This is Real Estate Rookie episode 318.
We all love seller financing, makes things way easier most of the time than going to a bank and doing conventional financing.
Say, the house is worth $300,000. Say I agree to buy her property and it’s a $2,000 a month payment. Now, she’s only paying taxes on $24,000 a year versus the $300,000 per year, that she get if she sold the property.
My name is Ashley Kehr and I’m here with my co-host, Tony J. Robinson,
And welcome to the Real Estate Rookie Podcast where every week, twice a week, we give you the inspiration, motivation, and stories you need to hear to kickstart your investing journey.
And today we are back with another Rookie Reply, as always, we’re happy to answer questions from the rookie audience. And if you want to get your question featured on the show, head over to biggerpockets.com/reply and we just might choose your question for an episode.
So Ash, I guess really quick, give me an update. What’s going on in Ashley Kehr’s world today?
Well, for the first time ever, one of my real estate friends that I have met across the country, I’ve met a lot of real estate people. Someone is coming to visit me in Buffalo, New York.
Going all the way to Canada to come hang out with Ashley for a couple of days, had to get his passport.
Yeah. Literally only for two days, but I’ll take it. So yeah, I’m super excited about that. He’s coming in this week and I’m going to show him some of my properties and hopefully do some fun stuff. And you just had your baby shower?
We did. We had the baby shower. So Sarah’s due here just in a few short weeks now. I think we’re about seven weeks away, so time is ticking. So we had a house full of gifts the day after the baby shower, so we’re starting to build stuff and we got to get the nursery repainted, so-
You got to build an addition on just to fit all your stuff.
Yeah. Just to fit all the stuff. And then my son actually started his sophomore year of high school today also, so just lots of stuff going on in the Robinson household this week when it comes to the kiddos, but exciting times. We’re happy for it.
Well, on this week’s Rookie Reply, we have five great questions. We’re going to go through, a couple of them even pertain to partnerships. So if you guys haven’t already check out our new book Real Estate Partnerships, you can go to biggerpockets.com/partnerships and you guys can even get a discount if you use the code, Tony or Ashley.
Okay. So one of the questions that we talk about is seller financing. So if you’ve been wondering how to structure seller financing, what are some of the pros and cons, and what you should do as far as approaching a seller about seller financing? We kind of do a little mini breakdown of the tax advantages for a seller and also how to present the seller financing to the seller too.
Yeah. We also talk a little bit about closing costs. What are typical closing costs in a real estate transaction? Who pays for what between the buyer and the seller? And we also talk about like, “Hey, just if I want to invest in real estate, what is kind of my roadmap of steps? What should I do first? What should I do second?” And we break that down. So overall, lots of good questions. Excited to get into those.
Before we jump over to the questions though, I would love to get a shout-out to someone that’d love to say 5-star review on Apple podcast. This person goes by the name of ScottyDude2314. But Scotty says, “Every time I run into a situation, I come back here, look for the episode that relates to that situation listed, take notes and execute. Thanks so much for y’all’s help. Closing on my first 12 plex this month.” And he says, “Constantly coming back for more knowledge.”
So ScottyDude appreciates you and kudos to you on getting that first 12-unit under contract. And just last piece, so Scotty makes an incredibly important point. We have hundreds of episodes of the Rookie podcast and I can almost guarantee that most situations you might find yourself in, has probably been solved and thoroughly discussed on some episode of the Rookie podcast.
So if you ever find yourself stuck, you’ve obviously got the BiggerPockets forms, the Facebook groups, but don’t sleep on the 317 episodes that came before this one, that have tons of information about your real estate journey. So be sure to check them out, use them as a resource and share it with someone that might benefit from it as well.
Okay. So today we have an Instagram shout-out to Artina Marie. So Artina, A-R-T-I-N-A, Marie, M-A-R-I-E. You can follow her on Instagram at her name, and she is a serial entrepreneur obsessed with passive income and sharing her real estate journey. So go and give her a follow and check out her Instagram and follow along her journey.
Okay, today’s question is asked by Nicole Marie. Remember, if you would like to submit a Rookie Reply question, you can go to biggerpockets.com/reply.
