I have been successfully investing in rental properties for approximately 20 years. I personally own 11 doubles, 2 condominiums, and have completed 4 flips with moderate success. 2.5 years ago I retired from my job after 22 years to pursue real estate investing full time. About the same time a great friend sold a business for millions of dollars. After doing a ton of research and analyzation I decided I was going to start investing in lower-middle income housing in a city of about 200,000 people. Its location is about 1 hour from my home, but housing prices are much more affordable and rents are comparable to my area. I decided to pitch the idea to my friend to see if he was interested in investing. Figured it would be a good match as he needed somewhere to park his money and it could save me the agony of dealing with lenders. Ultimately we decided to open a business together. Being somewhat naive to a larger scale of business his accountant and lawyers helped me with the footprint and the contracts. It was set up in a way where we both invested 100k personally then we borrowed the rest from him. He had no responsibility within the business accept to provide the capital at an interest rate of 4.25%. I was responsible for 100% of the responsibilities of running the business. This included the opening of multiple corporations (holding company, management company, sub LLC's that hold the properties). Within 2 years we controlled 82 units broken up between singles, doubles, threes, fours, a five, and a nine unit. I take a salary of approximately 70k per year. I work between 40-60 hours a week doing everything between finding, analyzing, and buying properties, personally doing renovations and make-ready's, overseeing contractors, leasing units, and working hand in hand with an excellent management company that takes care of collecting the rents, dealing with tenant relations, and day to day maintenance. The company has borrowed 3.7 million from my partner and is paying him approximately $19,000 per month in principle and and interest payments. As the company has grown and we are deciding on its future I have started to question whether of not this is equitable for me? It turns out that as the silent (money) partner he really has not injected anymore cash into the company than I have. He has merely loaned the company money at a fair interest rate. Not only does he have a first position lien on all the properties, but he also has a personal guarantee from me for half the money. Basically this is a risk free investment for him. With this money that he he has loaned the company he has also purchased half the equity of the entire company. It's often difficult for me to wrap my head around, but basically he hasn't invested any more money than I have because it's structured as a loan (with all of the investment due back to him), however he also gets half the equity. The terms of the loan are excellent and it allows us to purchase properties with cash and no contingencies. That provides us with great purchasing power and up-front equity. Is the structure of this company equitable for me or would I have been better off pulling equity out of my properties and going it alone? I don't want to seem unappreciative but ultimately for me to move forward I need to feel comfortable with our respective compensations for our part in the business. I appreciate any and all input on this dilemma.
The answer to your question is that anything two people agree on is by definition "equitable". The real question is what would be your ROI vs your risk if you structured the business in a different way?
Okay. Let’s start with your current structure. Since you both invested the same in equity you’re equal partners. Since you do the work you get a salary. This is pretty basic and common structure. The loan part can be seen as an inducement to have you agree to the partnership by providing a low cost, easily accessible debt component.
What would your cost of debt be if you had to access debt without the tie in? Unless you had a very, very strong balance sheet, and a very strong relationship with a lending institution, you’d be looking at considerably more than 4.25%. Private money starts at about 8%; with the relatively small amount of equity capital you’ve invested and the resulting high LTVs you’d pay considerably higher rates, and might have to invest more on the equity side yourself.
If you're venture is successful long term, and earns an ROI greater than the cost of capital and your salary, then by definition you'd make more money as 100% owner than as 50% owner. So the analysis you need to do will include these key components; you're ability to raise debt capital, the ROI , the decrease in ability to do deals based on not having your current readily available debt source, the cost of debt capital, and the risk factor. Then you'll be able to determine with hopefully some accuracy what your return would be going it alone and what the additional risk would be of not having your current capital source.
Btw, nobody lends their money at 4.25% at near 100% LTV mortgage loans unless they are lending to an entity they have significant interest in. Your partner has alternatives. For example he can invest in mortgage with us, at 60% or lower LTV, and receive a return of about 11% interest. Knowing this he may feel your partnership isn't equitable to him!
Don gives an excellent reply. I also see no issue whatsoever with the equity split. You both invested the same equity.
where I think the issue may lie is in your salary. 70k for 60 hours certainly may be under paying you given the broad responsibilities you seem to have.
While @Don Konipol provided you with a top notch feedback, I'll add that all comes down to your mindset. Do you look at the glass as half empty or half full? In other words, think where this capital at such incredibly low rate brought you today? What was your alternative back when you started? If you want to re-access your current situation, that's your right, but also, think about the future. Will these kind of capital injections continue supporting the growth of your partnership or you have a better alternative?!
Consider reading, "Think and grow rich" by Napoleon Hill.
