Buying property with friends and family

One common theme that seems to be on the 'up' this year, is two or more investors coming together to buy property through small private partnerships, LTCs or joint ventures. 

Common examples include:

1. Family members buying an asset from the deceased estate of a relative

2. Family members or friends pooling resources of capital to get enough deposit to buy a property together

3.  One partner has good cash flow, but no deposit. The other has equity in a home or a deposit, but no cash flow. Together, through a partnership they are bankable and safe investors, ticking both the cash flow and equity boxes and qualifying for finance.

4.  An 'asset rich, time poor' investor agrees to back an 'asset poor / time rich ' investor with skills in property. One funds the other, the other finds the deals. Together they can be a clever investing partnership, combining human and financial capital.

Combining resources can make sense

Combining resources can make sense for people in various circumstances, but care needs to be taken in setting up a good foundation structure. Any partnership agreement should deal with dispute resolution, and the rights and obligations of partners in advance of the partnership starting. Unfortunately over the years we have seen many a client spoil a relationship with a friend, business colleague or family member through bitter feuds in partnership.

Personally I have found partnerships very powerful and rewarding, allowing me to grow and extend my business and property interests. But in saying that, I have seen a few train wrecks emerging in the client base too, with clients very bitter and angry with their business partners.

Partnership agreement the key to avoiding disputes

I have always found that where a clear partnership agreement is put in place (for whatever your trading entity form e.g. LTC, partnership, or joint venture), problems are less likely to arise because the parties to the agreement know their rights and obligations before they begin. If you like, the time to have the argument is at the start of a new investment or enterprise, rather than 'working out the issues as they arise'.

Whether you are going to trade through an LTC, trading trust, general partnership, limited partnership, ordinary company, or joint venture.....the story is the same and the arguments that arise are similar.

Typically one party will say ' I am doing all the work (or more of the work), so I should get all the money'. Another party will say 'I am doing all the funding (or taking risk through securing bank loans) so I should get all of the money'.

Both parties likely have a point. Resolution lies in agreeing a remuneration formula which addresses both the issues of payment for work done, and payment for risk taken / capital supplied to a venture. By this method you simply agree over:

1. Payment for work done: The fee for time spent working on the investment portfolio will be an hourly rate of $x, payment by agreed method (either when the property is sold or week/monthly or as suitable between the parties). Where both parties agree that time spent is equal, they may elect not to draw remuneration. Where time spent is slightly unequal, the parties may agree that the party doing slightly more work will draw for their 'differential work' done. For example, if one party does 7 hours work a month and the other 3 hours, then the party doing 7 hours gets paid for 4 hours and that addresses the imbalance.

2. Payment for risk / capital invested: The remuneration for capital invested is interest, paid periodically. By paying interest on partners' advances at pre-agreed rates, no partner can claim any grievance for 'doing all the funding / doing more funding' because they have agreed to fund at that rate for the term of the investment. Where the capital is by way of security being provided, it may be appropriate to address the security risk by paying for it. Say your sister puts her house up as security for a loan in a joint LTC to buy a rental property, you pay a guarantee fee. Such fee may be say 5% annually, of the maximum security risk exposure. (Example: Your sister provides a cross security of 20% for a $300k house purchase by your joint LTC with her. At 5%, the annual fee is 5% of $60k = $3,000 annually).

Where one party is providing equity, and the other is providing time, it might be appropriate that by partnership you agree that one parties contribution (time) offsets the other's (capital risk). By putting numbers into the equation, you can maintain by partnership agreement a common understanding that if time goes up, or security risk goes up, then the imbalance is addressed by more wages paid or more interest or guarantee being paid for the emerging imbalance. This is fair, commercial, and stops arguments in their tracks.

Typical partnership agreement considerations

Your partnership agreement should address the following as part of its scope:

1. Funding obligations: Whose responsibility is it to fund and to what extent ? Is it based on proportion of entitlement (pro-rata) or is it unequal? Consider the funding obligation both in the context of initial advance and ongoing advances for any capital that is required to be injected in the future - what is the obligation to fund by the respective partners and in what proportion at what time frame?

2. Remuneration for time spent by partners: As stated above, what remuneration are you entitled to for time spent working on the portfolio and affairs of the company/partnership, if any? Will you draw the wages, or offset against the other party's contribution (of time or capital)? Where time spent is equal, typically no wage is drawn. Remember, wages require tax considerations to be addressed so should be avoided if possible.

3. Default of a partner: What will you do if one party cannot pay? Force a sale or exit from the investment? If so, what penalty should be paid by the defaulting partner? In some joint venture agreements I have written, I have provided in the agreement a provision that says the defaulting party loses their capital/shareholder's loan and all shares/units in the investment if they do not pay their dues. This is to stop people 'riding on the goodwill of others'. This is particularly effective between people that do not know each other well, as it provides real incentive to behave and meet obligations without stressing partners. If someone is interested in this concept, contact the writer (jr@gra.co.nz) and I can provide assistance here - this is a great idea that makes your partners behave properly and honourably.

4.  Voting rights and arrangements: Generally when partnerships are going well, formalities of voting are irrelevant. But when disputes emerge you should have a clearly defined voting process and your voting rights should be set out. It may by that if you are the partner with the most at stake (e.g. you are the funder), then you may require a 'governing directorship', giving you the ability to make unilateral decisions and force your will, if you believe the action of your partners is threatening your capital or security position.

5. Dispute resolution: Going to war in court can be expensive. It's best to have a pre-defined mediation or arbitration process that is binding on the parties, or at least an obligation to explore mediation. It's also best to have financial consequences for not following the rules...otherwise there is no incentive to follow them. If something matters to you, define breaking the rule as a 'default' and apply the 'forfeiture of capital' rule in point 3 above.

6. Rights and entitlements/obligations on dissolution of the partnership: When you sell property, sometimes the costs exceed the sale proceeds. Who loses and in what proportion? Should capital advanced rank in front of payment for work done by partners? Should interest rank in front of capital gains? Agree and write it down at the beginning, and you won't have a problem at the end.

7. Restraints: Are you allowed to steal tenants off the partnership, or resources for your own private activities? If not write it down.

8. Exit rights: Partnerships will always end. Someone will die, retire, go broke, remarry, or just have a change of heart. Give yourself the right to exit and stipulate when (at the earliest) this can be, how it will be done, and what penalty there will be for early exit. For example, if you agree you will be in an investment for 10 years minimum, and someone exits at year 2 because they have a change of heart, perhaps they forfeit their deposit and shares? It's up to you - you define the rules the way you want.

Summary

Investing with your friends and family is a powerful way to combine human resource and capital and get a great investing outcome. Make sure you think about what your rights, obligations and profit sharing agreements are. Set rules and consider penalties for rules not being adhered to. Do this upfront and you will be much less likely to have a problem later on when partners' circumstances or the investment circumstances changes.

Anyone forming a partnership who would like a hand with the tax or agreement drafting, is welcome to arrange a meeting to meet with me.