Another way to access funding 4 a small rehab?

Question

So many lenders will not touch a small deal. Could this be a remedy and if not why not?

1. Assume there are 10 investors in the City X who purchased with their own money 10 properties. Each property has ARV significantly larger than the price paid.

2. The 10 investors now form LLC for a very specific reason to fix and sell and repeat the cycle.

3. A private party able and willing to finance all 10 rehabs comes along and joins the LLC as a partner #11. His % of the company corresponds to the total amount 
due to him at the sale of properties.

QUESTION: How secure or not secure is the investment of the partner #11? Under which scenario could he experience a loss? (The exit strategy is a group Y concentrating on purchase of fixed properties to lease or re-sell)

Jon Holdman · Answer

By "rehabbers" I mean the people who purchase or want to purchase the properties, rehab them, and then sell them at a profit.  Not the contractors who do the work.

You say you're buying for cash.  So, now you own a property and need money to fix it up.  First some suggestions for dealing with this, then I'll come back to the LLC idea.

Why are you buying for cash then looking for money?  If you have some cash, find a lender who will let you put in a significant down payment and loan you the rest.  Even if this is a small loan, e.g., $25K, I would think you could find someone small and local who will do the deal.  If you're dealing with the big national hard money lenders, forget them.  Find local people you can deal with personally.  The first hard money loan I made was $48K.  Now, the fees may be hefty, compared to the loan amount.  That's just the price you pay.

Credit cards or personal lines of credit are a source of small amounts of cash.

Getting a construction loan from a small lender is a possibility.

For that matter, buy the property with a low LTV loan and save some of your cash for the rehab.

Now, if you want to form an LLC, many of the same issues I mentioned still apply.  What I hear you saying is that ten rehabbers all buy a property for cash and then contribute the properties to an LLC.  The LLC uses these for collateral and get a loan or equity investor.  OK, that will give the rehabbers a larger cut because they have contributed something of value - the properties.  You still have complexity of tracking each individual deal.  And what happens when one deal generates a lot of profit and another generates a loss?  If there's a solid understanding the profits and losses all get distriuted equally based on the value of the contributions (not ARV, otherwise you will have huge fight over the ARVs), then the guy who brought the good deal to the table has to share his profits with the guy who brought the stinker.  Even if you make that work once, that person never participates again.  And, I guarantee you he will feel like he was shafted by the other participants.

Jon Holdman · Answer

If an investor had enough cash to fund all these deals it would be much simpler to just do a straightforward individual loan with each of the rehabbers.

You seem to think the rehabbers are contributing something into this LLC.  They're not.  They have nothing to contribute.  They don't own the properties, so the can't contribute them into the LLC.  The only one I see bringing anything to the deal is the investor with the cash.  The investor brings in a wad of cash.  That cash is 100% of the value of the LLC.  The LLC then uses that cash to buy properties.  A rehabber fixes up the property, increasing its value.  The LLC sells the property.  Now the value of the LLC is higher because (presumably) the property is sold at a profit.

The question is, who gets that increased value?  Clearly the rehabber should get something because they did all the work.  The investor gets something, because its his money that made the deal possible.  The usual split is 50/50.  But what about the other investors?  Do the deserve anything from this particular house?  IMHO, no.  They all have their own deals.  But guess what?  The IRS will expect them to pay tax on the profit from this particular house.

Lets work through a real example with real numbers.  Say the investor puts in $850K to buy and fix up ten houses.  That is, the investor is going to invest $85K into each of ten houses.   Each of these houses will net $15K when sold.  So, the total value of the company will end up being $1 million.  On each house, the investor is going to put in 85% the value in cash and the rehabber puts in 15% of the value in the form of their labor.  They agree to split the profit, the $15K 50/50.

What this translates into is that the investor has 85% of the total capital in the company and each rehabber has 1.5%.  For the profit split (IRA treats capital, profits and loss as separate items and you have to report all three), the investor gets 50% of the profits and each reahabber gets 5%.  That is, the investor gets 50% of the profit from all ten deals and while each rehabber gets 50% of the profit from one of the ten deals.

Since the values of the ten deals are unlikely to all be the same and the expected and actual profits are all different, too, it won't be nice and neat.  One investor might actually get 1.2% of the capital and 3% of the profit because their deals is small and another with a large deal might get 1.8% of the capital and 7% of the profit.

All this would have to be sorted out at the end of the year, deal by deal.  And, its unlikely the deals would be all started and ended in one tax year, so the deals that cross over a tax year would be even messier to deal with.  Each and every deal has to be tracked carefully on its own.  So, there is no benefit at all to putting these ten deals into one LLC.  Its easier for everyone involved, especially the rehabbers, to just do a separate deal with the investor.

This doesn't even address the operational complexities.  That is, if these are all members of the LLC, they all have certain rights.  As do their heirs if one of them dies.  Or, if one needs to suddenly bail out.  ETC., ETC., ETC.

If the investor wants to form an LLC and have the LLC make the loans, that's their prerogative.  But its still going to be much simpler to make the loans or equity split deal directly with each investor.  If the investor wants to go to a bank and borrow money to add to their pool, that's between the bank and the investor (this is a pretty common arrangement, actually.)  This gives the investor more money to invest for money deals.

