Real Estate Partnership Structure Guidelines
By Percy Nikora, Owner, Co-Founder
There are many ways for someone to invest in real estate. Some will start off investing personally, buying one or two single family rental properties before scaling up into small multifamily properties with three or four a piece. This approach is time intensive and requires significant up-front capital. That’s why others choose to invest via a real estate investment trust, shares of which can be bought and sold as easily as stocks or bonds. The barriers to entry when investing in a REIT are significantly lower than trying to own property personally.
These two strategies – active investing and investing in a REIT – can be thought of like two ends of the real estate investing spectrum. There are many ownership forms in between. One common way to invest in real estate, for example, is through a real estate partnership. Real estate partnerships can be structured in many ways, which we’ll look at in more detail today. Read on to learn more.
What is a Real Estate Partnership?
Real estate funds. Partnerships. Syndications. Sponsors. Limited liability companies. General partners. Limited partners. S-Corps. If you’re interested in commercial real estate, these are probably terms you’ve heard before. They all have to do with real estate partnerships.
A real estate partnership is a way of holding title to and managing an investment property. Most real estate partnerships are structured as limited liability companies (LLCs), but can also take the form of a limited liability partnership (LLP) or S-Corp. Each has different tax benefits and implications. What’s most important about a real estate partnership, though, regardless of which form it takes, is how the roles and responsibilities of investors are defined. Typically, real estate partnerships are structured so as to have a sponsor or managing member who serves as the “general partner” whereas all other investors take a backseat role as passive, or “limited partners”.
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Types of Real Estate Partnerships
There are a few different types of real estate partnerships for investors to consider, including:
In smaller or less complicated deals, there may be a few investors who all actively take part in the day-to-day decision making of an investment. These are called active partnerships. In an active partnership, each investor will typically contribute the same amount of equity and then the roles and responsibilities will be divided equally among the partners. This format usually works well when there are two, three or even four investors. Active partnerships become much more challenging to manage when there are more than a few investors, as having too many cooks in the kitchen – each with an equal voice – can quickly lead to conflict. Active partnerships can also become challenged when one party does not lift his or her weight as originally anticipated.
Passive partnerships are the most common form of real estate partnership. These are typically utilized in larger deals in the commercial setting. Passive partnerships, often referred to as real estate limited partnerships, use what’s known as a GP/LP structure. The GP, or general partner, serves as the fund sponsor or manager of the LLC. The GP runs the day-to-day activities of the investment, from finding the deal to lining up financing. The LPs, or limited partners, play a passive role and as such, their gains are treated as passive income as well. From the outset, it is the GPs who’s capital is at stake during the due diligence and closing process. LPs have no “skin in the game” until a deal has closed, which makes this partnership form highly attractive to many passive investors.
Partnerships in Commercial Real Estate
As discussed above, partnerships in commercial real estate can be structured in many ways. The GP/LP structure has been used for decades. In the 1990s, many states began to allow limited liability companies (LLCs) to hold real estate. LLCs do not technically have a GP. Instead, LLCs are structured using an operating agreement. The Operating agreement identifies the manager(s) of the LLC, who have the same function as the GP would in an GP/LP structure. With an LLC, the passive investors are referred to as “members” instead of LPs. In either case, the roles and responsibilities of GP/LPs or managers/members must clearly be articulated from the outset.
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REITs vs. Limited Partnerships
Real estate investment trusts (REITs) are a special type of entity that can sell shares of its business to passive investors. REITs can be either public or private, but in either case, shares can be easily purchased and sold as easily as stocks. Some investors prefer to invest in REITs as a means of preserving liquidity, but any returns produced from the REITs are treated more like dividends than fund distributions, which carries additional tax burden. Real estate limited partnerships, meanwhile, benefit from income treated at the long-term capital gains rate upon sale (assuming the partnership has owned the investment for more than a year).
Maximizing the Benefits of Real Estate Partnerships
There are several benefits associated with investing via a real estate partnership, including:
One of the primary benefits to investing in a real estate partnership is scalability. The average person does not have the capital, personally, to invest in larger commercial real estate projects. By investing in a partnership alongside other LPs, you now have access to opportunities that would have otherwise been out of reach. This brings related benefits of scale: when investing in larger properties, say 100+ unit apartment buildings, the partnership benefits from economies of scale related to construction, leasing, maintenance, legal and accounting fees and more. The cost for each of these items is lower on a cost per unit basis than it would be if personally investing in a single-family or small multifamily rental property.
There are many skills needed to execute a successful commercial real estate deal, from relationships with brokers to financial modeling, from development experience to leasing and marketing. A sponsor will typically have a team in place that brings all of these skills together in harmony. An individual would be hard-pressed to take on all of these roles – and execute at a high level – when going at it alone.
Mentorship – Experience
When investing in a fund or syndication, you’re investing with a sponsor who has robust experience. The sponsor will have typically aggregated a best-in-class team that has the knowledge and experience needed to successfully execute the business plan. Prior to investing, you will always want to do your due diligence on the sponsor to vet their experience and ensure this is the case (more on this below).