So Nicole’s question is, “What is the first step? My credit score is good. I have about $40,000 to put down. I want to BRRRR a rental property, but I’m stuck trying to figure out if I look for properties, meet with the real estate agent or get financing first. But then it’s like how do you get financing without a property to give them numbers for? I also can’t HELOC, do a home equity line of credit or live in it for FHA. So that limits me to conventional or some type of financing that allows the rehab budget in the loan. I’ve been reading a lot and I’m just confused how you start and take the first step.”
Okay, so the first thing, awesome, you have a great credit score and that you have some cash $40,000 to put down. That definitely opens up the doors for you to have available. And then you want to do BRRRR, a rental property. So remember BRRRR is buy, rehab, rent, refinance it, and repeat.
So the question is, “Do I start looking for properties, meet with a real estate agent or get the financing lined up first?” These are actually two things you can do simultaneously. If you do have your financing and your funding lined up, when you find a property and you’re ready to make an offer, it definitely makes it a lot smoother, easier process because especially if you’re in a hot market and you put in an offer, you’re going to have to put in your proof of funds or your proof of financing. How you are going to fund the purchase of this property, and sometimes those offers have to go in quick and being able to go through the pre-approval process may not be quick enough to actually get that for your offer letter.
So Tony, let’s kind of break down as far as her options for doing a loan. So she can’t live in it and get FHA, or she had mentioned a home equity line of credit, but you have to actually already own the property and to be able to get the line of credit on the property, you can’t get a line of credit to use it to purchase, unless that line of credit is on another property.
So in her current primary residence, if she was able to go and get a HELOC, she could take that money to go and purchase the property. But she’s going to say she can’t do that and she can’t get an FHA loan, so conventional or some other type of financing, but she wants to do the rehab budget in the loan.
Yeah. I mean there’s tons of options out there. I mean, we’ve used a lot of private money to fund our rehabs. Ash, I know you’ve used similar and hard money, so those are always good options, Nicole as well in terms of how to make that piece work.
But Ash you mind if I just want to even take it one step back a little bit and just kind of give for all of our Rookies the framework of just in general, what are those sequence of steps look like? Because obviously we give a lot of content on the podcast and there’s tons of information on YouTube and social, but sometimes it’s hard to sequence those different pieces of content correctly. So you know what to do first and what to do next.
So when I think about a brand new investor, someone that hasn’t done anything yet, but they’re in that kind of early education phase. I think the first thing that you need to do is identify your investing strategy. Now Nicole, you’ve already seems like decided on that, that you want to borrow properties, that’s a good first step. But for everyone that’s listening, the first step is, “Do I want to do long-term buy and hold? Do I want to do short-term rentals? Do I want to flip? Do I want to wholesale? Do I want to do large syndications? Do I want to do self-storage?” Decide on your type of investing in your asset class first.
Once you’ve got that piece nailed down, the second step in my mind is to identify what your purchasing power is. So again, Nicole, you’ve kind of alluded to this a little bit already, but generally speaking, your purchasing power is made up of two things.
It’s the capital that you have available or at least access to invest, and then it’s what kind of loan product can you get approved for. So when you combine how much capital you have to put into an investment with the amount of debt you can get, that lets you know what type of property you can afford buying.
I think a mistake Ash, I see a lot of new investors make is they get all enamored with this certain type of investing strategy with a certain market. Then comes to find out they can only afford a fraction of what it costs to invest with that strategy in that market.
So I think identifying what your purchasing power is first before you do anything, can save you some wasted time because then, say that you look at your purchasing power and you’ve got half a million dollars in the bank and you’ve got the ability to get approved for a $5 million loan, that gives you a lot of options. On the flip side, if you’ve got $40,000 to invest and you can get approved for a $250,000 loan, okay, that’s going to dictate what kind of markets you can look at while you’re looking to invest.
So Nicole, you’ve already kind of taken that first step of identifying the 40K, but yes, I would 100% say understand the financing piece, so you don’t waste your time looking at properties as you can’t necessarily get approved for.
