(This is the fifth and final article in our Unconventional Financing series. To start at the beginning of the series, see Part 1: Real Estate Investing with Retirement Accounts).
You need $75,000 for a real estate deal. Your cousin happens to have $75,000, and wants to earn a good return on it.
Match made in heaven? Maybe.
Borrowing money from friends and family members has some very real advantages, but it’s not without its risks. We’ll scrutinize the risks and rewards of friends/family as a source of funding for real estate investments, review how to keep your father-in-law talking to you, and wrap up with some tips for persuading friends and family to buy into your real estate investments.
Advantages to Borrowing from Friends & Family
Where to begin?
With costs and fees, of course. You can borrow money at a much lower interest rate from your mother than you can from a bank – or worse, a hard money lender. And even over short periods, interest can put a big dent in your bottom line return.
Beyond interest, your friends and family probably won’t charge you points, and they definitely won’t charge junk fees like an “Administrative Fee” and “Processing Fee.”
Then there’s speed. If you think hard money lenders are fast, wait until you see your father’s quick draw with a checkbook. It’s like watching Clint Eastwood circa 1972. BAM! You blink and it’s over, you’re holding a check for $75,000.
Bad credit? What credit? Aunt Lulu isn’t pulling your credit report. You could be the Geoffrey Dahmer of bank charge-offs, a trail of bleeding debts in your wake, and no one will care. For that matter, no one will know.
The same goes for income. Remember the stated income loans of the mid-2000s? They may have gone the way of the dodo bird for conventional mortgage lenders, but not for Uncle Al. He won’t be demanding to see your paystubs or bank accounts any time soon.
And hey, circling back to cost, did we mention that you may not even have to make monthly payments? You can structure these deals however you want. Interest-only payments, or no payments at all. You can deliver a lump-sum payout upon selling or refinancing the property.
The Reins of Reality
If that all sounds like the wild times of real estate in 2005, well, it should. This kind of fast-and-loose lending and “irrational exuberance” that we saw so much of is a recipe for disaster.
Before we even discuss the most obvious risk, here’s something to consider. When you approach lenders, whether a bank, credit union or hard money lender, they will put you and your potential deal under a microscope. If they catch a whiff of risk, they’ll drop the loan. They’ll also tell you exactly what they find risky about the deal.
While it’s certainly possible to still make a mess and lose money you borrowed from a hard money lender or bank, they serve as a safeguard. A speed bump, if you will – they’ll force you to slow down, review some facts, walk them through the deal. They’ve seen it all, and they’ll know the red flags to look out for, even if you don’t.
These “institutional” lenders will also provide a completely unbiased perspective. They don’t care if they hurt your feelings, and they won’t be swayed by your winning smile. They will give it to you like it is, no holds barred, no punches pulled, just the facts.
And you know where else this is going. Captain Obvious here: if you lose your friends’ or family members’ money, you can lose that relationship. Is that a risk you’re willing to take? Even if your friend keeps talking to you, they will never trust you again. It will sit between you like a chaperone on a first date. A chaperone with bad breath and a mean streak.
The worst part? Most investors who borrow personally from friends and family members don’t just borrow from one person, but from many people close to them. When one deal goes bad, you might lose five friends over it.
Defend the Nest: The Ten Deal Rule
Want to keep your friends and family members? Keep their money safe.
My stepfather told me once about his Ten Date Rule, from back when he was in his 20’s and woke up one day realizing he was a rake. He had had too many flings with women boasting bright smiles but dim minds, and the flings always dragged on too long. He decided to clean up his act and institute a Ten Date Rule: no physical entanglements for the first ten dates. It prevented false positives, so he only invested time with the best dating candidates.
Entangling your friends’ and family’s money with your real estate investments follows the same principles. Institute a Ten Deal Rule: never accept offers from your friends or family members until you’ve made money on ten good deals.
Your first five deals should be done using either conventional mortgage lenders or hard money lenders, or a combination thereof. You should also be partnering with experienced investors on your first few deals, and they will introduce you to several sources of financing. After your first few deals, you can explore online crowdfunding websites, retirement accounts and other unconventional financing techniques.
When you know the real estate industry well enough to know you can have a successful future with it, you can get more intimate with your funding and accept investments from friends and family.
How to Approach Friends & Family
Feeling confident that you’re a money-printing machine when it comes to real estate investing? Had ten good dates deals and looking to move to the next level?
First, don’t count on money from friends or family for an immediate deal. Borrowing money from relatives and close friends should start as a side source of funds, that gradually builds over time.
Start by planting seeds of interest: when your friends and family members ask about how you’re doing, tell them about your most recent real estate deal. Wrap up with “Hey, I’m always looking for silent partners. If you ever want somewhere to park some money for an 8% return, you know where to find me!”
Then drop it and move on to another conversation topic, unless they express immediate interest.
Some of your friends will legitimately be interested. When they show enthusiasm, go through some of the details of your past deals, and explain your investing strategy. Be extra careful to explain your exit plan, for paying back investors’ money.
Do not gloss over risk. Tell it like it is: like any investment, real estate comes with an element of risk. Explain the risks in your particular investing strategy, and how you mitigate them.
Do not ask “How much ya got?” They’ll volunteer that information after they’ve bought into the idea of investing money with you. Don’t be pushy or presumptuous.
One Last Don’t
So you’ve put in your ten deals, and you’ve started talking to friends and family. It’s easy to be overconfident, when you’ve had some good successes but you’re not a ten-year veteran and true expert yet.
Be very, very careful not to be cavalier when investing with your friends’ and relatives’ money. You should never be investing cavalierly anyway (take it from someone who has, and who is still paying for the mistakes). But there’s a huge difference between losing your own money and losing your sister’s money.
Build trust and confidence over time, and you may find that your brother who put up $2,000 on his first deal with you puts up $20,000 next time around. Be transparent and open with your investors, and put their returns before your own. If you come up short on a deal, you should be the one taking the haircut on the deal, not your investors.
You might just discover that you never need another bank again.♦
Ever raised money from family or friends? How did it go? Are they still speaking to you?