Lending markets for small businesses are becoming increasingly expensive and inhospitable as interest rates rise and lenders look to shed credit risk. This is particularly true in the real estate industry, where mortgage rates are the highest in 15 years and applications are plummeting.
At the end of September, new mortgage applications fell by 14.2 percent in just one week. At the beginning of October, 30-year fixed rate mortgage rates hit 7.05 percent. Luckily for small real estate investors and other early stage, entrepreneurial businesses, there are alternatives. Among them is transactional funding, a fast, low-risk borrowing option.
What is transactional funding?
Transactional funding is a type of short-term loan in which an intermediary purchases an asset (such as receivables) from a seller and immediately sells it to a third party at a profit.
Transactional funding is typically associated with real estate flipping by investors, usually known as real estate wholesalers, who want to buy and sell an asset in a very short time frame, often as quickly as one day. This is why these short-term real estate investing deals are often called flash-funding or same-day loans.
Some commercial credit companies also offer transactional funding as an alternative to factoring or short-term bridge or asset financing, and to finance back-to-back sales of collectibles, luxury goods, or art.
Aside from the transactional funding lender, there are three entities involved in these deals, usually denoted as A, B and C. This is why these transactions are sometimes referred to as ABC loans.
- “A” is the original seller of the asset – for example, a bank or mortgage company disposing of a foreclosed REO asset through a short sale, or a small business selling receivables that cannot be factored economically.
- “B” is the intermediary investor or small business that buys the asset from A using the transactional funding loan and sells it on to C at a profit, then repays the loan using the proceeds from the sale to C. This process is usually referred to as wholesaling.
- “C” is the end buyer of the asset, which can extract further value from it; for example, a real estate contractor that can renovate a property and eventually sell it at a profit.
Who are the transactional borrowers?
These loans are designed to finance the purchase of an asset by an intermediary (B) that does not want to use its own capital or is unable to do so because of credit or cash flow issues.
Transactional funding deals have been used mainly in the commercial and residential real estate market by property flippers. However, they can be useful in other ways to small businesses facing capital constraints. The borrowers/wholesalers in these transactions provide to asset sellers:
- Short-term inventory financing if a company has a purchase order from a client but has not issued an invoice that can be factored;
- Bridge financing for short-term acquisitions outside the real estate marketplace, where the B business has a unique access to a motivated seller and the asset is reasonably fungible, so it can be resold easily;
- Bridge finance to overcome temporary supply chain disruptions.
In these deals, wholesale middlemen add value to the transaction by connecting the original asset seller (A) to the end buyer (C) and must have good contacts among both types of entities. Otherwise, the sellers would transact with the buyers directly. One example of such a middleman is an angel investor that has worked with both asset sellers and buyers, or which can assist a company in which it has a stake to arrange a deal.
Real estate flippers, however, predominate. While 2022 has seen a dramatic fall in real estate sales, last year saw significant flipping activity. According to data provider Attom, in the third quarter of 2021, 94,766 single-family houses and condominiums in the United States were flipped.
That represented 5.7 percent of all home sales that quarter, a figure that was up for the second quarter in a row after a year of declines. The gross profit on typical transactions was $68,847. With transactional funding loans costing at the time between $2,000 and $5,000, that made for an attractive profit.
Who are the transactional lenders?
Transactional funding creditors are nonbank private lenders like finance companies, venture capital firms and, in some cases, individuals. They are often called “hard money lenders,” a somewhat pejorative term that dates from when they were little more than business loan sharks. Now, however, they are usually competent professionals, and the term simply distinguishes them from regulated lenders like banks. They are able to work with borrowers that traditional lenders pass by due to credit concerns or the bespoke nature of their borrowing needs.
Because hard money loans typically do not require extensive documentation, the intermediary’s costs for title insurance, appraisals, inspection reports, and legal advice are minimized. Depending on the asset and the borrower, transactional funding loans have been made in recent years for as little as 2 percent, though this year anecdotal evidence indicates that transactional funding rates have risen along with rates on other types of loans.
These loans often do not require a credit check because they rely on the value of the collateral, rather than the creditworthiness of the intermediary borrower, as well as the fact that the eventual buyer of the asset (C) can prove that it has secured financing and committed to the purchase of the asset from the intermediary.
Since they are not dependent on an intermediary borrower’s credit, they are particularly useful for small or new borrowers, or even individual investors, who might have weak credit or no credit record, and would otherwise have to pay much higher rates in the traditional debt markets.
How does transactional funding work?
Here’s a summary of the steps involved in the transactional funding process.
- The wholesaler/borrower (B) finds a motivated seller (A) and a financially sound buyer (C).
- The buyer provides proof of its ability to purchase the property immediately from the wholesaler/borrower.
- The transactional lender provides the wholesaler/borrower with funding to purchase the asset from the asset seller.
- Once the A-B transaction closes, the wholesaler/borrower immediately sells the asset to the asset buyer in the B-C leg of the deal.
- The wholesaler uses part of the proceeds to repay the transactional funding lender.
Benefits and limitations
Here are the principal benefits of transactional funding deals:
- 100 percent LTVs: The loan can cover the full purchase price of the property, since the C buyer has already been identified and its financial wherewithal established.
- No credit score checks: These transactions do not require a credit check on the B borrower/wholesaler, only a proof of funds letter from the C buyer.
- Speed: These transactions can be arranged and closed quickly – in some cases within a day – allowing the B borrower/wholesaler to take advantage of opportunities that would otherwise pass it by.
