How to Structure an Equity Deal on a Mid-Sized Apartment Building

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Hey there BP! Last week I posted a video from one of our apartment buildings, an 18-unit in Philadelphia. Since I received so much feedback on the video, I decided to go into more detail on how we structured the deal and get a deeper conversation going on putting mid-sized apartment building deals together. Sound good? Ok, let’s get started!

So the way we buy buildings is through raising investors (Limited Partners) to come into the deal with us. We are the General Partner and get a percentage of ownership of the building also. Others on BP have asked about buying buildings like this on your own, which is great if you want to do it that way. We are looking to buy lots of buildings (more than we have our own cash to buy) so we are raising investors. It’s a win-win situation since they get to make a return on their money in a stable asset, and we get ownership of the building for little or no money out of our pocket. I’ll get more into deal structure in a minute, but wanted to clarify our strategy up front.

What to Tell Your Investors

So I don’t need to get into why apartment buildings are a good deal, right? If you are reading this, you know. The thing is some potential limited partners of yours may not know, so briefly here’s what I tell my investors.

People Always Need a Place to Live

If the economy tanks and the stock market drops by 15%, some people might stop shopping in the strip center you own or allow their beach house to go into foreclosure. But the people that rent in apartment buildings (the kinds I buy anyway) will keep paying their rent, as long as they keep their job.

Most people who rent in apartment buildings have stable blue collar jobs, or service oriented jobs that don’t go away when the economy shifts. Although they don’t own their home, they have housing at a reasonable price, and as long as they are taken care of by you and their living situation doesn’t change too much (having a kid, getting a job transfer, etc.), they will stay in your building.

They Allow for Leverage in Maintenance

There is only one roof to repair, one plumbing system, one area to shovel snow, etc. Although the costs can be higher because you have a larger roof and more plumbing, you can spread the cost across more units.

Forced Appreciation

This could be a whole article on its own, but it a nutshell, if I raise the rents on all my units in an 18 unit building by $20, I make another $7,200 per year. If that building is valued at a 8% cap rate, I just increased the value of the building by $90,000 based on that increase in income alone.

Related: How Over-Paying For An Apartment Building Can Get You A Deal In Real Estate

There are a ton more reasons, but for the purpose of this article, let’s stop there. Bottom line: You need to get some clear reasons as to why your investors should put their cash in with you on an apartment building purchase.

Finding the Deal

Finding good apartment building deals is all about building a network. You can go on LoopNet, but don’t expect to find deals to purchase. Use LoopNet to find agents that are selling in your trading area. The stuff that lingers online are deals they can’t sell. The good deals don’t even make it to the mass market (they get sold to people in the agent’s network).

You need to get into each agent’s network and have them take you seriously enough to give you the first pass at new deals. You can also network with local owners and see if you can find someone who is willing to sell. An off-the-wall idea is to call “for rent” ads for apartments and ask if they would consider selling. The reason this may work (it has in the past for us) is that the property is not performing as it could because of the vacancy causing some urgency with the owner.

Deal Structure

We use Limited Liability Partnerships (LLPs) for our deals. I don’t know if you can use this vehicle in all states, but you can in our trading areas of New Jersey and Pennsylvania. I used to use LLCs, but had a problem when I started approaching more sophisticated investors. Every bank I have dealt with has wanted to see a personal guarantee from everyone in an LLC that owns more than 20% of the company, regardless of what it says in your operating agreement. My high level investors had no interest in this and also didn’t want to get tied to liability claims if someone sued the LLC.

I did some research and found out about LLPs. These entities treat the Limited Partner (LP) completely different from the General Partner (GP). The LPs are LIMITED in their exposure to their investment, that’s all they can lose. They are what you would call a “silent partner.” They have no say in the direction of the company, but they do have an ownership stake. The GP has full authority of the company and is financially responsible for the company. The GP’s exposure goes beyond what they have invested; they take on responsibility for the company overall, including personally guaranteeing loans, and if the company gets sued the GP is the first line of defense. In shorthand, the LPs are the money, and the GP acts on behalf of that money.

SEC

Lots of people have asked me about the SEC (Securities and Exchange Commission) and how they regulate our deals. I should be saying this more in this article but I will say it here – I am not an attorney. When you do deals of this complexity, you need to have an attorney working with you closely to make sure you don’t step across the line, ever.

