So how much is Sweat Equity Worth… ?

Question

I would like to draw on the collective wisdom of BP to help me answer a question.

First some background; while I have been involved in real estate for well over 15 years, but it has always been on the office / retail side. Over the past year or so I have become convinced that there are ‘better’ returns on the residential side (I know, late to the game). I also believe that starting small and making small mistakes (i.e. not as profitable or losing a little) is smarter then risking it all (or most) in one shot to start. On the other hand, as a Canadian, there are additional overheads (read taxes, bookkeeping, etc.) that make opportunities that seem OK, very marginal when all the costs are included. This means moving up/out the risk / reward curve to get a reasonable return.

Recently I inquired about a MF property in a large urban center. Through a number of conversations with the agent, I was put in touch with a company that pitched the following; Instead of doing it all yourself and risk making the mistakes that usually get made, invest with us ‘experienced’ RE managers for a fixed return and equity participation. Not a new idea but attractive in the right circumstances

Let’s assume that their representation are totally above board and that they can find ‘good’ deals, get institutional financing, are efficient managers, know how to judge and determine exit, etc. etc. Also, that there are no issues with the bookkeeping, double dipping, or any other questionable practices. They are as honest as the day is long, totally transparent and fully verifiable. As well, they are putting their own skin in the game by putting in 20% of the equity for each deal.

The investment would look like this on a hypothetical project of $1,000,000

Investment:
Mtg (70% LTV):        $ 700,000
Managing Partners: $  60,000 (20% of the Equity Needed)
Equity Partners:      $ 240,000 (Balance of Equity Needed)

Ownership:
Managing Partners:  85%
Equity Partners:       15%

In addition, the Equity Partners would be paid a preferred 8%.

Based on their projections (and lets assume they are right), the Equity Partners would end up with ~20% ROI / Y + 15% of net proceeds on exit.

So ‘work’ free 20%/Y + longer-term capital gains; what’s wrong with that??

I understand and can accept that investors have to pay for sweat equity but this seems unreasonable. They are investing 6% ($60K/$1M) and receiving ~80% of cash flow, 85% of appreciation; nice if you can get it but WOW.

So what is reasonable compensation for sweat equity; 10%, 30%, 0% (they are lucky to have you invest), ???

As I said previously, this structure has been around for a long time but is this what the ‘market’ allows at this point in time? What are BPer’s seeing?

Jon Holdman · Answer

I thought about this some more and realize I didn't account for this:

That makes this really much more of a bond type investment than a equity investment.  For your money, you get a fixed 8% return plus a very tiny sliver of the equity.

Marc Ramsay · Answer

Hi Oren;

In discussions with some of my busier investors who all have businesses of their own to run, but still want to get into RE investing, I found there was a need by some of them to partner up with someone who does this full-time and can take care of all the phone calls and other demands that owning RE investments entails.

Most of these people have little RE investing knowledge, and need to rely on someone they trust to put their money to work for them. They have the cash to invest, but want someone to hold their hand through the process of acquisition and operation. The model I have worked out with them is that for between 10% and 20% ownership in the property, depending on the size of the project, plus 1.5% of gross rents, I would manage the acquisition and operation of the property. I manage the Property Manager, rehab crews, and any day to day issues that arise, and I get all the phone calls.

The investor gets monthly financial and property reports, full access to the bank account(s), quarterly profit checks, and access to my team of professionals (brokers, accountants, lawyers, rehab crews, property managers, etc). For many busy professionals this is the ideal scenario.

One comment a client made during a meeting a few days ago was that this is really no different than him putting his money into mutual funds, RRSP's, stocks, or any other type of investments, except with this one he has title to a piece of property and some level of control over his investment, and the return is better. I am simply facilitating that for him.

Judging by the numbers you gave, there are a few out there who are taking advantage of this scenario. I guess like everything else it comes down to the buyer doing their homework and making an informed decision.

Cheers,

Marc

Robert Blake · Answer

They might be sweating that the mark figures their game out...

Steve Babiak · Answer

There's no sweat coming from these managers ...

Oren K. · Answer

Yes, these guys make the Hedge Fund Managers and Vulture Funds Managers look like angels in comparison but that really was not my question.

Essentially what we are taking about here is JV with a managing partner (MP) and a passive partners who invest $ and are otherwise inactive.

There are a several ways to compensate the managing partner;
 - What is the going rate for the service and build that into projections
 - MP 'earns' equity over time
 - MP is paid up front for putting the deal together
 - etc.

or any combination of the above. It depends on what the MP wants, if they are investing $ as well, etc.

You can take two approaches to this:
 - MP is lucky to have my money. He gets paid a fee.
 - MP is adding value beyond just 'management' and this should be recognized.

How much equity is it reasonable for them to get over what period of time?
What kind of offerings are you seeing out in the market?

Jon Holdman · Answer

Absolutely ridiculous.  Absolute incredible.  Run away from these people!  You are going to get robbed if you work with them.

The correct split:

Managing partners: 20%
Equity partners: 80%

The managing partners should get paid for their management contribution, but not in equity.