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Jason L.
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Determining Profit Share for Spec Home - Risk vs Capital/Other Contribution

Jason L.
  • SF Bay Area
Posted Feb 12 2024, 19:41

Hello BP,    I'm looking to build a spec home on a piece of land I own in a relatively affluent Bay Area neighborhood. I'm negotiating with a prospective partner who is an experienced developer/RE Agent in the area.  I've known him for 8 years and he has a good track record of flips and spec projects.    

 I've extensively researched BP forums and have spoken to other developers, builders, atty's, and CPA's about how best to determine profit share between partners based on 1)Risk, 2)Capital Contribution, and 3)The Role of Each Partner in the project . . . BUT, I've yet to find a cohesive "formula" or "rule of thumb" for weighting these factors and determining profit share. Hence my request for help . . . 

I'll sketch out the (current) terms first and then lay out my concerns/questions:

Proposed Terms/Assumptions:

- I contribute my land to the project receiving accrued interest at end of project (at rate similar to hard money rate). Land is used to secure a hard money construction loan (CL).  My land "loan" is subordinate to the CL. 

 - I Co-Sign with the developer on an interest-only construction loan (ideally a "no payments" loan).

- The developer acts as owner-builder-GC and is responsible for securing financing, managing all subs as well as overall Proj. Mgmt. Basically he does all the work.   

- We hire a third party CPA for project accounting

- The developer (who has RE license) gets the sell-side commission (paid before profit share).

- After the CL and Land are paid off the developer is proposing we split the remaining profits 50/50.

- Hypothetical Numbers*: Land value = $1M, project costs= $2M, sale price=$4m, profit=$1M

* These numbers are approximations.  We've done a thorough proforma which I've vetted and feel comfortable with.  "Project Costs" are comprehensive and include arch/permits/site prep/contingency/financing etc. There are strong, recent comps on which to base the target sale price. 

My Questions/Concerns:

1) The developer is asking me to co-sign on the CL.  Is this standard practice or a red flag?  If I agree, how should this factor into profit share?

2) With my land as the only real asset in the LLC (and second position to the CL) I'm assuming a lot (all?) of the risk should things go horribly wrong. How should this factor into profit share?

3)  Is it common for the developer not to have any upfront "skin in the game" (no $$ capital contribution)? How should I reflect this fact in the profit share?

4) The developer wants his RE commission paid before profit share.  Is this common and/or should it be reflected in lower profit share for him?

5)  If I were to value all of the services the developer is providing I could probably get to a figure of $300K - $400K (15% GC fee, 5% proj. mgmt).  How should the value of his contributions affect profit share?

I'd love to hear any and all  thoughts on how these different variables factor into determining fair profit share.   Many thanks!!

Jason  

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Robert Ellis
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Robert Ellis
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Replied Feb 12 2024, 21:23
Quote from @Jason L.:

Hello BP,    I'm looking to build a spec home on a piece of land I own in a relatively affluent Bay Area neighborhood. I'm negotiating with a prospective partner who is an experienced developer/RE Agent in the area.  I've known him for 8 years and he has a good track record of flips and spec projects.    

 I've extensively researched BP forums and have spoken to other developers, builders, atty's, and CPA's about how best to determine profit share between partners based on 1)Risk, 2)Capital Contribution, and 3)The Role of Each Partner in the project . . . BUT, I've yet to find a cohesive "formula" or "rule of thumb" for weighting these factors and determining profit share. Hence my request for help . . . 

I'll sketch out the (current) terms first and then lay out my concerns/questions:

Proposed Terms/Assumptions:

- I contribute my land to the project receiving accrued interest at end of project (at rate similar to hard money rate). Land is used to secure a hard money construction loan (CL).  My land "loan" is subordinate to the CL. 

 - I Co-Sign with the developer on an interest-only construction loan (ideally a "no payments" loan).

- The developer acts as owner-builder-GC and is responsible for securing financing, managing all subs as well as overall Proj. Mgmt. Basically he does all the work.   

- We hire a third party CPA for project accounting

- The developer (who has RE license) gets the sell-side commission (paid before profit share).

