We all start real estate investing with some amount of money to invest – your ‘War Chest’. For some, this may be a little or for some, a little more. Eventually, most of us will come to the end of that initial capital and start to look around for other sources of funding.
A natural next step would be for you to be the ‘real estate expert’ in a relationship with others that bring in investment capital; the ‘money partner(s)’. This is called a Joint Venture (J/V). The best J/V’s are those where each group brings something different to the team, so a relationship like that can be very rewarding.
However, there are potential pitfalls when you start to deal with others. I am sure we all remember group projects in high school where one person did all of the work, one person thought they were the boss & barked orders while the other two just sat around and talked.
In real estate investing you need to keep the group as small as feasibly possible where each person has a different role. In general, you need a money person and a ‘doer’. Too many doers and you run into control issues. Too many money people with no doers and nothing gets done. Even in a well balanced J/V you still have to be clear about who is making the decisions.
For that reason I would definitely recommend that you have a J/V agreement that clearly spells out who is doing what, who is making the decisions, what the objective of the project is, what each persons percentage return will be and the rules if somebody wants to get out early. Talk about and decide these issues early in the project to avoid fights later on. Each person should have their own legal representative. Don’t be cheap and try to for go this step.
You also want to clearly lay out what each person’s expectations of the project are and make sure that they are realistic. You also want to be clear that things can and do go wrong and that the end result might not be exactly as anticipated. In the beginning of every project all parties are excited and dreaming of making a killing. Rising construction costs (both in and out of your control), time delays caused by slow moving bureaucracies / permit processing, changes in scope (what you originally planned to create vs what you decided to do mid way through), and downturns in the economy can greatly affect your projected profit.
I personally entered into a couple of J/V’s in 2014 when the local market was hot. We purchased a number of apartment buildings with issues with the goal of
a) buying at a low initial price,
b) fixing the outstanding issues (both management issues and the quality of the buildings),
c) get the empty suites filled with higher paying, higher quality tenants after the renos were done,
d) refinance the buildings to reflect the higher appraised value that these changes would bring, and
e) use the gains from the refi to repay back the initial higher interest lender AND my J/V money partners.
The end goal was to own the buildings for ‘free’ where we had a new, low rate mortgage with none of our money invested. I have done this many times over the past 15 years so the concept itself was not a bad one. You just have to be careful with timing.
Two years of a slumping local economy brought on by low oil prices caused vacancy rates to skyrocket while rental rates dropped. As a result, after all the repairs where made the appraised values of the buildings were basically the same as what we bought them for. We were able to barely pay off the higher interest original lenders (a lot of the buildings that I buy are in such bad shape that I cannot get a mortgage from a conventional bank until after I am done fixing them up) but not get any of my partners their cash back.
Try making those phone calls when early expectations were for a home run – own the properties AND get your money back. Plus there were unexpected cash calls during the renovation stage of the projects. Now the investments are still good as I remain confident that, eventually, over time, vacancy rates will go down, rents will rise and with them, the appraised value of the properties. In reality they are normal real estate investments – where you buy a building already full without any major problems. The difference is, in hind sight, why go to all that effort to fix up the building and deal with bad tenants just to end up in a place where I could have been had I bought another, already normalized, building. Oh well.
Speaking of higher interest lenders, some of them can be real interesting to deal with. Never be scared to walk away from a deal, no matter how good it looks, if they get too crazy with their terms. Case in point. I was buying an apartment building in pretty bad shape back in 2012. It had a ton of potential and I was excited about it. While it was in bad shape physically it was full of tenants. The goal was to use my line of credit to fund the physical repairs as tenants moved out then get back in better tenants at higher rents suite by renovated suite.
I met with a higher interest lender who was interested, the interest rate and terms weren’t horrible so we went ahead with the due diligence. The day before I was supposed to waive the financing condition he called me and told me he would only do the deal if he could ‘freeze’ my line of credit. His reasoning was that, if things went bad I could continue to service his debt with the money left in the line of credit. At the eleventh hour I had nobody else to turn to as there wasn’t enough time for anybody else to do their diligence on the property.
The problem with that was that it left me with no money to finance the renovations that needed to be done. As you can guess I was extremely pissed but I liked the deal so much that I went ahead with it. I had to self fund the renovations from the meager profits of the building so the repairs took wwaaayyy longer than expected.
If the same thing happened today I would say no and if that cratered the deal so be it. Having your hands tied like that is not a good idea.
In that same line of thinking never agree to a J/V partner that wants equity AND interest on their money. Even if the original projections show that you can support both an equity payment and interest at the end of the investment period, say no to that as well. A dip in the economy or any other delay or increased costs can result in little or no profit on the equity side while you still owe the partner money on the debt portion.
I have owned many properties and have done very well with real estate investing but sometimes I wonder how, given some of the stupid things I have done over the years. Just keep in mind that not everything is roses and peppermints when you bring in other people and their money. J/V’s can be a great way to purchase more properties and get to the next level. They can also lead to hurt feelings, lost money and lawsuits. Just go in with your eyes open.
And we haven’t even touched on the fact that some J/V partners can be real a__holes to deal with. Tread carefully.
Read more about this topic in Cash Management in Real Estate Investing.