Legally Speaking Cassandra Savoy, Esq. OP/ED
I told you this story. Three guys who had been best friends since high school decided that they wanted to go into business together, and because each of them has a 9-5 job, they decided that they would go into the real estate business and earn passive income.
The realtor showed them a great “three family” in East Orange. They could get the property at a good price because the owner needed to get to Atlanta ASAP. So, they each invested $15,000 and jumped for joy at the “steal.” They decided to have the title company handle the closing and saved another big bundle.
The owner vacated the property when title transferred leaving them with the second floor empty, and the first floor and the basement with rent-paying tenants! The realtor said, “Don’t worry about the tenants. If you don’t like them, you can always get the tenants out!” “You can get them out after you close.”
They thought the realtor was right! It was a good idea to keep the tenants because the tenants will pay the $3,300 per month mortgage, causing it to RAIN MONEY!!!
The three guys each put up $15,000, and the deal was done in two weeks! Buyers decided that it would be a good use of their funds to use a title company to be the settlement agent and it only costed them $1500 and closing costs. This was really a deal!
The closing was February 14, 2019. When they walked into my office, in February 2020, the three best friends were barely speaking, and they hadn’t collected a dime in rent! Since February, one of the “best friends” has walked away from the transaction and left the $15,000 from the original invested and another $10,000 he contributed to paying the monthly mortgage when the tenants failed to pay!
This travesty could have been saved on so many levels, but not the least of those ways would have been if the three friends had established a business relationship at the start; if they had started a limited liability company, commonly called an LLC some of the problems might not have come up.
The thing about LLC’s that gets investor’s excited is the fact that when you form an LLC, you and your co-founders, will only put at risk the money and the financial assets that you contribute to the LLC. If the LLC gets into trouble and can’t pay its debts, or if someone files a lawsuit against your LLC and wins, then they are not going to get your home, your IRA, your car or anything out of your personal bank account. This means that what you don’t directly put into the business is protected. With our three best friends, they have good jobs and houses. If one of the tenants were to file a negligence suit and win, their personal assets, including the IRA, and the house that provides a roof over their children’s heads, are at risk. What they really forgot was that they needed a plan.
The Operating Agreement forces the co-founders to make a plan and to really think about the investment and the people who are joining the group. An operating agreement at the start, before the parties ante up, forces the members to identify the enterprise’s goal which will drive many other decisions. The problem with going into business with others is that sometimes people use the same words but mean different things.
For example, the best friends all agreed “to buy a rental property,” but that could mean something different to each of them. Is the goal to buy a rental, make a few repairs, increase the rents and sell? Will you sell as soon as the fix-up is complete, or will you wait to get tenants with the hope of driving up the sales price? Is the goal to use the first property as a stepping-stone to the purchase of other properties: Reinvest the proceeds? Or, is the goal to buy the property and hold on to if for the long-term income benefits? This is a critical decision, because it will dictate many of the other considerations as you move toward your investment goals.
It seems clear that our three best friends only planned to buy a property and had made no plan for what they would do once they owned it. For example, if the goal is to buy, fix-up and sell, knowing that will lend insight into whether you borrow “hard money” or whether you go to the bank?
If the goal is to keep the property as an income producer, then that will not only direct where you seek financing but will remind the founders to make sure the tenants actually pay rents every month, when the leases expire, whether the tenants frequently make late payments.
Having a plan will help guide the roles of the various founders. For example, if one of the founders is a handyman, the founders might assign him the role in the operating agreement to make minor repairs.
THE most important part of going into business, alone and particularly with others, is to have a plan! An LLC is a good format to use with group investing, and having a plan is the safest way not to lose friendship or your shirt!
