Opening a real estate investment partnership

[Jason M.]

I have been successfully investing in rental properties for approximately 20 years. I personally own 11 doubles, 2 condominiums, and have completed 4 flips with moderate success. 2.5 years ago I retired from my job after 22 years to pursue real estate investing full time. About the same time a great friend sold a business for millions of dollars. After doing a ton of research and analyzation I decided I was going to start investing in lower-middle income housing in a city of about 200,000 people. Its location is about 1 hour from my home, but housing prices are much more affordable and rents are comparable to my area. I decided to pitch the idea to my friend to see if he was interested in investing. Figured it would be a good match as he needed somewhere to park his money and it could save me the agony of dealing with lenders. Ultimately we decided to open a business together. Being somewhat naive to a larger scale of business his accountant and lawyers helped me with the footprint and the contracts. It was set up in a way where we both invested 100k personally then we borrowed the rest from him. He had no responsibility within the business accept to provide the capital at an interest rate of 4.25%. I was responsible for 100% of the responsibilities of running the business. This included the opening of multiple corporations (holding company, management company, sub LLC's that hold the properties). Within 2 years we controlled 82 units broken up between singles, doubles, threes, fours, a five, and a nine unit. I take a salary of approximately 70k per year. I work between 40-60 hours a week doing everything between finding, analyzing, and buying properties, personally doing renovations and make-ready's, overseeing contractors, leasing units, and working hand in hand with an excellent management company that takes care of collecting the rents, dealing with tenant relations, and day to day maintenance. The company has borrowed 3.7 million from my partner and is paying him approximately $19,000 per month in principle and and interest payments. As the company has grown and we are deciding on its future I have started to question whether of not this is equitable for me? It turns out that as the silent (money) partner he really has not injected anymore cash into the company than I have. He has merely loaned the company money at a fair interest rate. Not only does he have a first position lien on all the properties, but he also has a personal guarantee from me for half the money. Basically this is a risk free investment for him. With this money that he he has loaned the company he has also purchased half the equity of the entire company. It's often difficult for me to wrap my head around, but basically he hasn't invested any more money than I have because it's structured as a loan (with all of the investment due back to him), however he also gets half the equity. The terms of the loan are excellent and it allows us to purchase properties with cash and no contingencies. That provides us with great purchasing power and up-front equity. Is the structure of this company equitable for me or would I have been better off pulling equity out of my properties and going it alone? I don't want to seem unappreciative but ultimately for me to move forward I need to feel comfortable with our respective compensations for our part in the business. I appreciate any and all input on this dilemma.

[Don Konipol]

@Jason M.

The answer to your question is that anything two people agree on is by definition "equitable". The real question is what would be your ROI vs your risk if you structured the business in a different way?

Okay. Let’s start with your current structure. Since you both invested the same in equity you’re equal partners. Since you do the work you get a salary. This is pretty basic and common structure. The loan part can be seen as an inducement to have you agree to the partnership by providing a low cost, easily accessible debt component.

What would your cost of debt be if you had to access debt without the tie in? Unless you had a very, very strong balance sheet, and a very strong relationship with a lending institution, you’d be looking at considerably more than 4.25%. Private money starts at about 8%; with the relatively small amount of equity capital you’ve invested and the resulting high LTVs you’d pay considerably higher rates, and might have to invest more on the equity side yourself.

If you're venture is successful long term, and earns an ROI greater than the cost of capital and your salary, then by definition you'd make more money as 100% owner than as 50% owner. So the analysis you need to do will include these key components; you're ability to raise debt capital, the ROI , the decrease in ability to do deals based on not having your current readily available debt source, the cost of debt capital, and the risk factor. Then you'll be able to determine with hopefully some accuracy what your return would be going it alone and what the additional risk would be of not having your current capital source.

Btw, nobody lends their money at 4.25% at near 100% LTV mortgage loans unless they are lending to an entity they have significant interest in. Your partner has alternatives. For example he can invest in mortgage with us, at 60% or lower LTV, and receive a return of about 11% interest. Knowing this he may feel your partnership isn't equitable to him!