The Unseen Dangers of the Family and Friends Investment Strategy

Lessons Learned From Hundreds of Practitioners

Picture of by Dr David Phelps

by Dr David Phelps

Everybody wants in on the latest and greatest investment, mainly due to fear of missing out.

It's human nature to want what everybody else seems to be getting.

You name it: Wall Street, crypto, tech stocks, real estate. If somebody invested in it and claimed a big victory, you’d also want to invest in it, particularly when it's your friends and family.

Why? Because you know them best and hear from them the most. “They're no better than we are; why are they getting in on something that I’m not? There must be something I don't know. I should jump in because I don't want to be in the backseat of the bus, unable to brag about my returns.”

It's a normal condition. Trust me, we've all been there. We have all jumped into things under that euphoria and exuberance and later wished we hadn't.

A prime example is Bernie Madoff. That was a friends and family investment deal. Bernie Madoff made great claims about the returns for his investors. Many well-to-do, well-educated people and celebrities, through their “friends and family network,” jumped on board.

Most people who hear about the great returns somebody is receiving will want to join. So, how do you protect yourself from your family and friends' promotion of bad investments? 

If You Don’t Understand It, Don’t Invest

You must understand what it is you're investing in. I know it's hard to do. You can't be an expert in all areas of investing. That's why you need to choose your arena and stick to it.

Find things that you can feel confident about outside of just investing in index funds or ETFs, which may be a part of your overall portfolio. However, If you really want more control over your money, like me, you must learn about what you want to invest in.

Good Investments Require Vetting of Operators

There's a time to be an active investor and a time to be more passive. When you're younger, you have more time than money and can be active on the ground floor. You can be a part of finding deal flow or managing properties, and this can allow you some confidence in what you invest in.

But we all arrive at a certain point in life where we don't want to be doing that. As I do, you value your time a lot more and desire a more passive investment model.

To be a more passive investor requires finding the right people. That requires looking beyond friends and family.

I build my network of “the right people” by investing my time in vetting and building relationships. There is a certain level of vetting to find the right people (underwriting and background); part of it is getting to know someone’s character. How they run their business and team, and how they run their life.

That kind of vetting and accountability is hard to do with friends and family because they're separated from whatever the investment is.

Friends and family usually don't know much about the investment. Due to the luck of the market going up, as it has in the last 15 years, they made money. They want to do it again, are excited, and want to tell you about it.

But the Market is Changing

You have to be more discerning in the marketplace today. We're in an era of investing altogether different from the last 15 years.

Yet, there's still exuberance in the marketplace. There's still a lot of liquidity that came out of the 2020-2022 pandemic stimulus money. Eight to nine trillion dollars were inserted into the marketplace, dramatically impacting the economy.

This was fiat currency that was stuffed into everybody's hands. Much of that money went into the asset classes that you and I are privileged to be able to invest in while most of mainstream America cannot.

But all of that fiat money is now gone. What does this mean?

The credit markets are tightening up. The underwriting for bank institutional financing is more stringent. Banks are slower and more reluctant to loan money.

Most syndicators or fund managers relied on the extremely low cost of capital (low-interest rates). This was when underwriting was not as stringent, and banks were ready to hand out money.

For many years, coming out of the 2008 Great Financial Crisis, interest rates were near zero. Compare that to today’s rate of over 5.25%.

That's a huge discrepancy. Many investment operators who did well while the cost of capital was cheap now find the economic headwinds too much to bear. And we're only at the tipping point. The ride down has not begun.

Signs of a Recession in 2024

The commercial real estate market is just starting to correct. We've started seeing it not just in real estate but also in other commercial spaces.

This year will be the beginning of a great fall. This means you need to be careful about who you give your money to.

A great track record in the past is not sufficient enough for even decent returns in the future. I'm not saying they're bad or that they're running Ponzi schemes.

I’m simply encouraging you to dive deeper. How do you know your investments will reap a return? How do you know your investments are safe? Because your friends or family say it will be? 

