Lender · San Francisco, CA · Member since 2016 · 12 posts · 9 votes
I would like to do bigger deals and get into multi-family investing. My wife and I own one single family house but I would prefer to jump to bigger deals as quickly as possible, whether a 6 unit or 20 unit apartment. I am trying to educate myself and get an outside perspective on the process. I am a commercial mortgage broker so the financing part is easy and I know a number of sales brokers that can help me find property. My questions surround how to set up the LLC and the splitting of the profits if I put a minority share of the equity but want to get paid for the work I put in to acquire, organize and asset manage the property.
Where do I learn about profit sharing and how to set up a win/win partnership with friends and family? Let's say we put in a minority part of the equity 10% or 20% how do I structure it so I get more than my share of the equity invested?
Can anyone give direct examples of their first couple deals they did their first deal with friends and family?
If I am the active partner finding the property and making all the day to day decisions how do I get paid for finding the property and making the asset management decisions? (not day to day property management decisions, we will hire a 3rd party.)
To warm up friends and family did you put together a "hypothetical package" and say if I find something like this will you invest? Or did you get the project under contract and then go find the money?
@Jeff Matlock you've been given some great advice above as to legal constraints so no need for me to repeat that. So I'll focus on structure.
There are two parts to a deal. 1. The "work". This means finding the deal, arranging the financing, raising the capital, asset management, selling the asset, etc. 2. Investing the money. In your structure think of these two components as separate functions even if the same person (you) is doing both.
Here is the most simple structure (freshman class): You do the work, a friend invests all of the money. You split the profits 50/50. 50% for doing the work and 50% for bringing the money.
Adding some complication (sophomore class): You do the work and invest half of the money. Your friend invests the other half of the money. You split the profits 75/25. 50% to you for doing the work, 50% of the other 50% (25%) for investing half of the money, and 50% of 50% (25%) goes to your friend for bringing the other half of the money.
And more complication (junior class): You do the work and invest 10% of the money. Five other friends invest the other 90% of the money. You get 50% of the profits for doing the work. The other 50% is split pro-rata amongst the investors so you get 10% of that 50% and each other investor gets the amount invested divided by the total invested by everyone (which establishes an ownership percentage) multiplied by 50% (the total investor share). Example: $1MM total invested. Investor contributed 250K. Ownership percentage is 250,000 / 1,000,000 = 25% X 50% = 12.5%.
Getting advanced (senior class): You do the work and invest 10% of the money. You raise the other 90% from 50 accredited investors. You get an acquisition fee of 3% of the purchase price and a fee of 1% of the loan amount for obtaining the financing and signing on the carve out guarantees and providing the net worth and cash reserves to qualify for the loan. You get an asset management fee of 1% of the gross collected income each quarter and a disposition fee of 1% of the sales price when you sell. The investors get an 8% preferred return, which means that they get 100% of the profits until they've earned 8% annualized return in their money. Everything after that is split 70% to the investors pro rata and 30% to you. You also get 10% of the investor distributions because you invested 10% of the capital. This includes both the 8% pref tier and the 70% surplus tier. If the property doesn't throw off enough cash to pay the pref current, it accumulates, so you have to keep track of the capital account. In other words, if the property throws off 4% year 1, 8% year 2, 12% year 3 and 14% year 4, the investors (including your 10% investment) get 100% of the cash in years 1-3 and by year 3 the pref is caught up so in year 4 the investors get the first 8% and the remaining is split 70/30.
The granddaddy (graduate school): Same set of fees as in the senior class. But you get incentivized for great performance. Here's how: Investors get an 8% preferred return, then they get 70% of the profits until they reach a 12% return (cumulative on unreturned capital contributions), then they receive 60% of the profits until they reach a 15% return, then the remaining profits are split 50/50. This is called a "waterfall" and it rewards the person doing the work if they do a great job and produce a great return.
Extra credit (postgraduate class): There are variations on how pref is treated. Is it compounded or non-compounded? Is it based on an annualized return or an IRR? If it's compounded (or based on IRR which is compounded by definition) is it compounded monthly, quarterly or annually. Is the compounding calculated with an arithmetic or geometric calculation? Are the distributions considered to be a return of capital (which reduces the pref accumulation)? If the hurdles are based on annualized return, how is the return of capital achieved?
I like to keep mine simple--non-compounding and based on annualized return. It's just easier to understand.
There are other structures where splits shift to 100% to sponsor after the pref to catch the sponsor up before the subsequent waterfall tiers and probably a thousand other structural nuances but a lot of that stuff is just either ridiculous, disingenuous, or downright designed to be confusing so that the investors can't possibly figure out how much the sponsor is getting. I won't even cover those because you just shouldn't do them.
At one time or another I've used each of the structures above (except the ridiculous stuff) but these days I'm nearly exclusively using the graduate school version with minor variations when necessary.
@Jeff Matlock. We just completed our first syndicated deal, a 202-unit, and raised money from friends and family to help fund it.
