The pros and cons of borrowing to invest with a buddy
Property has become the hot topic at many a backyard barbecue and dinner party in recent times. More and more people want to get into the game and with affordability continuing to be cause for concern, a lot of punters are willing to ‘partner up’ to get a slice of the action.
Capital city property prices have risen dramatically over the last decade, and first timers in particular are having a hard time trying to get a foot in the proverbial door of our inner urban residential housing markets.
Affordability and today’s modern, hectic lifestyle that makes it increasingly difficult to dedicate the necessary time to researching the markets, are just two of the many reasons beginner and experienced property investors are considering the concept of a ‘borrowing buddy’ to invest in real estate.
Of course this plan of attack can have as many drawbacks as potential benefits, and we’re all familiar with the old adage about working with friends and family.
So as an investor building what’s essentially a real estate based business, how do you reconcile with a partnership structure that involves friends and/or loved ones?
Is it possible to buddy up with an investment partner and still maintain a healthy relationship?
The buddy blues
Any number of business books will tell you that partnerships are more likely to fail than succeed. While this may seem like a pessimistic viewpoint, I could not agree more after having learned the hard way, from my own experiences.
The good news however, is that investing partnerships are not nearly as complex as business partnerships. So my gut feeling is that they have a better chance of survival.
Of course to ensure your chance of success, these partnerships cannot be the result of excessive alcohol consumption with your mate on a Saturday night at the pub. They have to be conceived in the cold light of day and without any rose-coloured glasses (or beer goggles!) clouding your judgment.
Approach the partnership with the expectation that it’s likely to fail and you will have to do everything possible just to make it survive. If you do this, you’ll probably have a good chance of making it work. Partnerships can be very rewarding but the majority require a lot of toil and truckloads of patience.
One of the most successful business moguls of our time, Sir Richard Branson, always suggests a 50/50 partnership is best because each party has equal incentive to make it work. On the other hand, other noted business people (Simon Reynolds for one) say the contribution of each partner is rarely equal and that’s why 50/50 partnerships don’t take.
Confusing as it is, I agree with both views, in that there is no easy way to make partnerships work. Perhaps the best thing you can do is recognise that the contribution made by each partner can never truly be equal and in fact, this can be of benefit to both of you.
For instance, a wealthy, time poor person might be a good partner for a not so wealthy person with plenty of time to burn.
In other words, partnerships may work better when each partner’s contribution is uneven (eg. one partner contributes the money and the other contributes the time). This way each partner needs and relies on each other equally and it all works out in the wash!
Sometimes a positive attitude is the key to success. The thought that constant perseverance will get you anywhere can indeed end up taking you all the way to your goal.
Although I believe the reverse is true with partnerships. While conceiving the partnership, you should always play devil’s advocate and think about the downside.
Have written agreements in place and a contingency plan to govern what you’ll do in the event of something going wrong, such as communication issues or making a loss. This type of preparation is worth its weight in gold, as the more planning and discussion you undertake upfront, the less financially detrimental disputes you will have down the track.
What will lenders think?
When applying for a loan banks will, for the most part, assess the application as an aggregate. That is, they’ll add up all the applicants’ combined income, commitments, assets and liabilities and assess the application as a ‘group’.
If the applicants can afford the loan as a group, then it will be enough to get the loan approved.
The bank doesn’t really give a great deal of consideration to each partner’s share of the debt (eg. if there are three partners the bank will not ensure each partner can afford one third of the total debt). The benefit of this is that financially stronger partners are able to support the weaker partners.
If the partners are investing through a non-trading company or trust, each partner will be required to provide personal guarantees.
Was it as good for you as it was for me?
There are many issues to consider when financing a real estate purchase that will be owned by investment partners. Most of these should be considered upfront to avoid any messy conflicts down the line. In fact, some issues can be so critical that they could prohibit the partnership from investing in any property at all.
The most significant concern is that each applicant to a loan is jointly and severable liable for the total debt. This means that each partner is liable for 100 per cent of the debt and therefore each partner’s liability is not limited to their share of the debt alone.
