Walking a Thin Line When Investing With Family and Friends

For decades it has been part and parcel of the real estate industry for new agents to go through training, be assigned an office and a desk and told to start making phone calls to everyone in the world they know. So who gets the first calls? Family and friends…of course.

So it would seem to make sense that when looking to finance deals — especially early in an investor’s career — family and friends could be a great source of seed money. That may or may not be a wise choice. And it most certainly requires some forethought and a lot of due diligence up front before proceeding.

“Buying real estate as an investment always has an element of risk attached to it no matter whether you are talking about residential or commercial property,” said Rick Sharga, chief marketing officer at Ten-X, an online real estate marketplace. “Adding a family relationship or friendship into the mix when it comes to raising funds for a purchase can place even more pressure on an already stressful situation. Therefore it is essential all parties involved go into the deal totally informed and with their eyes wide open.”

Sharing_Buyers_Trend

Research conducted by RealtyTrac reveals that market conditions — particularly affordability and tight lending standards — are causing young buyers to consider more creative ways to purchase homes, in particular by sharing the cost with family and friends.

The same is true when considering the purchase of investment properties, thanks to the acceptance of more non-traditional financing vehicles such as crowdfunding by today’s younger crop of investors.

“The fundamental reason for this is affordability, especially for younger investors who are not coming in with a ton of money,” said Daren Blomquist, vice president of RealtyTrac. “Using an informal crowdfunding of sorts, these investors are asking friends and family for money through their personal networks.”

With home prices continuing to rise, buying an investment property requires a bigger capital investment, which is in turn driving these investors to look outside of conventional financing sources — such as sharing the cost with others.

A Basis of Need
Twenty-five years ago, investor and author Andy Heller was not familiar with investing in real estate. And he did not know his friend of three years, Scott Frank, all that well either at the time. But what he did know was that Frank had already bought properties for himself.

“Our partnership is very, very rare,” Heller said. “Our original intent was to buy one home. Then we bought another one. It evolved into dozens of properties and an education business.”

Their friendship turned into a partnership, but even after 25 years Heller said if an investor can go it alone, then by all means go ahead and do it.

“You don’t go into a partnership unless there’s a need,” he added. “If you want to have a partnership that survives over time each partner should bring something different to the table.”

An attorney by trade, Frank had the experience as an investor that Heller didn’t have. On the other hand Heller had something that Frank didn’t — the time to focus on the investment business as well as great credit and no loans against that credit.

Frank had already maxed out the legally allotted number of loans he could obtain as an investor when the team paired up. So they started their partnership on a foundation of mutual need, each bringing something to the table that the other didn’t have.

“My time and my credit allowed him to buy one more property he couldn’t otherwise purchase,” Heller said.

Having respect for and trust in your partner is key to a successful business relationship, added Heller, who recommends taking baby steps out of the gate before jumping in too deep.

“Twenty-five years ago we did not sit down and decide we wanted to own so many properties in 10 years. We agreed to buy one property and see how it goes. We didn’t get ahead of ourselves.”

After buying that first property the new partners took a step back to critique how they felt the relationship was going. Based on that analysis they concluded they were both interested in ramping up the business to buy another property.

“Scott’s approach was brilliant. We were both comfortable with one another. We enjoy working together. You don’t know that on day one,” Heller said.

Let’s Talk Turkey

Nothing is a sure thing when it comes to investing, and real estate deals can and do go bust from time to time. So the question becomes are you willing to possibly lose a friend or strain a familial relationship over a business deal?

“It can make for a pretty difficult conversation around the Thanksgiving table,” said investor and attorney Bill Bronchick based in Denver, Colo. “You’re going to feel awfully bad about losing a friend’s or family member’s money.”

Just because someone is a relative or a friend doesn’t necessarily make them a good business partner. Bronchick noted that the best partners are those who have experience in real estate investing. What you don’t want is someone who is going to call you every week asking what’s going on or second-guessing you.

“If they’ve never invested in real estate then it’s probably not a good thing to do because they’re going to bother the heck out of you,” said real estate note investor Scott Carson, based in Austin, Texas.

“What if the deal goes south? Do you have an alternative plan like paying them back from your own money? Or are you prepared for the relationship to go south?”

In Portland, Maine, investor and real estate broker Debbie Kilmartin has represented investors who were doing business with friends and family. That experience had led her to believe that if an investor can do a deal on their own, then they are better off borrowing the money through conventional sources rather than taking funds from family or friends.

“If things don’t go well, it’s family. It can ruin friendships. It leaves a bad taste at the end of the day,” Kilmartin said. “If you’re going to do that you have to be on the same page as to what the expectations are.”

Get It In Writing

Partnering with family or friends may make an investor feel safer due to feelings of trust and the fact that they know the other person. But that closer relationship should wave a precautionary red flag as well. One that Heller said requires meeting with an attorney and putting everything down in writing.

“When you go into business with family and friends you should do the same things you do when going into business with a stranger. Do the same due diligence,” Heller said. “You want to define the roles of each partner, the responsibilities of each partner and the time investment of each partner. The agreement must be very specific and precise. Who pays for what? The percentages. How much is invested.”

Laying out up front what partners expect from the relationship is important, as is living up to the promises made, said attorney and investor Bronchick. There are boilerplate joint venture agreements available. However, depending on how complex the deal is, he suggests drafting up an agreement tailored to the parties involved.

“You don’t know what you don’t know,” Bronchick said. “Expectations, duties and the rest of the ‘what ifs’. Your lawyer can help you dream up the ‘what ifs’ you don’t know and don’t know what to expect.”

What if one partner dies? Do the remaining partners want to be partners with the wife and kids of the deceased partner? What are the buyout rights? What about in the case of a disability or divorce of one partner? These and more things must be considered and dealt with in writing.

Approaching family and friends may seem at first glance like an easy pitch for resources — especially for a new investor. In addition to a written agreement, Bronchick explained there are other legal issues that must be considered even when raising money from people the investor feels especially close to.

In particular he noted that the Securities & Exchange Commission has rules and regulations as to how funds for investments may be solicited and from whom in particular. Also, the investor should be familiar with the Blue Sky Laws — which regulate the offering and sale of securities in each state — of the state or states he or she is planning on doing business in.

However, those same regulations can make it easier to work with family and friends in certain specific instances.

“If you’re going to get into multiple partners, one advantage of family and friends is it comes within the securities exemptions. You can solicit friends and family whereas you can’t solicit the general public unless you are going after accredited investors,” he explained.

Considering the legal and potential relationship issues involved, an investor considering a partnership with family and friends is walking a very thin line. The general consensus seems to be don’t do it unless the investor absolutely has to. And if the investor does proceed, take baby steps before plunging into the pool feet first.

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