What's a fair percent of ownership to bring on partners?

Question

Good morning BP colleagues,

I have worked for a number of years to be in a position to build my first new mixed-use development.  It is located on a very desirable corner in Draper, Utah.  It took me almost four years to assemble the land, receive the needed zone changes, vacate easements, adjust underlying plats, etc...  Now I'm finally ready to start building an 11-unit apartment building and have an additional commercial pad for future development.  However, construction prices more than doubled in the time it took me to get ready to build and my 10% cap rate is now around a 5%.

The lender I've been coordinating with for three years now wants me to come up with an additional $500-600K to offset the loan-to-value of the construction cost. I don't want to assume that much more risk. I can either sell the development and break even, bring in a partner, or keep the land and wait for better construction prices (The existing houses can provide enough rent to cover my mortgages and make a little cash flow). That said, I have almost all my money tied up in this one development and don't want to sit on a 5-6% cap rate when I can free up money to buy more deals in the next several months and make more.

I've had a couple offers to partner but it seems like I'm giving away my equity.  The latest offer is the potential partner will secure the loan for construction and receive 50% (or possibly more) ownership in the project.  While I would rather have 50% of something as opposed to nothing it seems like 50% ownership simply for securing the loan is a steep price to pay.

What are your thoughts?

Respectfully,

Clayton

Bryan Hancock · Answer

I am sure if the project makes sense you can find credit support from a guarantor at far lower than 50% of the project's upside.  What do your pro forma models show you can pay for equity if you supply an investor a 18% or so IRR?  That is something you can use to roughly price the equity cost and then price the guarantor's credit support separately if it is even needed.  If building the project only yields a going-out cap rate of 5% and this is dominantly because of a movement in building costs I am not sure speculating on the price of construction dropping being a good use of the equity you have right now.  Remember that past costs are sunk at this point and all that matters is what happens on a go-forward basis.

Clayton Morgan · Answer

Thank you everyone, I appreciate your advice.

Moises R Cosme · Answer

@Clayton Morgan

1. Take 90 days, focus & prospect for a better deal.  What do your materials look like?  Is the presentation and the value proposition as good as it can be?

2. If you fail after the preset time frame - do the deal

I have made a similar mistake, investing years into a project that failed to deliver in the market; holding on does not help, make an objective decision and make the best possible deal.

Matthew Paul · Answer

My money speaks louder than your sweat equity . Its a toss up . I would shoot for 51% / 49%  . It keeps you in control .

Clayton Morgan · Answer

Randy and Bryan,

Thank you for your thoughts.  I really appreciate the insight.  I do not need to sell or build but will lose my city approval for this project in late November so I feel some pressure to do something.  Bryan, I really liked your thoughts on a 18%. (or other percentage) IRR, and determining what that is worth.  Unfortunately, my current pro forma isn't that sophisticated.  I'll have to work on that.

Respectfully,

Clayton

Randall Alan · Answer

I'm not the one to necessarily offer an educated opinion on the percentage, but I concur with you that your sweat equity brings value, and you should make that argument to your potential partner in negotiating a bigger piece of the pie.  Ask yourself (mention to him), "What does it (or did it) cost to bring all those things together that you mention?  What is months of your time worth?  Most (reasonable) people are willing to value the effort that someone has brought to the table.  If they aren't, you don't have to do the deal - so you put them in the position to decide whether to value your added contribution or not.  If it is still a good deal for them, they will cut you in for a bigger percentage.

The corollary to the above argument is that if it took the sweat equity you have done to make the deal attractive in the first place, it might be that you "comp" your efforts to saving a deal that seems to be slipping away from you due to cost factors, and you welcome the partner so that you both make some money, instead of breaking even.  Both points could be valid.  A lot depends your circumstances.  Can you wait out the market? Do you need the deal to go through to survive?  You both seem to be bringing a vital part to the table... but as the originator of the deal I don't think I would drop below 50/50 on equity if your financial contributions are equal.  (You don't mention the value of the things you have done (purchasing land, etc.)

Randy

What's a fair percent of ownership to bring on partners?

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