- After the CL and Land are paid off the developer is proposing we split the remaining profits 50/50.

- Hypothetical Numbers*: Land value = $1M, project costs= $2M, sale price=$4m, profit=$1M

* These numbers are approximations.  We've done a thorough proforma which I've vetted and feel comfortable with.  "Project Costs" are comprehensive and include arch/permits/site prep/contingency/financing etc. There are strong, recent comps on which to base the target sale price. 

My Questions/Concerns:

1) The developer is asking me to co-sign on the CL.  Is this standard practice or a red flag?  If I agree, how should this factor into profit share?

2) With my land as the only real asset in the LLC (and second position to the CL) I'm assuming a lot (all?) of the risk should things go horribly wrong. How should this factor into profit share?

3)  Is it common for the developer not to have any upfront "skin in the game" (no $$ capital contribution)? How should I reflect this fact in the profit share?

4) The developer wants his RE commission paid before profit share.  Is this common and/or should it be reflected in lower profit share for him?

5)  If I were to value all of the services the developer is providing I could probably get to a figure of $300K - $400K (15% GC fee, 5% proj. mgmt).  How should the value of his contributions affect profit share?

I'd love to hear any and all  thoughts on how these different variables factor into determining fair profit share.   Many thanks!!

Jason  


 we just did a project where I brought the land, capital partner and I negotiated. they build all cash for a 720 square foot plan we build that sells at a premium here. I sell at no profit and build at no profit. all money goes into the deal, lowest cost, lowest risk, and then distributions at the end are my deferred GC fee and realtor fee and cash for the land brought. it's dollar for dollar equity negotiation and I end up with 35% payout in the capital stack. tells hem to put all their build profit into the deal. if they won't take that move on. you are bringing more than enough 

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Jason L.
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Jason L.
  • SF Bay Area
Replied Feb 14 2024, 16:50

Thanks for the insights @Robert Ellis.

I'm totally aligned with your views on lowest cost/risk and the idea of basing equity on the valuation of each partners contributions.

I'm struggling with how to apportion equity (if at all) based on how my partner is proposing to do the construction financing; my land is collateral for the loan (I retain title vs transferring it or selling it to the partnership), the land is in second position at payout, I'm co-signing the loan, and my partner is not making an initial capital contribution.   

How do you think about this financing arrangement in terms of determining equity? 

Thanks again for your thoughts and time!

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Jay Hinrichs#1 All Forums Contributor
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Jay Hinrichs#1 All Forums Contributor
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Replied Feb 14 2024, 17:07

slow down.. you own the land.. its worth 1 mil  what is your basis?  thats the first question.

second is using your math of 1 mil profit which will probably boil down to something less than that but use 1 mil..  and 4 mil exit.  Project like this is a year at least right. 

cost to sell and carrying costs

land at todays HM rate 12 % thats 120k
commish                                       200k

so maybe net 750K or you think you accounted for those in the  2 million ?

Either way you put up land and go on the loan then your really just hiring a GC and realtor. Why would you give them any participation unless they did something other GC or realtor cant do which is doubtful in the bay area..  Anyway the point on the land basis is if you have a very low basis you have just now subjected your land equity to ordinary income and market risks on top of it.

Plus personal risk on the loan if it goes bad do you have the money to pay the first off if you need to. 

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Jason L.
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Jason L.
  • SF Bay Area
Replied Feb 14 2024, 20:13
Quote from @Jay Hinrichs:

slow down.. you own the land.. its worth 1 mil  what is your basis?  thats the first question.

second is using your math of 1 mil profit which will probably boil down to something less than that but use 1 mil..  and 4 mil exit.  Project like this is a year at least right. 

cost to sell and carrying costs

land at todays HM rate 12 % thats 120k
commish                                       200k

so maybe net 750K or you think you accounted for those in the  2 million ?

Either way you put up land and go on the loan then your really just hiring a GC and realtor. Why would you give them any participation unless they did something other GC or realtor cant do which is doubtful in the bay area..  Anyway the point on the land basis is if you have a very low basis you have just now subjected your land equity to ordinary income and market risks on top of it.

