INVESTING WITH PARTNERS

Many investors starting out have all the right intentions but fail to fully evaluate three critical elements paramount in succeeding in real estate investing. Strength in anything less than all three means the investor will need to seek a partner that has strength in that area. Let's take a closer look.

 

Many Toronto homeowners have witnessed this first hand with their own portfolios and are fed up. As a result, we are seeing a record level of funds being withdrawn out of RRSPs and redeployed into their own home - where there are two HUGE benefits 1) all capital gains are tax free (unlike an RRSP), and 2) you get to live in a much nicer home than if you kept the money in RRSPs. Simply put, you can't live in an RRSP.

 

1. DESIRE TO ACT

This may be influenced by one's lack of experience and confidence therefore leading to procrastination until one feels they have all the necessary information/experience. This point never comes and it's better to just start and learn what you need along the way. If you feel you've been procrastinating, perhaps the answer is in finding a partner who is already actively investing in real estate and will kick start your progress.

 

2. DOWN PAYMENT

Often at least 20% of the property's purchase price is required. This is in addition to closing costs such as legal fees and land transfer tax which, in aggregate results in approximately 25% of the purchase price. With Toronto's high prices, even a $750,000 property requires close to $200,000, well beyond most investors' available funds. If your intent is to invest in Toronto and you have less than the needed $200,000, then finding an investment partner who can come up with the difference can help you get into investing right away. Waiting to save a larger amount doesn't work because the market is advancing faster than most people's ability to save. An alternative is to invest far away in another city where you don't live. This brings up new challenges like needing to learn a new market and of course, managing a property from a distance.

 

3. MORTGAGE QUALIFICATION

After the financial crisis of 2008, banks significantly tightened their mortgage qualification criteria. This tightening has been ongoing and more recently, the Stress Test introduced in 2018 reduced the mortgage qualification amount borrowers can secure by approximately 20%. All this leads to greater difficulty in securing the mortgage funds necessary to acquire property. If you find yourself in this situation, then finding a partner that can qualify for the mortgage amount needed is key.

It seems that most investors have one, maybe two of the above and are missing the third. Does describe you? If so, you are not alone and in fact, in good company.

The rapidly rising real estate prices in the Greater Toronto area since 1996 has created a growing barrier to investment. Where once investors could have easily invested on their own, this window is rapidly closing for many investors for the three reasons cited above. The response by many investors has been to seek investments further afield and hence the popularity of places like Hamilton, Kitchener, Barrie, and Oshawa for example - places that will continue in popularity as prices continue to rise everywhere.

As the saying goes, necessity s the mother of invention and so the other solution for investors, although not new, but that is starting to take hold is that of partnering. And partnering can take form in one of two ways: Joint Venture Partnerships and Syndicated Limited Partnerships. There are many examples of successful partnerships both at the private level with just two people, but also on a large scale. Real Estate Investment Trusts (REITS) are publicly traded companies that sell shares in its stock and use investors' funds to acquire many millions of dollars of properties with ownership spread among many shareholders. Let's then take a closer look at these two forms of partnerships.

In its simplest form, a Joint Venture Partnership is one where two people buy a property together. This allows the pooling of resources - money, but also time, expertise, and the ability to qualify for the mortgage. The advantage is that one partner may be particularly strong in one area where the other partner may not be as strong, but who instead brings another strength to the partnership. In this way the partnership is stronger than either partner on their own representing the ideal partnership and affording the greatest chance of success.

Legally, JV Partnerships can be a casual arrangement where the two or more partners are buying in their personal name, or they may choose to buy in a corporation. Always seek proper legal and accounting advice which form of ownership is best suited for you based on your personal income level and other assets you own to minimize taxation as well as liability. The JV partnership, however, is anything but casual when it comes to documenting the JV agreement between partners, and it is strongly urged engaging a lawyer that specializes in real estate partnerships.

Let's look at an example to add clarity. Suppose Partner A is a very busy professional or business owner.

Partner B on the other hand may either have a lot of real estate investing experience and/or has a strong desire to invest and act.

Partner B even has identified a suitable property to invest and approaches Partner A with a proposal that they purchase the property together both pooling their funds equally, but Partner A qualifies for the mortgage in return Partner B agrees to manage the property.

The JV partnership would be formalized in a legal document to be prepared by a real estate lawyer (see "Preferred Service Providers"). The JV agreement would outline the property, the identify of each of the partners, what each partner's respective duties and obligations are, what happens in the event one or more partners cannot fulfill their duties and obligations, etc. This agreement in short, anticipates the various possible outcomes in advance so that all partners can refer to it in terms of how to deal with any issue that may come up between the partners.

