$185k into a six unit with a first time operator, out at 22 months, what actually held it together

This was the first time I've been the money rather than the person selling a service, and I nearly talked myself out of it four times.

Operator was a contractor I'd worked with on two of my own client projects. Six unit, brick, $640k purchase in a second ring suburb, rents about 22% under market because the prior owner hadn't touched anything since 2011. Total capital in was $265k including $71k of renovation. He funded $80k, I funded $185k.

Structure I pushed for and got:

9% pref to me, current pay to the extent of cash flow, accruing simple on the shortfall.
Return of capital next, then 50/50.
Capital calls pro rata. If either of us doesn't fund, the funding partner can elect a member loan at 12% that repays before either pref, or convert at 1.5x dilution. That clause got used, more below.
Major decisions requiring my written consent: sale, refinance, additional debt, any single capital expenditure above $15k, changing the property manager.
He got no acquisition fee. He got $1,000 a month construction supervision during renovation only, and market rate property management through a third party, not himself. That was my hard line and it cost me a week of arguing.

What happened: renovation ran $71k budget to $94k, mostly because two of the six units had cast iron drain stacks that failed pressure test. That's the moment the deal nearly broke. He couldn't fund his 30% of the $23k overage. He asked to be diluted. I lent instead, $23k as a member loan at 12%, because a diluted partner who feels punished on month five of a 24 month plan is a partner who stops answering the phone.

Rents came in at $1,285 average against $1,240 underwritten. Refinance at month 19 pulled $198k out, which repaid the member loan with $5,700 of interest, cleared my accrued pref shortfall of about $9,400, and returned $153k of my $185k. We still own it, I've got $32k of basis left in and a 50% interest in a building that cash flows about $1,900 a month after the new debt.

What I'd keep: no acquisition fee to a first time operator, third party property management, and the member loan option written in before I needed it. The consent threshold at $15k I'd raise to $25k. I got called four times in three months on things I had no business deciding and it slowed his crews down.

7 replies

2nataliehsuSO1BPRO7

The part I'd have gotten wrong is the member loan versus dilution choice. You framed it as keeping him motivated. Did you run what the dilution would have paid you? 1.5x on $23k against his $80k basis is a real chunk of his equity.

1stephen_ok9CO2CPRO6

plumb, that math is roughly $34.5k of credited capital against a $265k stack, so his 30% goes to maybe 22% and lantern's goes to 78%. On a refi at month 19 that's worth less than the 12% loan repaid ahead of everything, and it costs you your operator's head. I think the call was right on this deal.

lantern, the question I have is the drain stacks. Six unit brick from that era, you had a contractor as your operating partner, and nobody pressure tested before close. Was there a physical inspection scope you agreed to, or did his being a contractor substitute for one? Because the pattern I keep seeing in JV equity is the capital side relaxing diligence in proportion to how much they trust the operator's trade background.

3raj_mehta14CapitalPRO6

The waterfall part took me three readings to follow. So the member loan sits ahead of your own pref, meaning if you lend the money you get paid before you get paid? That still seems strange to me even though I follow the mechanics.

1monica_tran3SF4CPRO6

vellum, yes, and that's the point of it. Debt to the partnership is a different claim from equity in the partnership. It's ahead of both partners' pref, so it's the cheapest way to plug a hole without renegotiating the deal.

lantern, the $1,000 a month construction supervision. Did that stop the day the last unit turned, and did anyone actually check?

0samantha_ruizAU4APRO6

Where I think this got lucky is the refinance at month 19. You pulled $198k out of a $640k purchase 19 months later, which means the appraisal came in high enough to support it. Change that one number and the whole thing looks different. If the value only supports $140k of proceeds, you repay the member loan, clear the accrued pref, and you're still $50k in with no exit in sight and an operator whose supervision fee ended.

Not saying you didn't earn it. But the structure you'd keep was tested in a scenario where the exit financing cooperated. I'd want to hear what the plan B was.

2karen_whitfieldPG4APRO7

keystone's point is the whole post to me. The clause work was good and the appraisal did the heavy lifting.

lantern, what was in the agreement about a hold if the refi didn't clear? Anything about who decides to sell instead, or does your consent right just mean you both sit there disagreeing?

2kevin_lombardPG1BPRO5

I went through this a second time. The part I'm noting down is that you wouldn't let his own company do the property management. Is that a normal thing to ask for, or was it specific to him being new at this?

$185k into a six unit with a first time operator, out at 22 months, what actually held it together

7 replies