All Forum Posts by: Oren K.

I have found this discussion very interesting since just a couple of weeks ago I posed a similar question and got very different responses (see http://www.biggerpockets.com/forums/48/topics/88603-so-how-much-is-sweat-equity-worth). In my question, the 'manager' was claiming even more then has been suggested here (i.e. 1/3rd splits) so it was basically run for the hills from an investor perspective.

As J Scott put it in his reply, its how you put the question. Another way to ask it is: What is the value of the contribution? Marc Ramsay piped in that he has done deals of a similar nature to yours and gets 10% of the equity.

I think that there is general agreement that bookkeeping, tenant management, etc is worth 5-10% of the collected rents on an ongoing basis. Finding and pulling a deal together has value hence a commission or fee upfront. Also, just is time is not free, you should recognize that money is not free.

Based on what I have read, all three of you are on the note and so contribute equally and have the same risk on that component. One person is contributing all the financial equity and the others two are pulling the deal together and will provide the management.

Ask the question this way; how much would I be willing to pay a 3rd party for this;
Deal - Fee
Money - points + ongoing interest
Management - % of income

Figure out the 'value' and now any one of these components can be converted for equity points in the deal. Now you will be able to see if one party is getting a larger or smaller equity share then they 'deserve'.

Good luck.

The deal you are outlining is very similar to what I was pitched recently in a different market (see http://www.biggerpockets.com/forums/48/topics/88603-so-how-much-is-sweat-equity-worth). The response I got was not unexpected: Don't walk Run away from the people offering this.

I agree with all the comments made previously regarding what this deal really is: 0 down from your perspective and a fixed return for the $ investor. The $ investor is taking all the risk and if things work out, you get all the reward.

I am still not certain that there is no room for sweat equity but nowhere near this much. At best, a few deal points over time as you 'prove' your effectiveness and efficiency as a the 'manager'.

If you are putting together a deal and need people to invest, they should to be offered a premium to 'just' the equity risk,

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?

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?

A quick note to be watchful regarding the 'lifetime' representations on the CFL bulbs.

In a commercial building my family owns we started tracking how long the CFL's last (I had a suspicion). The non 'brand' name bulb we were using states 12,000 hrs (~17 M in a 7/24 applications like public hallways) but in fact we found that they only lasted 3 - 5 months. We are now switching to a Sylvania bulb to see if they deliver as advertized.

On the one hand, since we are tracking them we will return the bulbs under warranty and get replacements. We may never 'buy' a bulb again. On the other hand, replacing them is a pain and I would rather do it as infrequently as possible.

This is why I always include some text regarding the inspection / DD period that goes some thing like this:

"The Seller shall provide extensions to the inspection period, acting reasonably, provided the buyer continues to act in good faith towards closing the transaction. Time shall always be of the essence".

Basically, as long as I am moving forward and not intentionally delaying things, extensions will be granted.

As an example, if the bank insists on a inspector from a particular list but none of them are available for 2 weeks, this is outside of my control. Asking and expecting an extension is reasonable. This should also always be documented to avoid any uncertainty.

Steven,

While I'm usually all for more information, I'm not clear on the value of seeing their depreciation. If they've owned the property for 50 years and the building is down to '0' or just purchased it last month and are trying to do a quick flip, how do you think that should affect my thinking / offer.

The question is always; "Does this make sense for me?"

Also, what do Schedule E / 8845 show (remember I'm a Cunuck and I'm not familiar with US forms, eh ;).

Oren

Joel - So yes it is 'normal' and you use 3 years.

Does this apply to all forms of 'Commercial' (e.g. Multifamily, Retail, Office, etc.)?
Is that 3 years for both bank statements and IRS forms?
Do you ask for the entire Tax return of the company (they may have more then one property in the company)?
Is there a section(s) / schedules(s) that only relate to an individual property?
If so what are they called / numbered?

Thanks,

Oren

As a Canadian looking to invest in commercial in the US, I (not surprisingly) do a fair bit of reading on the topic. According to a number of books / articles, it is NOT uncommon to request several years tax returns and bank statements as part of the DD package.

The thinking being that while people may play a bit fast and loose with representations or declarations, no one wants to screw with the IRS. Also, that bank statements are more reliable then any self declarations or unaudited financial statements.

I have not seen this in either offers made to us nor have I ever asked for these items (perhaps we should??) here.

Is it accepted practice in US commercial transactions to request either bank statements or IRS returns related to a specific property? If so how far back is 'normal'?

I have also been researching this topic in anticipation of making an investment. I've discussed this with several accountants and also consulted with one of the top cross boarder tax specialists in Toronto.

Steven's response is correct; due to similarities in law, tax policies and bilateral treaties, there is little if any double taxation when Canadians invest in the US. There are some obvious extra administrative costs of multiple tax returns, probably a more involved corporate structure, etc. but not double taxation.

That being the case, the more important question is; how to minimize the overall tax obligation.

Disclaimer: I am not a Tax Expert or professional so consult someone with your personal situation.

On the assumption that the real estate investment is going to be an ongoing business and not just a one time thing or vacation property, there are techniques which can reduce the effective tax rate.

The specific one that I have been advised to consider is to ensure that the real estate business itself is operated on a break even basis so that no there is minimal if any tax owing. Assuming there is positive income, you take it out as consultant fees into a separate company. Yes, this is yet more overhead / administration / costs but due to the tax rates for what is considered a passive business (e.g. Real Estate Rental) vs. an active business (e.g. Consulting), there is a big difference in effective rates.

So if your investment is going generate a small income, it may not be worth the extra costs but as you scale up, at a certain point it does make sense to put the infrastructure in place.

Where that point is, is not clear to me yet and if you do not need it immediately, should you put it in place in anticipation or can you defer it until needed are still questions I am asking.

Anyone care to chime in?