The gap lender wants 15% of profit on top of 14% interest

Cost of the gap capital, straight: 1,350 points plus about 3,675 interest at seven months plus 10,600 profit share equals 15,625 on 45,000. That's 34.7% of principal over seven months, roughly 59% annualized. That's the number to compare against, not the 14%.

Against that, the equity partner at 50/50 takes 35,450 of your 70,900. So the debt with the kicker is less than half the cost of the equity in the base case. It flips if the profit is bigger than you modeled. At 560,000 ARV your profit is about 108,000, the gap guy takes 16,200 and the equity partner takes 54,000, so debt still wins. It only flips the other way in the downside, where the equity partner eats loss with you and the gap lender still wants 14% and a guaranty.

So the real question is what you think the distribution of outcomes looks like, not the point estimate. If you believe your 520,000 within 5%, take the debt. If your ARV has a fat left tail, the guaranty on the gap note is what will hurt you, because it survives the deal.

One assumption I'd stress: the six month hold. Every month past six adds about 3,400 of senior and gap interest and shaves the profit share base, which slightly cushions you and badly hurts you.

Different angle. You've underwritten the deal and the terms. Have you underwritten him?

I've seen two gap lenders blow up deals by being slow, not by being expensive. One funded 30 days after the signed term sheet because his own money was tied up in another borrower's extension. If your gap guy is recycling capital out of other people's flips, his ability to wire on your closing date depends on someone else's payoff.

Ask where the 45,000 sits right now. Ask for the two other flippers' phone numbers and actually call them, and ask specifically whether he funded on the date he committed to. Then ask what happens to your deal if he doesn't.

The profit share is there because 14% doesn't pay for second position. A subordinate lender on a flip is exposed to the entire downside between the senior's payoff and nothing, and their recovery in a real default means curing the senior or bidding at the sale. 14% is roughly what a senior charges. The 15% is the compensation for standing behind 351,500 of other people's debt.

What I'd want if I were him, and what you might offer instead of the kicker: a hard floor on the profit share, or a fixed exit fee. A flat 9,000 exit fee is cheaper for you than 15% of anything above about 60,000 profit, and it's a number he can underwrite without arguing with you later about what net profit means.

He may say no. Worth finding out what he's actually pricing.

Three comps in five months at the same finish level is a thinner file than it sounds like. What's the spread between them? If they're 505, 518 and 535 I'd believe 520. If they're 480, 520 and 560 you're picking the middle of a wide range and calling it a number.

Also, days on market for those three. A flip ARV that's correct but takes 90 days to hit costs you two extension points on both loans.

Get the gap note and security instrument in front of you before you negotiate price. The clauses that matter on a second:

Cross default. If his note says a default under the senior is a default under his, then a missed draw inspection can cascade into two lenders calling at once.

Right to cure. His documents will probably give him the right to advance funds to cure your senior default and add it to his balance at default rate. That's normal and it means your 45,000 balance can grow without you agreeing.

Definition of net profit. Yours in the post nets out your carry. I'd bet his definition does not. Written as sale price less purchase less rehab less senior payoff, your base becomes about 92,000 and his 15% becomes about 13,800. That's a 3,200 swing in one sentence of a document.

Guaranty scope. Payment guaranty or completion guaranty. Completion guaranties on a rehab with a soft 15,000 in the scope are how people end up funding a finish out with a credit card.

And Flint is right about the encumbrance covenant. If the senior won't consent, ask your attorney about a pledge of your LLC membership interests instead of a lien on title. Different instrument, different remedies, and whether it trips the senior's change of control language depends on that document and your state, so someone licensed has to read both.

Fathom got there first on net profit and that's the biggest single number in dispute. I make it 13,833 on the gross definition versus 10,642 on yours. Sextant's 59% annualized becomes about 66% if the gross definition survives into the note.

Second thing your model does: it charges the deal 17,600 of senior interest at six months but the term is nine. If you hold nine, senior interest is closer to 26,000 and gap interest to 4,725. Profit drops to about 62,000 and your all in cost of the gap money rises while the absolute dollars fall. Model the nine month case as your base and the six month as the good outcome. Every flipper I know has done it the other way around and been surprised.

