unusual RE funding deal - how do you value?

[Mr Mark]

Here's the deal.

rental property is about 45k, currently rented 700 a month. We think we can get it to 900 in 2 years. Recently remodeled, new roof. But low income area so very hard to get a good PM to take on the PITA factor. Area is OK, not a warzone.

Tax and insurance is 1700 a year.

Deal is structured like this. Partner 1 puts up the money to purchase. Partner 2 (part-time property manager, licenced) will be PM and run the rental. All net rents go to partner 1 (with no PM fee, just tax, insurance, maintenance) until purchase price recovered (estimate about 10 years). After that,  property is owned 50/50 and pays a standard PM fee to whoever is then managing it.

Essentially, PM is earning their equity via doing the PM work. I think it helps align the PM with the equity provider to find good tenents and minimise vacancy and damage, when incentive is usually other way (PM makes money for finding new tenants and usually takes a piece of maintenance charges).

How would you value the deal for the 2 partners? What do you think of the deal?

[MDM]

What is the definition of "net" in "All net rents go to partner 1 (with no PM fee, just tax, insurance, maintenance) until purchase price recovered"?

E.g., does it cover the income tax partner 1 pays?  How is depreciation treated?  Anything adjusted for inflation?

Guessing at some of the questions above, to get to the 50/50 time partner 1 is investing capital and accepting a negative real return, while partner 2 is investing PM sweat equity for no pay.  Then each becomes a 50% owner.  Depending on how one values investment capital vs. sweat equity (and how the fine print in the contract reads), it could be a fair deal for both. 

[sammybiker]

Mark,

I think that's way too much work for a 45k property spitting out 700/mo...especially over a term of 10 years.  If it was a shorter term, 12-24mos, maybe.  But a lot changes in 10 years and just the risk of things going ugly during that time.

I'm also a control freak and have passed on similar profit split/equity split deals before just because I want the control.  It's just easier. 

I buy in Toledo, just South of you.  In fact, I'm flying into Detroit and driving down in a few days.  Do you invest in the Detroit area right now?

I don't know about Detroit but in Toledo, 45k can put you into great 3bd/1ba starter homes in a nice neighborhood & a great school district...rents 650-850.

[Mr Mark]

Update.

New deal looking much better.

4 x similar properties for average 100k after reno costs ( about 35k for all 4 to renovate plus 60k to buy). Average rent total 3000k gross.

ARV 200k, so equity on paper straight back.

5 year payback, then 50/50 on prob. 2500 net.

I'm liking it.

[arebelspy]

It's an interesting structure proposed.  How much experience as PM does partner 2 have?  What happens if they suck and partner 1 wants to fire them and get a good PM?

Were I partner 1, I'd be more inclined to just own it 100% and pay a PM, than try to pidgeonhole in a "partnership" just for a few years of free PM and giving up half of my proceeds after that.

[Nords]

Then each becomes a 50% owner.  Depending on how one values investment capital vs. sweat equity (and how the fine print in the contract reads), it could be a fair deal for both.

I'm also a control freak and have passed on similar profit split/equity split deals before just because I want the control.  It's just easier. 

Were I partner 1, I'd be more inclined to just own it 100% and pay a PM, than try to pidgeonhole in a "partnership" just for a few years of free PM and giving up half of my proceeds after that.

I'm sensing a theme here.

It reminds me of MMM's post about his big real estate mistake where he went in with a partner who turned out to be more deadweight than partner.

[arebelspy]

Yeah... I just don't see any upside for partner 1 in this.

Even IF everything worked out, I think the split is pretty generous for partner 2.

[Mr Mark]

I've run the numbers, and the returns on investment look pretty good to me. Solid mid case, ok downside (still cashflow easily), and big upside.

more importantly perhaps, I get to partner not with an amateur looser like mmm did but a licensed broker, owner investor in the same area for 10 years, great references,  and smart and personable.  I'm going to learn a lot, while getting a 20%++ return.

oh, and the crew that we pull together will be able to do some other work I have to do on our new nearby sfh, so big side benefit. 

I'll keep you skeptics up to speed as we go. :-)

[arebelspy]

I've run the numbers, and the returns on investment look pretty good to me. Solid mid case, ok downside (still cashflow easily), and big upside.