Plus personal risk on the loan if it goes bad do you have the money to pay the first off if you need to. 

 Thanks for jumping into this @Jay Hinrichs

- My CPA assures me that by retaining title (not transferring it to the partnership) I can enjoy cap gains on the land profits portion.

- All the costs you list are in the $2M.  I think the cost estimates are conservative, the sale price is more on the "best case" end of things. 

- I get the "hire a GC" argument. But I'm okay paying something (within reason) for an experienced partner who knows what to build for resale in this price range and will manage the entire process.   

- You mention my personal risk co-signing, but what would it look like if I didn't?  We bring in a third investor/partner?  What does my return look like in that case? Certainly far less than 50%.   So I'm back to trying to provide a rationale for demanding a higher profit share, preferred status at payout, or both. I'm curious about how folks would approach negotiating that piece. 

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Jay Hinrichs#1 All Forums Contributor
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Jay Hinrichs#1 All Forums Contributor
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Replied Feb 15 2024, 02:32
Quote from @Jason L.:
Quote from @Jay Hinrichs:

slow down.. you own the land.. its worth 1 mil  what is your basis?  thats the first question.

second is using your math of 1 mil profit which will probably boil down to something less than that but use 1 mil..  and 4 mil exit.  Project like this is a year at least right. 

cost to sell and carrying costs

land at todays HM rate 12 % thats 120k
commish                                       200k

so maybe net 750K or you think you accounted for those in the  2 million ?

Either way you put up land and go on the loan then your really just hiring a GC and realtor. Why would you give them any participation unless they did something other GC or realtor cant do which is doubtful in the bay area..  Anyway the point on the land basis is if you have a very low basis you have just now subjected your land equity to ordinary income and market risks on top of it.

Plus personal risk on the loan if it goes bad do you have the money to pay the first off if you need to. 

 Thanks for jumping into this @Jay Hinrichs

- My CPA assures me that by retaining title (not transferring it to the partnership) I can enjoy cap gains on the land profits portion.

- All the costs you list are in the $2M.  I think the cost estimates are conservative, the sale price is more on the "best case" end of things. 

- I get the "hire a GC" argument. But I'm okay paying something (within reason) for an experienced partner who knows what to build for resale in this price range and will manage the entire process.   

- You mention my personal risk co-signing, but what would it look like if I didn't?  We bring in a third investor/partner?  What does my return look like in that case? Certainly far less than 50%.   So I'm back to trying to provide a rationale for demanding a higher profit share, preferred status at payout, or both. I'm curious about how folks would approach negotiating that piece. 

I dont know about that.. U build a house on a lot you own and sell it.. I dont see how that is cap gain.. but I am not a cpa.. anyway sounds like you have your mind made up.  I would not do what your doing though putting in the land and taking the risk on the construction loan..

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Darius Ogloza
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Darius Ogloza
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Replied Feb 15 2024, 05:24

Is the developer/GC providing materials and labor to the partnership at his cost?  Some kind of mark-up on costs?   

What happens if the construction loan is insufficient to cover the cost of finishing the project?  Who ponies up additional capital?   

What happens if your developer/GC friend bails on the project or screws up and you have to finish with a third-party? Does original developer/GC retain an equity interest nonetheless? 

Your contribution of land to the project is equity - I do not see why you are characterizing it as a "loan."  I think you need to pick a horse and reason from there.  

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Robert Ellis
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Robert Ellis
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Replied Feb 15 2024, 10:12
Quote from @Jason L.:

Thanks for the insights @Robert Ellis.

I'm totally aligned with your views on lowest cost/risk and the idea of basing equity on the valuation of each partners contributions.

I'm struggling with how to apportion equity (if at all) based on how my partner is proposing to do the construction financing; my land is collateral for the loan (I retain title vs transferring it or selling it to the partnership), the land is in second position at payout, I'm co-signing the loan, and my partner is not making an initial capital contribution.   

How do you think about this financing arrangement in terms of determining equity? 

Thanks again for your thoughts and time!


