my lawyer said "you're building a fund, not buying a house, so stop using house logic" and i can't let it go

we were going through the structure for a small equity vehicle, maybe 3 or 4 limited partners to start, targeting small multifamily in the 400 to 700k range in secondary markets in the midwest, specifically looking at terre haute and fort wayne right now. and i kept framing everything around what the building cash flows in year one, debt coverage, the usual. she stopped me mid-sentence and said that's the wrong unit of analysis when you have outside capital. the fund is the unit. the building is just where the fund lives for a while.

i've been investing my own capital for six years so the habit is deep. you find a triplex, you underwrite the triplex, you close or you don't. but when lp money is in the picture even two partners is different. she said i need to think about what the fund promises, what it can actually deliver, and whether those two things can survive a bad year on one of the properties without blowing up the relationship with everyone in the vehicle. she put it plainly: "a tenant who doesn't pay hurts your cash flow. a tenant who doesn't pay when you have investors hurts your reputation and possibly your legal exposure." that landed differently than i expected.

i'm not close to launching anything. we're maybe six months from having documents she feels good about. but i keep turning that sentence over. house logic versus fund logic. i thought i was further along than i apparently am.

2 replies

0colin_ferraroAP2C

fort wayne's vacancy swings hard enough in a bad quarter that a single non-paying tenant on a four-unit can miss your preferred return threshold for the whole vehicle, not just the property.

victor_lamCS4APRO8

the reframe that actually hurt to hear from my attorney was similar but came from the waterfall direction. i had structured a two-partner deal on a four-unit in rockford, illinois, 2021, and i wrote the preferred return off the property's net operating income the way i'd always thought about it, building logic, property cash flows first and then we split. she caught it in review and said that's not a preferred return, that's a participation, and if the property has a bad quarter your lp is structurally junior to your operating expenses with no protection. i didn't fully believe her until q3 2022 when we had a unit turnover and a furnace replacement in the same month, noi went negative for the period, and my lp got zero that quarter. legally fine. relationship, not fine. cost me about eight months of trust repair and i think that partner is out when this one exits.

the thing your lawyer is pointing at with "the fund is the unit" has a very specific mechanical consequence that took me longer than it should have: your reserves have to live at the fund level, not the property level. i was holding reserves per building, which sounds conservative, it's what you do when you own a triplex yourself. but with two properties and three lps, a bad year on property one can't be buffered by reserves sitting in property two's account if you've siloed them. i learned this the slow way. now everything pools at the entity level, minimum six months of debt service across all holdings before i'll accept a capital call from anyone, and i put that number in the documents so it's not a conversation i'm having under pressure when something goes sideways in terre haute at 11pm on a friday.