Many investors and wholesalers who need a short-term loan may have heard about using transactional funding to fund their real estate deals. However, before you can get started using this type of financing, it's important to be aware of the benefits and risks involved. With that in mind, we've created a primer on transactional funding in real estate investing, including what it is, how it works, and how you can use this type of financing to your advantage to purchase your next investment.
What is transactional funding in real estate investing?
Transactional funding is short-term funding that investors can borrow to complete real estate deals. This type of funding is also known as "flash funding" or "same-day funding" because it is commonly used in back-to-back closings.
A transactional funding program is frequently used by wholesalers and real estate investors who want to buy a property without bringing any of their own money to the table. This is because transactional lenders will usually lend to investors for a short period of time, as long as they can prove that they have a qualified end buyer willing to purchase the property.
When done properly, transactional lending can be a smart way for a wholesaler or investor to make a significant profit without ever having to bring their own funds into the deal.
How does transactional funding work?
Prior to the 2008 financial crisis, transaction funding was used on a pass-through basis, meaning that an investor would sign a contract to buy a good deal at a low price, sign another contract to sell the property at a higher price, and then use the end buyer's money to fund the first transaction.
These days, however, tighter regulations stipulate that each closing has to be entirely separate, meaning that the real estate investor or wholesaler must use their own funds to buy the property from the original seller before they can sell it to the end buyer. Therefore, investors and wholesalers will typically use transactional funding to buy the property and then use the funds from the buyer to pay off the loan.
A transactional funding example: How does it work?
- Investor B signs a contract to buy the property from Seller A for a purchase price of $200,000.
- Buyer C signs a contract to buy the property from Investor B for a purchase price of $225,000 on the same day that Investor B is also purchasing from Seller A.
- Investor B brings a proof of funds letter from Buyer C to a lender in order to be approved for transactional funding.
- Investor B gets approved and, on settlement day, uses the transactional fund to purchase the property from Seller A.
- Later that same day, Investor B sells the property to Buyer C.
- Investor B uses the funds from the sale of the property to pay back the transactional funding lender and keeps any money left over as profit.
What are the benefits and disadvantages of transactional lending for a real estate investor?
As an investor, there are many advantages to using transaction funding in a real estate deal. However, as with any loan, there are also some distinct disadvantages you'll need to keep in mind as you weigh your lending options. To that end, we've laid them out below for your consideration:
The main benefit of using a transactional funding loan is that for a real estate wholesaler or investor, there's little to no risk. Since these loans often offer up to 100% financing of the loan amount, you don't have to worry about bringing any of your own money to the table. You don't even have to worry about funding an earnest money deposit with your own cash.
The second benefit is that each transactional loan typically comes with easy and straightforward paperwork. Unlike a traditional loan where the borrower's income and credit score would be subject to approval, all that's required to be approved for this financing is a proof of funds letter from your end buyer.
That said, however, there are disadvantages to using a transactional lender to fund a wholesale deal or investment. First and foremost to the investor, these funds do come with a closing cost. However, those fees are usually taken directly out of your profit at closing, and you can usually recoup some of that cost by charging the buyer an assignment fee in exchange for finding the property.
The other big detail to consider is that timing is typically of the essence with these transactions. Since transactional funders only offer short-term loans, investors must settle with the end buyer relatively quickly after taking out the loan. Otherwise, they may have to be prepared to pay off the loan another way.
Most of the time, transactional loans come due between one and 14 days after they were first taken out. However, in some cases, the loan may come due in as little as 48 hours. In others, it's possible to apply for extended transactional funding, which may give you up to a year before it has to be repaid.
What are the alternatives to transactional funding?
Before taking out transactional funding or extended transactional funding, it is absolutely crucial to weigh the benefits and risks. If you've weighed your choices and determined that the risks are too great for you, take comfort in the fact that there are alternatives. They are as follows:
Hard money loans
Hard money loans are another type of short-term financing. With a hard money loan, the financing is backed by an asset that can be repossessed in order to pay back its value. Typically, the real estate investment will serve as that asset.
Since hard money loans come from a private lender, they can often vary greatly in terms of the loan terms offered and the fees charged. However, you typically have around six months to repay these loans, so they may give you more breathing room for finishing up your transaction with your end buyer.
Other private money lenders
A private money lender can be any non-institutional lender willing to loan you money. Private money lenders other than hard money lenders can often include your family, friends, or acquaintances or other investors. However, be aware that since this type of lending is largely unregulated, you may be subject to varying types of interest rates and fees.
The bottom line
If you're looking to invest in real estate or do a wholesale deal, transactional funding may be the answer you're looking for on how to fund a back-to-back closing. However, like with any type of financing, there are inherent risks involved in using transactional lending to fund a real estate deal. Be sure to use the information above, including the risks and benefits, to help you decide whether a transactional funding program is the right funding choice for your next investment.