Thank you for your responses. I actually have over a million in equity in my personal properties that i could have tapped into. Originally when my partner and i starting the process our plans were to keep compensations equal between my salary and his interest income. We were originally going to cap it at a million. I was buying so well and had really good systems in place so he kept lending us more and more. Now the compensation is way out of whack. 72 k in salary vs 160k+ in interest income. Our equity is equal. Obviously i should be receiving a much higher salary but that will weigh heavily on the business. My thoughts were if we kept my salary down but reduces the interest rate it could not only bring us closer together but it would be more tax efficient for him because he’s in the highest tax bracket. Plus that would keep more of the cash flow in the business to grow the portfolio and the cash flow. We are doing great. We actually just reached 100% occupancy (82-82) which was a goal i never thought we could achieve in this type of residential real estate. I work from morning until night 7 days a week in this business and i feel I’m being slighted a little.
If I’m the intellectual property and sweat partner and he is the money isn’t he supposed to inject the money into the business. I don’t have a problem with him being due all his money back however I’m not sure if he should be charging an interest rate. I’ve never heard of anyone buying equity into a viable business and also getting an interest and principle payment monthly. Have you?
@Jason M. it sounds like a fair deal to me. He is earning interest because he has lent money. That is fair. You can loan money and get interest too so this is equal. Also, you can hire out your job and sit back. Find a project manager to take over. Not familiar with your wages in your area but 70k is nothing to sneeze at. When your partner lent lots of money he took significant risk and lent at a great discount. If he were to ask for his money back your income would drop significantly.
Try stepping back and hiring out everything and refinance him out of it and see what you have. There are lots of people who would trade places with you and do your work.
@Jason M. Anything two knowledgeable, competent people agree on to form a partnership is fair. If one side no longer likes the deal, he can attempt to renegotiate, or, if not prohibited in the agreement terminate the partnership. Or one party may be able to buyout the other. Most people would agree that in smaller businesses, a disgruntled partner is never a good thing.
But you seem to be looking for some type of justification, or at least an agreement from posters on this forum, that your partnership situation is unfair to you. I don’t know whether you’re attempting to “test the wind” of your opinion of unfairness, or you’re torn between moral indecision about a friend who with whom you have agreed to terms and now desire to change those terms.
So maybe I can use my experience to help you out. As I previously stated, the interest rate charged on the debt financing provided is far below market. The interest rate is compensation for providing debt financing, it is in no way, shape or form related to either the equity, or your salary. Unless you provide an equal amount of debt financing, the only thing I see is your partner costing himself about 6-8% annually by charging below what he can get with similar or less risk ( don’t show him this thread, he may want to reconsider what he could be earning without additional risk).
Most structures I’m familiar with provide a percentage of equity equivalent to the percentage of invested capital. Hence, you each put up one half of the equity, you each own half the investment. The difference when one party does significantly more work, and or brings significantly more value, is made up in salary, and, or carried interest. Perhaps your salary is too low, or as likely you hadn’t negotiated any carried interest for yourself as the managing partner.
In my opinion, and realize this is just my opinion, but based on my experience, I would expect that in your situation you should have had a deal something like the following: When the properties are sold, each party gets his investment back plus profit at 6% per year. Anything above that you, as managing partner get 25% of all additional profit, and the partnership splits the remainder. I would also expect that besides the salary you received an ongoing percentage of gross income generated over a certain amount.
So, In my analysis there is no problem with the debt structure, or the capital structure. The problem is that you hadn’t negotiated a separate property management fee, acquisition fee, or carried interest.
Thank you Don, this all makes sense. Our our original earmark when we started was to borrow 1 million. Neither of us realized it would get this big and be this successful. Without much negotiating our plan was to keep our compensation close. Turns out that hasn’t happened and it’s much more time consuming to keep 3.7 million in small assets working properly than 1 million. I’m obviously not super experience with the business aspect of this so i didn’t have any contingency plans in place for such growth and capital injections. I’ve definitely done well on the equity side as did he. I would hate to see an increase in my salary hurt our cash flow and purchasing power going forward. I actually spoke to him about lowering the interest rate in lieu of a salary increase so that our money would stay in the business and work more tax efficiently. That didn’t go over so well. Can you explain to me why you believe he is carrying so much risk. With 3.7 invested our properties are worth approximately 4.8 million market value after purchase equity and renovations. We are at 100% occupancy with 82 units across many classes of homes and apartments. He has a 1st position Leon on the the property and a personal guarantee from me for half the loan (net worth is more than that). Barring an unseen disaster where’s the risk at this point? You are very experienced and knowledgeable and i really appreciate your opinion. Thank you