Also 8,200 in title and closing on a 285,000 off market purchase seems light if you're paying transfer tax, and transfer tax and who customarily pays it varies by state, so check yours rather than mine.

Question from the cheap seats. If the deal fails and the senior forecloses, what does the gap lender actually get? Pike says the second lien is on the property, but if the property sells at a foreclosure sale for less than 351,500 there's nothing behind it. Is the personal guaranty the entire actual security on the gap piece, with the lien mostly being a way to force a payoff at closing?

@sable that's roughly how I've come to understand it. The second lien means you can't sell or refinance without paying him, which is real value. In a wipeout the guaranty is what's left, and then he's chasing a person, and how far he can chase depends on your state's rules on deficiency after foreclosure.

Pike, I'm on the other side of this question, sitting on money and deciding whether to write gap checks. Reading your post, the thing that would make me want the kicker is exactly your uncertainty on 15,000 of the rehab scope. He isn't pricing your ARV. He's pricing your GC.

Your buffer isn't a buffer. You said 45,000 gives you 3,700 over the gap. That's one HVAC surprise.

When I ran my first deal's costs I forgot utilities during the rehab, dumpster pulls beyond the first, permit fees, and the two months of insurance after the projected sale date because it didn't sell on schedule. On a 95,000 rehab that's a few thousand, and it's a few thousand you're borrowing at 59% annualized after the kicker.

Slow question. Where does the second lien actually live? Is it recorded at the county the same way the first is, and does the recording order alone decide who's senior, or is there a separate agreement between the two lenders?

@vellum recording order generally sets priority, and lenders write a subordination or intercreditor agreement to spell out cure rights and standstill on top of that, and the specifics of recording and priority differ by state so don't take mine as yours.

Pike, in my market three comps in five months would be everything that sold, and I'd have no idea if 520 was real. Sounds like you've got more turnover than that, so ignore me, but I'd still want to know how many active listings sit between 490 and 550 right now. Your exit competes with those, not with the closed sales.

I'm reading this twice like everything else. If the rehab goes to 110,000 instead of 95,000, does the senior fund the extra 15,000, or is that suddenly a second gap that has to come from somewhere?

@juniper the senior almost always funds against an approved scope and budget. Overruns above it come from the borrower unless the lender agrees to a budget amendment, which they may or may not do, and which can be conditioned on more equity from you.

Pike, on the mezzanine idea Fathom raised, a pledge of membership interests is a UCC secured transaction rather than a real property lien, and the enforcement path and timeline look completely different from foreclosure. Whether it avoids your senior's covenants depends on how their change of control and transfer language is drafted, and that's a question for an attorney in your state, not for us.

The clause I'd fight hardest for is a written definition of net profit with a worked example attached as an exhibit. Two sentences and a spreadsheet tab. I've watched a profit share argument at a closing table where both sides were reading the same paragraph honestly and getting numbers 11,000 apart.

Nobody's asked what happens if it doesn't sell at all. If you're nine months in with a finished house and no buyer at 520, what's the rental number, and does it carry 351,500 plus 45,000 at any rate you could actually get? If the answer is no, your only exit is price cuts, and the gap lender's guaranty is the thing standing behind that.

Blunt version: this deal doesn't fit your balance sheet. You need 101,300 and you have 60,000, and you're solving a 40% shortfall with the most expensive money in the stack on your first deal.

There is a version of this where you buy something at 180,000 with a 45,000 rehab, need 55,000 total, and own the whole outcome. Smaller profit, no second lien, no guaranty, no argument about the definition of net profit. I don't think you'll do that, but somebody should say it.

@quill said the thing I was typing. Half of what pike is paying for is speed on a deal he found before he found the money.

Pike, separate from this one, have you priced anything else? Self directed retirement money in your own network usually lands well under 59% all in, and those lenders often don't ask for a profit share because they're comparing you to a stock index, not to another flip. Takes longer to line up. Worth having before the next off market call comes in.

The whole structure rests on one sentence in your post, that this suburb turns over fast. Every number downstream, the six month hold, the 520, the gap lender's willingness to take second position, is that sentence repeated in different units. I'd want to know what turnover looked like in that pocket in the slowest six months of the last three years before I signed a personal guaranty on 45,000.