Using OPM (Friends and Family) for a Down Payment and/or Rehab
New to Real Estate · Boston, MA · Member since 2022 · 16 posts · 14 votes
Hello!
I am getting started in RE investing, specifically looking at multifamily properties. I am currently exploring my loan options and I am being told that money from friends and family, or "gift funds", cannot be used. However, I do have friends and family who want to invest (not gift me the money) in my deals, but they do not have enough capital to purchase an entire property. What can I legally do to allow my friends and family to invest in my deals without it being considered a "gift fund" so I can still qualify for loan options to purchase a property and a rehab?
HI Logan! I actually have a book out with BiggerPockets about this very topic. It is in pre-order right now but will be availably July 28th.
Now to answer some basic questions you had. You can structure this a few different ways. If the people who want to loan the capital are comfortable doing this they could form an LLC together, everyone contributes the capital they want, and then you all agree on how the payments for that loan are divided up. Usually it is done by equity share, so if one person put in 50% of the capital needed, then they get 50% of the interest only payment. The caveat to this is that all the investors need to be "active" in the investment, so they have a say in what gets funded, what amounts, etc. They need to have some participation - even if it's just a member vote.
Another option, which may not be legal in every state because the may view it as a security is called fractionalized notes. So you would have multiple people on the same note, again by amount contributed usually. This would be Person A has $50,000 in the loan, Person B has $35,000 in the loan and person C has $15,000 in the loan. It is best to set these types of loans up with a loan servicer who can then send the portion of the payment due to each lender separately. Some states do not allow you to do fractionalized notes as a regular person, you would need to be a broker/dealer because they consider them a security, so ask an attorney familiar with lending in your state what those laws may be.
Lastly, if you have one person who could fund the majority you could have them in the 1st lien position, and then another person comes in with a second lien position. As long as the 2nd lien holder understands the risks associated with a second lien, then you could have multiple lenders that way as well. There are pros and cons to each of these options, so it really depends on the amount you are looking for, how much each lender has to offer, and what their risk tolerances are and the nature of the relationship between those people.
I would advise AGAINST using friends and family money for the downpayment, especially on something you are buying that may not have a lot of equity in the deal. If the friends and family are coming in as a 2nd lien holder, and you are buying the place pretty much as the current value, if the market bobbles even a little, their lien is underwater, and they now have debt on a property that isn't worth as much as the liens combined. Anything can cause this, broader economic forces, damage to the property, deferred maintenance, tenants trash it and it ends up needed some renovation work not covered by insurance etc. If you explain the risks to them about being at the very bottom of the capital stack (meaning they are last to get paid if something goes wrong) and they still want to do it, just make sure you are okay either losing the relationship with that person if you can't get them all their money back, or you have reserves somewhere to make them whole to salvage the relationship.
Also - if you are using any sort of hard money loan - I would strongly advise AGAINST trying to do a second lien behind a lender like that. If anything goes wrong with the first loan and it defaults (and you can default for a variety of reasons, not just lack of payment) - this lender will have things written into their notes such as default interest, prepayment penalties, legal fees, and all of those will eat up any equity buffer, which means the 2nd lien gets wiped out. Also - many do not allow 2nd liens, so making sure whatever lender you choose to work with is aware and ok there is going to be a 2nd lien is paramount as well.
HI Logan! I actually have a book out with BiggerPockets about this very topic. It is in pre-order right now but will be availably July 28th.
Now to answer some basic questions you had. You can structure this a few different ways. If the people who want to loan the capital are comfortable doing this they could form an LLC together, everyone contributes the capital they want, and then you all agree on how the payments for that loan are divided up. Usually it is done by equity share, so if one person put in 50% of the capital needed, then they get 50% of the interest only payment. The caveat to this is that all the investors need to be "active" in the investment, so they have a say in what gets funded, what amounts, etc. They need to have some participation - even if it's just a member vote.
