Credit Partners - How to Do Deals With a Partner's Credit and Cash
[This is part 6 of 7 in a series about creative financing]
This article is about buying properties with a credit partner. If you’re a visual learner, I sketch out the moving parts in more detail in my YouTube video.
First, if you want to review my previous articles in the creative financing series, here they are:
- 6 Reasons I Prefer Creative Financing to Bank Financing
- My Creative Financing Toolbox (And Why You Need It Too)
- How Seller Financing Really Works
- How to Create a Private “IRA-Bank” For Your Deals
- Lease Options - How to Profit Without Ownership
Some of my very first deals were with credit partners. The technique helped me to get started without a lot of cash and credit. It has also been one of the most fun and rewarding of my deal structures because it allows good profits for both me and my credit partner.
Amazingly enough, I rarely hear of other investors successfully using this technique. Hopefully by reading this article you will see its power and use it for your own deals.
A Story of the Entrepreneur & the Credit Partner
Once upon a time there lived a scrappy, enthusiastic real estate entrepreneur who had big dreams, a solid plan, but little money to get started.
What does our valiant hero do to find the money?
First, he stops into a bank for a loan. Where else would he get the money to start a real estate business but at a bank?
Unfortunately despite his charm, well-prepared business plan, and colorful power tie, the nice banker said “No, I’m sorry.” It seems a stable job history (i.e. not an entrepreneur), credit, and a large down payment are a requirement these days.
Second, he talks to family, friends, and colleagues looking for an angel investor who has a big chunk of cash to be loaned. Again, unfortunately, our hero strikes out.
Most conversations end in awkward silence, and the ones who are eager don’t have the large amount of cash he needs to buy a house.
Will our entrepreneur have to give up his dream and go back to a 9-5 grind working for the Man?
Fortunately, instead of just sulking, eating twinkies, and impulsively spending his last available credit card balance on seminars from late night infomercials, our entrepreneur did the right thing and reviewed his free E-Newsletters from Coach Carson and found the solution.
A credit partner!
A credit partnership brings together an entrepreneur who does the work and a money partner who has good credit and funds for a down payment. The money partner is usually someone who likes real estate investing but doesn’t have the time, energy, or knowledge to do deals on his or her own.
How a Credit Partnership Works
My business partner and I stumbled upon the idea of a credit partnership on our first fix-flip deal. We approached a friend and mentor, and we shared our plan to buy bank-owned houses that we would fix and then resell.
Our mentor had a large number of assets, but a lot of cash was tied up in other deals and in land. So he proposed this idea.
He would buy the deal, and he’d go to his existing local banker for the money. He’d ask the bank to loan him 80% of the purchase price, and he’d fund the down payment and fix-up costs himself.
Our job was to find the good deal, get it under contract, get it closed, manage the rehab, and get it sold. Basically, we were to do all the work, and he was to provide the capital and credit.
In the end, we would split the profit from reselling the house, which was net of all purchase costs, rehab expenses, commissions, closing costs, interest, and holding costs.
Our first deal was a roller coaster because we did a poor job choosing and managing contractors. But, we bailed ourselves out with long hours, hard work, and sweat, and we sold the house for a profit of over $10,000.
While the first deal was a learning lesson, luckily future profits on credit partner deals got even better.
How to Structure a Credit Partner Deal
On our very first credit partner deal, we made the structure more complicated than it needed to be.
We formed an LLC with our partner, and the agreement to split profits was built into the operating agreement. We also signed onto the loan with our credit partner to help build our credit with the bank. The bank loaned the money because of our partner’s application, not ours. But, it was a great arrangement for us because after demonstrating our abilities to the banker, he loaned money to us by ourselves on later deals.
After this first deal we closed down the LLC because we thought of a simpler way to structure the arrangement using options or lease options. Here is how the new arrangement worked:
- We (entrepreneurs) find a good deal
- Our credit partner puts the deal under contract
- Our credit partner closes the deal with a combination of bank financing and personal funds.
- We sign an option (or lease option with buy-hold deals) with the credit partner to control our interests in the deal.
The basic terms of our option would be this:
- Option price = total basis of credit partner + 10%
ex: $100,000 (purchase price)
+ $15,000 (rehab)
+ $5,000 (holding/closing)
$120,000 = total basis
$120,000 * 10% = $12,000
$120,000 + $12,000 = $132,000 = Option Price in Year #1
- Period of time to execute our option is usually 1 year with a fix-flip deal.
- Our option consideration is small ($10 - $100)
- Our option (or a memorandum of option) is recorded in the public records
When a buyer is found, the closing attorney will want to clear up our option because it’s a cloud on title. So to clear our lien, the credit partner pays us money at closing to cancel and release our option.
How do we calculate our release fee? Here’s an example.
$150,000 = Sales Price
($ 7,500) = Sales Costs
($132,000) = Option Price$11,500 = Release Fee (My Profit)
On the HUD-1 closing statement, our release fee is listed right below the bank loan which also must be paid off. Although this is a very creative arrangement, the final HUD-1 looks very standard. This type of arrangement also avoids the need for double closings, seasoning issues, or other complications of executing the option right before a sale.
Credit Partners for Long-term Holds
What if a credit partner and entrepreneur want to hold a property for 20 years, benefit from loan amortization and property appreciation, and then split the profits and equity 50:50? They can do a variation on the prior deal structure and still accomplish this goal.
Instead of just an option, the entrepreneur will lease the property for enough to cover principal, interest, taxes, and insurance. The entrepreneur will also manage the property and find a good long-term sub-tenant.
Any maintenance and repair costs will be split 50:50 between the entrepreneur and credit partner. After using positive cash flow to fund a conservative emergency fund, all extra cash flow will be used to accelerate paydown of the loan.
Let me show the power of this buy-hold arrangement with a single family rental house in a good location.
- $100,000 = Original purchase price (Full value = $120,000)
- $20,000 = Down payment
- $80,000 = Mortgage (4.5%, 20 years, $506/month)
- $10 = Entrepreneur’s option fee
- $50,000 = Entrepreneur’s original option strike price
- This option is to purchase a 50% ownership stake in the property
$216,000 = Future value of house in 20 years (~3% appreciation rate)
In order to share the loan amortization, the entrepreneur’s option price would simply be reduced by 50% of each principal payment made on the underlying loan. At year twenty (or probably sooner with additional principal paydown) the loan will be paid off. The entrepreneur then pays the credit partner $10,000 to buy 50% of the property.
If the free and clear property is worth $216,000 at that time, each partner owns 50% (or $108,000 in equity). They could sell the property or just rent it for free and clear cash flow.
How does each party benefit?
- The credit partner builds wealth using safe leverage and owns a completely passive rental investment.
- The entrepreneur builds wealth without credit or down payment by contributing just his or her knowledge, energy, and trustworthiness.
It’s a clear win-win when done correctly.
Video to Explain Moving Parts
If you’d like a more detailed explanation of a credit partner transaction, be sure to take 10 minutes to watch my YouTube video below. I use a sketch drawing to explain all of the moving parts:
Look for the final article in my creative financing series next week on buying properties subject to the mortgage.
Until then …
PS - I'd love to get your comments. Please share them below.