 In my most recent deal with a partner, I bought the land (10k), he pays all costs, I build it, he's building it cash, I put my fee into the deal and that was given dollar for dollar value. it's all based on dollars. so 10k, 25k GC fee on this 720 sq ft affordable house we are doing, plus my realtor fee so my basis is 41k and his is the cash to build which is probably 80k. so I get equity of my percentage contribution. shouldn't be too tough and that's super fair in my opinion. we build at cost when we use a retainer based model and I'm not extending any credit to the borrower. 

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Jason L.
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Jason L.
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Replied Feb 15 2024, 11:06
Quote from @Darius Ogloza:

Is the developer/GC providing materials and labor to the partnership at his cost?  Some kind of mark-up on costs?   

What happens if the construction loan is insufficient to cover the cost of finishing the project?  Who ponies up additional capital?   

What happens if your developer/GC friend bails on the project or screws up and you have to finish with a third-party? Does original developer/GC retain an equity interest nonetheless? 

Your contribution of land to the project is equity - I do not see why you are characterizing it as a "loan."  I think you need to pick a horse and reason from there.  

 hi @Darius Ogloza, thanks for the comments. All great points.

The plan is that the partner would not mark up costs, recovering his GC markup through profit share. 

The additional capital question is a good one.  I guess I would try to put my partner on the hook for that. 

I have some draft Operating Agreement language that I think addresses your points on equity retention and adding a third party. It doesn't eliminate the risk but at least anticipates the scenario.   

"loan" was probably a poor choice of words. I'm not issuing a note.  My partner has proposed that the I'm paid for the land, along with interest, in second position after the CL. The profit share is paid (based on equity) after that.  I agree, it is mixing concepts.  

I'm curious how you think about the idea of co-signing and its effects on equity (if any).  If land is $1M and the value of his services (in calculating equity) is $500K, and we co-sign a $2M loan secured by my land, how should equity look?

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Darius Ogloza
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Replied Feb 15 2024, 17:10

I like to reason from the point of the worst case scenario.  Assume you co-sign and your partner loses the proceeds of the loan in Vegas.  You will lose your collateral/land ($1 million).  What happens after that will depends on which of you has more reachable assets or, in case neither of you do, the bankruptcy law.  

It seems to me that by co-signing AND securing the loan, you are taking on a double portion of risk.  A fairer allocation of risk here would entail your partner signing for the loan and your providing the collateral.  In this way, you are each out $1 million in liability in the event the loan is not repaid.     

As to what this means in terms of equity split, reasonable minds can differ. I would insist at a minimum on a 66%/33% profit split if I were asked to cosign and secure the loan.    

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Leilah Davis
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Replied Feb 16 2024, 13:31
Quote from @Jason L.:

- I get the "hire a GC" argument. But I'm okay paying something (within reason) for an experienced partner who knows what to build for resale in this price range and will manage the entire process.   

Maybe I'm confused ... you own the land, so you're contributing the only real asset. Your friend who is a licensed GC is going to run the job, and you're sharing the risk of the CL ... Why do you keep calling him the "developer"? If it's a partnership then you are the developers TOGETHER. But I agree with @Jay Hinrichs it does not make sense to do it like this. Either don't accept any of the CL risk, let that be his contribution OR accept 100% of the CL risk, hire your friend as a GC, and collect 100% of the profits. 

The way this is set up does not feel or sound like a partnership. It sounds like he's just pushing you around and calling all the shots. It's your land! You get to do whatever you want with it. If you feel too inexperienced and you want his advice and guidance, hire him as a consultant. You literally said above that you're comfortable "paying something" for his experience and to have him "manage the entire process". Managing the entire construction process is literally what GC's are hired to do. So keep the land in your name, hire him as a consultant, pay him a generous GC fee for the build, and let him have the listing so he can earn commission. That's more than enough, and those fees can be factored into your CL. Doing it this way would require you to take out the CL in your name and bear all of the risk, but it sounds like you're confident in the numbers so I don't see why that should be a problem.  

Or, if you'd really truly rather have this be a partnership for some reason, then he needs to take full responsibility for CL. (Full disclosure I have never dealt with CL loans before, so I don't know how that would work for him to be the only signer on the CL while you own the land. Not sure if that's even doable. But as far as whether or not the current arrangement makes sense from a logical standpoint, no it doesn't seem like it does.) 