Another option, which may not be legal in every state because the may view it as a security is called fractionalized notes. So you would have multiple people on the same note, again by amount contributed usually. This would be Person A has $50,000 in the loan, Person B has $35,000 in the loan and person C has $15,000 in the loan. It is best to set these types of loans up with a loan servicer who can then send the portion of the payment due to each lender separately. Some states do not allow you to do fractionalized notes as a regular person, you would need to be a broker/dealer because they consider them a security, so ask an attorney familiar with lending in your state what those laws may be.
Lastly, if you have one person who could fund the majority you could have them in the 1st lien position, and then another person comes in with a second lien position. As long as the 2nd lien holder understands the risks associated with a second lien, then you could have multiple lenders that way as well. There are pros and cons to each of these options, so it really depends on the amount you are looking for, how much each lender has to offer, and what their risk tolerances are and the nature of the relationship between those people.
I would advise AGAINST using friends and family money for the downpayment, especially on something you are buying that may not have a lot of equity in the deal. If the friends and family are coming in as a 2nd lien holder, and you are buying the place pretty much as the current value, if the market bobbles even a little, their lien is underwater, and they now have debt on a property that isn't worth as much as the liens combined. Anything can cause this, broader economic forces, damage to the property, deferred maintenance, tenants trash it and it ends up needed some renovation work not covered by insurance etc. If you explain the risks to them about being at the very bottom of the capital stack (meaning they are last to get paid if something goes wrong) and they still want to do it, just make sure you are okay either losing the relationship with that person if you can't get them all their money back, or you have reserves somewhere to make them whole to salvage the relationship.
Also - if you are using any sort of hard money loan - I would strongly advise AGAINST trying to do a second lien behind a lender like that. If anything goes wrong with the first loan and it defaults (and you can default for a variety of reasons, not just lack of payment) - this lender will have things written into their notes such as default interest, prepayment penalties, legal fees, and all of those will eat up any equity buffer, which means the 2nd lien gets wiped out. Also - many do not allow 2nd liens, so making sure whatever lender you choose to work with is aware and ok there is going to be a 2nd lien is paramount as well.
@Logan French everything @Alex Breshears stated is spot on. I would advise against franctionalized notes because of SEC laws and regulations, but I would definitely use one paerson in 1st position and another person in 2nd position. You may even put someone in 3rd position if they agree to it. This way, which is the third way @Alex Breshears listed, is probably the most common way that most investors structure their capital raise.
@Alex Breshears Thanks for the detailed response, it was very helpful! What if my wife and I formed and LLC together and we were the active partners, and this LLC raised capital from passive investors (which would be from friends and family at first), how would we structure this? Would it just be the LLC taking loans from each individual who wanted to invest or is there a better way to structure their investment?
@Logan French - in the case you described, if you are taking on capital from purely passive investor you will need to get an exemption from the SEC. The JOBS act that was passed back in 2012 gives the different options for raising capital from passive investors. If you are interested in a debt fund, many are 506's. This is a rather expensive and tedious process, so this would not be my go to for the first time raising capital from others. If you have friends and family that are onboard with lending, you all would create an LLC and split equity ownership however it is worked out in the operating agreement for the LLC you make. There are so many ins and outs with capital that you would likely want to contact an attorney familiar with capital raising in your state specifically, because as I mentioned earlier doing fractionalized notes might be legal in your state and that means you wouldn't need to do the LLC at all.
You might want to find out from your lender what is considered a gift. Some lenders won't care where the money came from as long as it shows on your bank statements for 2 months. There is actually a term for this, its called "seasoning" a loan. So let's say you have a private money investor funding the down payment. You can schedule closing to be after you will have 2 bank statements showing the downpayment money in there. Then your loan is seasoned.
keep in mind for rental properties your lender might require that you show at least 6 months reserves for vacancy protection as well. So when you are raising money for the down payment you will probably need to show. Down payment plus 6 months plus closing costs sitting in the account you will use to close for two statement cycles.
This is not the case for all lenders, but find a lender that can work with you.