Once you’ve gotten your purchasing power, the third step is market selection. And I don’t think that Nicole in this post here, in this question, specifically talked about which market she’s looking to invest into, but I think that’s an incredibly important piece is the market selection to really be able to get good at finding deals in that specific market.
Because another mistake that we see a lot of investors make, Ash, is that when they first get started, they kind of have the shotgun approach where they’re just looking any and everywhere for properties. When ideally you want to be able to narrow it down to a small of, I guess a radius as you can. So your market selection, and then you can go into the deal flow and the due diligence piece.
But I just wanted to give that overview. I mean Ash, I don’t know, is that in line with kind of what you typically feel makes sense for Rookies also?
Yeah, definitely. I think we can kind of go into as to how she’s going to fund the rehab now. That was the next part of the question and looking for different ways and going through a bank to actually fund the rehab. So Tony, you did do this correct on one of your Louisiana houses?
Yeah. So my first two or three long-term rentals out in Louisiana, we had a bank, it was a local credit union that funded both the purchase and the rehab of those properties. Now, there were stipulations or I guess boxes we had to check to be able to get approved for that kind of mortgage. Specifically the purchase price in the rehab had to be no more than like 72% of the after repair value, but I was able to get funding for both the purchase and the rehab.
So Nicole, there are banks out there that will give you that type of loan product. I think it’s just a matter of picking up the phone and calling as many small and local banks and credit unions in your chosen market to see which ones have an option that might be able to work for you.
So one thing that I was thinking of when I saw that there was $40,000 to put available in this, would obviously depend on the market that you’re into as far as how much would $40,000 get you, but you could use some of that money for the down payment. So that means you are going to be able to afford less property since you now have a smaller down payment and then use maybe the other half or a portion of that 40,000 to fund the rehab.
With the rehab, you can also structure it with your contractors or if you’re doing the work yourself, that you will cover materials yourself that you will purchase them, instead of having the contractor go and purchase and then bill you for the materials. And one of the advantages of doing that, is that you’re able to get 0% interest rate credit card.
So this is usually over a period of time, you have to be super diligent about credit card usage and maybe not have a history of collecting debt on your credit cards, but in this scenario you want to be able to go and get a credit card. We did this recently for a property and we did a credit card that was 12 months 0% interest. Over those 12 months, if you made the minimum payment on time for the 12 months, they actually extended it to a 0% for 18 months. We didn’t end up needing the 18 months anyways because the project had completed, we paid it off.
But having a long time just in case something does go wrong with your project, you’re not racking up this debt of material costs and then all of a sudden you have a 22% interest rate, that you’re paying on the credit cards. But going through and putting those on and then you would go and refinance the property and then pay off the credit cards would be that last step to get rid of it.
But it can be a huge advantage that you are getting your materials paid for at 0% and not borrowing any money from anyone. And that can be a huge chunk of your actual construction costs, your rehab costs, and then you would just have to come up with the cash to pay your contractors unless some of them do take credit card.
We do work with some vendors, like plumbing companies and stuff that they do actually. They’ll send an invoice to email, which is through QuickBooks and they actually have an option to pay by credit card too if we wanted to. So it really depends on the contractor and vendors you’re using, but that is definitely a tool you can use, is the 0% credit cards to cover a portion of that rehab cost too.
Yeah. I think the other option is to, if you did want to bring someone else into the fold, like Nicole, let’s say that you have someone in your life that maybe has whatever, say your rehab budget is 50,000 bucks. Someone in your life that has $50,000 that’s just sitting in the bank account earning whatever single digit percentage, and you say that to this person, “Hey John Doe, I’m going to give you 12% annualized returns if you let me use this money.” Then you go out, you fund your rehab with that person’s capital and then at the end of the deal you refinance and you pay that person off.
So similar to the credit cards, but the benefit I think of the private money is that it is a little bit easier to use in all situations. So like most vendors, if you’ve got cash from your private money lender, then you’re going to be able to pay that person.
So again, we’ve used private money pretty extensively, actually exclusively for all of our rehab projects and it’s worked out I think well for both parties.