- Cost: The interest rate for transactional funding loans recently ranged from 2 to 12 percent, depending on the lender. (These figures are from 2021 before the recent increase in interest rates, so borrowers should expect them to be trending upwards.)
Some of the main risks and limitations to these deals are:
- Short loan tenors: If a borrower runs into a problem closing the second, B-C leg of the transaction, and cannot repay the loan within the agreed upon time period, lenders can impose fees or change the loan into a standard, more expensive, term interest rate instrument at a lower LTV.
- Closing costs: These must be paid on both transactions.
- Dependence on the viability of the end buyer: The end buyer (C) must prove it is financially capable of purchasing the asset in the time period allowed.
Traditional loan versus transactional funding
In a typical non-transactional real estate transaction, a B wholesale investor would identify a motivated A seller and a C buyer for a given property, such as a bank seeking to offload a foreclosed property and a contractor willing to rehabilitate it.
- The investor would then borrow some percentage of the property’s value, with a loan amount typically 80 percent loan-to-value, from a bank and put up the rest in equity as a down payment.
- It would have to undergo a credit check and wait for mortgage approval, title insurance, and other documentation.
- The cash equity would be put into escrow for 30 to 60 days, stretching out the time the borrower/wholesaler is exposed to market price fluctuations.
- And, once the deal closed the investor would turn to a purchaser and repeat the process, this time as a seller.
This approach is time and capital intensive, and requires the borrower/wholesaler to pony up a significant amount of equity, which cuts into the deal’s profitability. The wholesaler also has to have strong enough credit to secure a mortgage.
In the transactional funding transaction, the B wholesaler will establish a relationship with the A asset seller, the C asset purchaser and a transactional funding provider.
If a bank has a house in foreclosure or subject to a short sale, and the wholesaler knows of a contractor that can upgrade it and sell it at a profit, the stage is set for transactional funding. Say the bank is willing to sell the house for $500,000, the lender is willing to lend at 4 percent in fees and interest, and the end purchaser is willing to buy it at $575,000. That comes to a gross profit of $55,000 for the wholesaler, before closing costs.
Alternatives to transactional funding
Small businesses that want to avoid the document-gathering hassle and restrictive covenants typical of standard bank loans, but are not looking to do a back-to-back asset flip, have a number of financial alternatives to consider.
Crowdfunding: There are several crowdfunding platforms, such as Fundable and Kickstarter, where you can post your ideas or objectives and which offer equity in exchange for business funding.
Angel investors: High net worth individuals who provide financing for startup companies and entrepreneurs are known as “angel investors”.
Venture capital firms: Venture capital firms provide longer-term to grow into something substantial. In exchange for equity, a venture capitalist could fund a pre-seed, seed, or growth stage. VC investments range from $100,000 to several million dollars.
SBA loans: The US Small Business Administration (SBA) works in conjunction with local banks to partially guarantee loans for startups and small businesses. The terms are more flexible than a normal bank loan, interest rates are lower, and the qualifying criteria are less stringent.
Venture debt: Companies that are funded by venture capital can qualify for venture debt offered by specialized lenders. This option is often used to extend the cash runway or cover capital expenses as the startup scales between equity rounds.
Revenue-based financing: Companies with recurring revenue models (e.g., SaaS, payments) can work with specialty lenders to access capital in exchange for, or underwritten per, future revenue. This option allows companies to scale on their terms, leveraging future sales to drive near and long-term growth.
Peer-to-peer lending: Several popular business loan sites are run by peer-to-peer lenders. Terms and interest rates vary and can run high with certain sites, but the P2P lending approval criteria are typically lenient.
How Ramp can help you with alternative funding
Through our platform, businesses can access the working capital they need to grow their business faster, while having the finance automation tools at their disposal to manage it. We can even help you build your business credit. Here’s how:
1. Commerce sales-based underwriting
Unlike some revenue-based lenders, Ramp has reasonable banking and revenue requirements to offer you the credit bandwidth you need to cover expenses and finance growth. This is particularly useful for companies with limited funds in the bank and e-commerce companies that are working with small margins. Ramp can assist in both of those scenarios.
2. Expense management
Getting the funds to start and grow your company is only half the equation. Managing those funds by controlling expenses and tracking cashflow through effective business expense software is how a company builds a healthy financial culture and reaches profitability. Ramp has the tools to help you do this, including prepaid credit cards for business and virtual credit cards for business. We offer real-time tools to track business expenses, spending controls, and API integrations with your go-to accounting software to keep it all in order.
3. Building credit
Utilizing our commerce sales-based underwriting and controlling your spending are two great ways to build business credit. And since Ramp is a charge card, there's no need to worry about carrying a balance month-to-month, incurring interest, or pesky utilization ratios to calculate.
Need working capital to fuel your business? Consider Ramp
Running a business is hard and accessing working capital to help streamline your day-to-day operations can be an even bigger chore. With Ramp, you can access the working capital you need, faster, with our commerce-sales-based underwriting process.
The transactional lender provides the same-day funding necessary for the borrower/wholesaler (the B entity) to purchase an asset from the original seller (the A entity). The borrower/wholesaler then sells the asset at a profit to the end purchaser (the C entity), and pays back the loan with the proceeds from that sale.
Transactional funding can be used to help an asset seller (the A entity) monetize receivables, obtain short-term asset financing, and overcome supply chain disruptions. The borrower/wholesaler makes a profit by acting as a middleman in these transactions.
Transactional funding deals have fewer upfront fees, appraisal, inspection, title insurance, and other costs. Also, since the borrower can obtain 100 percent LTV, rather than only 80 percent on a traditional mortgage, it gets the advantage of the additional leverage.