Using OPM (Friends and Family) for a Down Payment and/or Rehab

[Logan French]

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? 

[Alex Breshears]

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.