Partnership Structure and Incentives

[Forrest H.]

Hello, I'm considering going into a real estate partnership with someone I've known for a while now.  We're looking at purchasing homes in college towns, doing some renovations and adding rooms, and renting out rooms individually. They have done this same model onto properties already and I had expressed interest in being involved in the next one.

Here's how they proposed it would be set up:

1) They find the deal

2) I get the financing and put down 2/3, they put down 1/3

3) We are both on the deed

4) They manage the property, get tenants in , deal with tenant issues, etc...

5) We both have 50% equity

My goal is to not be involved with the day-to-day management, but rather oversee the financial side of things.  I have more capital than time.

My partner has less capital and is willing to do more of the day-to-day for higher equity.

What I'm looking for a specifically is feedback on the structure of the partnership and ways to make sure the incentives are aligned.  For example, it seems common to have a preferred return for money invested that incentivizes the performance of the manager.  But, I would also be worried about a scenario where the property isn't doing well and my partner doesn't manage the property well.  Since they already have 50% equity and are on the deed, it seems like this is a big risk?

Please give me your feedback on this structure and if you can think of ways the structure might be adjusted to better align incentives and protect both parties. (And yes, obviously we will see a lawyer to put together all of the legal agreements and everything, but we are just talking about the high level structure at this point)

Thank you!

[Benjamin Aaker]

First, it sounds like you have a good reason to partner - you don't have time and the partner doesn't have the money. Lots of partnerships are formed because it sounds like a fun thing to do and this is a bad reason. Make sure you have considered how well you both will work together. Even though you won't be managing, you'll likely have to discuss how the project is going and have some input in it.

If you think you'll work well together, then consider your terms. I think that the idea to have 2/3 come from you is ok, but long term, it favors you financially. Partner's doing 100% of the management in return for the difference between 33.3% down and 50% of equity. They aren't getting any annual payment for doing the work which might cause friction.

You should form an LLC and have the attorney draft the operating agreement. This LLC is what takes title, not you as investors.

The OA needs to explicitly document what each of you will do for the business. You should have one partner have slightly more decision-making capacity than the other to avoid gridlock. It can be different for day-to-day decisions than for capital expenditures.

To your question about the scenario where the property isn't being managed well: put a shootout clause in the OA (your attorney will know how to do this).