Okay. So our next question is from Rob Malloy. Okay, so Rob’s question is “I just read Ashley Kehr’s article on finding a partner and I had a couple questions about method number one. Ashley got a partner to purchase the duplex in cash. They split the cashflow 50/50 and she pays them five and a half percent interest over 15 year for the purchase price without bio option at any time. Why go this way? Is this more beneficial than financing through a bank to begin with? Reason I ask is that I’m looking at a duplex, both sides already rented and the numbers seem to work if I go with 15% down and I just manage the property myself, what would you do? Does partner make sense? Thanks for taking the time.”
Okay, so this scenario that Rob is talking about, is my first ever partnership with Evan and I had the limited belief at this point in time that you could not go to a bank to purchase an investment property. I just thought that you could only pay cash because the investor that I worked for, that’s what he did. So I didn’t even know there was an option to go to the bank. I would not do this scenario again.
Now, Tony and I have been talking about this a lot lately as to the value of having experience and knowledge and other types of sweat equity, that brings so much value to the table rather than just the money. And I didn’t value myself enough at this point where I gave 50/50 partnership. So they got 50% of the cashflow, we eventually sold the property so they got 50% of the profit of that property and then they got five and a half percent interest plus all their money back that they had invested into the purchase price. So sweet deal for my partner on that. The thing with this is that it got me started.
So this is an option for you and this is maybe your only option, then yes, if that gets you into a deal because me making that 50% of the cashflow was better than me making no money off of this property at all.
So in Rob’s situation, he’s saying he’s able to put 15% down and manage the property himself. So he must have found a bank that would allow him to do 15% down. As far as managing the property yourself, if you’re going to do that, make sure when you run the numbers, you’re still adding in for a property management company.
So research your areas, find out how much it would cost for a property manager in your area so that later on if you do decide you have the option to be able to go and hire a property management company and it’s not going to kill your cashflow.
I think the only thing I’d add there, Ash, is that for Rob and for everyone that’s listening. Anytime you enter into a partnership, there should be a reason why. Ash and I talk about in the partnership book about your missing puzzle piece, so ideally you should be entering into a partnership because you’re partnering with someone that has a complimentary skillset ability resource to yourself. But if you have everything you need to do this first deal, then maybe it doesn’t make sense for you to partner.
So Rob, if you are in a position where you’ve already got the financing lined up, you’ve got the capital available, then maybe giving up 50% of your deal doesn’t make sense. So I think every person should be assessing their own unique kind of personal situation, trying to understand where you feel that you have maybe a shortcoming or where you’re lacking or whether it’s experience, money, time, whatever it is, and that’s when you want to partner. But if you can check all those boxes for a deal, then it might make sense to move forward by yourself.
Next question is from Brett Miller, “How common is it as a buyer purchasing a cash only property is expected to pay closing cost? Isn’t the seller supposed to pay closing or is that traditional financing typically?”
So this is a great question, because it really can go either way. Before we even talk about that, let’s break down what some of the closing costs even are when doing a property.
Yeah, you read my mind. I was actually about to pull up my last closing disclosure here to look through what those closing costs were. So there typically are just like as an aside, there typically are more closing costs when you have financing, because lenders are going to require more paperwork and there’s more things that they need and they got to get paid.
So a lot of times there is more, but I’m just going to read through here and see what some of my closing costs were on this last flip that we recently sold. So I had taxes. So there are taxes that were due that I had to pay. Me as a seller, I had to pay those. There was my payoff to my private money lenders. I had mortgage security documents recorded with the county. So before I could get paid, I had to make sure that my private money lenders were paid back, their principal plus their interest.
I had my real estate commissions. Typically, a seller will cover the commissions for both the seller’s agent, so for their own agent and for the buyer’s agent. So for this flip that I sold, that’s what it was. Mine was a total of 5% in commission. So two and a half percent went to my agent. The other two and a half percent went to the buyer’s agent.
There’s a bunch of title cost. I probably spent, I don’t know, somewhere around 3000 bucks, maybe a little bit more on everything related to title and escrow. There’s some county taxes just for paperwork and things like that. Some additional kind of inspections for septic and natural hazard disclosures and things like that. That was actually everything that was on this closing disclosure.
