How to split profits on a flip in a partnership

Question

I just discovered this awesome site.  Thank you all for taking the time to post advice, it's very helpful, especially to a newbie.  I hope this is the right forum for the questions  I have.

I've already done my due diligence and I'm not jumping into something I can't handle yet, especially since my first order of business is to work out my partnership structure, so I'm only seeking advice on that at this moment.  I'm partnering with a general contractor who is the husband of a very good long term friend of mine, whose ethical values I know, and who I trust.  I approached him - I bring cash to the project, he brings his experience and employees.  He also used to rehab and flip before the market crashed, although the one strike against him is that he found himself holding the bag at that point.

I also decided I'd rather partner with him, at least until I learn more about rehabbing, rather than just hire him as a contractor.  I feel that there is more incentive for him to manage costs and make good decisions in choosing what property to take on if he has an ownership stake.

What I'd like to know is how should we split up profits.  His workers will need to be paid and we'll have materials costs, and we haven't discussed yet if all that will be at cost or with a general contractor's markup (we will when we sit down to hammer out the partnership, which is why I'm soliciting advice!).  I had thought about dividing profit according to the investment each puts in, but that could end up being really low for him, say if I put in $300k for purchase/closing/carrying expenses and he puts in $60k of labor and materials without including a markup, and the net profit is $100k, he would only get $20k, and I can't imagine he would agree to that.  Plus, if I'm the one taking the financial risk, I wanted to take a little extra for that as well.

My other idea is to set up the partnership as a 50/50 split, but we would each have separate entities that are "hired" outside the partnership.  I would be the hard money lender and charge an appropriate percentage (if anyone can suggest what sounds reasonable for this, I'm all ears) for my risk and opportunity cost, his company would be paid as if they were hired, and then we'd split what was left.  However, there's also a time cost for each of us, yet mine won't be compensated until (and from) the profit, but his time will be compensated for in the general contractor services, and he'll still get half the profit, so should we work out a discount for the contractor services that would still allow his operating costs to be covered, and then his personal time cost would be covered in his share of the profit?

Sorry this post is so long.  Has anyone ever partnered up with someone like this and how did you work out the partnership agreement?   What, besides hiring a contractor and just paying him, makes most sense in setting this up?  I really appreciate any and all suggestions!

Rich Peterson · Answer

Maya - Now that its 3 years later - how did this all workout for you?  I am debating the same thing, same terms, etc.  I just dont see exactly what my GC brings to the table if I have all the financial risk.

J Scott · Answer

Welcome to BP, Maya!

Here's the problem with this situation and question, as I see it...

You say that you don't want an investor/contractor relationship, but ultimately, unless you define the extra value the GC brings to the deal (other than the construction side of things), that's essentially all he is.  And as long as that's all he brings to the table, then the "correct" amount to pay him would be whatever a typical GC would charge to complete the job.

Now, it sounds like you believe he brings more than just the construction side of things to the table.  If that's the case, how much more?  Is his value to the project commensurate with yours?  If so, perhaps he deserves 50%.  Is his value to the project worth more than the cash you're bringing?  If so, perhaps he deserves more than 50%!

Without knowing what each of your brings to the table -- and how each of you value what each of you brings to the table -- there's no way to answer your question.  Only the two of you can quantify the value each side brings, and that is what the percentage split will be determined by.

Deanna McCormick · Answer

I am working on doing a like venture, I have cash for the purchase of a property that I have looked at with a family member that's a licensed contractor. He want's me to split the profit on the property after costs.
My question is what is a good percentage to offer him on this.We have to hold the property for 1 year per the purchase agreement. My utility costs and property taxes will add another 6K on the initial cost for a total cost 198K for a year.

We have a budget of $55K for materials and I am looking at a budget of $30K for labor total costs 85K.

