What is Fair for this real estate transaction?

[carfire2]

So I have a friend that had an idea for a real estate investment.  There was a house on a good sized bit of land.  He was convinced although the house would have potential to split the property and sell it off for good profit.  Somewhere between $100k - $500k on an investment of $625k.  The $625k is above market or top of the market at time of investment.  I am investing 100% of the money, my friend brings the idea, but has no downside.  What is considered a typically reasonable split?  Assume we both put in the same amount of labor to make the deal work. 

Don't try to talk me out of it, that is not what this is about.  It is about what is typical, common, "Fair" for the "idea" person with no downside vs the "Money" person risking their principal. 

Thanks for the feedback!

[Villanelle]

You ask what is "fair" for an inherently unfair deal.

Whatever % you decide on, can you stipulate that if the transaction losses money (after all your expenses!), he owes you that % back?  I doubt you'll do that, but it seems reasonable.  At a minimum, I would insist on covering all my expenses (carrying costs included, and even capturing opportunity costs at a set rate) plus x% (with x probably = at least 20) before he made anything.  So if the place makes $200k (so sells  $925k with a $625 investment from you), you get the first $625k plus 20% (or $750k total), and then the remaining $175k is divided according to whatever % split you decide on.  (At a bare minimum, please please please insist on recouping your costs before any split!!!!)  For me, I would give him no more than 15% (after expense are recovered) if he is risking nothing.  Then again, I wouldn't do such a deal at all, so...

[Jon Bon]

Well a realtor gets about 3%, so honestly that is what they probably deserve. To be clear I would probably give about 3% of the profits if they are taking zero percent of the risk.

Do you even know about the mechanics of this? You can't just split a parcel, it takes professionals and government approval. Like has this idea been vetted? I would be pretty concerned if you get stuck with the house and have issues on the part where you actually make the money.

[matchewed]

0 risk and 0 work? At least the realtor is supposed to facilitate. I'd put it at somewhere <3% then.

[GuitarStv]

Your friend has done nothing but pie in the sky musings, will bring nothing into the deal, risks nothing.  About 0$ is fair for his share.

[former player]

People have ideas for books all the time: it's the person who writes and publishes it that gets the money.


Your friend doesn't deserve anything for having the idea.  The idea is how he passes the interview for the job.  He will deserve something if he puts in labour and/or materials, and that may be on a hourly basis or a share of profits.

[jwright]

OK, so I work in development and while this seems very unfair to you, the idea is pretty common.  The developer has the "idea", sources the deal, does all the legwork getting permitting, putting together consultants, managing construction, etc.

The developer (your friend) has to pitch this to the investors (you) to show them this is worthwhile.  Has he put together a business plan?  A proforma model showing potential profits?  Had an preliminary discussions with governing bodies regarding zoning, easements, permitting etc?

In our business, once we have a plan for successful project, we typically negotiate an 80/20 split (sometimes different depending on project) between the developer (who is the general partner and manager) and the investors (who are limited partners and passive investors).  The 20% is sometimes called the "promote".

In your case, assuming you have vetted this and are going to move forward -  I would want at least 80% for the investment of money with a preferred return of 8% (to make up for time your money is not on the market).  Since you are both providing the labor and legwork, I would demand to split the remaining 20%.  If you are truly doing an equal amount of work, I guess 10/10 is fair. 

So when this sells, you 1.  get your capital back 2. get the return on investment 3. get 10% of the GP split.

[wbranch]

Fair sounds a lot closer to 0% of the profits than 50% depending on the partner's experience. I have known a couple "idea" people that always have ideas for real estate, businesses and/or products have never managed to pull anything together and it is always because other people wouldn't give them the money. Not because their idea is shit. Based on the limited info in the post I would lean more towards this.

If the partner has some experience with real estate and you vetted it and are confident in the partner I like the breakdown jwright gives.

[Samuel]

They should get a fixed finders fee for bringing you the deal, not a percentage. The Fargo rule.

[clarkfan1979]

One of my friends flipped houses for about 10 years using silent partners. The silent partner would bring all the money. He would do all the labor and they would split the profits 50/50.

Try to structure the deal in which your friend puts in their own money or labor. If they are not putting anything into the deal besides finding it, I'm guessing a 2% finder fee.

[genesismachine]

If it were me, I would very much hesitate to take a deal with the other party having no skin in the game. That being said, preservation of capital + preferred return has to be as close to guaranteed as possible. Leveraged real estate where I'm at currently returns ~15-20% virtually risk-free tax-free right now (cash on cash return, principal repayment, ~1% price appreciation).

So if you paid $625k, you get $625k + any expenses incurred+ 20% return before your partner gets anything. Then after that, I would personally want at least 50% of the profits since the other party has no risk. My guess is that this will likely render it unprofitable for your partner, which should not be your concern.

A good test of a fair deal is if you traded places (and traded situation fully, like you had no money like your friend), would you still think the deal is fair?

Even if it's fair, I personally would not do the deal either as you or the friend. I think it's an inherently unworkable deal unless this is a 99% certain slam dunk after doing serious due diligence.

[carfire2]

Ok, thanks to everyone for their input!   So the reality is that this deal was proposed and executed on in 2014.  We split the house and half the land and sold it.  We recouped about $700k after expenses, but put total $725k into it so I am still $25k in the hole before selling the 2nd parcel.  The remaining land is worth $550k-$600k.  My friend believes that he should get "an out-sized" share of the profit because the idea was his.  I disagree.  I did offer to advance $50k of the proceeds from the first sale against a final share.  He was pissed and said he did not feel like his contribution was valued.  I feel like that is more than fair until it is all finalized since we don't have profit until it sells.  He doesn't have alot of money and I am FIRE.  Thoughts?  Again thanks!