So some of those things are going to be present no matter if you’re going with financing or if you’re going with cash. But we actually also gave the buyer a small credit because they had things on their end like an appraisal they still have to pay for. There are points they might have to pay to their lender to close this deal.
So sometimes as a seller you might also give credits to the buyer, which is what we did in this situation as well. But I feel like that’s a decent idea of what you could expect to see for closing costs on a property transaction like that.
Yeah, one thing too, depending on what state you’re in, you may have to pay attorney fees too at closing. So New York State, you have to use an attorney to close on a property and usually it’s the seller’s paying their own attorney and the buyer is paying their own attorney too. And sometimes that would just be added into the closing cost or your attorney can actually bill you separately, but that’s still going to cost you and that’s still money you need to have to come up with the closing costs too.
So I guess to answer the question in a nutshell for Rhett, because again, he’s saying, “How common is it as a buyer to place some closing costs?” So the answer is yes. There’s still probably some closing costs you’ll incur. Definitely not as many as if you have a mortgage or a lender that’s kind of facilitating that transaction.
But you can also negotiate with the seller to say, “Hey, Mr. and Mrs. seller, I’m super interested in your property, but my one condition is that you cover all of my closing costs.” And depending on where we’re at in the market cycle, they might say yes. And like I said, the last flip that we sold, we covered all of that buyer’s closing costs because it still makes sense for us to sell the property that way. So don’t be afraid to ask Brett, I think to have those costs covered. And the worst I can say is no.
Okay, we have a seller finance question next, and this is by Bill Rogers. “So once you have a house under contract, how long until you are able to refinance? I know you don’t want to do it right away, especially with these rates, but isn’t that one of the ways you actually get sellers to do seller financing is for tax mitigation reasons? Is this something that would have to be written in the terms of the contract?”
Hey, so seller financing, we all love seller financing, makes things way easier most of the time than going to a bank and doing conventional financing. But the first question here is, how long until you are able to refinance? So in Bill’s situation, we’re going to assume he’s going and doing seller financing and then going to refinance out of the seller financing.
So you can set it up however you and the seller agree, but you want to make sure that you have enough time that it’s not too short of a time. So some banks require a seasoning purchase from when you purchase the property a seasoning period. So it can be six to 12 months from the date of purchase. So you don’t want to make your seller financing due, you are only doing it over the course of three or four months.
You want to make sure that you have enough time to go and do the refinance on the property, but really you could set it up for… Pace Morby, we’ve had him on the show, he talks a lot about seller financing and he’s done 40-year terms where he doesn’t, he’s paying the person for the next 40 years on the property and there is no rhyme or reason for him to go and refinance. It’s really all about how you set it up.
Maybe if you do get a great great interest rate with them or you have great terms where your payment is low enough that it works for the property. When you structure the seller finance deal, you want to create an amortization schedule. So the amortization schedule is going to show you the full amount you’re borrowing, the monthly payments, how much of that monthly payment is principal, how much of that monthly payment is interest, and then what the balance would be due if you were to pay it off.
So this is one way you can kind of negotiate with the seller too is like, “Hey, look, over the course of one year, I’m going to be paying you an extra $10,000 in interest that you wouldn’t get if I went to a bank.” So Bill had mentioned the tax mitigation reason, the tax advantage of doing seller financing for a seller, but there’s also ways that the seller actually makes more money because they can make the interest off of you too.
So he said something in here about how he doesn’t know if he would go right away, especially with these rates. So if you can get a great rate and great terms from the seller, there is no reason to go and refinance, but you want to make sure in your contract that you have that.
So what I do in several of the times that I have done seller financing is I will do instead of a balloon payment. So a balloon payment is saying that you’re going to do seller financing for 12 months and then the balance that is locked after you’ve made payments for 12 months is due in a balloon payment, paying that whole chunk. So that’s where you typically go and refinance with the bank.