That being said, the SEC normally does not regulate deals like this. They are exempt from SEC regulations based on Regulation D of the Securities Act of 1933, as long as you operate within the guidelines of the code. All you need to do is register your deal with the SEC and let them know you are exempt, which is done through an online form. This form can be found on the SEC website, along with a very good explanation of the code.

It’s not a hard work around. I have heard of people paying tens of thousands of dollars to avoid SEC regulations and keep them within guidelines. I do use an attorney also, but have found that the code is nowhere near as complicated as people make it out to be.

Equity Splits

This is another big conversation piece I’ve seen on BP. Hopefully I can shed some light. The General Partner gets a percent ownership in the deal for their role, as I said above. The GP may put money into the deal, but usually puts this cash in on the Limited Partner side so they can get an LP return on that money also. The Limited Partners get a percent ownership based on how much cash they put in compared to the entire LP share of the deal.

So for example, the LP side is 60%, and total funds raised from LP’s is $500,000 and Investor A puts in $300,000 and Investor B puts in $200,000. Investor A gets $200,000 / $500,000 * 60% = 24% of the project.

Many people on BP have also asked me how much to give the Limited Partners, and the easy answer to that is that it depends on the deal and your investors. You need to look at the profit potential of the deal and compare that to the return your investors want to see and make a call from there. If your deal has a cash on cash return of 15% once it’s stabilized, if you give investors 75% ownership, they make 11.25%, which is a very good return. You then get to keep 25% of the deal for your efforts as the GP.

Related: The Step-by-Step Guide to Making Offers on Apartment Buildings

Investor’s percent ownership applies to the profit we make as well as ownership percentage of the building. If we made $10,000 in profit over one quarter, I will usually pay out around 80% of that and retain 20% to be conservative. The payout to each investor and the GP is based on percentage ownership. My primary source of income from the deal is that GP split. I also charge a management fee, which goes to my team for managing the building; I don’t see much of that at all. In the future, I could outsource the management at the same fee if I choose to.

The LP’s Expectations

The biggest thing my LPs want from me is communication. They want to know how their money is doing, when they will get their first checks, etc. I have a scheduled conference call with some investors, and I also shoot a YouTube video with an update and email it to all of them regularly. I also pay quarterly dividends to all investors once the project is stable. I pay on the same day every 3 months, like clockwork.

Exit Strategy

We tell investors that their money is in the deal for 5 to 7 years. When it comes time to unwind a deal, the easiest way to get everyone out is to sell the building and break the profit down based on the percent ownership. If you can swing it, a great exit is to refinance the building and generate enough cash from the refinance to pay out investors and keep the building for yourself! That is ideal, but you need to work hard to raise the value of the building by increasing income and reducing expenses.

So there’s a crash course on equity deals! I know I didn’t cover everything, but I hope it got your wheels turning. Feel free to ask some questions in the comment fields below so we can get some more conversation going.

Have any questions about structuring this kind of deal? Want to add some advice yourself?

Be sure to leave a comment, and let’s help each other out!

About Author

Matt Faircloth

In 2005, Matt founded The DeRosa Group along with his wife, Elizabeth. At the time, the two person company owned and managed two assets – a single family home and a duplex. Over the last nine years, they have grown the company to a 12 person team owning and managing over five million dollars in residential and commercial assets throughout the central NJ and Philadelphia area. One of DeRosa’s mantras is “to make money while making a difference.”

46 Comments

    • Matt Faircloth

      Hi Shirley,
      Thanks, I’m glad you enjoyed the article. The GP does take risks, but they are calculated. The risks are no different than ones you would take as an owner of a property held in an LLC. It’s just that you, the GP, are taking all these risks, the LPs are not. These risks are normally personally guaranteeing the mortgage and getting named in liability claims.
      I hope that helps!
      Matt

  1. Daniel Ryu

    Awesome! Really great stuff (& the video was great too ^^)

    I had a question about taxes.

    In an LLP, how are the dividends treated for tax purposes? Will LPs pay personal taxes on the dividends they receive? And the GP? The same?

    Oh.. and one other thing – is there a list of states somewhere that lists in which states this type of deal is allowed?

    Thanks for the great info!

    These are the type of articles that make me love BP so much!

  2. Matt Faircloth

    Hi Daniel,
    Thanks for reading, and I’m glad you enjoyed the video from last week!