We expect the property to sell for 360K.
Any hope for profit of around 67K
I'd like to hire him as a contractor and pay him the 30K for labor, he wants to split the profits. 
I will be and paying for all the materials and original cost of the property I would like the percentage to be fair.
His thought was he found the listing and should be compensated for the find.
My thought is I have the cash and that equals his find for the listing.
We signed a purchase agreement together and are stuck trying to work out this percentage.
We either agree on a percentage or walk from the deal, were set to close in one week. 
He want's 65% which would net him about $43500.00 I think that's unrealistic.

What would be the best way for me to set this up ?
Any suggestions would be helpful, Thanks

Maya Kellogg · Answer

Hi J - sorry, I think I caused some confusion.  I'll explain:

I brought a GC friend along with me to give me an estimate on some auction properties, and my friend's GC husband had nothing to do on this, so there weren't two bids.  My post was just pointing out the rehab cost differences from one market to another, as the costs my first GC friend estimated combined with the final auction price made the house more expensive than it would even be worth rehabbed.  In the areas I'm looking, the flips I'm seeing done are mainly cosmetic as it's rarely financially feasible for a rehabber to do much more.  Houses where I'm looking are could easily use new copper plumbing, new electrical, pretty much new everything, and I prefer not to be selling the only $500k house on a block of $275k houses, so that's one of the things that will be part of the partnership discussion.

I would love that, but then how can I, as a partner, then say that I want, for example, 10% interest on the money I bring (lend) to the project, before the remaining profit is split?  I suppose I can say that I'm obtaining the funding and the person providing the money is making a loan with interest, so the loan + interest has to be repaid.

Can you clarify if you meant "he shouldn't be getting paid until the property sells?"  Did you mean when the property sells, he can take out the GC expenses, like paying his guys, first before the profit?  Basically, how do we pay everyone who is actually doing the work if he's also a GC with his own business?  Again, what he brings to the table is helping me determine if a project is financially feasible and giving him an interest in getting the work done well, promptly, and as low cost as possible, and that last one is where the issue of conflict of interest comes in.

I wrote in my original post that he did have experience flipping before the market crashed.  He's also green-certified, and I believe that might be what's behind the prod. co.'s interest.  I knew he had been contacted for the show way before I ever even thought of asking him to work with me, his wife is a very good friend of mine and she had mentioned it in a conversation a while back when we were just catching up.  His own GC business has creative clients, and it didn't seem illogical to me because of the entertainment-centric nature of this city.

I'll find out more about it, but my concern at the moment is what to do about profit-sharing if I want to have the money I bring to the table treated as a hard money loan, but not pay him as a GC since he'd be bringing his people to do the work (because the workers are paid officially and have workers comp and social security, etc., and that is run through the company.  I do still want to go 50-50 on the profits.  Do I just tell him that the rehab expenses need to be provided at cost and that those expenses will be paid for with the "loaned" money?

J Scott · Answer

What makes you think the first GC was wrong while the one you plan to partner with is right?  Perhaps the one you plan to partner with is thinking about under-rehabbing the property in the hopes that they'll generate more profit -- but of course, that can backfire when it doesn't sell because it's under-rehabbed.  Or what if the GC you're looking to partner with does lower quality work?

I'm not saying the GC you're looking to partner with is wrong, but you need to determine why you got two wildly divergent bids, and then determine what the real rehab number is.

If he's a partner, he shouldn't be getting paid until the property sells.  If he's getting paid to do the rehab work AND gets a split of the profits, he will have to bring more to the table than just the rehab work.

Wait...he doesn't have experience flipping houses (based on everything else you've said), yet he has a production company willing to pay him up to $40K on each rehab?

Sorry, that doesn't make sense.

I've talked to a couple different production companies about doing rehab TV shows, and they've never offered anything close to that kind of compensation.

