Seeking advice RE: Selling equity of a positive cash flowing property??

Question

Hi everyone. I recently found BP and it happened at a great time. I currently have a couple SFRs in Irving, TX but my long term strategy has always been to get into small multifamily properties. After reading Brandon Turner's case study blog on how to buy a small multifamily property I decided it was time to actively pursue a property and found a great deal in a nearby market that I'm planning to purchase with a friend. We are planning to put 20% down of which I will be putting down 80% making us 80/20 partners in the deal.

This is where my question comes in... My friend recently asked if I would be interested in selling my equity in the future to bring the total ownership split to 50/50. He doesn't have the cash to make this arrangement initially and he is planning to use his net income proceeds to purchase the additional equity. Since this is a very trustworthy friend I do not have a problem with selling the equity but want to make sure I am fairly compensated. My thought is to put a clause into our partnership agreement that states we will have the property appraised in a set amount of time (3 years) and after deducting the mortgage amount owed use that total to calculate the equity value. Is there a standard formula used to calculate the cost of the equity? My fear is I'm overcomplicating the valuation but definitely think my initial equity is worth more than a 8-10% simple interest rate based on risk, appreciation, etc.

Being a relative REI novice, I'm appreciative of BP's forum filled with so many experienced investors willing to assist. I'm looking forward to everyone's input. Thanks in advance.

-Marshall

Marshall Stewman · Answer

Thanks for the great feedback. Definitely some good points to consider.

@David Jackson - you nailed it and that is exactly the scenario I'm trying to avoid. I like your thought about me loaning the entity the funds but I need to look at the numbers to determine which rate works for both parties.

@Ryan Logsdon - good point on the multiple appraisals. Even with a friend as a partner, it will be better to have this explicitly stated upfront in the deal as a CYA measure if nothing else

Jody Leblanc · Answer

I was in a similar situation where I had the opportunity to buy into a higher position in the company at market value. My issue was that if I were looking for properties, I'm looking at something BELOW market value. So, buying in at top price is no good to me.

In your case, it's a little sketchy, but SELLING to him at market value basically ensures a full price buyer down the road for those shares.

Ryan Logsdon · Answer

A single, bad appraisal in the future could poison your 80% interest.  Allow for multiple appraisals with an appraiser (or appraisers) of your sole choosing.

Tom Goans · Answer

There comes a point when it is more productive to seek new investment opportunities than keep refinancing the old ones.

Spread out the risk and cash flow. Do some investing with your friend who contributes cash to a newly formed business you both own. Two cash flows are a better risk than one.

David J. · Answer

Another option is to set up an LLC that buys the property (or a partnership would work) and both contributions would be equal so what he can contribute now, and you can loan the entity (or your partner) the remaining amount needed to get to 20%. The loan can be paid with his share of the cashflow or out of his pocket over time.

Example 100k property (20k down needed):

He has 4k you have 16k.  You both contribute 4k and you loan the other 12k (at an agreed upon interest rate) to either your partner or the entity.  That way you are compensated for the extra cash outlay and he can own half.

The problem with him buying in in the future, like you mentioned, is you have a property that is kicking off cash flow every month that is not being taken into consideration when valuing the purchase price of the equity.  Like selling a business for only the value of the assets of the company (businesses are valued on the assets and cashflows the create).  If you sell to him based on equity on a cashflowing property he is taking very little risk. (you have 20k in equity from downpayment and it is generating positive cash so he could just wait until the positive cash is enough to pay you the other 6k).

That is like me asking you to put down the 20k and get the property up and running. Once I see if you have a winner I will gladly give you 10k for half (the equity alone is worth this so little risk).  Buy a bad property and see how excited he is to pony up the other half in the future... and buy a good property and see how excited you are to give up half.

little green houses

Wayne Brooks · Answer

Sounds like a reasonable approach, and he could pay you 30% of whatever the equity is.  You might deduct 6-10% off the total value, or not, since that would be your disposition costs if you were to sell it.