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Jason L.
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Jason L.
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Replied Feb 17 2024, 09:21
Quote from @Darius Ogloza:

I like to reason from the point of the worst case scenario.  Assume you co-sign and your partner loses the proceeds of the loan in Vegas.  You will lose your collateral/land ($1 million).  What happens after that will depends on which of you has more reachable assets or, in case neither of you do, the bankruptcy law.  

It seems to me that by co-signing AND securing the loan, you are taking on a double portion of risk.  A fairer allocation of risk here would entail your partner signing for the loan and your providing the collateral.  In this way, you are each out $1 million in liability in the event the loan is not repaid.     

As to what this means in terms of equity split, reasonable minds can differ. I would insist at a minimum on a 66%/33% profit split if I were asked to cosign and secure the loan.    

 Thank you @Darius Ogloza, I realize that factoring risk into the profit split is a bit subjective.  Any thoughts on how you'd split profit in the case where the is land used as collateral without co-signing (if that's even possible with lenders)?  Again assuming my partner is handling everything else?

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Jay Hinrichs#1 All Forums Contributor
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Replied Feb 17 2024, 10:15
Quote from @Jason L.:
Quote from @Darius Ogloza:

I like to reason from the point of the worst case scenario.  Assume you co-sign and your partner loses the proceeds of the loan in Vegas.  You will lose your collateral/land ($1 million).  What happens after that will depends on which of you has more reachable assets or, in case neither of you do, the bankruptcy law.  

It seems to me that by co-signing AND securing the loan, you are taking on a double portion of risk.  A fairer allocation of risk here would entail your partner signing for the loan and your providing the collateral.  In this way, you are each out $1 million in liability in the event the loan is not repaid.     

As to what this means in terms of equity split, reasonable minds can differ. I would insist at a minimum on a 66%/33% profit split if I were asked to cosign and secure the loan.    

 Thank you @Darius Ogloza, I realize that factoring risk into the profit split is a bit subjective.  Any thoughts on how you'd split profit in the case where the is land used as collateral without co-signing (if that's even possible with lenders)?  Again assuming my partner is handling everything else?


Just thought I would jump in here quickly since I do quite a bit of this.. If your putting up the land and getting the your right back to square one your hiring a GC to build it whatever fee and profit split is really up to you guys to determine/negotiate. Builder has no liability to your equity and no liability to the construction loan.  Just need a good GC contract that you can enforce if they dont perform.. pretty simple at that point and frankly much safer for you not to give the GC any formal ownership at all.. I would NEVER EVER do that .. Did it one time cost me.
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Eric James
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Replied Feb 17 2024, 11:59
Quote from @Jay Hinrichs:
Quote from @Jason L.:
Quote from @Darius Ogloza:

I like to reason from the point of the worst case scenario.  Assume you co-sign and your partner loses the proceeds of the loan in Vegas.  You will lose your collateral/land ($1 million).  What happens after that will depends on which of you has more reachable assets or, in case neither of you do, the bankruptcy law.  

It seems to me that by co-signing AND securing the loan, you are taking on a double portion of risk.  A fairer allocation of risk here would entail your partner signing for the loan and your providing the collateral.  In this way, you are each out $1 million in liability in the event the loan is not repaid.     

As to what this means in terms of equity split, reasonable minds can differ. I would insist at a minimum on a 66%/33% profit split if I were asked to cosign and secure the loan.    

 Thank you @Darius Ogloza, I realize that factoring risk into the profit split is a bit subjective.  Any thoughts on how you'd split profit in the case where the is land used as collateral without co-signing (if that's even possible with lenders)?  Again assuming my partner is handling everything else?


Just thought I would jump in here quickly since I do quite a bit of this.. If your putting up the land and getting the your right back to square one your hiring a GC to build it whatever fee and profit split is really up to you guys to determine/negotiate. Builder has no liability to your equity and no liability to the construction loan.  Just need a good GC contract that you can enforce if they dont perform.. pretty simple at that point and frankly much safer for you not to give the GC any formal ownership at all.. I would NEVER EVER do that .. Did it one time cost me.

