Disclaimer: I am not a legal or tax professional, and all matters of real estate partnering should go through either legal or tax professionals (or both) before being implemented.
I hear the question quite a bit: How can a partnership be structured for investing in rental properties? I assume I get this question a lot because if you’ve read many of my articles, you know that I have used an investment partner for a lot of my properties. So I figure, why not just tell you exactly how my partner and I are structured so if you are thinking about doing it for yourself you have a little more clarity on how it can work?
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A Starting Point for Structuring Partnerships
Before I tell you how I’ve structured things with my partner, I want to give you a quick backstory as to how I came up with the structure, mostly because if you are pondering partnerships at all, this may help. Basically you are going to get two structuring options for the price of one!
I was in Las Vegas at a self-storage convention (when I thought my life path was going to be owning a self-storage facility rather than being a real estate investor), and I met a guy there who was in town from Miami. This guy owned a couple businesses, and it didn’t take long for me to realize that he could be a wealth of information. I got on the topic of telling him that I knew someone who was interested in going in on a self-storage facility with me, but I had no idea what kind of partnership to offer — what would it even look like? What kind of splits? What kind of investment requirement?
Here’s the structure he suggested to me:
Your investor puts down the money required to buy the business, then you give him 30% off the top of the NET each month and then split the remainder 50/50 until he is paid back, at which point the split then goes to 50/50 straight.
I was intrigued! He went on further to say it can be very incentivizing to the investor because that 30% goes a long way, and then it’s free money after that. And it’s of course a good deal for me because I’m making free money the entire time. I had to say — he had a point! I stuck this idea in my back pocket and thought about it often, and then when it came time for me to take on an investment partner, I pulled it out of my back pocket!
Rental Property Partnership Structuring Options
So there’s the first way to structure a partnership: 30% off the top of the NET, then 50/50 split after that. I was so excited about how awesome this sounded that I couldn’t wait to do the math when an investor partnering potential came around. However, I ran into a hiccup.
Being the spreadsheet nerd that I am, I started working all of the math for my first potential rental property purchase and my newfound favorite partnership structure in quite a bit of detail in Excel. I knew the numbers on the property (anticipated cash flow, income vs. expenses, purchase price, etc.), and I tried to apply the 30/50/50 split to it. I ran into a major problem. That 30% off the top then 50/50 split bit led to negative cash flow! I don’t remember how exactly, but basically the numbers didn’t work. I thought, oh no, my magical partnership structure proposal is in the water! I tried every which way to make it work, but it just wasn’t happening.
I continued working on it, trying everything I could pull out of my hat, and I finally came up with a logical solution. So, remember that one method — the 30/50/50 method — because it could be very useful on some partnerships. And now here is one that works for smaller-dollar investments:
On my first little rental property I wanted to buy, a lonely little (adorable) $55,000 single-family house in the suburbs of Atlanta (oh, the days of those prices!) that was going to rent for $975/month, I just couldn’t make that 30/50/50 split work because it led to negative cash flow. Here’s what I did find that would work, though, and it did because my partner and I still operate several rental properties under this exact partnership.
- Partner puts in the cash required for the down payment and the closing costs; I take out the mortgage and do the work.
- We split the NET (profit or loss) 50/50.
- If we sell the property, we split the NET (profit or loss) 50/50.
- Equity is always split 50/50, including appreciation and any possible refinancing.
- I provide my investor with a statement and direct deposit every month.
- We both report the 50% income (or loss) on our personal taxes.
- Our partnership is legalized through a legally documented Partnership Agreement (no LLCs, etc.).
Pretty simple, huh? All I needed to adjust from the 30/50/50 thing was the 30% off the top part. But wait, why would that deal be enticing to an investor? That 30% off the top to pay him back for his initial investment seems kind of important, no? The answer is: Yes, it is important. It’s an important enticement. When you are talking about high-dollar investments, like commercial level, i.e. an investor is going to be putting down a mega chunk of change, that 30% off the top may be critical to offer in order to convince anyone to buy in. But at the residential level, it’s not as critical.
