“What if my investor wants out of the joint venture deal?”
Our worst partnership was created when I was more focused on my new career after graduating from my MBA than I was on our real estate portfolio. It was 2004. Dave had begun to dream really big and had met someone to work with on these big plans.
This guy was a creator and innovator. He had started a company that was growing rapidly and was already winning some business awards. He was an idea man and was well connected to a lot of people with money who would be keen to put it into real estate.
The two of them thought that they could create a syndicate with this guy’s contacts and Dave’s expertise. Dave spent hours and hours meeting with him and planning the syndicate. They did a couple of deals together and planned to do a lot more.
I was busy with school and was not interested in a syndicate. I also didn’t think this was the guy to do it with. He was controlling and yet scattered. He insisted on being involved and yet was hard to get in touch with.
Dave was frustrated with the challenges he faced in working with this guy but continued to push forward as he saw the potential. When they had the first two under their belt, Dave found a couple of other ones. Dave made offers but Dave could not get him on the phone. He had to let those deals go (those deals promptly doubled in value so Dave was pretty upset he’d relied on this guy instead of doing them without him).
He couldn’t even get in touch with this guy to discuss the properties they already owned. Sometimes it would take 2 weeks before Dave would hear back from him.
Eventually Dave accepted it wasn’t working. So he needed to break up the joint venture.
This is the only time we’ve had to break up a joint venture. We quickly realized how important it was to only work with our ideal investors. So what are your options?
First, prevention is the best medicine.
You may pursue Joint Ventures (JVs) for flips, big deals like apartment buildings or commercial developments and your specifications of what you’re looking for may be different than what we do (see structuring real estate Joint Ventures). For us, we tend to look to private lenders for money for anything outside of buy and hold residential deals and rent to owns. There are a lot of reasons for that but the biggest reasons are the increased risks and the increased need that someone has to be on the same page as you for the future financial requirements of a deal (we’ll be teaching you how to find private lenders and joint ventures in April in Toronto). We prefer to handle those issues on our own and work with a joint venture for the more stable investments like small multi unit or single family buy and holds and rent to owns.
In those cases you want to make it clear that you are looking for a minimum of a five year commitment. You want this even for rent to owns because if the deal doesn’t close as expected it likely will be a property you hold for close to five years (or longer) (see why rent to own investing can stink).
In our agreement we state a minimum hold of 5 years or an increase in value of 25% before either party can exit.
Despite the prevention measures, life happens. If it’s time to exit, someone needs out or the relationship is challenging and you want out, what are your options? These need to be spelled out in your joint venture agreement, but here’s a few options for you:
Right of First Refusal – if the term has completed and one of you wants out the other partner has the right of first refusal to buy them out. This ensures that either party doesn’t turn around and try and sell the property from under the other party. It gives the other partner a chance to buy the person out before they sell it to the market (a third party).
What does that process look like? Your agreement needs to spell out how you determine fair market value. For most people you will get an appraisal done and if both parties agree with the appraisal or the value then the one party may buy it from the other for that price. We allow for the average of two appraisals to be taken to determine fair market value in the event that the parties don’t agree on the value of the first appraisal.
Splitting the Chocolate Bar – Now, if you have not reached the five year term, if that is what you agreed to, (or the value hasn’t increased by 25% as per our agreement) and one partner wants out, our approach to this is something we call “splitting the chocolate bar”. Other people might call this a shot-gun clause.
If one party wants out before the contractual time frame this is how we handle it.
Imagine you have a chocolate bar. One party breaks it in half and the other one picks which side they want first. If I am breaking it to share I am going to split it as close to the middle as I can so you don’t take a bigger piece from me.
If, however, I am a crazy person that doesn’t like chocolate, and I don’t want to end up with the chocolate bar, I should break the bar so that there’s a bigger piece for you to take so you are more likely to take it.
Taking this to the property to explain the concept: the person who chooses the value would be the one that wants to break the contract. The other person determines if they will buy the property at that price or sell it to you. If you want me to buy you out and you’re choosing the value, you would be wise to offer it to me at a slight discount so I am motivated to buy it from you (or it’s attractive for me to bring someone else in to replace you in the deal). I basically get the choice of whether I buy it from you at that price or sell it to you at that price. If you get too greedy I can tell you to buy it from me.
For example, I know the property is worth $240,000 but I want out. When I decide the value of the deal I might say $220,000 to give the other person an incentive to buy from me. If I say $240,000 there is a good chance the other party will say “Ok I’ll sell it to you for that!”