I'd love to see the numbers.  I just don't see the "big upside" if your PM fee on your expenses is "half my profits."

more importantly perhaps, I get to partner not with an amateur looser like mmm did but a licensed broker, owner investor in the same area for 10 years, great references,  and smart and personable.

No doubt you want to work with someone like that - I just don't get the partner part of it.  Hire them, and pay them a PM fee.

I'm going to learn a lot, while getting a 20%++ return.

Definitely skeptical of a 20% return when giving up half of the profits after 5ish years.  You'r projecting a 30-40% return, basically, and then your portion will be 20%?

oh, and the crew that we pull together will be able to do some other work I have to do on our new nearby sfh, so big side benefit. 

Sure, but if you were hiring the PM, you should be able to hire them for extra work as well.

I'll keep you skeptics up to speed as we go. :-)

We're not skeptical that it can work, just questioning if it's the best way to do it.  With only vague numbers, I'd err on the side of caution.  If you've run the numbers, great.  But we haven't seen those, so on its face, this appears a no-go, to me.  It seems that partner 1 just gives up too much value over just buying it and hiring a good PM/crew.  :)

[chesebert]

My rough rough calculation says your partner's "investment" has a much higher IRR and NPV at the end of 30 year holding period. Essentially, the partner is paying you 10% monthly PM  fee for 5-7 years and getting 50% cut in future cash flow and sale proceeds. The partner has every incentive to spend as little as possible on PM, which will maximize his NPV and IRR on the investment, unless you can define the quality of work required to keep his call option.

The financial model is he is paying you 10% of your gross cash flow for 5-7 years with a call option to purchase 50% of the equity for $1. I wouldn't touch this personally.

[arebelspy]

My rough rough calculation says your partner's "investment" has a much higher IRR and NPV at the end of 30 year holding period. Essentially, the partner is paying you 10% monthly PM  fee for 5-7 years and getting 50% cut in future cash flow and sale proceeds. The partner has every incentive to spend as little as possible on PM, which will maximize his NPV and IRR on the investment, unless you can define the quality of work required to keep his call option.

The financial model is he is paying you 10% of your gross cash flow for 5-7 years with a call option to purchase 50% of the equity for $1. I wouldn't touch this personally.

That's an interesting way to look at it.

mark, if I said: you pay for the whole investment and I will pay all the PM fees for 5-7 years (until you get your investment back), then after that I get half the investment (and I don't even continue to pay the PM fees, we split it), would you agree to that partnership?

Cause I'm ready to take that side of it.  ;)

[Mr Mark]

This is why running the numbers is preferred.

Imagine the deal this way: partner 1 instead contributes 50% of capital, $15k, and loans partner 2 their share $15k at an 8% interest rate paid as fast as possible from their share of net rent and half the pm fees avoided. Partner 1 gets half net rent, plus the rest until 15k plus interest paid back. Sound better? After that, 50 50.

Isnt that a pretty standard deal, with some hard money thrown in?

Which deal is better?

;-)

[arebelspy]

This is why running the numbers is preferred.

Imagine the deal this way: partner 1 instead contributes 50% of capital, $15k, and loans partner 2 their share $15k at an 8% interest rate paid as fast as possible from their share of net rent and half the pm fees avoided. Partner 1 gets half net rent, plus the rest until 15k plus interest paid back. Sound better? After that, 50 50.

Isnt that a pretty standard deal, with some hard money thrown in?

Which deal is better?

;-)

Sure, if you want to loan me the proceeds for half of a property, then pay yourself back out of the profits, I'm in for being partner two!  We can think of it however you'd like.

I pay for PM until your investment is paid back, and after that we split everything 50/50.  I'm in!

(For serious though, if you want to invest with me that way, I have good properties and good management, and am more than willing to invest your money.)

[Nords]

Sure, if you want to loan me the proceeds for half of a property, then pay yourself back out of the profits, I'm in for being partner two!  We can think of it however you'd like.

I pay for PM until your investment is paid back, and after that we split everything 50/50.  I'm in!

(For serious though, if you want to invest with me that way, I have good properties and good management, and am more than willing to invest your money.)

OK, my eyeballs just perked up and now I'm paying attention again.

How much capital would you want from your partner, how long would the payback period be, and how long would the partnership last?  How many partners would you want on one property?  Would we be holding the properties indefinitely in a TIC, or would we decide to sell out at some point and take capital gains?

What does the typical Bigger Pockets investor do, and have you worked with them?