    The LPs and the GP gets a K-1 at the end of the year which is the same as you would get as an owner of an LLC or S Corp. It’s a pass through entity meaning that the income or loss is passed through to the owner’s personal tax return. They pay taxes on the income from that point.

    To be clear, I was saying that I’m not sure if an LLP is legal in all states. I would think that if the LLP does not exist, there is something else out there that shields the LPs and gives control to the GP. I THINK that deals like this are legal in all states as I’ve never heard anything different. I don’t see why it would be as it’s a pretty standard structure. Check with an attorney in your local state or check on your state’s web page to see what’s out there.

    I hope that helps!

    Matt

    • Matt Faircloth

      Hey Jeremy,
      Thanks for reading – I’m glad you enjoyed the article! We have kept things pretty simple to date. We haven’t done things like a waterfall structure or preferred returns yet. We have considered them, but have always aimed to keep things very simple as the first priority. Also, the largest fund we have raised is $565,000 to date. More complex structures come up in larger funds, north of a million.
      I hope that helps!
      Matt

  3. Brian Karlow

    Once again, you’ve delivered an excellent article which is very transparent and very helpful! Aside BP as a resource, do you have any recommendations for books that have helped you in becoming so well versed in this strategy?

    Great job Matt!!

    Brian

  4. Matt Faircloth

    Hey Brian,
    I’m glad you enjoyed the article! Check out a book by one of Rich Dad’s advisors, Garrett Sutton “Start your own Corporation”. Also Dave Lindahl has some good stuff out there on buying apartment buildings with investors, along with Ken McElroy.
    Take care,
    Matt

  5. Josh Prince

    Hi Matt,

    Thanks for the interesting read. What is the difference between an LP and an LLP? I usually only see LLPs used for professional associations like doctors or lawyers. What you described (limited partners have no management authority and no liability outside of investment in LP, general partner has unlimited liability and all management authority) sounds like an LP to me, but I am curious on your take.

    Also, It has been my experience that banks will want any limited partner or LLC member with a certain percentage interest (usually 20%) to guarantee any recourse loan. However, it sounds like your experience has been a materially different treatment between LLC members of a manager-managed LLC and limited partners of an LP. Interested to hear your thoughts on this.

    Thanks again.

    • Matt Faircloth

      Hey Josh,

      Thanks for reading and for the comment! You actually pose a very good question about LP’s versus LLP’s From what I understand, they are very similar in that they allow for investors to come on as limited partners and are treated as a pass through entity from a tax perspective. My attorney recommended the LLP for our purposes, so we went with it. I did some research on the LP after your question and found that they would work for these types of deals also. At the end of the day, check with an attorney in your home state to be sure.

      With regards to personal guarantees, what you are saying is correct about LLC’s. Anyone above 20% ownership has to personally guarantee. That’s why we don’t use them, because many of my investors are not interested in personally guaranteeing. Banks understand that the LP’s in these types of deals don’t have to go on mortgages have not pushed me on this at all. They do want to know who the investors are, but only ask for name and address.

      I hope that helps!!

      Matt

      • Josh Prince

        Hi Matt, thanks your reply. So to confirm – your lenders are not asking for anything on limited partners regardless of the size of their investment (e.g., >20%)?? That is very interesting as I have had a different experience, but this motivates me to push back a little and see if I can get it that way too.

        • Matt Faircloth

          Hey Josh,

          We have never had a problem, as long as they completely understand that it’s not an LLC. They see LLC’s all the time but rarely see other entity structures so you may have to remind them that it’s treated differently.
          Good luck! Let me know how you make out!
          Matt

  6. Matt – excellent article. Thank you. Question – my syndications are structured very similar. However you mention that the ideal part of the exit strategy is to refinance and buy out your limited partners. We’ve been wanting to do that too but we are concerned that it violates our fiduciary duty that we owe our investors. How do you get around this? Is this exit strategy disclosed early on? What language in your operating agreement do you use to exercise this option.

    • Matt Faircloth

      Hi Jared,

      Thanks for the comment. Interesting question on your fiduciary duty to your investors. I would say that your primary duty is to get them a fair and equitable return on their money. At some point, it’s also your duty to give them an exit from the deal. If you can do that through a refinance versus a sale, why not do it. The caveat is that the GP’s equity must be enough to cover the difference of the new appraisal minus the new mortgage. If not you will need to bring some cash to the table to buy the investors out.