What I have done is I try to push it out as long as possible, but I will do a loan callable date. So this would be in three years, the seller has the option to call the loan instead of a mandatory balloon payment. This is where the seller can say, “You know what? No, keep making payments. I’m not going to call the loan.” But anytime after that year three, they can call it, but they have to give me eight months written notice to be able to call the loan. And then I would have eight months to be, “Okay, I need to figure out how I’m going to go and refinance this and pay this off.” But eight months will give me plenty of time to do that.
So when you are writing up your contract with the seller, make sure you are putting in these kind of different exit strategies or things that work for you and the seller. And that’s where I really like to get face-to-face for seller financing, sit down and go through everything.
I will send a seller the contract and the amortization schedule. And as much information as I can, the night before I’m meeting with them to give them some time to review it, and then I will sit down with them the next day and walk through the whole thing, so that way I can pick their brain as much as possible as to, “Okay, you don’t agree to this, let’s figure out what we can change, what we can do.” And I try to get down to figure out what’s their real motivation, what do they really want, and then just try to negotiate and adjust the contract right then and there to make it work. So that’s the amazing thing with seller financing is you can set it up so many different ways.
One thing I would really try to avoid is prepayment penalties. And a lot of commercial lenders will do this for banks where they’ll say, “Okay, we’re doing this loan, but if you pay this loan off within the next five years, you’re going to owe us 2% of whatever the balance is as a fee for paying this loan off early, because we’re banking on making this money off the interest.
So if you can avoid that with sellers, then you can go and refinance at any time. And that keeps your options open, especially if you decide you want to go refinance because you want to tap into more equity to pull that out of the property. Or maybe rates do go a lot lower than what you’re paying in seller refinancing, so you can go ahead and refinance to the better rate too.
Yeah. What a world-class breakdown Ash, on seller financing. I think the only part of the question that’s probably still lingering there, and I just want to clarify a little bit, is the tax mitigation piece.
So to explain what Bill’s talking about here. Again, he says, “Isn’t that one of the ways you actually get sellers to do seller financing as for tax mitigation reasons?” What he’s referring to here is that when, say that I’ll use Ashley myself as an example.
Say that Ashley owns a property and whatever, say she owns it free and clear and say, the house is worth $300,000. If Ashley goes out and sells that property, she’ll have a taxable event on the net proceeds of that sale, right? So again, say, whatever, say she makes $300,000 if she were to sell that property in full.
What some folks, now obviously there are some ways to get around that you could do like a 1031 exchange or something to that effect. But say she wanted to avoid that big taxable event for selling that property, yet she still wanted to tap into that equity. The reason that seller financing becomes attractive to folks in Ashley’s situation is because say I come to her and say, “Ashley, look, if you sell this property to John Doe, you’re going to have $300,000 taxable event that you have to worry about. If you sell or finance it to me, the only money that’ll be taxable is the payments that I’m making to you on a monthly basis.”
So instead of say, I agree to buy her property and it’s a $2,000 a month payment. Now she’s only paying taxes on $24,000 a year versus the $300,000 per year that she get if she sold the property. So for some people there is a tax incentive to not cash out on day one and instead take those payments over time. Now, I’m not a CPA, forgive me if I explain some of that incorrectly, but at least it gives you an idea. There’s a tax benefit to deferring that big lump sum payment and instead taking it in small chunks.
Yeah. And there’s also some great books on tax strategies for specifically real estate investors. If you go to the BiggerPockets bookstore, Amanda Hahn has written two really great books for BiggerPockets about tax strategies.
One’s just very basic knowledge we recommend for the rookie investors. And then there’s also an advanced tax strategies book. I think it’s Tax Strategies for the Savvy Real Estate Investor is what it’s called. But if you go to the BiggerPockets bookstore, you can find it on there.
Okay. And our last question today is from Denise Biddinger. This question is, “What’s the best way to structure a first time partnership?” And Tony, I know you have our book there if you want to hold it up.
I do. So for those of you that don’t know, hopefully you know by now, but Ashley and I have co-authored a book published by BiggerPockets called Real Estate Partnerships: How to Access More Cash, Acquire Bigger Deals Than Achieve Higher Profits. And the book is available for you to purchase. So head over to biggerpockets.com/partnerships and you guys can get all the nitty-gritty about how Ash and I structure our partnerships and use partnerships and avoid partnership pitfalls, but there’s a lot about partnerships structures.