[arebelspy]

Sure, if you want to loan me the proceeds for half of a property, then pay yourself back out of the profits, I'm in for being partner two!  We can think of it however you'd like.

I pay for PM until your investment is paid back, and after that we split everything 50/50.  I'm in!

(For serious though, if you want to invest with me that way, I have good properties and good management, and am more than willing to invest your money.)

OK, my eyeballs just perked up and now I'm paying attention again.

How much capital would you want from your partner, how long would the payback period be

Heh, I wasn't expecting to be taken up on that.  It's a weird structure.

But I enjoy diving into numbers, so let's play with this hypothetical scenario.

If I use conservative numbers it'd look like for the money partner: 40k(ish) investment, payback in approximately 6 years (6500/yr annual cash flow or so for first six until investment paid back), afterwards cash flow would be approximately 2700/yr. annually (assumes no rent growth over those 6 years).

If I do an IRR of selling after 10 years, assuming net sales price = purchase price (i.e. only enough appreciation to cover selling cost, which works out to about 0.84% annually) and they split it with the second partner (so get 20k of the initial 40k back at that point), IRR is 11.35%.

(Full disclosure, if I do an XIRR for my part, of paying PM for 6 years and getting no returns for 6 years, then splitting cash flow for four years, then selling and getting half of the sale, aka 20k, it's an XIRR of 25.26%.)

I ignored taxes (actually, this is probably an ideal structure for a self directed IRA, so you don't have any taxes, on the cash flow or sale).

how long would the partnership last?  ...  Would we be holding the properties indefinitely in a TIC, or would we decide to sell out at some point and take capital gains?

Both of these questions would have to be determined on a per-deal basis with each partner ahead of time.

How many partners would you want on one property?

One.

What does the typical Bigger Pockets investor do, and have you worked with them?

As far as I know, this is not a typical partnership structure at all.

All of my previous partnerships have been with other local investors, none with BP strangers.

[Mr Mark]

"I'll pay for your PM..."

This is the misunderstanding you're making.

To get $800 in this area for a $30k investment only works with highly involved property management done right. With a normal pm in this setting ( class c moving to class b) you would suffer much higher vacancies and maintenance costs. A 10% fee just isnt enough to pay for decent PM. This is why the turn key deals so often go sour in Detroit.

But, do it right, and the yields are outstanding.  Afterall, that's well above the magic 2% rule.

I'll go crunch some numbers for you. The second deal, a normal 50/50 deal with one partner earning their half as they go and paying a decent interest rate of 8% to the investor who fronts the money, sounds very fair. But I'm betting the numbers are much better on deal 1...

[arebelspy]

only works with highly involved property management done right

I agree.  I'd pay for one of those PMs.  ;)

The partner you're working with is a licensed property manager, and presumably manages properties for a fee, right?  I just don't see why you aren't paying them.  No doubt you need a great PM, and you have one.  But why are they also a partner in this weird structure?  If anything I feel like they should continue to manage it for free for the life of the investment, rather than getting paid for the work - that would be part of their "half"/contribution.

I mean, it makes no difference to me, knock yourself out.  It's just a very odd partnership, and I don't necessarily think you're getting full value.

One caveat I will add - if they are finding the deals, and they're good deals.  That can add a good chunk of value.

[Mr Mark]

Thanks for the interest and great challenge.

More background: my PM isn't interested in managing the properties as a contracted PM, because the return on per hour is just too low given these neighborhood levels. But, yes, he's a licensed broker and will contribute both discounts on the deals and contribute his fees on sale. He will also project manage the renovations, and has a crew - if I tried to do that on my own it would take twice as long and im sure cost 20% more, as I dont have the networks with the contractors and local planning guys.

My numbers, for your own analysis:
Base case assumptions. Cost to aquire and renovate $30k out of pocket plus contributed fees from partner. ARV $50k, probable appreciation over 5 yrs of 50 to 100%. Taxes and insurance $1900/yr. 10% vacancy rate. Maintenance $1000 /yr, plus establish in 1st year a capital account of $5k as a buffer for longer term capital items. Normal pm fees, if available, around 1.5 x rent / yr. Rent $800/mth.

(Here I'll assume no real increases in rent, T&I, maintenance, and also ignore inflation. But net of inflation I've used a wacc of 7%, my baseline portfolio estimate for the stash growth going forward pretax.)

