Being the bank in your own multi-family real estate deal?

Question

I am considering a partnership with a real estate investor to buy and hold multi-family real estate deals. We will call it "XXX Company" for example. The partnership is 50/50 (as defined by our operating agreement), and the distribution for each deal is determined by how much equity each investor contributes towards downpayment. To keep things simple, we both plan to put in the same amount of capital to yield 50/50 equity stake in each property moving forward.

There is one catch: I have the ability to contribute significantly more than my partner towards downpayments but in order keep equity contributions and interests 50/50, I plan to contribute less than I am able to instead of contributing 70/30 or 80/20, for example.

With this in mind, I am also considering acting as the bank for the rest of the debt, loaning the remainder of the downpayment to XXX Company and collecting interest.

An example would be:

- $2M property

- $400k down payment (20%)

- $30k equity contribution (each investor, $60k total)

- $340k remaining, loaned by me to XXX Company

Is this is a common structure? Are there any significant cons to doing this?

Bill F. · Answer

@Harry Williams depends on how you define "well". I'd imagine that your partner, as time goes on and the deals you do cash flow, should be able to put more cash into each new deal, which will lessen the severity of the split.

At the end of the day, every partnership is different. If you both are ok with you getting the lion's share of the cash flow for the foreseeable future, while he still has equal decision making power, go for it.

You could also have him "earn" more decision making power by being responsible for more of the day to day operations. A version of sweat equity if you will.

Bill F. · Answer

@Harry Williams That structure isn't uncommon in other niches of investing, mainly the PE space, and there it is called mezzanine debt. It may be a bit out of the ordinary for the mez debt and equity to be held by the same person, but not unheard of; however, the lending norms are a totally different ball game.

The risks for you comes in two flavors, upside and downside. The upside risk is that your total returns will be a lot lower if the deal does do well will since you put more money in, but since its debt, the payout is capped. The downside risk is simply that you have more money to loose.

Like @Greg Scott said, the deal will have to meet all of your bank's overlays, which could make this idea dead on arrival and/or your debt payment will eat up so much of the post bank note cash flow that it makes the deal unattractive to your partner.

A simpler way could be to make the payouts based on equity shares but decision making 50/50 in the operating agreement.

Harry Williams · Answer

@Greg Scott Thanks for your relpy and concerns. To give a bit more context: I plan to do this as preferred equity and not a loan, which looks better to banks from my understanding. Under this structure, the preferred dividend is paid before any distributions are to be taken.

More details on this example:

- Property Basis $2,000,000.00

- Bank Debt $1,600,000.00

- Preferred Equity $340,000.00

- Members Equity $60,000.00

- Bank Debt Interest Rate 4.25%

- Preferred Equity Div. Rate 7.25%

- Property Cap Rate 6.50%

- Net Operating Income $130,000.00

- Bank Interest $68,000.00

- Preferred Dividend $24,650.00

- Available for Distribution $37,350.00

Greg Scott · Answer

I'd be really careful with that idea.

Even if you contribute equal amounts of equity, you have MUCH more at risk.   First, your loan to the partnership at risk.  Also, if the deal goes sideways and the bank has recourse, they are coming after you, not your partner.  The deeper pockets are always the target.  Be sure you are comfortable that you are taking on much more risk.

I would also check with a mortgage broker that this is feasible.  They don't like over-leveraged deals and because the capital is provided in the form of a loan, lenders may reject it.

Scott Mac · Answer

@Harry Williams

Hi Harry,

If you're going to do that it might be a good idea to run that scenario by your Tax CPA first.

Good Luck!

Bill F. · Answer

@Harry Williams I'll give you the classic, it depends. Without an in depth knowledge of federal and GA tax codes, and reviewing the Operating Agreement for your LLC's no one on BP can help with that question.

To get an answer you'll have to pony up some cash and engage an accountant.

At first blush the corporate structure seems overly complex for rentals, but there are facts I'm most likely not aware of.

Tj Hines · Answer

@Harry Williams this doesn't sound like it will have a good ending to it. You're the bank and you're loaning money to yourself? So you're giving yourself the debt and contributing equity. I don't know. Sounds confusing. Not to mean that as an insult. hmmmm

Harry Williams · Answer

Thanks @Bill F. one more follow up question here.

We have a parent company that will sit above the portfolio of properties. This company will receive all distributions made from the properties and then further distributed to each partner based on ownership. Over time, this ownership will fluctuate as we each put in different %'s per deal.

Given that the parent LLC will be the LLC filing tax returns, will we run into trouble or difficulty when making distributions or filing taxes as the portfolio grows?

Harry Williams · Answer

This is actually how the operating agreement currently reads. If I put in more equity per property, let's say 70/30, does this scale well as we purchase more and more properties?

Being the bank in your own multi-family real estate deal?

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