If you were an investor and you got a proposal from a contractor for the deal below. Would you accept it? if so, under what conditions? what questions would you ask the contractor? what aspects would you consider? if the deal does not make sense a lot, how would you modify it to make sense for both of you?
I know this information is very vague but my goal is to learn to judge a good proposal from a bad proposal with little initial information and developing the judgement required to modify a proposal so that it makes sense for both parties in case the other party has too much advantage over me.
Here is the deal: Contractor proposed to buy a lot and build a duplex. The ownership would be 50/50. The contractor won't participate in cash investment. His equity is his work (according to online estimations, the contractor's fee for this type of construction is $80000). The idea is to buy, hold for 3 to 5 years and maybe sell afterwards. The investor has $40000 available for cash investment and the rest would come from a hard money or construction loan with an interest rate from 9% to 11%.
City: Sacramento, Oak Park
Cost of the lot: $60000
Lot size 4000sqf
Cost of construction: $250000 (according to contractor's estimation)
Total amount: $310000
Time of construction: 6 months
Property would rent for $3000 Mo
Partner 1: Contractor. He would make no initial downpayment. His equity would be his work. According to online estimations, the contractor's fee to build a property like this would be $80000
Partner 2: Has $40000 for initial cash investment available. The rest of the money would come from a hard money/construction loan at a rate from 9 to 11%
I think I would want to see the contractors plan and check his figures against costs to see if he isn;t counting in his profit to build it so he can profit more first, and then get some bids and comps in the area to see what the ARV would be when completed. And check both contractor's references and licenses and see if there are any complaints Without seeing the plans it is hard to know how to answer. There are a lot of variables. And do you need a partner if you have to get a loan anyway? who pays for materials, permits, clean up? This part is unclear and makes a difference.
I'm not sure the deal makes sense from the information that was provided. As Cindy stated, you need to check the contractor references. What exactly does the 80k include? Does this include all his labor? From what I understand the hard money loan would be for about 200k? Most hard money loans are for short term. Are you certain that the contractor will complete the construction portion within 6 months? What if he doesn't? Did you account for the time it will take for city permits and approvals? Do you require any zoning modifications to build? As stated above, why not keep 100% of the equity if you can get a hard money loan for the project. Doesn't make sense to give away 50% when the contractor does not have cash. Just my two cents.
Why build a duplex when you can just buy the one on 4th for $360k? I don’t know if any lots with a better location in OP. I would Buy that thing and then get approved to build a prefab granny flat in the back.
Also, I don’t know of any local hard money lenders that will fund ground up Construction.
Definitely check for past projects like the ones being proposed.
Thank you all. Really good points to consider and questions to ask myself and the person who's proposing the deal.
Does the cost of land include going through entitlement (all the fees and plan reviews)? As an exercise, I made a quickie spreadsheet to run numbers on new build, renovation, or 2nd units a year or two ago. The cost of entitlement could easily be in excess of 30k depending on what you propose to build. Some areas in Sacramento have slightly cheaper developer fees, and if I remember right, Oak Park is included.
Take a look at the fees for yourself at the website below:
Jake, I believe they have streamlined the fees associated with second units within the city as of 7/1/17. I know this because I had just finished building one in Land Park in May and it was a 12 month nightmare... then they changed everything on 7/1.
@Alexandra Gomez I did my first flip with a contractor. A couple of things I learned from that:
1. Will the contractor have to do other jobs simultaneously in order to keep food on his table? If so, that effects your timeline and thus your carry costs (HML, RE taxes, insurance, utilities).
It might be smarter to pay him something during the project if it lets him concentrate on your project alone.
2. Be sure your on the same page regarding the level of finishes. In our duplex project, my partner assumed it would be sold to an investor (it wasn't), so he went with cheap finishes - Formica counters, linoleum kitchen floors, cleaned up the old appliances.
I'm not saying we should have gone with Sub Zero, Thermador, Silestone, etc, but in the end the project wasn't something I was proud of. On a scale of 1 to 10, it was a 5. I was hoping we'd come out with a 7.
3. Finally, understand what each partner brings to the table. In my case, I found the property, brought the lender and the real estate representation. It wasn't clear to me what your contribution was.
All reputable contractors are busy and will not have time working on his investment involving his own money.
Unless he is putting his own money down with just you as investor/pusher I am leery about this kind of long term investment. Assuming it is a 3000 sf deluxe duplex in SFBA the most one will need for owner occupied is no more $600K with premium materials. The lot of 4000 sf is on the small side needing may be 6000sf. I will not hesitate to put it on the market not to let tenant make a dent on a newly constructed duplex wreck your place. New Duplex command premium value as few surface the market. 5 year commitment is quite risky as I am sure you want him out or vise versa way before. If he puts little down he gets a smaller share not on equal 50-50. The investor owns the bulk of the property.
Sacramento has many duplex and those under water. It seems to be cheaper to fix an older unit and renovate it than build?
@Jake Weir here is some clarification I got from the potential partner
Total cost of project would be $250000 including Building Permits (is this what you mean by entitlement?) and lot ($60000) My cash investment would be $40000.
What are your thoughts based on this updated info?
Thanks for sending that link!
I would bring some cash equity and I guess I will be bringing the lender as well. Probably hard money lender. And this is a whole new world to me.
Here is what I was thinking and please bring me down to earth if my idea makes no sense
Total cost of project including land: $250000
My cash equity: Let's say it is $40000
Contractor's cash equity: None. I guess it would be sweat equity. Let's say that the contractor fees for a project like this (excluding materials, permits, etc) is $80000. I looked it up online so I am sorry if I am way off, this is just a guess.
Let's say that somehow he can manage building this property without a salary (because his salary is the $80000 he is putting down in sweat equity)
Here is the loan:
$250000-$40000(My cash equity)-$80000(his sweat equity)=$130000
Now things get complicated when I think of who assumes the loan and how much of it. I was thinking about assigning a portion of the loan to each of us based on our "equity". So because his equity surpasses mine by $40k I think it would be fair to divide the loan by two and add $40k to my portion, the remaining amount would be his part of the loan
$130000/2=$65000 (if we both had put the same equity)
$65000+$40000=$105000 (my part on the loan)
$130000-$105000=$250000 (his part)
The reason why I would like for him to assume part of the loan (as small as it looks in comparison to what I am assuming) is for him to also feel that the longer the project takes until is finished, the more interest we would be paying (both of us!)
Since you have experience with this type of partnership, please let me know if this makes sense to you. What would you change? suggest? How did you take roles and financial responsibilities on your first flip?
Did you and your partner have an attorney, financial advisor or a third party that would help guiding the partnership and writing agreements?
I appreciate it
@Sam Shueh it all makes sense. There are many other factors involved. One of the reasons why I am doing this exercise is to pragmatically understand how a partnership with a contractor would work out fairly for both parties.
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