Maya Kellogg · Answer

I wouldn't expect that kind of broker to be.  However, many brokers don't have those kind of listings or that type of customer.  But I would expect it from a broker who makes their living selling homes in El Sereno or the like.  To put things into perspective, the median home price in Valencia is around $385,000 compared to $2,395,000 in Beverly Hills.  Totally different areas with different brokers servicing them. I haven't seen any houses listed as "sold by owner" in Baldwin Park (median price $240k) because no agent wanted to bother representing the seller or the buyer.  Strangely enough, in much of the rest of the country, including where I grew up, which was very nice, suburban, big lots, big houses, and safe, that's what most homes go for and that's what agents are selling.

In addition, I know several people who have found something to quibble with in every multi-million dollar property they've gone to see (and I'm talking 6,7,8 million dollar places), so their brokers are putting in a lot of effort setting up all these visits, and then the client just doesn't vibe with anything they see.   Bottom line, this is why a broker should be interested in $200k or $300k property - he might say to himself that cash buyers looking for properties to rehab and flip are going to make purely financial decisions - if it makes sense to buy, they buy, no pussy footing around, no long escrow, deal signed and sealed, and they'll keep doing it as long as they have a supply.  Let's say the average deal would be $200k to buy, $350k to sell if they get the listing, for a total of $550k per transaction, times that by the number of properties each cash buyer buys, lets say four customers each buy four properties, that's $8,800,000 in sales on sixteen homes.  Yes, a broker could just focus on making sure he got the most out of the one transaction, so he would prefer to sell a $300k house over finding one for a fiipper at $200k, but that flipper's house could be, under my example, a total of $550 in sales, multiplied by however many times the flipper reinvests and flips, instead of just that $300k one time deal.  On top of that, if the agent works in a particular section of town, and prices go up because of flipping activity, two things happen - gentrification, and then even higher prices, resulting in a nicer neighborhood, and higher sales commissions.  So that's why a broker would want to do those kinds of deals with flippers, because it's a benefit to them.

As for how I know that broker gave a cut to Keller Williams, I don't, I assumed that's what an agent of a firm is supposed to do.  If he didn't, then he's pulled in more on those deals.  And what I came up with is based on a sample of seven flips the company did that I got from a list of their properties someone created in a forum, so he's buying/selling more than that.  As for his cost of living, it's no different than for anyone else pulling in whatever he makes net after business expenses.

Joel Owens · Answer

"In about six months, my rough estimate is that he pulled in $72k in commissions AFTER the split with the other side's agent and what he shares with Keller Williams."

How do you know the agents commission split with Keller Williams??

I am sure the agent has a bunch of business expenses that have to be deducted from that.Cost of living in California is high as well compared to other states.

It all comes down to does a broker/agent want to allocate their time to accept a certain book of business??

If that broker/agent is already taking down million to multi-million dollar deals at a time then they won't generally be interested in a 200k or 300k property.

Maya Kellogg · Answer

@Ibrahim - Thank you for sharing the experiences you had.  Just to clarify, I would be sharing the net profit 50-50, not the equity, unless by equity you were referring to what will be our profit given that the money I'm fronting will essentially be a lien that gets repaid first.

There are still a number of things he and I have to discuss.  We've only had one conversation, which was when I contacted him to see if he was interested, and the only "business" we talked was what neighborhoods would be good to look into.  I learned he doesn't want to go south of the 10 freeway, while I think there could be good opportunities there, and we agree on other areas.  We were supposed to meet Friday night to talk, but I felt I needed more time to gather information on the first thing we need to work out, before looking at properties, which is what are the expectations of each side in terms of profit-sharing, what the cost of my providing the money will be, which then leads to whether he should charge for work done at full cost or not.  And then, as I feared, the "green" idea came up, so it could be that we just don't have the same philosophy and I will figure out another alternative to working with him.  And that's why I turned to the community here first for advice.

What is your specific approach to buying direct from homeowners - are you putting up bandit signs or doing mailings?

I thought about including a third person in the partnership, a licensed broker, but I'm holding off on that at the moment.  I was going to put together a team modeled on that of a busy flipper here in L.A.  They come complete with a RE broker who lists everything through Keller Wiliams and someone who works for a private money lender.  On every property they bought and resold, the same guy represented them on the buy and then on the sale.  In about six months, my rough estimate is that he pulled in $72k in commissions AFTER the split with the other side's agent and what he shares with Keller Williams.  He might not be making as much as an investor or rehabber, but he's doing much better than many agents out there, so it's to his advantage to keep finding financially solid deals for this company.

