Buy/hold partnership structuring

[Brian Stieler]

I've put together a partnership agreement and presented it to my potential partner. It's structured so I am the managing partner, and they're the financial partner. They are responsible for the downpayment, closing costs, and initial repairs. I just presented it to them, but they've come back with an interesting question.

How is it a win situation for my financial partner if they don't see a true profit for ~10 years? Let's say they invest $30k for the house, and we split the cash flow. If they're only getting $3k/year, it's going to take 10 years before they see a profit. 

I proposed letting them get the full cash flow until their original investment is paid off, we'll split the cash flow, but then I'm getting nothing ( not counting appreciation and equity) for 5 years.

Am I missing something?

[Roy N.]

@Brian Stieler

I presume the nature of the arrangement is you are going to "earn" your half of the equity in the property?   Initially, your financial partner will have all the liability, but only a portion of the equity (80 - 90% I trust).

The first rule of using OPM is that your financiers/lenders/[non-active} partners come first.  Always take the best care of the golden goose.

In the arrangement you described above, you need your financing partner far more than they need you.   In your shoes, the first thing I would determine is whether my partner really should - and wants to - be a partner in the enterprise. Do they really want to own the property in the end, or would they be better served, and more content, simply extending a note/taking a mortgage on the property for 3 -5 years (say at a rate of 6 - 8%)?

If they want to co-own the property long term, then looking at it from your perspective, the partner owns 100% of the equity starting out and you are going to "earn" your share.  As such, I would look at a sliding scale of repayment of your partner: i.e. 100% of the free cash flow for the two years; 80-85% for years three and {maybe} four; then 75% until their "half" of the initial equity has been returned (out of your half of the cash flow).  Once you have earned your 50%, then you can start taking your 50% of the cash flow.

viz. Property is acquired for 30K, plus 6K in closing costs and initial renovations ($36K total). Partnership arrangement is 50/50. Property produces NOI of $500/month ($6K/year).

You owe your partner $18K.  In years 1 & 2, you forgo your portion of the cashflow ($3K x 2 = $6K); In years 3 & 4 you retain only $600/year and send $2400/year to your partner ($4800 total).  At the end of year four, you have repaid $10800 of your 18K.  Three more years turning over 75% of your half of the cash flow ($2250/year) and you have repaid your partner ... though I would pay them one additional year to make them whole.

There are many alternatives, for example, once the property is stablised under your management (say 3-years), you could finance it and pay back your partner's capital.

Regardless of how you proceed - borrower/lender, partnership, shareholders in an LLC, etc. have the partnership agreement / shareholders agreement or note & mortgage documents drawn-up by an attorney with experience in business law and real estate ... do not do it yourself.