      Our LP’s are entitled to a percentage ownership of the deal which includes percentage of cash flow and value of the building. We also tell investors that we will give them an option to exit in some defined time frame, typically 2 to 5 years. On top of that we agree that their original equity is first out in an exit, then we divvy up the additional equity from there based on percentage ownership. All that’s defined in our operating agreement.

      I would love to hear more about how you are doing with you deals so be sure to send me a PM on Bigger Pockets.

      Matt

  7. Scott Babcock

    Very informative, Matt.

    In this scenario with LP, do the LP’s need to be accredited investors?

    Would you ever buy a building with a JV structure? Or does that create perhaps too many cooks in the kitchen whereas a partnership lets the GP(s) manage the deal with the LP’s being silent?

    • Matt Faircloth

      Hey Scott,

      Not all the LP’s need to be accredited, they can be sophisticated also. More explanation of this is on the SEC website I cited in a previous comment.

      We prefer a GP partnership, and have brought others into the GP side that run the deal along side us. The structure we use allows multiple GP’s, so it’s the best of both worlds. Sharing roles with others while having a space limited partners also.

      Thanks!

      Matt

  8. AJ P.

    Great article and nice overview of your process.

    To me, the one thing that is always missing from syndicate articles like this is the “finding investors part.”

    If you, ” cannot use general solicitation or advertising to market the securities;”

    how do you find investors for these deals?

    Do you just approach people on a face-to-face basis to present your investment?

  9. Matt Inman

    Matt, great article! I happen to run across it today as I was catching up from the weekend. I try to pick a topic a month to learn about and think I found my March topic. I may have a few questions for you as I delve in a bit deeper.

    Thanks again for the information.

    Matt

  10. Matt Faircloth

    Hey Glen,
    Glad you enjoyed! Thanks for reading.

    MOST of my LP’s use taxable funds. Because the investments are in real estate, it’s tax advantaged so they are not paying high taxes on their returns.

    They can use retirement accounts also but if the real estate is leveraged they can be subject to Unrelated Business Income Tax. More on this is available online or from a Self Directed IRA custodian.

    I find that some IRA holders prefer to be private lenders on deals versus buying equity. The deals are short term so they can reinvest their returns into the next deal, taking advantage of compounded interest.

    I hope that helps!
    Matt

  11. David Hays

    Matt,
    Thanks for this very simple, layman’s breakdown; I really enjoyed your video the other day, as well. Your distinction between the LLP and LLC structure is a defining piece that’s been missing from my understanding for some time – I knew there had to be some kind of way to delineate the GP and LPs as you said, but figured that I was just ignorant for not having actually set up an LLC. Unfortunately, I’m not sure whether we have similar legal structures in my area (southern Spain), but I can definitely see trying to develop business with partners in this fashion as we expand our business into the States in a few years.

  12. Matt Faircloth

    Hey David!
    Thanks for reading, I’m glad you found it helpful. I’m sure there’s something overseas as there is always a need to structure deal where there is a doer / action taker and the provider of equity / silent partner. It might go by a different name but I bet it’s there.

    Best of luck!

    Matt

  13. Trent Shirk

    HI Matt,

    I might have missed this in the previous comments above and i apologize if i did. I have read many books on investing in multifamily but i have yet to find a good book that covers a lot of detail on LLP and investing with partners. Your article does a great job with an overview but i would really like to learn the ins and outs of each stage and hows its structured. Do you recommend any good resources?

  14. Pete Viti

    Great article Matt! I am a little late to the party seeing that you first posted this article in Feb 2015. Our first Reg D private placement was in 2003 for about $500K. Starting then for a period of 5 years, we raised another $500K from a bunch of private individuals as loans. Along with a few partners, we did well with the money and cashed out before the crash (some of the loans still linger). Fifteen years later (rounding), crowdfunding has changed the world and equity capital has so many more alternatives. For one reason or another, my investors are retired (crave liquidity), happy in equities, or simply not in real estate anymore. So for the new sponsors out there or some of the old ones returning to the game for another round, What are some your best success stories in where and who you raised capital from short of friends and family? I would certainly consider becoming a Pro member of this blog in order to pitch my projects. Thanks.

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