JV partnerships are great for investors just starting out, especially with small residential investments i.e. a single family property purchase. Ideally, it's just two partners but may include 3 or 4 but it quickly gets complicated if too many investors are involved. In that case, Syndicated Partnerships are better suited.

Limited partnerships in many ways are a level up from JV partnerships. They are more sophisticated and robust and offer a clearer separation between the investors versus the operator, which for larger property investment requires a higher level of both Asset Management and Property Management - two very different skills set.

 

PROPERTY TYPE / VALUE

In an LP, the property is usually no longer a single-family residential property at say, $500,000 or $1,000,000. Instead, it's a commercial property and the value is likely $5,000,000 or more but may be as little as say, $2,000,000.

 

LEGAL STRUCTURE

The legal structure for a Limited Partnership is more complicated than a JV Partnership. In a JV Partnership there are two or more essentially equal entities, each with the same liability, and in most cases unlimited liability. In comparison, a Limited Partnership has two very different entities referred to as the General Partner (GP) and the Limited Partner (LP). The GP can be one or more people who are fully responsible for finding the property, acquiring, securing the mortgage financing, closing, and all asset management and property management decisions, and then selling the property as part of the exit strategy to the investment.

The LP on the other hand are the investors and they can be a few or many. They are the money behind the investment. And they typically are not involved in any of the day-to-day decisions in operating the property. For that reason, they are not liable for the decisions the GP makes and hence, the term "Limited Partners".

The LP's liability is limited to the extent of the funds they invested. To show good faith and have some "skin" in the game, a GP will also have funds invested and so they are also to a small extent, LPs themselves. It's not uncommon to have a GP participate 5% or 10% of the total funds raised by all the LPs.

Whereas a JV Partnership is documented in JV Partnership Agreement, a Limited Partnership is documented in a Limited Partnership Agreement.

An example of a JV partnership is where two investors get together to buy a duplex together. Neither wants to leave Toronto to invest, not only because of difficulty of managing the property from afar, but also because neither knows any other municipality well enough to invest anywhere beside Toronto.

Let's then assume a Toronto duplex with a $1,200,000 purchase price.

 

Duplex Purchase:

 

Equity Required:

 

The total equity required for this investment is $295,250. Let's call it $300,000. That means that each investor would need to invest their 50% share or $150,000 for 50% ownership in this duplex. It is important to note that both partners are investing equity, but at no point does either partner have a right to the other partner's equity. Upon sale of the duplex, both partners would receive their initial investments back before splitting any profits

 

Mortgage Qualification:

The mortgage qualification would need to be done by one or both the partners. For example, in the event one partner is particularly strong financially, it may be better to have just that one investor qualify for the mortgage. In return, that investor may have to put in less money, or else, have less work to do in the day-to-day operations in recognition of their value in qualifying for the mortgage.

Again, this is open for negotiation and there is no set rule. It's important the partners fully discuss all the resources they each bring to the partnership and who is willing to assume which duties to see the investment a success. Whatever the partners eventually agree to that they all feel is fair is all that is important. For the purpose of this example, let's assume that one partner is better suited to qualifying for the mortgage, and let's say that after discussing amongst themselves they came up with the following arrangement that they both felt was equitable.

 

Partner A:

Puts up $150,000 and qualifies for the mortgage but is not involved in the day-to-day operation.

 

Partner B:

Also puts up $150,000, but since this partner couldn't help in qualifying for the mortgage, they look after the day-to-day operations including for example, looking after finding a tenant, collecting rent, dealing with any tenant issues including issuing tenant notices in the case of late rent payment, handling with repairs and maintenance, etc.

 

Exit of Investment and Partnership - Sale of Duplex

Before the two partners bought the duplex, they would have agreed on many items to be documented in the JV Agreement including for example, the holding period. It could have been for 5 years to match the 5-year mortgage. Or they could have agreed in advance that they would sell the property once they reached an appreciation of say, 25%. The point is, there would a pre-defined time that would determine when to sell and not left ambiguous.

At the point of selling the duplex, the funds from the sale would be allocated in the following order:

1. First, pay off the existing Mortgage. 2. Next, the Closing Costs are paid (real estate agent fees, lawyer's fees). 3. After that, each partner's Initial Investment in the property is returned. 4. And finally, with what remains, the profit is split according to what was agreed to in the JV agreement which is typically on a 50%/50% basis, but this can be whatever is agreed to at the start of the JV partnership. If instead of each partner investing $150,000, one invested $100,000 and the other $200,00, then they would split the profit at this stage 1/3 and 2/3.

