your buyer and seller come to your closing timely. Set up any extended transactional funding you may need ahead of time including private funding from friends and family members. This will avoid you losing an EMD and embarrassing yourself in the investment community. We consider ourselves the best transactional funding lenders because we take care of our clients and provide quality services.
I wish you limitless success in all that you do,
What is Transactional Funding and how does it really work?
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