Flipping real estate requires access to capital. Most investors fall into one of two categories: investor/deal sponsor or lender/gap funder. Regardless of which side of the coin you are on, it is important to understand the various options available when using financing.
The last thing you want to adopt is a “one-size-fits-all” mindset when it comes to structuring your deals. This type of planning will backfire when the joint ventures encounter rough water.
Often joint ventures focus primarily on the money and not enough on the details of the deal itself and its implications, both short- and possibly long-term. George, a real estate investor new to gap funding, paid dearly to learn this lesson.
George met Ian at a real estate investor conference in Texas. Ian represented that he was an investor with a remarkable rehab property under contract in North Carolina. Ian was in need of $80,000 in gap funding and $120,000 in rehab money. In exchange for $200,000, Ian was offering 10 percent interest plus 50 percent of the profits when the property sold. To memorialize the deal, Ian presented George with a “joint venture agreement” containing the following:
• Financial term—profit split between the ventures, plus interest on money contributed.
• Purpose of the joint venture—buy and rehab a property.
• Name and term for the joint venture—take seven months to complete.
• The funds would not be secured against the property because the primary lender will not consent to any other liens.
• It’s the investor’s duty to perform all of the rehab work.
• Some various other clauses regarding dissolution, liquidation, etc.
After some due diligence, George liked what he saw and told Ian he wanted in on the deal. After signing Ian’s joint venture agreement, George wired the money. Fourteen months later, George is served with a lawsuit by a person injured while working on the house, followed by a phone call from Ian informing George his projections were wrong and he is considering walking away from the project unless George comes up with another $75,000. George calls a local attorney, but he is unable to assist because the project and lawsuit are located in North Carolina and George lives in Texas. George’s investing comes to an immediate end.
George’s situation may appear to be extreme, but it is closer to reality than most gap funders realize. I often tell gap funders to never enter into a joint venture agreement in your name. (I often recommend investors avoid them altogether unless engaging an attorney to draft the agreement.) At the very least, use an entity to be a partner in the joint venture, so you have some protection from lawsuits.
Why do I bring up protection, you might ask? Well, it has to do with the fundamental nature of most joint venture agreements—they are lawsuit landmines waiting for unsuspecting gap funders like George to stumble across and end up with severe damage.
THE LANDMINES IN JOINT VENTURE AGREEMENTS
A joint venture is essentially a general partnership that is limited in scope and duration. If you are not familiar with a general partnership, it is an endeavor taken on by individuals with an agreement to share in the profits or losses of the endeavor. Both partners split the profits after the sale.
Profit sharing is the first problem in joint venture agreements—they are disguised general partnerships with joint and several liability, i.e., both partners are fully liable for any claims made against the endeavor regardless of control by either partner. In George’s situation, even though the project was managed by Ian, in another state, George was a partner and, thus, the injured party has a legitimate claim against George for his injuries—all of them.
The second problem with joint venture agreements is typically the agreement itself. Very few joint venture agreements plan for the real contingencies typical in many real estate transactions. Here are some examples of issues ignored in many real estate joint ventures:
• How is the sale price determined, and what is an acceptable reduction?
• What happens if the property does not sell?
• If the property is rented because it does not sell, how are rents divided?
• What happens if the investor does not perform?
• Limits on borrowing or expenditures?
• Is the agreement to be recorded?
• How is dispute resolution handled, and how are costs paid?
• What happens if there is more project left at the end of the money?
These are just a few of the areas typically ignored in joint venture agreements that quickly morph into a lawsuit because of violated expectations.
The third problem with joint ventures is the lack of security. In many cases, the gap funder is not provided security for the loan. Far too often, the hard/private money lender will not consent to a second on the property. Thus, the gap funder has no recourse if the deal goes bad because the gap funder is an unsecured creditor. In George’s situation, Ian was considering walking away from the project. If Ian pulled out, the property risked foreclosure by the primary lender. George could lose his entire amount because he did not receive a security in the project.
CREATING A JOINT VENTURE-GOOD, BETTER, BEST
When evaluating a joint venture, I like to break it down into three categories, with each structure becoming progressively better, moving from a position with some protection into the ultimate joint venture scenario where you have security, protection from the unexpected and some degree of control. However, one must keep in mind that you may not be able to attain the best structure because the investor is not willing to accept your proposal. Therefore, if you must resort to Good or Better, then at least you can minimize the kinds of risks faced by George.
‘GOOD’ JOINT VENTURE
George’s situation is fairly typical in the world of gap funding joint ventures. The investor presents the gap funder with a joint venture agreement he found online or was given at real estate workshop. These agreements, typically, are very rudimentary and offer little to no protection for the gap funder. That is understandable, given that many investors are unwilling to spend money on an attorney to draft an acceptable agreement. So long as nothing goes wrong with the deal (since everyone stands to make some money) why bother? Well, things do go wrong, and investing a few thousand dollars up front to save you tens of thousands later on is a sound decision. Think on this: Have you ever met an investor who told you, “I sure regret spending money on a well-drafted agreement that protected me when the deal fell apart”? I am sure you have met a few that told you the opposite. So how can you prepare yourself if you are stuck at Good? Make sure you do the following:
Enter into the joint venture as an entity, i.e., an LLC or corporation—never your personal name. This will provide you liability protection should something go wrong with the joint venture and a lawsuit is brought.