If you are in the position where it’s favourable to buy out your partner but you can’t qualify for financing or you don’t have the cash then you can consider bringing in a new person to replace your investor. If they have made the price attractive enough and it’s a good asset, you should be able to find someone to take their place. You could also look at private money if the cashflow is strong enough to cover the higher cost of a private mortgage. And, if all else fails and you can’t buy them out when they want out no matter how attractive they make it for you, you’ll have to put the property on the market.
How Do You Determine Fair Market Value?
It’s easy for us to determine fair market value for most of our properties because we are hands on and very active in the market. We know what is selling and for what price. But for the purposes of splitting off a partnership or where fair market value needs to be determined, we spell it out in our agreement how the valuation will be done.
You should include something in your agreement that spells out how fair market value is calculated. Our agreement typically states that each party hires an appraiser and take the average of the two appraisals.
We have a term in our agreement that says that the property will be held until the property appreciates by 25%, or we’ve held the property for 5 years. When one of those conditions is met, either party has the right to sell – and the other partner basically can’t refuse. This is when the right of first refusal kicks in.
If one of you wants out before either of those conditions is met, for example if your partner wants to sell after three years and the property has only gone up in value by 5% it’s probably not advisable to sell. In that situation you would use the ‘splitting the chocolate bar’ method to separate.
One of the questions most people will ask you is when they will get their money back. As we’ll discuss shortly, the most important thing for you to do is align your investments and your strategy with the right people. In our case, buy and hold real estate investing, we’re always holding for the longer term. Our ideal partnerships are those that really don’t have a need for the cash anytime soon. We want to hold for as long as possible to maximize the return and profit. That can take more than seven years depending on where you bought in the real estate cycle. We would prefer someone who is continuing to generate income and is using this as part of their overall income strategy to grow their wealth. As a result they won’t need their money out until we believe it’s the best time to exit. But regardless, everyone wants to know when they will get their money out so having something in your agreement that shows them there is, in fact, a way to end and get their money out will give them comfort.
And since we’re talking about breaking up a joint venture, let’s talk about a darker subject.
What Happens If Someone Dies? The incapacity Event
This is a subject nobody likes to consider, but it is important.
For your own comfort and that of your loved ones, you should know what is going to happen to your properties if you pass away. For your partners assurance they need to know you have a plan.
For your assurance you need to know your partner has a will so the property doesn’t get tied up in probate hell for years.
We spell this out in our agreement and you should too. It outlines what happens if someone can’t make decisions anymore or they pass away.
In our case, if Dave or myself were to be incapacitated, the other would just take over. We run our business together and while Dave handles more of the day to day operations, I am capable of running the entire business. If we both were to pass away, we have a real estate experienced lawyer who is our executor and he would take over the managing role.
We have it spelled out that he would contact the JV partners and review the options.
One of my coaching clients was concerned about what would happen if she passed away. Her husband is not involved and she fears the amount of stress it would put on him if he had to manage the properties himself. My suggestion to her was to hire a property manager for at least one of her properties so that she built a relationship with someone who could take over all of the properties if something were to happen to her. I also suggested she create a spreadsheet that outlines all the important information for each property (including bank account numbers and passwords). Keep that locked in a safe and up to date.
It’s not a foolproof plan, but it’s much better than no plan at all.
If something happens to your JV partner and they’ve qualified for financing what is going to happen to their side of the deal? Does it transfer to a spouse? Do they have insurance that will pay out the debt? Just like you have to cover your side of the deal, you also need to understand they have their side covered.
In most cases, in the event of death, you’d probably sell the asset or the surviving party would buy out the estate of the passed partner. The important thing is that there is some commentary around that. Ensure you have that conversation with your JV and with your lawyer.
As with every legal document there are a lot of areas to cover and this is not every single detail. I am also not a lawyer nor have I had any legal training. This gives you some critical elements to discuss with your real estate specializing lawyer when you get your own document drawn up but should not replace the advice of legal counsel.
Joint ventures are a great way to grow your portfolio but it’s a business relationship. It’s important you treat it like that and consider the ways to exit the deal as well as all the ways you’re going to find people to enter a deal with.
You are about to become a compelling conversationalist that attracts money right to your door.
Eliminate the fear you have around asking for money for your deals – forever.
Natural born salespeople need not apply – this is for folks who aren’t sure how to structure their joint ventures and lending agreements. This is for people who feel uncomfortable pushing their money raising agenda in front of people. And, this is absolutely for people who want to learn how to be comfortable AND confident when they talk about their deals with other people.
There’s no fancy techniques or slick selling tactics. What we teach is what we do … We don’t teach weird sales tactics. We teach you how to have people COME TO YOU!
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