You may hear the terms debt partner and equity partner thrown around when working with other investors on a joint deal. What are the differences between these two partnership structures and which one is better? Here is a quick overview of these two ways to partner on a real estate investment.
DEBT PARTNER: A debt partner is someone who loans money to someone else for an investment in return for an agreed upon interest rate until the debt is repaid. The debt partner has no ownership stake in the investment but the property is generally used as collateral through a promissory note and mortgage. If the borrower defaults on the loan, the debt partner can foreclose and take ownership of the property.
Example: Jim finds a great deal on a single family home that can be rehabbed and flipped for a substantial profit but he doesn't have enough cash to purchase the property and fund the rehab. He reaches out to his friend Mary who has a nice nest egg sitting in the bank earning very little interest. Mary agrees to loan Jim $100,000 at 8% interest for 12 months. They have an attorney write up the proper documents and purchase the property in an all cash deal using a reputable title company. Jim gets to work on the rehab which takes 3 months to complete and another month to sell the property to a happy new family. During each of these 4 months, Jim pays Mary $666.67 in interest (($100,000 * 8%)/ 12 months). At the sale of the property Jim also pays Mary back her $100,000 original investment but keeps 100% of the remaining profits from the flip. They are now free to go their separate ways or look for another deal to partner on.
EQUITY PARTNER: An equity partner is someone who is a partner in an investment where they have an actual ownership in the investment. An equity partner may or may not have a voice in the decision making depending on the Operating Agreement of the partnership. Equity partners generally participate in both the upside and downside of an investment.
Example: Using the same example as above, Jim finds a great flip opportunity that will need $100,00 to purchase and rehab. Since he only has $60,000 in cash available, he reaches out to Mary to see if she is interested in becoming a partner and chipping in the other $40,000. Mary agrees so they have an attorney write up their new LLC documents with Jim being a 60% owner of the LLC and Mary being a 40% owner of the LLC. The LLC Operating Agreement lays out the roles and financial expectations for each partner. The property is purchased in the LLC's name. Jim manages most of the day to day operations on the flip and the property sells for $150,000 4 months later. Per their Operating Agreement, Jim receives 65% of the proceeds and Mary receives 35% of the proceeds. The reason it is not 60/40 per their original investments is because Mary agreed to give Jim an extra 5% for managing the project since she has a full time job and didn't have time to be involved in all of the details. The LLC can now be dissolved or Jim and Mary can take their funds and invest in another deal.
Which is better?
There is no right or wrong answer to which is better. Every investor has their own set of criteria, goals, risk tolerances, and preferred way of doing business.
In general, a debt partnership is simpler and contains less risk but doesn't have as much potential upside. I like to start working with people using a debt structure to build up confidence and see how well we work together. These types of partnerships also allow me to "cash out" a partner easier and more quickly should the need arise.
Equity Partnerships are preferred when the investment is going to be a longer term or when taking down larger deals where a pool of investors is required. These arrangements often have a greater upside since equity partners share in the profits from the investments but carry more risk and are much harder to cash out before the business plan is fully executed.
If you are interested in learning more about partnership structures or how we can work together to meet your financial goals, reach out anytime via the contact page at jbfoxcapital.com