 

2. LIMITED PARTNERSHIP - APARTMENT BUILDING PURCHASE

What do you think when you hear the word "Syndicate"? For many who are not familiar with real estate syndications, images and references to TV series and movies come to mind. So, what then is a Syndication? A Syndication or Syndicate is a temporary alliance of investors, who join and pool their resources to manage a large asset, which would be difficult, or impossible, to acquire on an individual basis. Syndication makes it easy for investors to pool their capital and thereby participate in more lucrative commercial properties while sharing risks.

As an example of a syndication, let's look to multi-family investments which are perfectly suited for syndications and why they are so popular. These are highly regarded investments because of their high rate of return (often 15% per year and up) and low risk due to a very low vacancy rate in the GTA (1% or less) and so a steady supply of tenants. Most of the multi-residential properties in the GTA were built in the 1950's and 1960's when lucrative government incentives lured builders, but construction halted as soon as the incentives were removed in the 1970's.

With limited new builds keeping supply stagnant, but demand growing because of continued migration to the GTA, GTA rents continued to climb amidst a very low vacancy rate (under 4% for the last 40 years). This imbalance will be further skewed in coming years as there are more tenants who would have otherwise become Buyers but can't buy because of the expensive real estate market. There is, therefore, a growing interest in multi-family investments.

A multi-family syndication might buy an apartment building that the GP has sourced and pre-qualified in terms of a suitable investment. The GP will have sourced the property in one of two ways and is yet another example of how the GP brings value to the syndication. The GP sourced the apartment building through their direct contact with other apartment building owners. Alternatively, the GP will have received details on a property through their relationship with only a handful of real estate agents that specialize in multi-family investments and who contact select GPs before ever listing on the MLS. Either way, the GP ends up buying "off-market" (ie privately and not on the MLS) which affords acquiring at a better price than having to buy a property on the MLS which promotes bidding the price up and is very much geared to helping the Seller get the highest price.

Let's assume a 25-unit apartment building in the GTA where the GP has already negotiated a Conditional Offer at a price of $6,250,000. That works out to approximately $250,000 per apartment or per "door". The GP has already done their financial analysis and negotiated the Offer on the basis that the investment will yield LPs an annual IRR of 15% or greater. Given the size and scope of the investment, the holding period is at least 2 to 3 years, but is often tied to time deemed necessary to create the intended value as part of the exit strategy or may simply be tied to match the term of the mortgage which is typically 5 years.

 

Multi-Family Building Purchase:

 

Equity Required:

 

The total equity required for this investment is $2,629,950. Let's call it $2,700,000.

The GP will start by approaching investors on their short list and who have either invested with the GP in the past or currently, as well as those who have expressed an interest in the past partnering on these types of investments. These potential investors will receive a detailed investors package outlining the current and projected financials, investment strategy, financing, and exit strategy. In short, a business case for why an investor would want to invest in the property.

Note that the GP will also invest and it's reasonable to expect that the GP will contribute 5% to 10% as a sign of good faith in the venture, and to be motivated to act in the best interest of the investors since by having funds invested, the GP is also part LP and will think as an LP. Let's assume in this case the GP contributes 10% or $270,000. That leaves $2,430,000 to raise.

To keep the number of LP investors to a manageable size let's assume that there will be 12 at an average of $200,000 each. Of course, some of the LPs will contribute less than that while some more. The $200,000 then becomes an ideal target per investor but there is some flexibility around that. On the one hand, the GP would prefer just a few LPs, but then on the other doesn't want to turn down possible investors if they don't happen to have a full $200,000 to invest. This is where a judgement call must be made. As is often the case, open communication is the best course of action and if the investor is interested, its best that the LP approaches the GP with the investment level they can participate and revolve the discussion around that.

 

Mortgage Qualification:

The mortgage qualification in a syndication is fully the responsibility of the GP making it one of the main advantages to the LP in that their credit score, rating, or income is irrelevant for the purpose of investing. For example, an investor who has $200,000 but is recently divorced leaving them with a poor credit rating for the moment, or is in between employment, can still invest in the syndicated investment

 

LP's Obligations / Duties:

The LP has the obligation of the initial investment, and any other investment calls as outlined in the investment agreement. Even though an LP will have committed to say a $200,000 investment, the GP may not need it all at once and may elect to take part of it up front with the remainder or part thereof throughout the investment term. The spacing of cash calls may be made to match major capital improvements in the property.

GP's Obligations / Duties:

In addition to their capital investment (in this case 10% or $270,000), the GP will look after all the duties in finding, financing, funding, and operations of the property throughout the holding period

GP's Compensation:

The GP has the task of finding the property, and then eventually selling it, and everything in between in the interim. That's a lot of work and responsibility. In addition, as explained, the GP also has their own funds invested to show commitment to a successful outcome of the project.

