Business (RE) Proposition (Practical Considerations)

In My Humble Opinion
1

In these days of tightened credit a lot of real estate wheeler-dealers are having a hard time getting mortgages, either due to too many short sales or foreclosures on their record or due to lack of a steady income, and this presents opportunities for people who have better credit and steady income. I’ve been offered the following proposition.

A couple of savvy real estate investors have located what they believe to be a very good deal on some (income producing) RE. They have money for the down payment but can’t get a mortgage, while I should have no problems with a mortgage. So they’ve offered me what is effectively a 20% share of the profits in return for assuming ownership of the house and mortgage.

The way it will work is that both the house and mortgage will be in my name. The money for the down payment and any related expenses are paid by them. The income goes first to pay the mortgage and other expenses, and the excess to these guys to repay their initial investment. After their initial investment is repaid, the excess of income over mortgage/expenses is to be divided 80/20 (with me getting the 20%). Similarly, if the property is sold, then the money goes first to repay the outstanding mortgage balance, then to pay these guys for any outstanding initial investment, then the remainder is split 80/20.

On the surface, it looks like free money for me, with no cash investment at all. I do have concerns about control - I would need to have control of the cash, both incoming and outgoing, to ensure that these investors don’t find a way to make sure that the profits are zero, with all the money finding it’s way into their pockets somehow, and to make sure the mortgage is paid on time etc. I have a cousin in the RE management business, and the idea is that he would manage the property. Similarly, I need veto power over the selling decision, for similar reasons.

I think these guys would accept the above. Nonetheless, there are some other concerns. One is that I think this is to be a short sale. Suppose unbeknownst to me these guys are paying money under the table to the seller, do I have any way of proving that I don’t know anything about it? Or more generally, suppose these guys do something illegal connected to the property - in which they have an effective 80% interest and thus an incentive - how do I get out from under the assumption that they acted on my behalf?

In addition to the above are the tax consequences. By the county tax/land records I own 100% of the property, and my deal with these investors is just a side contract between me and them. But if I have to pay taxes - whether income or capital gains - on 100% of the income/profit while actually making only 20%, then I lose money. Question is how to get around this. If I have a clear contract with them outlining the arrangement, does this mean that I get to deduct their share as some sort of business expense (similar to paying interest). (My father is a former tax accountant and he doesn’t think so, but he wasn’t sure.) I would have to think there’s a way around this, because the arrangement sounds like something that should be fairly common, but I obviously can’t go ahead with this unless I have it nailed down.

Other considerations would include the possibility that the property loses money and these guys walk (I think this is low, but not impossible) and the opportunity cost (my understanding is that you can only take 4 FHA mortgages in your name, so I’d be giving up one of mine for a 20% share).

Anything else? And what do you think of the above?

2

I wouldn’t do it. Except MAYBE if you set up a business as partners, then you give a personal surety for the mortgage.

From the sounds of things, you don’t get anything for your risk until and unless they have all their money back - yet you are on the hook for the full amount if, for whatever reason the deal goes bad.

And it can - anything from bad tenants to bad luck could cause this to be a money losing proposition.

3

Sounds risky and does not pass the comparability test. You’d probably be better off buying a home outright and hiring a property management company to mangage the property for you.

4

Sounds like you’re taking all the risk and they’re taking all the money.

5

I don’t see it that way. These investors are taking the major risk, since they lose their entire down payment before I lose anything. In order for me to lose anything, the value of the house has to decrease by the entire amount of their downpayment plus. (If we lose money along the way due to bad tenants, vacancies, repairs etc., these guys will have to pay it (& add it to their investment amount), and if they don’t I can sell the place from under them.)

And this is not a property being bought at the top of the market. This is being bought at a low point in the market, by shrewd investors, in a short sale. The likelihood that a property like this will decrease by an additional 25% from this point is very low, IMHO. Not impossible, but very low.

Well yeah, that’s a good idea too, and in fact I just recently purchased an investment property. But there’s only so much money that I can or want to sink into RE investments (which I regard as a long term sure thing but which might not pay off for years). This is an opportunity to make some return at zero cost.

6

I don’t buy it. Yes, it’s harder to get a mortgage now, but qualified buyers can still get financing. If these guys and this property were a good risk, a lender would be happy to take their money. Do you think you are better at making these decisions than the people who do it for a living?

And I already know the answer the investors would give to my question - “The underwriters just have a checklist and anything that doesn’t fit neatly into their rules is rejected. The new regulations are ridiculous.”

7

It is your name on the mortgage, and your credit report at risk if things go bad. Also…why do you need the other guys at all? If you want to do this, and qualify for a mortgage in your own name, why give them 80% of the profit? Sounds like a bad idea and possibly a scam in the making to me.