This creates two significant issues. Firstly, if your partner(s) decides to do a runner, then you’re left holding the bag. If this happens, you could probably sue that individual and claim ownership of 100 per cent of the property, which might seem OK. But what happens if the property has decreased in value and there’s a net loss?
The second (and more realistic) problem is that joint and severable liability can destroy your future individual borrowing capacity. For example, if you apply for another loan (as an individual), the lender will assume in its application assessment that you are liable for 100 per cent of the loan repayments for the partnership’s debt (in reality repayments might be split 50/50 between partners) because that’s your legal liability.
However, they’ll only take into account your share of the rental income. This could spell the end of any future borrowing capacity.
Another consideration when applying for a loan jointly in a partnership arrangement is how it will be treated in the event of a fallout.
Consider the situation where three partners invest and apply for a loan together. Assume that one partner is significantly stronger from a financial perspective than the other two parties. What happens if the stronger partner decides to withdraw from the partnership and therefore withdraw their name from the loan documents?
In this case, if the two remaining parties can’t afford the debt by themselves, the bank will refuse to remove that partner from the loan and they’ll essentially be stuck with the property (and in the partnership).
The only possible solutions in this scenario are to find a replacement partner (which might be difficult given one partner wants to leave), or sell the property. Let’s face it…neither solution is optimal.
Another issue is that if the partners are not relatively equal in terms of financial strength, this could cause problems sourcing finance. Lenders must make sure that every borrower has a ‘financial interest’ in being party to the loan.
A classic example is where parents act as co-applicants on their child’s mortgage, even though the title of the property is in the child’s name alone. In this situation, the parents have no ‘financial interest’ in being party to the loan…so why should they repay debt for a property that they don’t own?
Some borrowers (parents) have taken the banks to court and argued it was unethical for the bank to approve a loan structured in such a manner – especially where the bank didn’t make sure the parents fully understood what they were entering into – because they were not acting in the clients’ best interest. In some cases, the court has agreed and relieved the parents of any responsibility for that loan.
Therefore, one partner providing all the serviceability may cause problems, because the bank could conceivably question why that person would be willing to essentially ‘carry’ the other partner(s).
One solution to this conundrum may be to provide the lender with a solicitor’s letter confirming that all partners are aware of the risks and responsibilities of entering into the loan.
Get your own money!
A really good solution that greatly reduces risk (and probably appeals more to equity-rich investors) is for each partner to borrow his or her share of the money using another asset as security.
For example, I recently advised some clients involving two partners (friends) owning a $500,000 property 50/50. I advised them to each borrow $250,000 in their own name against this home (i.e. using their home as security).
That means the investment property wasn’t used as security at all. Therefore, there are no joint liability issues and it’s all nice and clean. Of course, it’s not a perfectly efficient use of equity (because there’s an un-geared asset) but this probably doesn’t worry people that have more equity than their borrowings needs.
My advice: Nothing is forever
In nearly a decade of advising borrowers, I have never once seen an investing partnership work well. My number one bit of advice would be to treat every investment partnership as a short-term solution – a stepping-stone.
Normally, investors get together because they are weak on equity or income. If this is the case, I suggest you sit down and work out what you need to do, over what time period, in order to stand on your own two feet.
For example, you might suggest buying a property together, renovating it and holding for say 5 to 7 years and then selling. This might give each partner enough of a deposit to then purchase a property investment on their own.
I think this is a far better approach because it acknowledges that nearly all investing partnerships have an expiry date. One partner is generally left wanting out (to move onto the next transaction) whereas the other party isn’t ready.
They can subsequently end up wasting years being polite and both getting nowhere. Look at it as a short-term joint venture and you have a far greater chance of success.
That’s not all…
There are many other factors to consider when determining the best structure if you are contemplating entering into an investment partnership. Apart from the lending factors I’ve explored, you also need to take into account legal and taxation issues.
Always seek your own independent tax and legal advice before acting upon any suggested structures.
Investing with partners has many pros and cons, along with countless issues to consider. The finance concerns can be complex, but the right structure and advice can generally resolve most things.
The point is, the more work you do upfront the more likely you will be to succeed. Better still, find a reputable and experienced accountant, solicitor and mortgage broker and let them do the work for you!
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