So, the GP has money and a lot of time invested in the project so you may wonder what's in it for them? How are they compensated? The GP is not paid a salary since that would not offer much of an incentive to optimize profitability or returns on the project. Instead, the GP is compensated in two ways that promotes the interest of both GP and LP.

First, the GP often receives a one-time acquisition fee of 1% of the asset value which is the purchase price. This is paid on the closing day when the property is acquired. Secondly, the GP is incentivized in optimizing the performance of the asset which will be determined when the property is finally sold. The syndication will offer a minimum return to LP also known as the hurdle rate. Let's assume 15%. That means that the GP gets zero compensation or participation in the returns for the first 15% - the minimum return to investors. After that, the GP is offered a larger percentage through what's known as a waterfall event and is the GP's incentive to having the property perform as best as the GP can get it. The waterfall can be looked at as a financial structure that determines how returns on a real estate investment are distributed to investors.

To illustrate this, let's assume that the syndication is set up so that all investors share equally in the profits up to say, a 15% rate of return. With the profits that remain, the GP is given a larger proportionate share. This could mean that the remaining profits (beyond 15% return) are split say, 30/70 with 30% of the remaining profits going to the GP and the 70% of remaining profits to the LPs. This 30/70 split is the waterfall.

The GP's bulk of the compensation rests with the waterfall and hence, the motivation to having the asset perform as profitably as possible

Capital Event - Sale or Refinancing of the Multi-Family Investment:

A Capital Event is defined as either the occurrence of a refinancing or sale of the property. The Limited Partnership Agreement will have a clearly defined holding period. As the end of the holding period approaches which is usually in line with the expiry of the mortgage, several months prior to that event the GP will hold a meeting with the LPs, during which the property's performance will be reviewed and the various options available ie refinance or sale and the pros / cons of each event. Depending on the current state of the real estate market, it may or may not be an ideal to sell. In addition, depending on prevailing interest rates, as well as the extent to which the property can be refinanced, it too will determine whether refinancing is a favourable option. All these will be factored, and the group will decide on the best course of action going forward at that time. You may be wondering, what if one or more of the LPs want to sell and cash out, but most LPs want to stay in and refinance? There is language in the Agreement that handles this situation basically stating how other LPs can buy out the LP who wishes to cash out, as well as financing options of that LP's share. In an ideal situation, both the property and real estate market will have done well enough that the property can be refinanced, with the initial investment returned to all investors thereby retaining their full ownership in the property with no equity in the project. Their rate of return from that point is infinite since they no longer have any equity in the investment. This is what makes this the most ideal outcome for both LPs and GP

 

No discussion of real estate investing with partners would be complete without exploring the risks. And the partner risk is in addition to the underlying real estate risk in buying any property. Both forms of Partnership, whether a JV or a Limited Partnership, have definite advantages that go beyond investing on your own. But human nature being what it is, whenever there are two or more people there is always the possibility of conflict. Here then is a look at both the Pros and Cons

 

PROS

• As the saying goes "two heads are better than one" and having one or more partners gives the group more confidence. This may be particularly effective with likeminded individuals that are looking to invest in their first property and learn together
• As stated before, the LP is able without needing to qualify for the mortgage (so credit score and their personal income is not important), and the LP is not required to devote any time to the management or operation of the investment
• Minimizes the risk since the investment is divided among the partners
• Allows access to larger properties than one could invest on their own
• Allows for diversification in that rather than investing all your funds in one transaction on your own, you can participate instead in a few projects with smaller investment amounts
• Allows for finding complimentary partners ie money partner versus an operating partner
• Allows for more rapid growth through synergy meaning that two or more partners working together could create an investment portfolio quicker than either of the partners on their own

 

CONS

• Potential for disagreement especially if very different goals and objectives or personality/management styles
• Potential for disagreement at the capital event stage especially if the real estate market has dramatically changed either up or down to that projected
• Minimizes the potential for a partner's growth if they are not active or engaged and defer most or all of decision making to the other partner

 

 

Finding suitable partners and pooling resources can be a very profitable way to invest that has the potential to allow for much faster portfolio and asset growth, opening more opportunities, and joining partners that bring resources of time, money, or expertise where we may perhaps not be particularly strong and therefore limiting our ability to invest. Whether a Joint Venture or a Limited Partnership, one needs to first properly evaluate what one's investment goals are and be clear what they are looking for in a partnership. The next critical steps is to find partnerships that truly allow one to leverage their investments based on finding complimentary partnerships based on mutual like and trust

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