Chris Martin · Answer

Question. You say "All participants, 10 or less, agree to hold interest in the venture equal to the ARV of their respectful properties." How did these 10 participants get their property to contribute to the venture? Did they buy free and clear? Where does the contribution come from?

Do the investors join this JV at the same time? Over a year time frame? If not at the same time, JV ownership stakes change relative to... the perceived contribution value of the new partner? I'm just trying to figure out the mechanics of this venture, since it seems way overcomplicated with so many investors.

Craig E. · Answer

You don't have rehab funds,   You do have properties in need of rehab.   Do you want an investor to finance all of the rehabs for a percentage of the ARV's at resell?

Can I simply purchase all of your properties "as is" before rehab?   You will make the same amount and I will improve my margins by flipping or rehabbing in-house.  The only problem with this is your contractor would be out of the picture.

Joanne Basecki · Answer

I see I need to be more clear. Let's take as an example Investor 1. What I said was:
ARV - price paid for the property = 90k - rehab = 50k
To put all the details it could look like this:
ARV of 100K - price paid for the property 10K = 90K - rehab price of 40K shows that there is 50K left to be maid and after 50/50 split with Major Investor that person would be left with 25K profit. Thus his share of LLC would be 5.5% as the 100% is 450K

Joanne Basecki · Answer

Please give me just a bit more of your time in hope I could change your opinion to a more positive one. The numbers below present exactly how I see the situation in real life, except that I am using 5 properties in place of 10 for simplicity.

Note: This would be a service to all those who cannot receive a conventional loan for unknown reasons, often unfair reasons for sure, as they are contributing members of society who have never done wrong to another. (We can always do background check on these folks) IT IS OBVIOUS that for those persons this would be much better situation to commit to than to accept total losses:

Investor 1:

ARV - price paid for the property = 90k - rehab = 50k

Investor 2:

ARV - price paid for the property= 70k - rehab = 50k

Investor 3:

ARV - price paid for the property = 20k - rehab = 10k

Investor 4:

ARV - price paid for the property = 80k - rehab = 50k

Investor 5:

ARV - price paid for the property = 190k - rehab = 100k

Note from above: Rehab price must be less than half of expected profit

Contractor committed to the total rehab price of 40 + 20 +10 + 30 + 90 = 190K

Major Investor committed to an investment of 190 paid directly to contractor and profit of 25 + 25 + 5 + 25 + 50 (50% from profits of each of the 5 property investors) = 130K It is obvious he almost doubles his investment. Lesser the rehab price in comparison to the profit better for him. EVEN if that investor needed to pay 20 for atty and closing he still made 110K in a SHORT TIME from his initial 190 which is 58% - A HUGE PROFIT WITHOUT MUCH EFFORT

Now all involved need to commit to the numbers and the % need to be calculated. (The end buyer must as well commit to his price at this point)

All involved expect to be paid as follows at closing:

Investor 1

25k  = 5.5%

Investor 2

25k = 5.5%

Investor 3

5k = 1.1%

Investor 4

25k = 5.5%

Investor 5

50k = 11%

Major Investor:

190 + 130 = 320K = 71%

The price buyer must pay is the total of  130 + 130 + 190 = 450K which is exactly the sum of all ARVs (He will now lease each property for profit. Thus stinkers could not be accepted to the group in the first place)

Joanne Basecki · Answer

Jon and Chris, I must say I finally understand your point. Thanks for making it so clear for me. One day soon I would like to explain why this particular concept was and still is so important to me. I really appreciate your help and patience very much. The conclusion that I now see is as follows: The major problem would be in a fair distribution of profits. If and only if an attorney could set up an LLC arrangement where those percentages could be easily predetermined and agreed upon ahead of time, perhaps there is some chance of success with this, for those folks who are denied conventional loans for one reason or another. An exit organization, a buyer, would need to cooperate as well.

Chris Martin · Answer

Jon, thanks. Your post was 99% what I was thinking when I said "Bullet #2 is problematic on multiple fronts." The only thing I'd add is that this JV concept seems to be positioned to fail rather than positioned to succeed... but Jon that comes out clearly in your post. Joanne, I think this concept just adds too much complexity and inserts unnecessary potential traps. It is very hard to execute. It would be a lot easier to find another hard money lender(s)... or maybe even a commercial or local private lender.

Joanne Basecki · Answer

David, you seem to understand me and likely you would be able to help, except that my property and investment focus is in Chicago. Thanks so much for the understanding!

Joanne Basecki · Answer

Jon, you misunderstood me. The concept is NOT created for the contractors but for the people who in fact purchased fixer properties and cannot find any loans to pay for their rehab project. I experienced it myself. I purchased a property with cash and was told by HM my deal is too small for them. Yes, the people like me would indeed bring the value in. The cash investor would only bring a part of the value. There is nothing wrong with your concept and I thank you for your input but I am painting a picture of a totally different situation. (Smile.) The steps of my concept:
1. Investors purchase their fixers
2. LLC is formed
3. Now a large (new) organization is looking for funding for its projects
4.The projects are sold as soon as the rehabs are accomplished and proceeds are distributed according to % values.

Another way to access funding 4 a small rehab?

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