But wait. What’s in it for the investor in this straight 50/50 deal? Good question. The theory of this split is it’s a 50% investment for the person willing to put up the cash and a 50% investment for the person willing to take the risk. My partner’s name is not on the property, so if anything happens to it, he is not liable. So him putting up the cash constitutes a reward of 50% of the NET income, and my accepting all of the liability and also doing all of the work and management for the property (although minimal since we bought turnkeys) constitutes the other 50%.
Further Points to Consider
If you aren’t convinced this is a balanced enough split (money vs. risk split), here are some further points to consider with regard to why this may be an enticing deal for the money partner:
- What if someone doesn’t qualify for a mortgage but they have cash they want to invest? This is a great deal for them because they can still take advantage of leveraging, even though they can’t get it under their own name. Score!
- What about the 10 mortgage limit? A big stress for buy-and-hold investors is what to do after they hit the 10 mortgage limit. Well, investing with a partner this way frees up one of those mortgage usages for you! My investor partner also invests in properties by himself, so with our partnership he is able to still do 10 of his own with mortgages and THEN have ownership with me — so he can go way past 10!
Starting to see why this setup may be enticing for the money investor? And then of course for me, the risk investor, my returns are infinite! Since I am no money into the deal, any returns I make are technically infinite returns. That’s hard to beat! And then of course the more obvious reason someone may want to be the risk investor, so to speak, is if they are low on cash but still want to buy into properties.
Now a couple of points worth noting:
This setup can be done with or without the use or mortgages or other loans.
It can easily be done with an all-cash purchase. However, I don’t know the exact balance of the money vs. risk investment — like if you own it outright, you don’t have the mortgage risk or the offering of covering the mortgage side of things (see previous incentives for the cash investor), so I’m not positive how you would convince anyone to do it. But who knows? If you pull it off, let me know how you did it.
Don’t partner with just anyone!
My investor partner is a very long-term friend of mine, and we have done a lot of business-related things together. I trust him fully, as he does me (obviously, since his name isn’t on the house), but even that has risks. I don’t anticipate anything going crazy, but you just never know. So know who you are going into business with!
Not just from the standpoint of giving your money to someone, but in how well they will manage the properties once you guys own them together. Bad management will tank an investment, so that isn’t good if you dump money into something and that happens. I recommend a ton of networking and other awesome stuff on BiggerPockets, but I don’t recommend soliciting around to anyone who is willing to invest with you. Come on, now.
Speaking of partners going crazy, make sure you are protected.
It’s important to be smart going into a partnership, and it’s also important to be smart legally with the partnership. Spell it all out so there is no question later. And if you do it like I did, where the cash partner’s name isn’t on the house, make sure it is set up that should something happen to you (death), that person has a way of getting the house. You can do this type of legalese with an LLC or a legal real estate contract, etc. But do something.
Make sure your numbers make sense.
This type of split is based on rental properties that generate monthly cash flow, and in order for the split to be worth it, the margins need to be of certain size. It wouldn’t be very enticing to offer a partner $10/month in cash flow split. If you are wondering if a cash flow or margin is high enough to entice anyone, run a calculation on how long it would be until the investor would get his initial investment back. Oftentimes running that number suddenly will make it seem like a pretty good deal!
For example, on the margins, one of our properties nets anywhere from $400-500/month, so that is $200-250/person/month, and his investment was only around $16,000. So that’s actually not too bad of a turnaround time — never mind the equity and tax benefits he gets from it as well.
Consider your conscience.
There is one factor I didn’t think to consider before I jumped into properties with my partner. This was my conscience. We had a couple properties that did pretty badly for about a year, and essentially I had no profit to give him. I was SO stressed about it! I would’ve been fine with it all had he not been in the picture because the margins on these properties were so high, I’d be able to make up for it pretty quickly once they were cash-flowing again, and I knew the big picture about how good of investment properties these things were, but nonetheless, I felt horrible. I was so stressed out having to report nothing good to him. It was not something I had taken into consideration going into it. So don’t forget to weigh the “what if things go wrong” scenario.
There you have it! Now you know how I am structured with my investor partner on my rental properties.
Any other creative partnership structures you guys have tried and liked? Have you been involved in any partnering? If so, pros and cons?
Leave your comments below!