ETA: May also want to investigate how much insurance will run, and what condition the property is in. If it doesn’t meet whatever code requirements apply, you, as the owner of record, might end up on the hook for repairs…

8

The answer is basically true, although the new regulations are not ridiculous. The new regulations, like so many other regulations and corporate policies, are the result of people at senior levels of companies (in this case, banks) needing to set policies that will work on the whole, without allowing too much leeway that might be abused. (And they are a reaction to actual abuses of this leeway.)

IOW, if I’m lending the money, I can look closely at the situation, knowing what I know about the local conditions, people involved, and properties, and make a decision. A bank employee might be able to do this (although I think they’d be at a disadvantage to a local and experienced investor). But a bank employee might also be corrupt and/or incompetent. The senior people at the bank can’t afford to allow their bank’s future to depend on the individual decisions of hundreds of local employees. So the uniform “checklist” policies make sense in that context. These are policies that will work in aggregate. But that doesn’t mean that an individual who has discretion to do what he wants can’t do better.

As an example, I have a much easier time getting a mortgage than my father, and I know that he’s a far better credit risk. Besides for being the most honest man alive, he also made quite a lot of money investing in the stock market over the years, and has more than enough assets to cover any conceivable RE losses. And yet, I have a far easier time getting approved for these deals, simply because I’ve held a steady job for a while. But I could lose my job at any time, and my father is a much better risk.

So is the bank foolish for thinking otherwise? No, they’re not foolish. They can’t afford to have their local employees making judgments about how good of a risk this guy or that guy is, and they’ve determined - likely accurately - that steady jobs are better risks than assets. But that’s not true in every case.

In this case, the proposed deal is being brokered by my brother, who is himself a very experienced and shrewd RE wheeler dealer in his own right. He knows these investors personally, and has an informed opinion on both them and the deal itself.

And I myself have a bit of experience dabbling in RE myself.

So in sum, the bank’s policies are not ridiculous. But to think these policies, set by executives at a national level, offer a more valid assessment of the risks involved in a particular deal than that of knowledgeable investors, is ridiculous.

I’ve addressed this earlier. I’ve already made an investment in RE, and don’t want to invest any more money in it. The point of this investment is that I put nothing down.

9

First, SDMB members aren’t very business savvy people as a whole, so take what advice you get with a big chunk of salt. I fully admit I’m no business guy, so I won’t offer my opinion on that aspect.

Second, for tax purposes, it sounds þo me like you have entered into a partnership with the other guys (a partnership for tax purposes can be created simply by contract even without a separate entity). Note that income should be allocated in the residual 80-20 ratio even when the other guys are getting all the cash. So, you may have taxable income even when you don’t have cash from this investment to pay the tax. This can be solved through a “tax distribution” (ie, you get cash equal to your tax even before the other guys get their money back, and those distributions are treated as advances against future distributions to you).

10

Maybe I’m misunderstanding you but aren’t they getting their down payment repaid before you get any month-to-month income and before any profit goes to you at sale? Doesn’t sound like they’re taking much risk at all given that. I’m not sure what else you mean by the income goes to repay their initial investment after the mortgage and expense are paid.

Also, the mortgage process will be a lot more complicated than you’ve acknowledged if you do it on the up and up. You’re not actually putting any equity into the property, you’re basically buying the entire thing on credit with 20% in the form of a loan from these guys subrogated to the mortgage.

In other words, if I were the bank, I would look at your deal and say that you’re borrowing 80% from me and 20% from some other guys. Not the kind of deal I’d want to make. And if you don’t disclose that the 20% is from them and you are obligated to pay it back, that’s fraud.

11

If you and your brother are both experienced real estate investors, what are you looking for in this thread? Are you going to get better advice than what you’ve gotten from your brother?

12

Seems risky from both sides. You are on the hook for the entire mortgage if this goes south and they bail, and since legally everything is in your name if it works out well you could keep the entire profit and screw them. I think you both need a contract in place to protect yourselves.

ETA: Just noticed your brother is brokering this - did you post the thread because something is bothering you? If so, just say no.

13

Who came up with this idea?

If it wasn’t you, I would run away. If it was you, I would just drop it. The very fact that the following is even a question tells me you’re getting over your head:

You should structure the deal so that nobody gets paid until all taxes are paid, including your portion of any income taxes paid on capital gains resulting from the asset appreciation. If you don’t, you’ll get screwed.

Let’s assume your profit is $100 and you owe $50 in taxes. Under an arrangement where the pre-tax profit is split 80/20, your numbers would be the following:

100
-80 (your partner’s share)
= 20 (your share)
-50 (taxes)
= -30 (your loss)

However, if you word it so that all taxes are paid before profits are divided, you come out… OK.

