How do I set up a partnership structure in a real estate investment project?

Question

I live in the suburbs of Washington, DC and trying to embark on my first real estate investment.  Since I don't have much capital or experience, I wanted to partner with a real estate friend who is willing to contribute both skill and capital towards the project and mentor me through the process. He wants a 50/50 profit sharing scheme with the following parameters:

- We purchase a house in the neighborhood of $300K.  Renovation costs will be around $30K for a total investment of $330K.  Out of this, the cash requirement will be $90,000 ($60K for the 20% down + $30K rehab costs).

- I will finance 80% of the purchase price (or 240K) and contribute $40K additional towards the downpayment and renovation costs (btw, this is all my life's liquid savings).

- He will pitch $50K towards the remaining cash requirement

Once all expenses are subtracted, the profits will be shared 50/50.

Some questions:

1) Is this a reasonable deal?  I am contributing about 85% of the total investment costs but getting 50% back from the profits.  I realize my friend's skill and abilities in locating a deal, managing the rehab process, selling the house, and teaching me about the process should have a financial reward but how do you quantify that?

2) Is there a industry practice/standard on how to set up a partnership structure between investors?  For example, let's just say that I simply hired a realtor (instead of working with realtor friend) to find me a deal and got my brother to contribute 50K that I am deficient.  What percentage of the profit does my brother get?

3) In a partnership deal, do cash investors get a better reward than those investing through leverage?  And if yes, again, how do you quantify that?

I am trying to understand how to set up a partnership structure among investors based on the three essential elements of Time, Skill, and Capital.

Thank you in advance for your help.

-weis

David C. · Answer

@Weis Sherdel ,

If you just want to help your friend, maybe have him borrow HML on the first and you lend him the rest as second loan position at an interest rate you are comfortable with.  Just a thought.

Arlen Chou · Answer

@Weis Sherdel  you cannot really quantify the percentage or dollar amount that your friend is going to put into this.  The operative word you should be focusing is "friend".  Things get really sticky when you mix money and work together with friends and family.  I have no idea how much experience he brings, but from your post it sounds like substantially more then you are bringing to the table.  If you are friends, don't discount his knowledge and compare him to some random real estate agent and contractor team that you have never worked with.  If you go down that road you are going to put your friendship in jeopardy, so you are better off just starting with strangers.  But then the question is would you even start if it was NOT your friend that was willing to partner with you.

It is all more about managing expectations for all parties involved.  Detail out what the expectations are for each party BEFORE you start anything.  That way it is clear what your friend is doing for his 50% share.  Be especially clear on who puts money into the pot if the renovation goes over budget.

To be honest, it sounds like you are expecting him to do all the heavy lifting: find the deal, get the rehab done, sell the property AND teach you.  Assuming the property sells for a profit, you get all of your money back and you get half of the profits, basically all you had to do is write a check.  On the other hand, your friend will have some money in the game, but he is on the hook to MAKE the profit.

Take a minute and think about which is actually more valuable to a successful venture: the money in your pocket or your friends knowledge.  At the end of the process, you should have your money back, 50% of profits and the knowledge to go off and do this again on your own if you want.  If your friend is willing to give you 50% of the profit and do all the heavy lifting on his own, I think that this is a win for you. Keep in mind your last statement:

"I am trying to understand how to set up a partnership structure among  investors based on the three essential elements of Time, Skill, and  Capital."

It sounds like your friend has 2 of your "essential elements" and you only have 1.

But most importantly, having a clear written understanding of who does what BEFORE you start is key if you don't want to screw up your friendship.

Good luck on what ever you decide to do,

Arlen

Troy Fisher · Answer

Weis,

And there-in lies the biggest problem of all.  There is no "easy or best or" it can all be overwhelming, intimidating, troublesome, keeping awake at night.  The reason that everyone talks about setting your goals, and then evaluating your skill set is to find the path which is not going to let you get discouraged.

Landlording has just as steep of a learning curve as flips do and it requires a longer event horizon.  Walking away from a rental is harder then walking away from a rehab.  Spending months learning how to wholesale take patience and time, and self-doubt and more money then most people expect.

The best answer is always, it depends.

Are complicated entity structures good for you?  Depends.

Should I 1031 this property? Depends.

Should I invest locally or out of state? Depends.

SFH or MFH? Depends.

Sell now and wait for the ensuing crash to buy more cheaper? Depends.

I would suggest that it's time to stop reading, and get out there and talk to a lot of Investors, hit the REIA circuit in your area and listen to the other investors.  Hear their stories to see where your values and your abilities lend yourself to.  Develop that goal.

Troy Fisher · Answer

@Arlen Chou  has given you some great feedback!  Listen to what he has to say!  The conversations I've had with him at Meetups are incredibly valuable and he's pretty smart to boot.  However, I'll point out 1 or 2 things.  Here. The Capital Split is your 45% vs his 55%.  You need to drill down on a couple of questions in regards to why he is asking you to

1) take on the loan, why isn't it done by the partnership deal?