So I guess the first thing that I’ll say is that there is no right or wrong way to structure a partnership. At the end of the day, as long as you’re not breaking any laws, you and your partner can agree to whatever terms both or at least make the both of you happy. Now, there are some things I think to consider when you’re putting a partnership together and I’ll call out some of those.
I think the first thing I’ll say though, is that there’s also two types of partnerships and people kind of, I think usually just think of one, but you have debt partnerships and you have equity partnerships. In a debt partnership, there’s the money person and there’s the sweat equity person. So one person’s just going to loan the money, the other person’s going to do all the work, and the person who’s doing all the work, we’ll pay some kind of fixed return back to the person that’s lending the money.
I’d say the majority of partnerships that we see in it that a lot of the rookie investors do are actual equity partnerships. And within an equity partnership, there’s several ways to structure, I guess at least several levers you can kind of look at.
So the first thing you wanted to think about is the distribution of labor. Every project that you think about should have some sort of distribution of labor. It could be that one person’s going to do all the work. It could be that you guys are going to split it down the middle. It could be that one person’s going to do 75%, the other person’s going to do 25%. But you want to do your best to think about, how are we distributing labor between the both of us? And the reason this is important is because if one person is doing more work in that partnership, then ideally they should be compensated more for that.
If you guys are split everything down in the middle and the time commitment on the labor side is equal, then it makes sense to have your equity and profit distributions match that. But I think the first thing to consider is, “Hey, how are we divvying up the labor?” The second thing to consider is the actual capital. Are you both bringing capital? Is one person bringing the capital? Is it split down the middle? Was one person bringing 80%, the other person’s bringing 20%? How are you divvying up the capital that you needs to purchase this deal?
The second piece of the capital is the mortgage itself. If you’re going out and getting debt, are both of you going to carry the mortgage? Is one person going to carry the mortgage? How will the actual debt be structured? So you want to start thinking about all the different roles that each person will play inside of that partnership, and then try and assign a value to each one of those roles that each person is playing. And ideally, you want to get to some kind of structure that accurately represents the amount of effort and value that each person is putting towards the partnership.
Now, I’ll say a lot of my deals are just straight 50/50, right? We have partners that bring the capital, they carry the mortgage, we do everything else, and we split it down the middle. And it’s been a mutually beneficial arrangement for both of us. We have some deals where we brought a little bit of the capital and we charge a property management fee as opposed to taking a bigger equity stake.
So there’s a bunch of different levers you can pull, but I think the most important thing is identifying who’s doing what and trying to assign values. What are your thoughts on that Ash?
Yeah, and I think that’s actually the hardest thing, especially for rookie investors or even going into a different strategy where maybe it’s your first time doing the strategy and you don’t know exactly what effort or time it’s going to take for the roles that you are going to be performing for the property.
So one thing I would suggest is that when you are doing the operating agreement, maybe you could put in there some kind of clause where after one year it becomes, you have that discussion as to, “Okay, do we need to actually change things as to, now you’re going to be paid a hundred dollars per month for bookkeeping.” Or something like that.
I think leave your options open, so that in your partnership agreement there is room for change, especially if you’re going to be doing a buy and hold property where maybe you’re both doing a lot of the rules and responsibilities is to look at it every year and be like, “Okay, this is something I don’t want to do anymore. What can we do? What can we change for this?” But definitely sitting down and figuring out what your partner, what is fair, because there is no, as long as it’s legal, there is no wrong way to structure your partnership.
As we just went over, it was the second question that we went over today for Rookie Reply. My first partnership, and that was awful for me. I did all the work and I got the least amount of benefit from it, but it got me started, it got me in that deal. And honestly, that property wasn’t a ton of cashflow.