Net revenue initially is around $5740/yr, giving a cash on cash return of 19%, but dropping to 8% once the loan is paid off in around year 6 to $2270 per year. Average coc over the first 10 yrs is 14%.

Assuming a sale in year 10, with 50/50 split, of 60k, minimal appreciation,  of that cashflow, and I get a year zero NPV of $16400.

By my way of doing economics, that's a net return/investment ratio of 55%. (With zero increase in house value return investment ratio would still be 29%, btw)

Return for the partner is huge of course, if the property performs. They'll earn it! Im ok with that. For partner 1 it's a pretty passive  with no sale, and those pretty conservative numbers, indeed, it ends up a poor 8% return cash on cash, which is still not a disaster. But by then you've recovered your capital, so its gravy anyway.

[Mr Mark]

More explanation,  hoping it will assist those reading the analysis.

-neighborhood is on the edge of much nicer properties.  Close ish to where my main base is, so there are a few side benefits to this deal.
Opportunity via being a good landlord,  to work with community groups on improving the area. Good for the people, the community,  and the equity owners.
if we can get prices up enough and the area a bit more stable, ability to then get mortgages would see a wave of influx and appreciation as the area gentrifies ( for want of a better term). Indirectly that would add a bit more equity to my portfolio elsewhere but nearby.

- will get a great opportunity to learn, with a lot less downside for a newbie to rental RE. While it looks great on paper what you do ARS, I'm sure it isn't as easy as you make it look. ;-)

- as an investment the downside is pretty limited, as the houses arent worth much to start with. But the upside of full-on gentrification would be huge. The houses could aappreciate to 100 - 130k, as they are in a neighborhood right next door.  I know, dont invest for appreciation is the mantra,  and I say bs. Don't invest in a non cashflowing property or a poorly cashflowing property in the hope of appreciation.  But ignore it? Nope. But it is cream.

- and I hope it's going to be fun and interesting, and the start of more!

[Mr Mark]

Now, as for your proposal, how about 75/25, once the capital is repaid nominal?

also ran the numbers on the 100% loan to the joint venture,  vs 50% loan at 8% to partner 2. Almost identical cashflows and npvs. Interesting. However I suspect the 100% loan option should have lower tax exposure....

[Nords]

Sure, if you want to loan me the proceeds for half of a property, then pay yourself back out of the profits, I'm in for being partner two!  We can think of it however you'd like.

I pay for PM until your investment is paid back, and after that we split everything 50/50.  I'm in!

(For serious though, if you want to invest with me that way, I have good properties and good management, and am more than willing to invest your money.)

OK, my eyeballs just perked up and now I'm paying attention again.

How much capital would you want from your partner, how long would the payback period be

Heh, I wasn't expecting to be taken up on that.  It's a weird structure.

But I enjoy diving into numbers, so let's play with this hypothetical scenario.

If I use conservative numbers it'd look like for the money partner: 40k(ish) investment, payback in approximately 6 years (6500/yr annual cash flow or so for first six until investment paid back), afterwards cash flow would be approximately 2700/yr. annually (assumes no rent growth over those 6 years).

If I do an IRR of selling after 10 years, assuming net sales price = purchase price (i.e. only enough appreciation to cover selling cost, which works out to about 0.84% annually) and they split it with the second partner (so get 20k of the initial 40k back at that point), IRR is 11.35%.

(Full disclosure, if I do an XIRR for my part, of paying PM for 6 years and getting no returns for 6 years, then splitting cash flow for four years, then selling and getting half of the sale, aka 20k, it's an XIRR of 25.26%.)

I ignored taxes (actually, this is probably an ideal structure for a self directed IRA, so you don't have any taxes, on the cash flow or sale).

how long would the partnership last?  ...  Would we be holding the properties indefinitely in a TIC, or would we decide to sell out at some point and take capital gains?

Both of these questions would have to be determined on a per-deal basis with each partner ahead of time.

How many partners would you want on one property?

One.

What does the typical Bigger Pockets investor do, and have you worked with them?

As far as I know, this is not a typical partnership structure at all.

All of my previous partnerships have been with other local investors, none with BP strangers.

Thanks.  I think I understand now why hard-money lenders are on every street corner.  Your returns seem appropriate for the division of labor. 

I'm going to do more research over on BP and see why they think they're getting a good deal.