Multifamily Deals – Three Things That Can and Do Go Wrong (Part 1)

In my multifamily law practice, most every problem can be boiled down to three issues. First, bad partnerships. Second, bad due diligence. Third, no money. I will evaluate each of these problems over the next three weeks and what you can do to avoid them.

I. Bad Partnerships

Does this sound like the start of your last business relationship?

Does this sound like the start of your last business relationship?

Remember giving or receiving one of these notes back in third grade?  The response usually came back quickly without much thought being given to the answer. And if it didn’t work out, you drafted the same note next week and sent to the next lucky girl or guy.

When people come to my firm seeking partnership advice,, usually because they are already in a bad partnership, I ask them how they became partners in the first place and I never cease to be amazed at the responses. Many times, though, it sounds just like the third grade note; quick response and not much thought behind it. Why is that? Why do you enter into long-term business relationships with very little thought or planning?

It can be boiled down to one thing – a lack of confidence.

Many new investors do not feel confident in their ability to lead the acquisition team so they solve that problem by finding other people to join them in their dilemma. They hear only what their itching ears want to hear. Did you ever think that the other person may have the same issues and possibly even bigger problems than you have? Is that really a good partner?

So how do you protect yourself from getting into bad partnerships? (Legal Disclaimer: Following the steps listed below is no guarantee that you will not find yourself in a bad partnership but failing to follow these steps will almost guarantee it).

1. Ask the questions you are afraid to hear the answer to. Have you ever been married before? (figuratively speaking). How much money do you have? How is your credit? What properties do you currently own? Have you ever lost a property to foreclosure? What experience do you have in managing property? managing a business?

You would be surprised at how many partners never even get into this much detail before they get married (I use matrimonial terms interchangeably with partnership terms because, but for one major difference, marriage and partnerships are the same. What’s the major difference you ask? Sex. But in a partnership, you could still get screwed).

2. Discuss the double “D’s” – divorce and death. What happens when it doesn’t work out? What happens when one party decides that multifamily is really not for them, instead they want to go and open up a sub shop? What happens to the partnership when one party dies? If you are not asking these questions, your investors absolutely should be. Think about it from their perspective. They are investing their retirement funds with you and neither partner has even discussed disaster planning? That is not a sound business plan and one that investors should not be too excited about.

Burn the Ships

Burn the Ships

3. Burn the ships. Remember the story about Cortez and his motivational exercise of burning all his ships in order to convince his soldiers that it was all or nothing? Do the same thing with your partnership. Put incentives on the other party to achieve the partnership’s objectives.

OK, this next part is extremely important and one that I see all the time. When you start a partnership, you do not have to make all initial partners equal partners on Day One. You can require them to achieve certain mileposts in order to receive their percentage interest.

Many times partners come together because one person has one expertise while another has a different expertise. For example, one partner is great at raising money while another knows how to rehab a property.

What they do not understand, especially if this is their first time, is that once the money is raised, that job is over. If the investment strategy was to hold that property for five years, what role with that partner continue to play? If he was given his membership interest because he raised the money and now does not have to do anything but sit back and enjoy his acquisition fee, then that is going to cause some serious strife with the partner that is busting his butt everyday making the investment work.

Hold back on the membership interest when the entity is set up. Make people have to earn their share over time. If they are truly committed, they will do whatever it takes to make the investment a success. They will burn the ships.

5. Talk Money. All the time. Discuss expenses. Talk about where the money is coming from. Who is bringing what to the table. Make sure that the two of you have the same philosophy when it comes to spending partnership resources.

I saw one partnership break up because one partner would jump on a plane and fly out to the property every time there was a problem. That happened to be almost every month. The other partner finally blew the whistle on it and said he was doing it more to get away from his wife than it was to solve the property problem. (Editors Note. He turned out to be right. The partner and his wife divorced soon thereafter but the partnership was thousands of dollars poorer because of it).

6. Document Everything. Who said what? When did they say it? Are all parties in agreement after what was said was written down and shared among all members?

So many times partnerships break up because of a misunderstanding in what one party thought the other party was supposed to do. If the two of you agree on something – document it. Don’t leave it to chance.

One of my cases involved a partnership where the investors (they are your partners too) thought they were buying one investment but when it was all said and done, turned out to be an entirely different investment altogether.

Sounds crazy? Here’s what happened.

The investors were recapitalizing a property by contributing more cash to the LLC. For this, they were receiving a membership interest in the existing company. They thought the company owned a multifamily property but instead, the company had outside ventures that were draining it of cash in addition to the multifamily property. The money that my clients were putting in was not being used for the real estate. It was being used to pay past debts of the side business.

What was the outcome? They never read the documents that they were signing and did not do the proper due diligence and ended up essentially getting exactly what they paid for. This was one of those cases where I heard that infamous catch phrase – “I wish we had met you sooner.”

How do you protect yourself from bad partnerships? Do all the things mentioned above and then communicate, communicate, communicate. And then CALL ME. Please do not be the next person I hear say, “If only we had met sooner.”

 

  • Great post Charles. The parallels between partnerships and marriage are important to keep in mind whenever you’re ‘getting into bed’ with another investor or business person.