How to Structure an Equity Deal on a Mid-Sized Apartment Building
Hey there BP! Last week I posted a video from one of our apartment buildings, an 18-unit in Philadelphia. Since I received so much feedback on the video, I decided to go into more detail on how we structured the deal and get a deeper conversation going on putting mid-sized apartment building deals together. Sound good? Ok, let’s get started!
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So the way we buy buildings is through raising investors (Limited Partners) to come into the deal with us. We are the General Partner and get a percentage of ownership of the building also. Others on BP have asked about buying buildings like this on your own, which is great if you want to do it that way. We are looking to buy lots of buildings (more than we have our own cash to buy) so we are raising investors. It’s a win-win situation since they get to make a return on their money in a stable asset, and we get ownership of the building for little or no money out of our pocket. I’ll get more into deal structure in a minute, but wanted to clarify our strategy up front.
What to Tell Your Investors
So I don’t need to get into why apartment buildings are a good deal, right? If you are reading this, you know. The thing is some potential limited partners of yours may not know, so briefly here’s what I tell my investors.
People Always Need a Place to Live
If the economy tanks and the stock market drops by 15%, some people might stop shopping in the strip center you own or allow their beach house to go into foreclosure. But the people that rent in apartment buildings (the kinds I buy anyway) will keep paying their rent, as long as they keep their job.
Most people who rent in apartment buildings have stable blue collar jobs, or service oriented jobs that don’t go away when the economy shifts. Although they don’t own their home, they have housing at a reasonable price, and as long as they are taken care of by you and their living situation doesn’t change too much (having a kid, getting a job transfer, etc.), they will stay in your building.
They Allow for Leverage in Maintenance
There is only one roof to repair, one plumbing system, one area to shovel snow, etc. Although the costs can be higher because you have a larger roof and more plumbing, you can spread the cost across more units.
This could be a whole article on its own, but it a nutshell, if I raise the rents on all my units in an 18 unit building by $20, I make another $7,200 per year. If that building is valued at a 8% cap rate, I just increased the value of the building by $90,000 based on that increase in income alone.
There are a ton more reasons, but for the purpose of this article, let’s stop there. Bottom line: You need to get some clear reasons as to why your investors should put their cash in with you on an apartment building purchase.
Finding the Deal
Finding good apartment building deals is all about building a network. You can go on LoopNet, but don't expect to find deals to purchase. Use LoopNet to find agents that are selling in your trading area. The stuff that lingers online are deals they can't sell. The good deals don't even make it to the mass market (they get sold to people in the agent's network).
You need to get into each agent's network and have them take you seriously enough to give you the first pass at new deals. You can also network with local owners and see if you can find someone who is willing to sell. An off-the-wall idea is to call "for rent" ads for apartments and ask if they would consider selling. The reason this may work (it has in the past for us) is that the property is not performing as it could because of the vacancy causing some urgency with the owner.
We use Limited Liability Partnerships (LLPs) for our deals. I don’t know if you can use this vehicle in all states, but you can in our trading areas of New Jersey and Pennsylvania. I used to use LLCs, but had a problem when I started approaching more sophisticated investors. Every bank I have dealt with has wanted to see a personal guarantee from everyone in an LLC that owns more than 20% of the company, regardless of what it says in your operating agreement. My high level investors had no interest in this and also didn’t want to get tied to liability claims if someone sued the LLC.
I did some research and found out about LLPs. These entities treat the Limited Partner (LP) completely different from the General Partner (GP). The LPs are LIMITED in their exposure to their investment, that’s all they can lose. They are what you would call a “silent partner.” They have no say in the direction of the company, but they do have an ownership stake. The GP has full authority of the company and is financially responsible for the company. The GP’s exposure goes beyond what they have invested; they take on responsibility for the company overall, including personally guaranteeing loans, and if the company gets sued the GP is the first line of defense. In shorthand, the LPs are the money, and the GP acts on behalf of that money.
Lots of people have asked me about the SEC (Securities and Exchange Commission) and how they regulate our deals. I should be saying this more in this article but I will say it here – I am not an attorney. When you do deals of this complexity, you need to have an attorney working with you closely to make sure you don’t step across the line, ever.
That being said, the SEC normally does not regulate deals like this. They are exempt from SEC regulations based on Regulation D of the Securities Act of 1933, as long as you operate within the guidelines of the code. All you need to do is register your deal with the SEC and let them know you are exempt, which is done through an online form. This form can be found on the SEC website, along with a very good explanation of the code.
It’s not a hard work around. I have heard of people paying tens of thousands of dollars to avoid SEC regulations and keep them within guidelines. I do use an attorney also, but have found that the code is nowhere near as complicated as people make it out to be.
This is another big conversation piece I’ve seen on BP. Hopefully I can shed some light. The General Partner gets a percent ownership in the deal for their role, as I said above. The GP may put money into the deal, but usually puts this cash in on the Limited Partner side so they can get an LP return on that money also. The Limited Partners get a percent ownership based on how much cash they put in compared to the entire LP share of the deal.
So for example, the LP side is 60%, and total funds raised from LP’s is $500,000 and Investor A puts in $300,000 and Investor B puts in $200,000. Investor A gets $200,000 / $500,000 * 60% = 24% of the project.
Many people on BP have also asked me how much to give the Limited Partners, and the easy answer to that is that it depends on the deal and your investors. You need to look at the profit potential of the deal and compare that to the return your investors want to see and make a call from there. If your deal has a cash on cash return of 15% once it’s stabilized, if you give investors 75% ownership, they make 11.25%, which is a very good return. You then get to keep 25% of the deal for your efforts as the GP.
Investor’s percent ownership applies to the profit we make as well as ownership percentage of the building. If we made $10,000 in profit over one quarter, I will usually pay out around 80% of that and retain 20% to be conservative. The payout to each investor and the GP is based on percentage ownership. My primary source of income from the deal is that GP split. I also charge a management fee, which goes to my team for managing the building; I don’t see much of that at all. In the future, I could outsource the management at the same fee if I choose to.
The LP’s Expectations
The biggest thing my LPs want from me is communication. They want to know how their money is doing, when they will get their first checks, etc. I have a scheduled conference call with some investors, and I also shoot a YouTube video with an update and email it to all of them regularly. I also pay quarterly dividends to all investors once the project is stable. I pay on the same day every 3 months, like clockwork.
We tell investors that their money is in the deal for 5 to 7 years. When it comes time to unwind a deal, the easiest way to get everyone out is to sell the building and break the profit down based on the percent ownership. If you can swing it, a great exit is to refinance the building and generate enough cash from the refinance to pay out investors and keep the building for yourself! That is ideal, but you need to work hard to raise the value of the building by increasing income and reducing expenses.
So there’s a crash course on equity deals! I know I didn’t cover everything, but I hope it got your wheels turning. Feel free to ask some questions in the comment fields below so we can get some more conversation going.
Have any questions about structuring this kind of deal? Want to add some advice yourself?
Be sure to leave a comment, and let’s help each other out!