Private money lenders offer their borrowers incredible leverage. For you as a borrower, leverage means using the other party’s funds to pay for as many expenses of buying and rehabbing a home as possible. Still, all private lenders want their borrowers to invest at least some of their own money. That helps them manage their risk by ensuring that their borrower is financially vested in the transaction. For real estate investors, the most prevalent reason to create a real estate investment partnership is to pull together enough funds to satisfy their lender’s contribution requirement. However, many of them define their partnership in loose terms without realizing the pros and cons of each scenario.
A great element of working with private money lenders is that, unlike conventional lenders, they don’t have strict sourcing and seasoning requirements. Your contribution may come from different sources including formal and informal real estate investment partnership arrangements. Let’s talk about different types of such arrangements and discuss their risk and benefits, and how to manage them to your advantage.
Borrowing money from your family
Some first-time rehabbers are lucky to get their start with the help of their family. This is probably the loosest arrangement you can have. You may call your grandma “a partner,” but let’s face it: she is a generous benefactor and is taking the risk of lending your money because of her devotion to your cause. If you are a recipient of such generosity, I hope that your transaction is a success and you repay her promptly, since she would have few mechanisms to collect from you. All benefits of such transaction are in your court, and all the risk is with the Grandma. Don’t forget to call and thank her often.
Using a silent partner
Many borrowers mention a partner who will remain silent and mysterious throughout the transaction. It’s often someone (a family member or a friend) willing to contribute the funds in exchange for the predetermined interest on these funds. It’s a more formal arrangement than borrowing from a grandma and usually involves signing a promissory note.
Wikipedia defines a promissory note as a legal instrument, in which one party promises in writing to pay a determinate sum of money to the other. The terms of a note usually include the principal amount, the interest rate, the parties, the date, the terms of repayment and the maturity date. A promissory note is a legal document that protects the interests of your creditors by documenting your arrangement. It also provides them with a legal path to collect on their debt if you default. Here is a good example of a promissory note.
Though you might want to refer to this person as “your partner,” legally they are not. They are your lender or your creditor who is letting you borrow specified amount of money, for the specified amount of time in a form of unsecured debt. This debt will have to be repaid regardless whether your make money on your transaction or not.
Formal real estate investment partnership
A partnership is commonly defined as a formal arrangement by two or more parties to manage and operate a business and share its profits. There are many types of partnership arrangements. In some, partners make equal financial contributions and put equal effort into managing the process of buying, rehabbing, and selling investment property. It’s also common to have one partner who contributes the majority of funds and another partner who is more active in day-to-date management. In other words, the second partner provides labor and expertise.
The key difference between borrowing funds and creating a real estate investment partnership is that in a partnership you split profits in a predetermined way. If your fix-and-flip results in a profit of $60K and there are two partners, each partner will receive $30K each.
To make you partnership official you need to create an LLC that names each partner as its member. You will also need a robust operating agreement that lists the percentage of ownership for each partner and delves into the details of that LLC is operating. For example, you need to specify how the decisions are made, who can borrow money on behalf of the LLC, how to split the profits, and how to dissolve it.
While many first-time real estate investors choose to form a partnership with a friend and or a trusted associate, things get complicated fast as soon as more partners are added. First, each added partner is going to “eat up” a significant part of your profit. Perhaps most importantly, businesses with more than two partners are notoriously difficult to manage. If one partner is slacking off, does she or he still deserves a share of a profit? According to the operating agreement, they still do, though it might create resentment on behalf of more hard-working partners. How do you sell the property or borrow funds if one of the partners is unavailable? These are the examples that you need to think about in advance.
Joint ventures can be loosely defined as a partnership not between individuals but between the businesses. You don’t necessarily need to form another business entity to operate a joint venture. However, what you do need is a robust agreement that describes the responsibility of each company that enters the joint venture as well as how to split the profits.
In the context of private money lending, the joint ventures are most often brought up by borrowers with insufficient funds to contribute to the transaction. They are looking for creative ways to make money in real estate without contributing their own capital. Private lenders like us are rarely interested in such arrangements. Our main business is lending and we are not set up to manage the daily intricacies of the construction process.
Creating a real estate investment partnership is a good way to start a rehab business. Joining your capital with the partner’s capital and sharing resources throughout the renovation process can give you a tremendous boost and should be considered when you develop your real estate investing business plan. Still, the majority of more experienced rehabbers sooner or later strike on their own to gain more control over the transaction and, ultimately, maximize their profit.