Easier to Finance
Real estate partnerships often have an easier time securing financing, as well. Investing in commercial real estate requires different loan products and lending solutions than one would use when buying a single-family home. It helps to have strong relationships with lenders who specialize in the product type you’re investing in. Partnerships are able to bring this experience, and these relationships, to the table. The sponsors generally have someone who is adept at underwriting and who can anticipate the terms that a bank might offer when seeking debt for a project.
There’s an added benefit to investing through a real estate partnership: the GP is responsible for lining up all financing. The sponsor will also be required to provide any recourse required by the lender. This reduces the risk for LPs who aren’t obligated to put capital into the deal during the pursuit of a project; their capital isn’t required until closing.
How to Deal with Common Challenges
Credit risks are a part of every business, including commercial and residential tenancies. Tenant creditworthiness is used by lenders and investors to determine the value, stability, and earning potential of a property. If your tenants are unable to pay their bills regularly, you will have cash flow and related problems with your operations.
Even the best, or most well-intentioned partnerships often encounter challenges. This is particularly true in active partnerships where there are many voices involved in the decision-making process. Here are a few ways to deal with common partnership challenges:
When investing with a few people in an active partnership, it can be difficult to determine a “fair share” of equity; it really depends on who is committing to do what level of work. One way around this challenge is to invest in a real estate limited partnership, which will typically outline equity splits from the very outset. The partnership agreement will indicate how the deal is structured, when a sponsor is getting paid and how (via fees or based on performance), and the rates of returns owed to both GPs and LPs. For example, a common structure used by Penn Capital is to offer LPs a preferred return whereby we collect nothing until achieving certain hurdles. Then we have an 80/20 equity split whereby LPs get 80% of profits and we, as the sponsor, only collect 20% until achieving a certain IRR. Each deal structure may vary, but nevertheless, it is important that this equity split be laid out for investors in advance.
Whether investing as an LP or as a member in an LLC, it is important that all investors’ goals are aligned. A passive real estate partnership, such as the GP/LP structure, will typically require that the sponsor or fund manager meet certain hurdles before collecting any profits.
Conflict can be a challenge in any partnership, but this is particularly true in the case of active partnership where assigning roles—and sticking to those responsibilities—can be a challenge. In a passive partnership, the GP or managing member takes on all day-to-day responsibilities which reduces conflict with investors as situations inevitably arise.
How Taxation Works
The IRS treats income earned by active and passive investors differently. There are benefits to being a passive investor in a fund or syndication, for example, your earnings are treated as passive income. Passive investors still benefit from depreciation, which is allocated to investors on a pro rata basis. That depreciation can be used to offset income generated by the investment, which is a rather powerful tool. All other tax benefits are shared amongst investors depending on the level of equity they have in a deal. Upon sale, proceeds will be taxed at the long-term capital gains rate assuming the partnership has held the property for more than a year.
Should You Have a Partner?
There are certainly times when even limited partners feel as though they could have managed a deal on their own, but typically, there are so many nuances to any substantial commercial real estate deal that the benefits to having a partner outweigh the benefits to investing alone. There are many duties required to make a real estate investment successful; expecting any one person to do all of these tasks alone can prove daunting.
That isn’t to say there aren’t challenges even amongst partners. It is critical to have a decision-making process. One strategy we’ve used is the “RACI” methodology, which stands for responsible, accountable, consulted and informed. When making decisions, a team should ask themselves: what’s the decision that needs to be made? Who’s responsible for making that decision? Who’s accountable for that decision? Who needs to be consulted to make that decision, and eventually, who needs to be informed as to the result of that decision? This is just one methodology, but nevertheless, having a methodology in place can lead to better decision making within the partnership.
How to Find the Right Partner
There are many considerations when trying to find the right partner. For now, we look at this from the perspective of how an investor can find the right partnership in which to invest.
An investor will want to do thorough due diligence on the sponsor whom they’re looking to partner with on a specific investment or via a fund. Consider the sponsor’s experience and who else they have on their team. Specifically, look at their history with that asset class. Evaluate their portfolio to determine how well they know that asset class and how well it has performed over time. Don’t be shy about talking to other investors who have partnered with this team previously to gauge their experience. Learn as much about the sponsor as you can before committing any capital to a partnership.
Set Clear Goals
Investors will want to be sure they understand how partnerships are structured, particularly around compensation (fees vs. performance) and equity splits. Determine whether the partnership is structured to ensure all interests are aligned.
Read through partnership documents closely. You’ll want to understand the terms of the deal, including the key decision rights granted to the sponsor vs. limited partners. For example, what if the sponsor fails to perform? What recourse, if any, do the limited partners have? This should all be clearly outlined in the operating agreement. Some decisions, such as whether to refinance or sell, might require a majority approval amongst all partners or LLC members. As an LP, you want to know who has which rights and under what circumstances.
Investing in commercial real estate can be an excellent way for someone to diversify their portfolios. Yet there’s a common misconception that investing in real estate will always generate passive income. In fact, that’s only true when investing in a passive structure, such as through a fund, syndication, LLC, REIT or other vehicle that is explicitly designed to have passive investors. Otherwise, the investor can end up owning real estate in a more active manner, which is not only more time consuming but also results in different tax implications.
Anyone who’s interested in passive real estate investing will certainly want to consider the passive real estate partnership models described here today. Adept partners can steer the process, doing all of the heavy lifting while still generating tremendous returns for their LPs.
Interested in learning more? Contact Penn Capital today!
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