100
-50 (taxes)
=50 (after-tax profit)

  • 40 (your partner’s share]
    =10 (your gain)
14

If there are profits then I can’t conceivably lose any money. The only way I take a loss is if there are no profits and only losses, and if this is the case they are the ones who lose first. More below.

Suppose the purchase price is $240K with 25% down, income is $2K per month and mortgage plus expenses are $1,800. These guys get $200 a month until their $60K is paid up. But this monthly amount lessens their outstanding invested principle as well. So if they invested $60K, then after a year of $200 per month, their invested principle is $60K - $2.4K = $57.6K. And suppose the mortgage is $180K but $250 of this is being amortized per month. After a year, the loan balance is $180K - $3K = $177K. If the property is sold at that point for the same $240K, then the $177K is paid first, leaving $63K. Then the $57.6K is paid, leaving $5.4K. This $5.4K is divided 80/20. If the property sells for $250K. then there’s $15.4K to divide up at 80/20.

If we held onto the property for 25 years at the same $200 per month profit, then their investment principle is paid up. At that point, the $200 itself is divided 80/20. (Also at that point, the any sale price is used to pay the outstanding mortgage and the entire remainder is divided 80/20).

Suppose instead that the property is sold at a loss, for $210K. The $177K is still paid first, and I come out whole. They get the remaining $33K, and lose 41% of their initial investment (they put in $60K and got back $2.4K plus $33K, a loss of $24.6K).

The only way I lose is if the sale price is so low that they’ve lost their entire investment. While they lose (in this example) if the sale price is anything less than $234.6K.

Conversely, suppose we have bad tenants/vacancies/repairs and the income averages $1,600 per month instead of our expected $2,000. Then the property is losing $200 per month. They have to pay this $200. If they don’t then I can pay it, and if we sold after a year the money would go first to the $177K of mortgage debt and the $2.4 of expenses that I laid out, before they get back their initial investment. (If they paid it, then the $200 per month would be added to the $60K invested principle.)

I would certainly not be willing to conceal anything from the bank. But I’m not sure why the bank should care. They get their money first.

My brother is very experienced. I myself have dabbled in it. I don’t expect “better advice” here than what I get from my brother, and I wouldn’t rely on the judgment of anonymous MB posters even if they were business savvy. But sometimes people see things that other people miss, and it’s worth hearing different perspectives. For example, the point that Fuzzy Dunlop brought up about the bank’s perspective is something that I had not considered.

Agreed. My brother suggested that I might be in a stronger position if there was no contract, since I hold title, and as above it would have to go very sour before it lost more than their entire investment. I’m not really worried about that. But I’d like a contract anyway, because I would want everything spelled out so as to avoid disputes about it later. Plus, I might need a contract to deal with the tax angle, as Rand Rover suggests.

As above, I’m interested in hearing different angles and perspectives. My brother is an experienced RE wheeler dealer and he personally knows these investors, so I rely on him for those aspects (obviously I would look closely at it myself as well). But - for example - he did not even think of the possible tax consequences - these are not his field. And so on. This is quirky deal and it’s worth hearing everything that could possibly go wrong before making a decision.

15

Maybe. I’m not going to crunch the numbers for you, but while this may be at “zero cost” it is definitely not “zero risk”. And if things go wrong, you might find your costs to be at the wrong side of zero.

16

Because you aren’t really putting any money down, you’re borrowing all of it. The down payment is supposed to make it a safer investment for the bank because you own 20-25% of the property outright, but in your case you own none of it. Adding contingencies to the other loan, like it only being repaid if the income is available makes it safer but it’s still a liability.

You might be fine… or able to work with them. Just something to keep in mind, and I see you’re open minded about it being a potential issue. The other thing I would say is that in my experience, buying an investment property in the size you’re talking about gets you working with a normal mortgage person who is normally used to dealing with people buying their principal residence. Even business bankers who are used to working with businesses tend to have a hard time grasping anything out of their normal procedure and you have to really fight with them to do what you want.

17

So suppose a young couple borrows money from their parents for the down payment. Does the bank care about that? I don’t see this as being any different, from the bank’s perspective.

If that’s the bank’s attitude, then it’s an issue. I’m not going to get involved with lying to banks. Sounds strange to me, but you never know.

Agreed. But this is again assuming that the bank cares about what sort of side arrangement you have. Otherwise they don’t need to bother with any of it.

18

Yes. The bank will require both the parents and the borrowers to attest in writing that it is a gift, not a loan. In practice it’s commonly done and bankers know this, but they’ll still get it signed off in writing that the money was given freely with no expectation of repayment. I’m not sure exactly what would happen if the borrower started mouthing off about it being a loan not a gift but I don’t think they’d be underwritten.

19

Yes they absolutely do.

20

I’m confused. :confused:

Why would you assume the bank wouldn’t care about any side arrangements?