2) If he is experienced and has a track record (You've asked to see his track record, right?) why are you getting a loan that requires 20% down?  Does he know a Hard Money Lender that would get you guys in at 10% of LTC? Does he have any private money?

Some questions:

1) Is this a reasonable deal?  I am contributing about 85% of the total investment costs but getting 50% back from the profits.  I realize my friend's skill and abilities in locating a deal, managing the rehab process, selling the house, and teaching me about the process should have a financial reward but how do you quantify that?

This is a personal question that you need to ask yourself.  Is spending $40k worth having a mentor, is it worth fortune builders or a webuyhouses franchise?  How do you learn?  How should you spend your money to educate yourself?  Is it by doing your own deals and expecting to lose money?  Is it to be taught one on one with a coach?  Is it to go through a systemized system?  That is when you can ask yourself, "Is this  reasonable?" and "How do I quantify their contributions?"

2) Is there a industry practice/standard on how to set up a partnership structure between investors?  For example, let's just say that I simply hired a realtor (instead of working with realtor friend) to find me a deal and got my brother to contribute 50K that I am deficient.  What percentage of the profit does my brother get?

No.  There is no industry standard.  From the people I've met there tends to be a JV partnership structure that begins early in peoples career as they build a track record and experience.  As they move forward they tend to partner less, and gain investors who risk less but get less also.

3) In a partnership deal, do cash investors get a better reward than those investing through leverage?  And if yes, again, how do you quantify that?I'm not sure what your question here is?  But I will try to answer it anyways.  I think what you are trying to ask is: Is a cash contribution worth more than my ability to get secured capital?  No.  If it is a deal you can find people willing to give you money to do it with or without a credit score.  It's less expensive with a good credit score sure, but that's how you mitigate some risk.

And to address you last question, you are trying to quantify qualitative values. Inherently impossible to do.  This week I heard two investors strike up a partnership discussion.  The partners began with, "What are your goals, and what do you need from this partnership?" Then hash it out from there.

Arlen Chou · Answer

@Weis Sherdel  if it is just a skin in the game issue, then it becomes much more simple, just base it on the numbers.  Straight up money investing is just that, a percentage of return based upon the amount put into the pot.

BUT, it is never that simple in cases like this.  All mistakes in partnerships start off with people saying "we will both participate EQUALLY". If you get a realtor, are you both going on the tour or just your friend.  How about when you start renovation, who will find the contractors? Who approves the paint colors or the fixture that you will use?  If the contractor calls with a problem, who answer the phone to make the decision? I can't imagine that you both will head to Home Depot to go look at sink faucets and towel bars, that would just be a waste of time.  Its a great idea that people will "share the work equally", but stuff comes up in daily life that just does not make this possible.  Additionally, if you create a process where both of you have to AGREE on every little decision the renovation process will take forever and increase tension exponentially.

There are no "standards" for this because each situation should be viewed on a case by case basis.  On one project any given partner might have more or less time to commit.  If you are going to base the profit break down on funds invested then you need to outline, in detail, all of the work that will be required to make a successful deal.  At that point, the two of you can split that list and agree on what are equal work loads and make clear who is responsible for what.  It would be very important to outline what happens if one partner does not hold up their side of the work load.

If your friend wants more of the pie, then it just becomes a straight negotiation discussion.

Good luck!

-Arlen

Troy Fisher · Answer

Note Investing! Yes!

Robert Williams · Answer

Hi Weis,

I think your friend's offer is quite generous if he's a seasoned investor and knows what he's doing.  He's offering you 50% of the profits plus substantial mentoring all in exchange for providing some working capital to get the deal done.

I've had cash investors that I've partnered with in my deals and the most I've offered them is single digit returns.  Getting the money to do deals is important, but it's just a very small part of any real estate development deal.  Identifying and closing the deal, planning and managing the renovation work, and then successfully selling the finished product are where are all the heavy lifting of a real estate flip take place.

I'm definitely not trying to minimize the dollars that you're putting into the deal.  As you said, it's basically your life's savings so you should really consider how much you trust your friend and carefully examine his track record.  I'm just offering my two cents that the proposed profit split is more than fair in my opinion.

-Rob

Weis Sherdel · Answer

@Carlos Asuaje - Thank you, Carlos.  I am interested to learn about your first project.  May I ask if it was a rehab project, wholesale, buy-and-hold?  How did you do?

Carlos Asuaje · Answer

@Weis Sherdel speaking as a newbie who just completed his first deal(with a partner btw), I think any investment in real estate is going to feel a little overwhelming and take a learning curve..it's something you've never done! But trust me when I tell you, it's going to be ok. As long as you take the time to educate yourself, analyze the deal thoroughly, and take appropriate risks, you'll be fine! And honestly, you are lucky to be entering this business with a partner you can trust and that has both cash and knowledge...it really helped me learn a lot, working with a partner and I can definitely say the next deal will probably much less stressful. Best of luck!

-Carlos

How do I set up a partnership structure in a real estate investment project?

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