I mean, we ended up having, I had no money into the deal and I was making a hundred bucks a month or whatever. So it’s like, “Okay, if I got a little bit more equity, it’d be 20 more dollars a month.” But to have that opportunity to get into that first deal, that was what was important to me at the time, and I really wanted to prove myself and show my partner that I knew what I was doing. And the way for me to do that is to really put up more safeguards for him to get his money back, and the property and to have it be an advantage for him and the opportunity for him.
So I think just really look and understand what’s important to you, what do you really want out of this deal and the partnership that you’re going to do. And then go and talk to your partner and see what’s really important to them, and from there, you can structure it. There’s just so many different options you have. And if this is your first time partnering with this person, make sure that you’re setting it up, that you’re dating them.
Maybe you’re just doing a joint venture agreement and you’re not committing to an LLC where you’re going to buy 10 properties over the next year. You’re going to do one property and see how it goes, and then maybe you can branch off and add on from there, depending how that is.
But in the book, we do go over some case studies, and Tony has talked about before how he actually walked away from a flip he was doing with a partner, or it was a BRRRR, right? To be a short-term rental, not a flip. So he walked away from that long-term commitment with that partner just because it didn’t feel right. And having those kind of exit strategies in place I think are almost more important than the actual structure and the benefits of it.
Yeah. Super important point, Ashley, and I’m glad you finished with that. I think the only other thing I’d add is, and you talk about this a lot as well, but it’s as you kind of think through what every person’s going to be doing, you have some options on how you compensate.
So for example, in one of our partnerships, we took a reduced equity stake of only 25%, but we also charged a property management fee of 15% of gross revenues. So we are compensating ourselves for the work that we’re doing in the property with that 15% management fee, which is a slight discount from what you see in that market. Most Airbnb, short-term rental hosts charging 20 to 25% at least. So we gave a slight discount to the property, but then we also retained 25% equity because we put up 25% of the capital.
So just think through like, “Hey, who’s going to be doing property management?” If there’s rehab, we should be managing that bookkeeping and accounting, finding the actual deals, analyzing those deals, managing the tenants, the guests or whoever. There’s a lot of different roles to go into that. And you can either say, “Hey, I’m going to compensate myself for doing this work by charging a property management fee.” Or, “I’m going to pay myself an hourly fee.” Or maybe it’s a fixed flat amount per month for doing the bookkeeping. But just try and think through what those look like and try and work that into your partnership.
I think the last thing I’ll add is when it comes to the capital side, two important things that you want to discuss, and this is me assuming I think in this question, she said, Denise said, “Hopefully finding a partner.” Because they don’t have the capital. So it sounds like you want someone to bring all the capital.
The other questions you’ll want to ask yourself, Denise, are what is your method for paying that person back if there is one? So we have some partnerships where there is no payback, right? It’s like, “Hey, you’re putting in your $50,000 and that’s your contribution to the partnership because I’m doing everything else.” We have one partnership where there is a mechanism for that partner to get paid back. And Ashley’s example of her first partnership, that partner essentially had a loan against their partnerships. So they got back a fixed amount every single month before any profits were distributed. So you could do it that way if you wanted to.
In our partnership, the capital recapture is what it’s called, only kicks in if we refinance or sell the property. So just think about like, “Hey, are we going to want to pay this person back the 50K?” You don’t have to, but it is something that’s kind of important to think through. And the last piece on the capital side is how would you handle potential shortfalls in revenue?
So one of our Louisiana properties, we had a massive shortfall because we had this crazy, you guys probably know the Shreveport story, but we had this crazy increase in our homeowner’s insurance, and then we tried to sell the house and we ended up finding foundation issues. So when things like that happen, is it the partner who contributed to the capital that’s going to be covering 100% of that cost? Will you split that 50/50? Will you split it 75/25? So just think about those little details as well to really hopefully avoid some of those more difficult conversations before they happen.
Well, thank you guys so much for joining us on this week’s Rookie Reply. Don’t forget to check out Tony and I’s new book at the BiggerPockets bookstore, that’s biggerpockets.com/partnerships.
Okay. I’m Ashley, @wealthfromrentals, and he’s Tony J. Robinson, @tonyjrobinson on Instagram, and we will be back on Wednesday with a guest.
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