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Partnerships – Equity Vs Debt And Active Vs Passive
Almost all of us invest in real estate with partners. Even your wife and mother-in-law who has a stake in it is a partner. While maybe some parties did not contribute the funds initially to purchase a house, they can still have a legitimate stake in it as they have contributed significantly to maintaining and upkeeping it.
But let us put aside family or friendly partnerships where the only reason they are in it together is because of family. That can be discussed on another day. This write up is about property investment partnerships you enter into where all parties involved have a financial interest in the success of the project. To boil it down there are only 4 categories of partners you can get involved with. And these 4 categories can be further segmented into 2 – financing and operating.
One is either an equity or debt partner. While also being an active or passive partner.
An equity partner is one who wants a share of the profits gained from the investment. If a partner pumps 40% of the funds needed for the investment, he would probably expect a 40% portion of the profits generated. This is much more attractive than just giving out a loan at an interest rate that cannot keep up with inflation. An equity partner however, also take up the risk of losing everything if the project fails.
When you run into big opportunities, corporations may get involved when you seek investors. If the partnership structure is complex, you should seek legal advice. There are many ways these partnerships can be structured. There are also legal parameter that differ from state to state on legalities. So it is best you check up yourself on what laws are applicable to you. It could be a joint venture, a private placement, a new incorporation with partial corporate ownership, etc.
A debt partner is one who lends you the funds to go ahead with the investment. He will charge you an interest rate on the cash you have borrowed. So any lender whose sole business with you is interest on cash is a debt partner. Even if the venture fails, you have to honour the agreement which you are liable for.
They will usually insist on placing a lien on the property in question while using it as a collateral. And at the very top of the creditor food chain. The most common debt partners are lenders like banks, and private money lenders. However, it is not uncommon to get debt partners from companies or even your family members. Corporate lending between related entities are a common place especially among huge conglomerate organizations.
Raising funds for a deal can consist of all these parties. Example below for a $1m investment.
$200,000 – Down payment from your own pocket
$500,000 – Mortgage
$100,000 – Loan from your mother
$200,000 – Equity partner
If your plan is to build a real estate empire, you will run out of your own money sooner or later. And when that happens, you have to kowtow to potential investors who have the means to make your goals a reality. When that happens, expect to share a huge chunk of your profits with equity partners. The comforting part is that by that time, deals are probably big enough to make your tiny profit share worth big bucks.
An active partner will be one who is involved in the operations of the investment. He could be part of your sourcing team, creative team, marketing team, whatever. The important point that makes him an active partner is that he is contributing an active role towards the investment being a success.
When just starting out with real estate, you could be very excited to get involved in everything like a new born exploring the world. You want to see what is going on and learn the skills of the trade. But once you know the ins and outs of this business, you would probably find the activities of investing becoming too routine and mundane.
So when a partner wants to be an active player, it is either one of 3 things. He is a newbie who wants to learn the trade, a veteran who has no confidence that you can see through with the project, or his expertise in certain areas are paramount to the success of the project. If a big equity partner insist on getting involved in operations, you might have no option but to agree. Should that happen, draw up clear boundaries on what areas each of you are in charge of. This is to avoid stepping on each other’s toes.
A passive partner is usually just someone who is funding your project fully or partially but plays no role in the running of operations. All you have to do to keep them off your back is send them regular statements on how the project is performing and drop the cheques in the mail.
Most investors prefer passive sleeping partners so that they themselves have room to maneuver without having to explain themselves or seek approval on operating activities. But to attain this level of freedom from investors, you must demonstrate yourself as someone who is capable of running the show. A track record would be helpful but not necessary. If a passive partner has huge experience and connections that will aid the success of the project, do yourself a favour and try to convince them to contribute.