You need to have evidence and justifications as to why your investments will be safe in this changing marketplace and why your money will generate a return during economic volatility.

Everybody talks a good talk. Everybody is friendly and charming and accessible until they're not.

I've seen this too many times with seemingly good people. People I thought carried a strong track record and later found out that they were swimming naked when the tide went out.

Do Your Investment Managers Know What They’re Doing?

From my experience, I’d say about 70% of the people who raise capital for funds and syndications are running deficient operations.

They don’t have bad intentions, but they don't know what they don't know. Their accounting, financial dashboards, and management are usually subpar. I've seen some that are ridiculously subpar.

How can they manage your money or investments if they don't even have the basics in place? They got away with it when the markets had cheap money. There was always someone else to buy them out, even if they had poor financials.

As an investor, you might have never known about their struggles because as long as you receive a decent return, everybody's good. No harm, no foul.

It's different now. Be very, very careful. Your financial advisor most likely does not know the questions to ask regarding an investment. Your attorney or CPA probably doesn’t know what to ask, either.

You need to be able to do a deep dive on investments and their operators. Otherwise, you're putting your money at risk.

What Can You Do to Invest Safely Today?

My general strategy is to avoid investing in funds and syndications unless you're in a position to do a deep dive or are connected with a community or group of people who can help you do a deep dive. Don’t take the risk.

If you take a year or eighteen months off from investing starting today just to watch and wait till the market corrects, your risk of losing money, even without deeper due diligence, will be far less than if you keep investing today.

Why? Because those who have been swimming naked will have been flushed out of the market.

If you’re still with them, then your money will be flushed out with them.

Wait to see who's standing strong on the other side. Those are often the people you want to invest with.

The Deep Dive to Ensure My Investments Are Safe

Personally, before I invest my money with anybody, I want to know what their financial accounting is like. I want to know their back office.

Certainly, I'm looking at their track record, but I am not relying solely on their track record. I need to know how they're prepared to go into the current economic headwinds, including the higher interest rates and higher cost of capital.

What is their credit underwriting for their bank loans? What kind of leverage are they using? What are the terms of that leverage? What is the loan-to-value they're aiming for with their assets?

Many syndicators and fund managers have been leveraging equity capital from people like us. They have been riding on our capital. As long as the deal runs fine, we’ve been okay.

But today, I would make sure that any operator you're investing with has a bare minimum of five percent of their own hard money invested in their offering.

Their invested money should not come from fees and commissions, It needs to be their own hard money in a deal. I like to see ten percent of the capital come from the fund manager or syndicator today.

If they’re not willing to put enough of their own capital in the deal, then why would you want to invest with them?

These are questions many of you are not asking. Without further inquiry, you are putting your money at risk.

Can You Read and Understand the Operating Agreement?

Many of these investment operators have become too comfortable with the quick turn of the deal. They make much of their money on the front end on the acquisition fee.

This is legal. They disclose it. They take a certain percentage for loan guarantees, asset center management, etc. They take a piece of your money before you get a dime. Again, it's not illegal. It's in their operating agreement.

This is why it’s important to read and understand the operating agreement. To understand what they're doing.

If the deal goes fine, then nobody cares. The problem is the deals are not going fine today. The old models investors and operators have become comfortable with are no longer profitable in the current marketplace.

If operators have built an infrastructure that relies upon quickly flipping properties, and now they are taking longer and longer to flip, what will they do?

They still need your money, but where are they going to put it? In marginal deals to collect the fees and keep the lights on. They’re still making money, but your capital is the one at risk.

If the operator has no money invested, they have no risk at all. That is not where you want to play ball.

Trust me. I've been through this. I’ve avoided many investments once I’ve seen what some operators are doing behind the curtains.

Most of them have good intentions. They just don't know what they don't know. 

If you’re not able to look behind the curtains of your investments, I’d stay out of them for now.

To your freedom!

– David


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