It baffles me that brokers aren't more eager to locate good deals for a cash buyer-rehabber, as they stand to benefit in multiple ways - first, with cash the client isn't going to be turned down for a loan costing the broker time for nothing, and second, if they are a good person to work with, they might get the listing when the rehab is done and the list price has gone up another $150k (I'm stuck on $150k for all my examples for some reason) so they make money on the same property twice, like the guy who works with the flippers I just mentioned.  Anyone have an idea as to why this is?  Especially in LA, where a POS in a gang-infested neighborhood costs $300k, so it's not like they are devoting their time to selling a $50k property.

From what I understand, what happened with this GC before the market crashed is that he kept reinvesting  all his profits into more flips.  As you can imagine, the price increases in LA up until 2007 were out of control, so even buying at market prices one could flip three months later and make money.  When the market stalled, he got stuck with the properties, which then fell in value, wiping out whatever equity he had put in, which was everything he had, leaving him with the remaining mortgages.  However, the rent multiple in LA for anything purchased later than, let's say 2000 (or even earlier), doesn't come close to covering expenses, so renting out what he got stuck with wasn't an option.

Maya Kellogg · Answer

By the way, Chris and J, it's really interesting to see your projects on your websites.  J, I'm dizzy just looking at all the projects you've done in, what, four years?   By the way, a lot of what you write for House #36 Lessons Learned, from point 1 to point 5, is exactly the reason I want to start out with this guy as my partner.  For all intents and purposes, taking on my first project is similar to an experienced rehabber taking on a long distance project.  I live in this market, so I see what goes on daily, I know that the homes will most likely be from the 20s and 30s, that we have earthquakes and termites, and I'm aware renovation costs are out of control here (I am pretty certain most of the guys I see working in construction are not making much at all, so unless in other markets labor makes $5/hour, I still cannot understand the cost of construction out here - maybe it's just going into the GCs' pockets) BUT as a newbie, I would face the same problems of finding a contractor to trust, making sure one doesn't take advantage of me, and having "someone on the ground," because I myself still have a lot to learn about construction.

Finally, while I'm savvy and not afraid to get involved and fix what I can myself, I will need to use professionals for a good number of things. I may be wrong on this, but I can just see contractors taking one look at me and thinking they can milk me for all I have based on my physical appearance and being female, which is all the more reason I think I really need either an experienced flipper or GC as a partner until I learn more.

I'm perfectly fine with splitting things 50-50 to start because all of what I've mentioned so far seems worth it, to me at least.  Now, to figure out how much to charge the partnership for fronting the money...

Chris Calabrese  It looks like hard money lenders in LA have LTV limits up to 75%, so there's no way my GC friend is going to be able to come up with, say $75k on a $300k property, plus renovation expenses, to get back into flipping on his own in the LA market.

Ibrahim Hughes · Answer

I think you may be seeing why he got left holding the back during the last market crash. Those investors who were inexperienced enough to believe that they could just go to a broker during a hot seller's market and trust him/her to send them financially feasible listings were in for a very rude awakening.  Doesn't sound like your GC learned his lesson.

I got burned during my 3rd and 4th deal from a realtor who took advantage of my naivete. I've been buying undervalued properties directly from homeowners ever since.

It's obvious that you will have to be the analytical control freak and that he will have to be ok with that in order for this to work. Additionally, you will have to strictly monitor the rehab budget as he comes across as the type who will overspend without any real thoughts of the consequences.

50/50 may work here with you having the final say so over the decision making since it's your money and thus your risk. As you get savvy with the rehab costs, however, I would likely look to simply hire the GC as opposed to give him/her 50% of the equity.

How to split profits on a flip in a partnership

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