Michael Blank goes over some of the pros and cons of using your friends and family as a lending source.
It’s important to consider what will happen if you take a loss on a property. Who will be out the money? Michael explains your options and what he does personally in these situations.
Mike: Welcome back to the flipnerd.com REI Classroom, where experts from across the real estate investing industry teach you quick lessons to take your business to the next level. And now, let’s meet today’s expert host.
Michael: Hi there and welcome to the REI Classroom. My name is Michael Blank. You’re in the right place if you want to learn all about apartment building investing. Today’s topic is going to be should you raise money from friends and family.
Mike: This REI Classroom real estate lesson is sponsored by theinvestormachine.com, FlipNerd’s private investor coaching program and your blueprint to investing success.
Michael: So if you followed me for any amount of time you know I’m all about raising money to do real estate particularly to get into apartment building investing. Now, some people are afraid of approaching friends and family to raise money. So the question, should you do that, should you shy away from them or should you go ahead and approach them?
So, the reason that some people don’t want to do that is because they’re afraid that they’re going to lose money, lose friends or family’s money and ruin a relationship and that’s a real concern. And plus it’ll make very uncomfortable Thanksgiving dinners. But let’s drill down on the fear, sometimes I do this worst case scenario exercise and actually think through what could happen versus what’s likely to happen. And sometimes we find that actually the worst case scenario isn’t really so bad. So let’s do this.
You know, first of all when I take money from people I feel a very overwhelming responsibility for that money and far greater than if I’m using my own money. Like, if I use my own money that’s bad enough, but if I’m using a friends or family member’s money, to me it’s just disastrous and most people feel the same way. So I don’t want to belittle this fear because the responsibility is really overwhelming. But let me go through an example and normally I talk about apartment building investing, but I know a lot of you guys are just real estate investors. So I’m going to use an example that you can probably relate to a little bit more and I know a lot about as well which is flipping houses.
So let’s say . . . let’s first talk about the probability of this happening, because a lot of fears are improbable. And so, we have to kind of think about what’s most likely. But let’s say you’re buying a house and you raise $100,000 from, whatever, four private friends and family $25,000 each and use $70,000 for the house and $30,000 to repair it. And after repair value you estimate it as 150,000. So after all expenses and stuff like that, you’re thinking you can probably net 30,000 from this house flip which is reasonable.
Now, at the end, the time you’re done, instead of making a $30,000 profit, you actually made a $5,000 loss because your construction guy went over budget and you underestimated the after repair value. And so that compounding effect caused a loss. Now, first of all the probability of loss of actual losing money to me happened really only one time out of like, 34 houses. And so, the probability of that happening if you do your homework right, are probably not very high, but it can certainly happen.
So the probability itself most likely what normally happens in a situation is not a complete loss of . . . well, first of all, you’re not really actually losing their capital, because real estate inherently still has value. So you improved it and yes, you went over budget, but very rarely is there a complete and utter loss of capital. But there could be loss of capital, but it is a bit remote. But let’s say . . . so that’s number one, point number one is the actual . . . normally, what happens is you don’t make the money that you’re thinking which is disappointing, and a lot of flippers make a little money or none at all and it’s like, “Why did I do all that stuff?” That’s the most likely scenario if things go bad.
Actual loss is pretty remote. But let’s say it happens. So number one, remote, number two let’s say it happens. You have two options with your friends and family. You can call them up and say, “Hey, guys, I’m sorry. I just lost $5,000 of the money you put in. So each of you guys lost $1,250 in principal.” And you could do that, because, I mean, what can you do? There’s just nothing there.
So, are they going to stop talking to you over a loss of 1,200 bucks? Probably not. They’ll probably get over it and go, “Wow, that was . . .” they might not invest with you anymore even though I think they would potentially because . . . especially if you’re going to do more of this stuff. But they’re not going to stop talking to you over this kind of money. Now, if you lose all their principal that could be a problem, but again it’s very, very . . . it’s not likely that you’re going to have an utter loss of capital, it was real estate, multifamily or houses.
Option number two is eat the loss yourself and this is my preferred method. So if you’re doing this, if you’re flipping, how to do real estate you’re going to have income hopefully. And if you do have a loss you do your best that you can to eat it. I’ve done it. I’ve eaten losses for my investors. I’ve made my investors whole, not just the principal, the interest at my detriment and I know others who have lost a boatload of money on like, luxury houses. They got themselves in over their head and I mean, literally in the hundreds of thousand dollars.
And I know an example of one investor and she actually borrowed out of her IRA to make her investors whole. I’m just getting goosebumps thinking about that. That is commitment guys. That is commitment to your investors when you will go and basically make your investors whole at whatever price. That is character. That’s option number two and that to me is the best option.
So, if you look at the two options either of those options preserve your relationship with your friends and family. Let’s look at the downside of that. Let’s look at the downside of not taking friends and family money. So it was just a fear, but let’s look at the actual downside. Here’s the thing, if you philosophically don’t take money from friends and family, you have a much bigger hurdle to overcome because your friends and family are the people who know you, trust you, like you, are more likely to help you with your real estate investing.
So if you say, “Nope, I’m good. I don’t want to ruin our relationship for fear that will never happen,” you have a lot more work to do. Now, can it be done? Of course, you can go out to the cold network and it’s going to take a lot longer to do it. So I really would challenge you to look at your fear and examine your fear that you have of actually involving your friends and family in your real estate. And my opinion is that it’s better that the pros far outweigh the cons, but I don’t know.
Let me know if there’s a chat box below the video, let me know what you think about that because we can have a discussion about that. So that’s what my opinion is about raising money from friends and family. I think you should do it.
All right, I hope you found that useful in getting started with apartment buildings or real estate in general, but apartment building specifically about raising money. If you want more information about raising money, you can look more on my other REI Classroom episodes. I do spend a lot of time talking about money.
I also have additional resources on my website where you can find me on themichaelblank.com. There’s a free e-book there that you can download. It’s called the “Secret to Raising Money.” And if you scroll down to the homepage and click on the “Raising Money” thing and it shows you all of my podcast, articles, and videos on the topic of raising money. So that’s all I got for you today. Thanks very much for your attention and I will catch you on the next episode of the REI Classroom. All right, take care.
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