Commercial real estate investing is like wanting to date someone who is way out of your league. She’s smart, beautiful, and funny; she has everything you’re looking for, but you just don’t quite have what it takes to get her. You need help. Maybe you get a makeover, or your friend coaches you on how to talk to her. That friend brings you up to the level you need to be at so you can get what you want. In commercial real estate, that wingman is your equity partner.
Working with a good equity partner is probably the most important decision you can make for your real estate project. This person or group is your business partner. Not only is his capital critical to the success of the property, but a good equity partner may provide additional capital to help your property “weather the storm” if things don’t go as well as expected.
On the other hand, the wrong equity partner can cause significant problems for you and your property. At best, you have an uncomfortable and unsatisfying work situation. At worst, your relationship with your equity partner could devolve into a legal dispute. Several years ago, our company encountered a situation in which one of our main equity partners had little understanding of the normal processes of property investment in development. This lack of understanding led him to believe that we were not working in the best interest of the property, and he became belligerent and unrealistic in his expectations. Ultimately, a lawsuit ensued, which caused a large drain on our time and resources.
How to Find the Right Equity Partner
Finding the right equity partner isn’t always easy, but it’s always worth the trouble. Here are a few tips for finding the right equity partner for your real estate investment:
- Analyze the property. First, you should analyze your property, taking into account its size, location, price, and type (office, shopping center, hotel, land, etc.). Furthermore, consider whether it’s an existing property or a ground-up development project.
- Determine who will be interested. Next, you need to figure out what kind of equity partners will be interested in the property. The happiest equity partner is one whose needs are met by the investment. For example, if the investment is a large, fully occupied shopping center, that would be suitable for an institutional investor. However, smaller properties that will seem like “small fish” to institutional investors might be very interesting to individual investors.
- Contact potential equity partners. Once you’ve determined what kind of equity partner will be interested, you’ll need to contact them and present the opportunity. To find institutional investors, it’s a good idea to work with a mortgage banking firm. To find individual investors, your best bet is to work with real estate investment firms and mortgage bankers. On the other hand, if you already know a lot of wealthy investors, you may be able to approach these friends or family contacts about providing the equity.
- Select an equity partner. When you have a few potential investors, it’s time to pick one. However, there are several skills, qualifications, and other attributes you should look for in an equity partner.
What to Look for in an Equity Partner
When finding an equity partner, you don’t have to jump at the first person to offer you money. In fact, it’s best to choose a partner with certain attributes. A good equity partner has:
- Real Estate Investment Experience. Someone with real estate investment experience can understand the ups and downs of real estate markets. His experience may prevent him from overreacting or making irrational decisions when things don’t go exactly as planned. In addition, if your equity partner is experienced, he should understand what’s needed of him and respond in a timely fashion.
- Sufficient Liquidity. Your equity partner should be well-diversified and have a large amount of liquidity compared to the equity investment made in your property. You are much more likely to have issues with your equity partner if the property investment sucks up a substantial portion of his liquidity. If your partner doesn’t have sufficient liquidity, his personal financial issues can put undue pressure on your property to perform faster or better than is realistic. Furthermore, if your property needs additional capital at a critical moment, your partner may not have the resources to provide it.
- Intelligence and Rationality. During the course of your real estate investment, there will be several times when you need your equity partner to approve one of your business decisions. You want a smart and rational decision maker who will consider issues carefully and make the right decision each time so your property can become successful.
You Found Your Partner… Now What?
Once you’ve found your equity partner, you’ll have to determine profit splitting. Most mortgage bankers and real estate investment firms will be able to clearly explain to you the current “market” for partnership profit splitting. You should speak with multiple firms, asking each one for their take on the market. Equity partners will want to make a good return on their investment, usually 15 to 25 percent annually, depending on the type of property. In addition, they will want much of their capital and return back before you earn a sponsor’s profit.
One option for profit splitting is the IRR waterfall technique. Under this option, the debt provider (i.e., the bank) has first priority for repayment and carries the lowest risk, followed by the equity investor, and, lastly, the developer. Under this arrangement, the risk for the equity investor is minimized, while the developer is positively compensated if the project does quite well. If returns are higher than expected, the developer gets a larger share, but if returns are lower, the equity investor gets more of the returns.
Another option gives a specific preferred return percentage to the equity investor and ensures that cash distributions in excess of the preferred return are split between you, the developer, and your equity partner. This split “excess” cash flow is usually highly negotiated on each property. There are other options to be considered by you and your equity partner, and you’ll need to come to an agreement — together.
Finding the right equity partner is more than a simple matter of one successful real estate investment — just like a first date earned through a friend’s help doesn’t necessarily lead to another. If the first investment goes well, the success may convince your equity partner to invest in multiple projects in the future. At that point, you’ve created a real estate investment “marriage” by creating an efficient, effective, lasting partnership that is far more valuable than a one-time deal.