 How did giving a GC an ownership stake come back to bite you?

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Jay Hinrichs#1 All Forums Contributor
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Jay Hinrichs#1 All Forums Contributor
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Replied Feb 17 2024, 12:08
Quote from @Eric James:
Quote from @Jay Hinrichs:
Quote from @Jason L.:
Quote from @Darius Ogloza:

I like to reason from the point of the worst case scenario.  Assume you co-sign and your partner loses the proceeds of the loan in Vegas.  You will lose your collateral/land ($1 million).  What happens after that will depends on which of you has more reachable assets or, in case neither of you do, the bankruptcy law.  

It seems to me that by co-signing AND securing the loan, you are taking on a double portion of risk.  A fairer allocation of risk here would entail your partner signing for the loan and your providing the collateral.  In this way, you are each out $1 million in liability in the event the loan is not repaid.     

As to what this means in terms of equity split, reasonable minds can differ. I would insist at a minimum on a 66%/33% profit split if I were asked to cosign and secure the loan.    

 Thank you @Darius Ogloza, I realize that factoring risk into the profit split is a bit subjective.  Any thoughts on how you'd split profit in the case where the is land used as collateral without co-signing (if that's even possible with lenders)?  Again assuming my partner is handling everything else?


Just thought I would jump in here quickly since I do quite a bit of this.. If your putting up the land and getting the your right back to square one your hiring a GC to build it whatever fee and profit split is really up to you guys to determine/negotiate. Builder has no liability to your equity and no liability to the construction loan.  Just need a good GC contract that you can enforce if they dont perform.. pretty simple at that point and frankly much safer for you not to give the GC any formal ownership at all.. I would NEVER EVER do that .. Did it one time cost me.

 How did giving a GC an ownership stake come back to bite you?


did not pay the bills and I had to pay them twice.. 

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Robert Ellis
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Robert Ellis
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Replied Feb 17 2024, 14:23
Quote from @Jay Hinrichs:
Quote from @Jason L.:
Quote from @Darius Ogloza:

I like to reason from the point of the worst case scenario.  Assume you co-sign and your partner loses the proceeds of the loan in Vegas.  You will lose your collateral/land ($1 million).  What happens after that will depends on which of you has more reachable assets or, in case neither of you do, the bankruptcy law.  

It seems to me that by co-signing AND securing the loan, you are taking on a double portion of risk.  A fairer allocation of risk here would entail your partner signing for the loan and your providing the collateral.  In this way, you are each out $1 million in liability in the event the loan is not repaid.     

As to what this means in terms of equity split, reasonable minds can differ. I would insist at a minimum on a 66%/33% profit split if I were asked to cosign and secure the loan.    

 Thank you @Darius Ogloza, I realize that factoring risk into the profit split is a bit subjective.  Any thoughts on how you'd split profit in the case where the is land used as collateral without co-signing (if that's even possible with lenders)?  Again assuming my partner is handling everything else?


Just thought I would jump in here quickly since I do quite a bit of this.. If your putting up the land and getting the your right back to square one your hiring a GC to build it whatever fee and profit split is really up to you guys to determine/negotiate. Builder has no liability to your equity and no liability to the construction loan.  Just need a good GC contract that you can enforce if they dont perform.. pretty simple at that point and frankly much safer for you not to give the GC any formal ownership at all.. I would NEVER EVER do that .. Did it one time cost me.

agreed on this, we only do JV deals when I'm deferring the GC fee into the equity stack or I'm putting cash into the deal or both.

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Kenneth Bell
  • Developer
  • Charlotte, NC
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Kenneth Bell
  • Developer
  • Charlotte, NC
Replied Feb 18 2024, 10:16

@Jay Hinrichs

I have to agree with Jay, this is not development. You are hiring a GC and Broker to build and sell a spec home for you. I can almost guarantee the builder is not going to do it at actual cost either. He will want compensation for doing the building and equity as well. You would be better off if you have the resources to get your own construction loan and builder to build the spec. There will be plenty of realtors who want to sell your product after the fact. My 2 cents