#1--get a good attorney who has experience setting these up. You need to make sure you are abiding by all SEC regulations when you start raising money and determine whether you want to include only accredited investors or not. I am by no means an attorney.
The general structure will have you operating at the General Partner, and your investors as Limited Partners. As the General Partner, you have the flexibility to set up the entity however you want--and however you can "sell it" to investors. A very common structure, and how we set up our entity, is for Limited Partners to receive an 8% Preferred Return. Above the 8%, profits & equity are split between the GP and LP. In our case we did 70% to LP / 30% to GP. There are also acquisition fees and asset management fees you can receive as the General Partner.
From what I've seen, you can make it as complicated or as simple as you want. But there are absolutely ways--and very common ones--for you to be compensated for your time and energy in finding the deal and operating it. Exactly how you set it up is up to you and your attorney--and the agreement you can reach with your investors.
On the capital raising side, I would suggest starting to talk with your network about your current experience as an investor and your desire to move into bigger deals. Lay out the general parameters for what you're looking for--geography, property condition, investment profile, etc--so that once you find a deal, you're not approaching people out of the blue asking for money for the first time. This is also an important topic to cover with your attorney--there are laws about who you can and can't talk with about a deal and raising money.
So every state has its own requirements for securities, crowdfunding, solicitation of investments, etc., and then there are federal requirements. If you intend to stick to friends and family, there is probably an exemption in your state and you don't have to comply with certain regulations. BUT, important point is that if you are looking to give membership interest and the other members have voting rights, as opposed to just a passive investment, so, obligations to review plans, or anything that makes them more involved than just collecting the check (even really really minor involvement), then you should be outside of the securities regulations. For smaller deals where they will have ownership interest, that's probably the best way to go. Are you planning on investing in just CA properties?
As for your LLC structure, whether you put in 100% or no funds at all, you don't have to only get the percentage of interest commensurate with the money you contribute. If you put in 10% of the money, but you have other value to the entity, you can certainly get a bigger percentage of interest, even with a smaller initial capital contribution, which is probably the way to go.
As to timing, you should have at least some of the funds in advance so that you don't lose a deal because you can't put up the down payment immediately. You can always do another capital call when you find a project, or if you would rather the money up front, you can set a budget for purchase and reno (if you are flipping? or are you holding?) and collect based on the budget.
You can certainly put together something akin to an offering statement that explains exactly what you intend to do as the LLC, , but I think the cleanest way (and lowest legal fees!) is to have a comprehensive operating agreement drafted, with some blanks for names and numbers, and let your 'investors' review that. That way, it's only 1, not 2 documents that need to be prepared, and you use that when they are ready to commit and sign. It will set forth all of the details of what the permitted activity of the LLC is, reporting to the members, what responsibilities and duties everyone will have, when they get distributions and of how much, etc.
There are lots of ways to handle, but that would be the way I would go about it. Please feel free to email me or PM to discuss further.
Jeff I would suggest getting yourself an investor qualification form to establish a preexisting relationship with any investors. This accomplishes multiple things: provides protection for you in case there is an issue in the future and also establishes you as a professional that respects the rules. Investors respect that. It also says "I am not looking for just any investor, I am looking for the right investor." This includes friends and family.
Our internal firm policy (this is not a law, just our rule) that anytime you are dealing with unaccredited investors, more than 5 investors, or raising more than $500,000 we insist you use a PPM. It provides the most protection.
Most of my clients create a "property package" containing pertinent info on the property: area, unit mix, pictures, vacancy, etc. If you email me, I can send you some samples that you can use as a template.
I'm interested in this and finding out some other "general" structures for deals. Joint ventures, partnerships, how they're typically structured when we raise private passive money and we're the deal-finders, strategic partners, management etc.
One thing that I do, not mentioned take returns like andrew said, but when I put money into the deal that gets treated the same as a normal LP. so if I put in $100k and that is 10 shares, then I get 10 shares worth and get the 8% preferred return on that money and 70% equity
@Andrew Campbell In your deal, you are giving 8% preferred rate to the investors and on top of that you are also giving 70% of the upside. Wondering if your cash flow covers this amount each year or do you have to defer the pay outs? Just curious how big of the deals you are doing to offer such generous equity splits.
@Jeff Matlock you could also bring in an experienced multifamily operator to JV with you. That may give family and friends peace of mind when working on your first syndication.
@Account Closed The cash flows will pay for the 8% preferred return. We target deals that return 9%+ Cash Flow. The majority of the returns will occur when we either sell or refinance the property.
How would you suggest structuring a deal where the projected cash flows won’t cover the preferred return until year 2? Do you put a big kicker on the back end, or raise the preferred return for year 2? Or just leave it be?
@Kyle Bryant I am raising capital for a deal that won't cover my preferred return for year 1. In this case the investors are projected to only get paid about 4% the first year and I get paid nothing. The deal works well because by year 3 the Cash on cash will be double digit. Just be up front with your investors so they know what to expect.