The entity you use for the joint venture should not own a lot of assets. Again, if something goes wrong, everything owned by your entity will be at risk.
Seek security. If the investor is unwilling or unable to provide you security in the property in exchange for your funding, then ask for a secured interest in his other assets, i.e., a personal residence or a rental property. If this is not available, then consider taking a lien against his ownership interest in the company he is using to develop the property. Many real estate investors are unaware you can lien a person’s ownership interest in their limited liability company or corporation. Thus, if the borrower defaults on the loan or does not perform, you can take over the company and, by extension, the property it owns.
‘BETTER’ JOINT VENTURE
If presented with a joint venture agreement wherein the investor is willing and able to provide you a secured interest in the property, then consider skipping the joint venture agreement altogether for just a promissory note but with a twist.
Most investors think of promissory notes as only involving interest, i.e., you loan money to a borrower in exchange for a specified rate of interest on the loan. Ideally, as a lender, you might want to charge 40 percent interest on your money and forego the profit interest you receive in a joint venture. The advantage to the lender is obvious; you begin making money on Day One regardless of the amount of profit ultimately recognized when the property is sold. From a borrower perspective, such a loan is too risky for the same reasons it is attractive to the lender. A better middle ground would be a participating loan, otherwise known as a shared appreciation mortgage.
A participating loan is a financing arrangement that is a cross between a joint venture agreement and a traditional note. In a participating loan arrangement, the promissory note provides the lender interest on the money loaned plus a percentage of the profits on the sale of the property. Unlike a typical joint venture arrangement, the only documents are a promissory note containing all of the terms and a deed of trust securing the loan. The gap funder is viewed as a lender and does not run the risk of liability exposure for mishaps associated with the property.
Now before you stop reading, thinking you just found the perfect solution to your joint venture arrangements, keep in mind this is only the Better scenario. There is still risk in this situation even though you have a secured interest in the property. Gap funder Larry learned this costly lesson when he relied solely on the Better strategy for his lending.
Larry was approached by an investor, Sam, offering 10 percent interest plus 50 percent of the profits on a rehab deal in California in exchange for $400,000 in gap/rehab money. Sam offered to secure Larry’s money against the property behind a $600,000 first deed of trust in favor of a private money lender. After crunching the numbers, Larry prepared a participating loan agreement memorializing the terms and recorded it against the property. Larry and Sam were set to make some money. Two months into the project, Sam calls Larry and informs him he needs an additional $500,000 to finish the rehab. Larry cannot believe this turn of events and asks to meet Sam at the project. To Larry’s astonishment, Sam bulldozed the house he was working on, thinking they could make even more money if they built anew. Larry refused Sam’s request and threatened to sue. Sam could not find other financing and abandoned the project. The first position lender foreclosed and took the property, wiping out Larry’s loan.
Larry lost $400,000 because he did not have any control over the project. The primary risk in using a participating loan is relying upon the investing experience of the investor. Larry should have asked for more security before loaning Sam $400,000. When using a participating loan, do or ask for the following:
• Secure the interest against the project.
• Receive a personal guarantee from the investor.
• Request additional collateral in other assets.
Do not make this your story. Request the investor to provide you a personal guarantee and outside collateral. One would assume a successful investor should have other assets.
THE ‘BEST’ STRATEGY
Up to this point, you may have noticed I refer to the lack of control as a recurring problem for investors entering into joint ventures. If this was not lost on you, then congratulate yourself for noticing the issue. I can appreciate control is not always desired nor is it offered by the investor. However, consider this: What if you could create an arrangement where you have ownership of the investment, control over major decisions and protections from an investor who goes off the rails and acts contrary to the best interest of the joint venture? Does this read like a joint venture you would feel comfortable investing in? Further, why not embody the expectations of the parties in a thorough agreement, so expectations are not violated and outcomes are somewhat predictable? If this is something you have been looking for, then my Best strategy is your answer—establish a special purpose limited liability company, “SPLLC.”
An SPLLC is a limited liability company established for the acquisition, rehab and sale of a specific property. The SPLLC agreement can provide for a split of profits and a preferred return for the money partner, i.e., interest on the contributed gap funds. I am positive George’s joint venture with Ian would have ended quite differently if they used an SPLLC in place of a standard joint venture agreement. First, George would not have been sued because an SPLLC offers liability protection for its members. Second, if the project was running over budget or missing deadlines, the SPLLC could have given George the ability to take over the project before costs spiraled of control. A well-drafted SPLLC should address the following:
• Profit split on the sale of the property.
• Timing of profit distributions to ensure all partners are paid once the property sells.
• How the sale price is determined and what happens if a price reduction is warranted.
• What happens if the property does not sell within a set period.
• Will the property be rented and, if so, for how long?
• Refinancing considerations.
• If and how much the investor should receive for managing the project.
• Prevent either party from profiting with side deals.
• How to remove the investor for nonperformance.
• Matters that require unanimous consent of both partners.
The advantages to using an SPLLC are numerous, and this is why I refer to it as the Best strategy. The key to a successful joint venture is an arrangement where expectations are met and not violated.
Many investors have lost a lot of money in bad joint ventures and the resulting legal fees incurred in trying to unwind the agreement. Spend some time and money before you begin a joint venture, and you will be rewarded in the end.