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Investing in real estate is a great way to grow your wealth. Property tends to appreciate in value over time and has the potential to show great returns through rental income and future resale profits.
To start investing in property, you will need capital — and a lot of it. Securing funding acts as one of the biggest milestones of any real-estate project. Although most home buyers use traditional home loans to purchase property, they have other funding options that residential and commercial real-estate investors can explore.
Low interest FHA loans, which private lenders issue and then have backed by the Federal Housing Authority, work great for projects such as house hacking. Veterans, active duty service members and their surviving spouses can qualify for VA loans, which have competitive rates and terms.
If you already own property, you may qualify for a HELOC or home-equity loan (or, a “second mortgage”), which borrows against your current home equity. And for fix-and-flips and BRRRR Method renovations, many investors opt for hard money loans, using the property itself as collateral instead of credit.
Today, however, we’ll focus on a more personal type of borrowing. Perhaps you have already tried taking the paths laid out above and received rejections, or maybe you just don’t like the risk involved with certain types of lenders.
While certainly a more socially risky proposition, this article will provide tips on how to ask your family and friends to help fund your real-estate project. Involving money in any relationship can complicate matters and you should only pursue this outlet if you operate prudently, vet your investments, provide transparency and prepare your investment thesis thoroughly.
Do your research
Before you ask anyone for money, spend some time fleshing out your ideas. Research the area you want to purchase property and ask yourself questions like:
•●What is the asking price versus selling price of other properties in the neighborhood?
•●What is the average monthly rental income or vacation rental income for similar properties in the area?
•●Has the population increased in recent years? If so, why?
•●Has the local government made major investments in the area recently? (e.g., to infrastructure)
•●What are the crime rate and school district quality like?
●•●What types of businesses, retailers and entertainment centers are in the neighborhood already? Are there any holes your idea could fill?
You can find the answers to these questions and more by simply doing some Googling, driving around the area, virtually “walking around” with Google Maps’ Street View, checking public records or asking a local real-estate agent.
Prepare an investment plan
Once you’ve done your research and analysis with useful apps and software, put together an investment plan for yourself. This way when you start approaching your network, you can answer their questions and show you have a fully baked idea.
Because you plan to ask for a loan from someone close to you, you do not necessarily need to make a formal appearance when presenting your idea. You may lay out your investment plan in writing, but you can also present your plan to your friends and family verbally.
Though, showing you’ve done the legwork to vet this idea might serve as a powerful indicator of your seriousness in the project and how much due diligence you’ve managed to conduct.
It never hurts to go the extra mile and make a formal pitch complete with written up investment research and supporting evidence for the claims you plan to make to your friends and family.
Rehearse your pitch
Although you do not want to come off as too contrived when pitching your friends and family, it is still a good idea to repeat your business idea out loud. This exercise can help you build confidence and shake off any nerves before you approach potential lenders.
That means practicing how you phrase certain pros and cons, often by playing up the pros and minimizing concerns around the cons. You don’t want to lie, though.
If something can truly sink an investment, you need to ask yourself honestly whether this investment is worth the risk. Don’t rush into an investment with your loved ones’ money only to go bust and cause tension with ones who love and support you. No real-estate investment fraught with risk is worth anything near that gamble.
Lay out potential for ROI
In addition to determining income generated from these assets and potential resale value, you have other costs you, your friends and family should know about.
Demonstrate that you’ve thought through all the details and have accounted for things that could reduce your return on investment. For instance, you might consider purchasing a home warranty in case anything goes wrong on the property and you don’t want to risk paying for every repair yourself.
You can determine how much it will ultimately cost to sell the property using a seller net sheet to compare estimated sale price with selling costs. These include costs like renovation fees, loan repayment, property taxes, real estate commission, etc.
Also take into account that you will need to pay capital-gains taxes once you sell the property, unless you make a 1031 exchange transaction and reinvest the proceeds from the sale into a similar property of equal or greater value.
Discuss funding options
Once you have someone signed up and willing to provide you with funding, make sure you understand the terms attached to that funding. You have a few different routes to take:
Gifts
If a family member or friend “gifts” you money, that means you do not have to pay it back. You also can avoid paying taxes on gifted money. Currently, an individual can gift up to $15,000 tax-free a year, but they can also use the lifetime gift tax exemption worth $11.58 million.
When you give a gift over $15,000 to one person in a single year, you decrease both your lifetime gift tax exemption ($11.58 million) and the federal estate tax exemption you receive upon your death. This might not matter for most Americans as their estates will fall nowhere near that range.
Even in the event where you land far below your lifetime gift tax exemption, you must still report any gift over the $15,000 annual exclusion. The IRS will want to keep track to make sure you haven’t gifted your wealth away over time and skipped out on paying estate taxes.
Finally, a letter or a signed document stating that the money was gifted could be helpful down the line if your project succeeds and the lender suddenly wants a share of the profits.
Loans
Loans allow the lender to set repayment terms, interest rates, etc. You can work with an attorney to draft up a “promissory note” detailing the terms of the loan, or you can structure the loan through a peer-to-peer lending company that will act as an intermediary.
Equity
Offering someone equity means that you do not have to pay back their loan until you make a profit. However, this will also make your friend or relative a business partner with partial ownership of your venture, so make sure to consult with an attorney.
Set a repayment schedule
Show the people you are borrowing from that you’ve put thought into how you will pay them back. Will it be monthly? Yearly? Once the property is sold? How much will you owe them for each installment? Will they be charging you interest? Think about these things ahead of time.
Pro-tip: Before asking for personal loans from loved ones, it’s a good idea to make sure that your other debts such as credit cards and student loans are paid off or at least substantially paid down.
Keep your network updated
Let your friends and family know about where you are in your investment journey. You can do this through social media, with an email newsletter or during casual conversations. Keeping your network updated about your plans can make them feel invested in your goals and can also attract new investors.
Finding funding for your real-estate project might be tricky. Asking for money from friends and family can potentially strain relationships or cause them to end altogether if you do not respect their repayment terms.
You can avoid this by being upfront about the risks, managing the project prudently, keeping people informed with regular updates and providing 100% transparency. That means including both good and bad news. Loved ones will also likely be more forgiving about ups and downs in your business plans.
Ultimately, putting the rules of the loan agreement in writing can set clear expectations at the beginning and avoid any drama down the line.
Riley Adams is a CPA and the author of the Young and the Invested website, which focuses on financial independence and investing.