@Jeff Matlock you've been given some great advice above as to legal constraints so no need for me to repeat that. So I'll focus on structure.
There are two parts to a deal. 1. The "work". This means finding the deal, arranging the financing, raising the capital, asset management, selling the asset, etc. 2. Investing the money. In your structure think of these two components as separate functions even if the same person (you) is doing both.
Here is the most simple structure (freshman class): You do the work, a friend invests all of the money. You split the profits 50/50. 50% for doing the work and 50% for bringing the money.
Adding some complication (sophomore class): You do the work and invest half of the money. Your friend invests the other half of the money. You split the profits 75/25. 50% to you for doing the work, 50% of the other 50% (25%) for investing half of the money, and 50% of 50% (25%) goes to your friend for bringing the other half of the money.
And more complication (junior class): You do the work and invest 10% of the money. Five other friends invest the other 90% of the money. You get 50% of the profits for doing the work. The other 50% is split pro-rata amongst the investors so you get 10% of that 50% and each other investor gets the amount invested divided by the total invested by everyone (which establishes an ownership percentage) multiplied by 50% (the total investor share). Example: $1MM total invested. Investor contributed 250K. Ownership percentage is 250,000 / 1,000,000 = 25% X 50% = 12.5%.
Getting advanced (senior class): You do the work and invest 10% of the money. You raise the other 90% from 50 accredited investors. You get an acquisition fee of 3% of the purchase price and a fee of 1% of the loan amount for obtaining the financing and signing on the carve out guarantees and providing the net worth and cash reserves to qualify for the loan. You get an asset management fee of 1% of the gross collected income each quarter and a disposition fee of 1% of the sales price when you sell. The investors get an 8% preferred return, which means that they get 100% of the profits until they've earned 8% annualized return in their money. Everything after that is split 70% to the investors pro rata and 30% to you. You also get 10% of the investor distributions because you invested 10% of the capital. This includes both the 8% pref tier and the 70% surplus tier. If the property doesn't throw off enough cash to pay the pref current, it accumulates, so you have to keep track of the capital account. In other words, if the property throws off 4% year 1, 8% year 2, 12% year 3 and 14% year 4, the investors (including your 10% investment) get 100% of the cash in years 1-3 and by year 3 the pref is caught up so in year 4 the investors get the first 8% and the remaining is split 70/30.
The granddaddy (graduate school): Same set of fees as in the senior class. But you get incentivized for great performance. Here's how: Investors get an 8% preferred return, then they get 70% of the profits until they reach a 12% return (cumulative on unreturned capital contributions), then they receive 60% of the profits until they reach a 15% return, then the remaining profits are split 50/50. This is called a "waterfall" and it rewards the person doing the work if they do a great job and produce a great return.
Extra credit (postgraduate class): There are variations on how pref is treated. Is it compounded or non-compounded? Is it based on an annualized return or an IRR? If it's compounded (or based on IRR which is compounded by definition) is it compounded monthly, quarterly or annually. Is the compounding calculated with an arithmetic or geometric calculation? Are the distributions considered to be a return of capital (which reduces the pref accumulation)? If the hurdles are based on annualized return, how is the return of capital achieved?
I like to keep mine simple--non-compounding and based on annualized return. It's just easier to understand.
There are other structures where splits shift to 100% to sponsor after the pref to catch the sponsor up before the subsequent waterfall tiers and probably a thousand other structural nuances but a lot of that stuff is just either ridiculous, disingenuous, or downright designed to be confusing so that the investors can't possibly figure out how much the sponsor is getting. I won't even cover those because you just shouldn't do them.
At one time or another I've used each of the structures above (except the ridiculous stuff) but these days I'm nearly exclusively using the graduate school version with minor variations when necessary.
Ok that makes sense. The investors get what they get, but they should know not to expect a full preferred return rate until later on. I am looking at a deal now that would have minimal cash flow for at least 6 months during rehab phase, so I was wondering how to pitch that to investors. Big upside, but they’d have to wait a while.
@Brian Burke - Your answer was incredibly helpful. As far as the LLC structure for "sophomore class". Would you recommend a member-managed / manager-managed LLC structure? Purpose: I'd do the work, they'd be passive generally, but are non-accredited and are friends.
Wanted to make it a bit more formal for folks without getting too complicated with legal work, yet set it up in such a way that makes sense for the future.
@Alice K. that is something your lawyer should advise you on—but I'll say that I most often see these as manager-managed. But every arrangement is unique and there could certainly be circumstances where member-managed would be more appropriate. But my guess is your counsel will probably structure this as a manager-managed LLC.
Brian Burke - Thanks for the thoughts.
Was checking out what all the others who are doing this structure it as and your thoughts were what they did 9 times out of 10.
Was worried about the tax implications and SEC regulations but I don’t intend to do anything massive at this time.
Will consult a lawyer to make sure I’m following all the rules correctly.
Hope you and your team’s current deals are going well!
Best,