[PizzaSteve]

Thoughts are that you are crazy to enter a financial transaction with another person without agreed terms in writing.

[Villanelle]

Would have been less annoying to just be straightfoward in your OP.

But my answer remains more or less the same.  Recouping all costs before any profit is split (because until then, it isn't profit) is perfectly fair. 

Since it seems you aren't recapturing any opportunity costs, consider that the offset for the value of his idea.  He had the idea; you lost the money that your investment would have made in the market for all this time. 

JWright said this is fairly common, but what he describes is different than your set up, since you said you and the Ideaman did the same about of leg (and other) work.  And he still only has the Ideaman getting 10%. 

You guys didn't hash this out ahead of time??

[former player]

Yikes.  So -

1.  In 2014 you invested $725k, based on an idea of your friend's.  You got back $700k plus a plot of land worth up to $600k.

2.  The costs of this investment are a) the opportunity costs of $700k for the period between buying the land and sale of part of it, b) 25k, c) the opportunity cost of $25k between 2014 and sale and d) the sweat equity you and your friend put into the project.

3.  You mention the risk to your capital as a part of your input.  The 700k was theoretically at risk for the period before the first sale, but those risks did not materialise.  The risk to the $25k seems minimal.

4.  After taking off costs, you have a profit of about $500k.  Nice work.  Your friend considers that 10% of this is not an adequate value of his contribution.


Here's where I think you are.

5.  There seems to be no written agreement between you and your friend, and he seems to have no legal rights over the land or control over when it is sold.

6.  There may or may not be an oral agreement between you and your friend.  If there is, you should honour it.  In law, an oral agreement is just as much a contract as a written agreement, the only difference is that it is hard to prove, on the balance of probabilities, the existence and terms of an oral agreement.

7.  If there is not an agreement, or its terms are not sufficiently defined, then you are looking for ideas as to what would be fair.  Presumably this is somewhere between 10% and 50% of the profits?  At this point I think your considerations are a) do I want to keep this person as a friend?  b) do I want to be thought of as a decent human being by others?  c) do I want to think of myself as a decent human being  d) at what point does the share I give to my friend become so high that I will think I've been a patsy?  e) when I propose to my friend the share I'm offering how do I explain how I have reached that decision?   To look at it another way: you've got yourself into a pickle here, and need to find a way to extract yourself from it in a way which leaves everyone feeling OK.  It's a good thing that you are already FIRE because that takes your personal financial need out of your considerations and gives you more leeway as to what you decide.

[CSuzette]

I think that contracts regarding land must be in writing.

[marty998]

Ask him to cost out (and justify) his labour and work effort. Think of it as payment for services rendered.

In this situation I definitely do not think he is entitled to a % share of profits as an equity partner.

Next time, you should have the experience and skills to source out and complete your own deals.

[wbranch]

I think that contracts regarding land must be in writing.

Not a lawyer, but my understanding is that it is real estate contracts for buying/selling or other related transactions must be in writing in the vast majority of cases. But OP's contract would be regarding a business investment/partnership, so a verbal contract would probably be enforceable. But OP has not really indicated what the agreement was to begin with. 

This thread should be stickied for anyone that is thinking about investing with a partner.

[affordablehousing]

Yeah this is just a "finder's fee" scenario. I'd decide to pay your friend a few thousand dollars for their "business plan" and call it a day. No reason to involve them further. If you'd like to you could always hire them hourly later for the subdivision work.

[genesismachine]

So if you sell the remaining parcel for $550, then if I understand the numbers right, your total profit will be $525k on an investment of $725k after 4 years.

Going back to 15-20% annual preferred return, that would actually take pretty much all of the profit. My guess is that you were better off investing all your money on rentals and you probably would've seen much better returns than that. The S&P 500 returned 40% during this timeframe as well. I think it's important to note that this investment actually was not a great investment of your money.

So let's be generous and say you only ask for 40% return for those 4 years as a preferred return on your 725k. So $290k in preferred returns. That means the remaining profit to divide up is $235k. And again, this is very generous to your friend.

You offered your friend $50k, or 21% of the actual money left. They had no potential for loss, and you at least theoretically could lose $725k. Your friend would not have shared in the losses. How guaranteed was this return when you started? Were you near-certain that it would work out? Why did this take so long to work out? 4 years is a very long time for real estate... Did something go wrong?

I would offer up no more than 50% of the remaining value (~117k), and that would be very very generous. It depends how much you value your friendship I suppose. Really, as others have said, you should've worked this out in the beginning in lots of detail, but hindsight is 20/20.

[theoverlook]

With dividends reinvested, VTI returned 58.04% between 7/1/2014 and 9/4/2018. (You didn't say when the deal started so I just chose the mid-point of 2014.) That means if you just left your $725,000 in VTI and expended zero effort and with much less risk and vastly higher liquidity you would have had $420,790 in gains, for a total of $1,145,790 on hand now. It seems like even if you do sell the extra land for $550k today with no additional costs or risks, you've only really made $104,210 in additional returns while assuming a very high level of risk with a very large amount of capital. To me, $50,000 is way more than his share. Ideas are a dime a dozen, $725,000 in available liquid assets to do a deal like this is very difficult to come by.

10% of profits, and to me actual profits are $104,210, is more than fair. That assumes you hadn't made any other prior verbal commitments. Have you?