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What to Consider Before Starting a Real Estate Partnership

by Jeff Rohde, posted in Investment Strategy

Directly owning property isn’t the only way to invest in real estate. Placing capital in a real estate partnership can help to diversify a real estate portfolio, generate income, and offer the opportunity to invest in bigger deals.

In this article we’ll take a look at how a real estate partnership works, along with some of the pros and cons of investing with other people, to help you decide if a real estate partnership is right for you.

 

How a Real Estate Partnership Works

If you own a home with your spouse or partner, you already have a type of real estate partnership, although you may not think of it that way. You’ve saved and pooled your money, worked together to buy a home, and are now enjoying the fruits of your labor.

For investors, a real estate partnership works in a similar manner. Two or more investors combine their investment capital and leverage their expertise to invest in income producing real estate. 

While it’s possible for each partner to be actively involved in a real estate partnership, group investments like these are frequently formed as a real estate limited partnership or RELP. In a limited partnership for real estate investing, one member acts as the general partner (GP) and the other partners are limited partners (LPs).

The general partner is responsible for the day to day operations of the investment, such as locating the investment, negotiating the deal, arranging financing, leasing and managing, and eventually selling. Because there is more responsibility and potential liability, a GP generally receives a larger share of the profits as compensation for the extra effort. They often take an acquisition fee for each property that is purchased.

On the other hand, limited partners simply contribute investment capital (and sometimes their knowledge and connections in the local market) in exchange for a share of the recurring revenue and a piece of the profits when the property is sold. 

 

Types of Real Estate Partnerships

Real estate partnerships are normally structured as pass-through entities. The most common types of real estate partnerships are:

  • Limited Liability Company or LLC
  • Limited Liability Partnership or LP
  • Subchapter S Corporation or S-Corp 

The profits or losses from the investment flow through (or are passed through) to each partner and are reported on the partner’s tax return. 

This avoids double taxation, once at the corporate level and once at the personal level, which is what happens when you own real estate in a C-Corporation or have shares of a dividend paying stock.

 

Active and Passive Real Estate Partnerships

Real estate partnerships can also be structured as active or passive investments in an almost unlimited number of ways, depending on how the real estate partnership agreement is written. 

For example, one partner may agree to accept a lower percentage of potential profits in exchange for having no or limited partnership responsibilities. On the other hand, another partner might want a larger share of the net cash flow to compensate for assuming leasing and property management services.

Active Real Estate Partnership

In an active real estate partnership, all of the partners are actively involved with the investment in one way or another. 

For instance, an investor who owns a property management company might team up with another investor who is an experienced handyman. The property management investor takes care of leasing, rent collection, and tenant management. The handyman investor deals with repair and maintenance issues when they arise. 

By working together, the active partners are able to increase the property value by keeping cash flow strong and the home in good condition.

Passive Real Estate Partnership

In a passive real estate partnership, a group of real estate investors might pool their capital as limited partners or LPs to invest in a portfolio of single-family rental homes in different cities. The LPs agree to share any recurring cash flow (or losses) on a pro rata share based on the amount of money each passive partner has invested. 

However, even though each home is professionally managed by local property management companies, a general partner or GP may still be needed to oversee the portfolio, communicate with each local manager, and keep a close eye on the ongoing financial performance of the portfolio.

In the partnership agreement, the passive LPs may agree to give a larger percentage of the profits to the active general partner or GP as compensation for overseeing the entire portfolio. By having a general partner in the real estate partnership, the LPs can earn passive income without having to be involved in the daily details.

 

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Potential Benefits of Using a Real Estate Partnership for Investing

There are a variety of potential benefits to forming a real estate partnership compared to owning property as an individual investor. 

Some of the many reasons for investing in a real estate partnership might include:

  • Tapping into a partner’s knowledge of local planning and zoning laws to speed up the building permit process.
  • Leveraging a partner’s knowledge of financing to obtain a mortgage with favorable terms for the real estate partnership.
  • Investing in larger, more complex investments that would be out of reach of the individual partners by pooling investment capital together.
  • Reducing the liability of each limited partner (generally to the amount of money invested) by forming an LLC to keep other business and personal assets outside of the real estate partnership. 

 

How to Create a Real Estate Partnership Agreement

Each state has its own laws for creating a real estate partnership agreement. To find the laws for your state, search online using “how to create a real estate partnership in [your state]” or consult with an attorney who has experience drawing up limited partnership agreements.

The legal resource website Nolo.com lists the steps in forming a real estate partnership agreement:

  1. Select and register the name of the partnership with the state. You’ll also need to check that the name currently isn’t being used by another company.
  2. Obtain a federal tax identification number (also known as a TIN or EIN) from the IRS. Banks will require this to open up a business checking account in the name of the real estate partnership or LLC.
  3. Determine each partner’s contributions to the real estate partnership, whether it is cash, property, or services to be rendered.
  4. Determine how profits and losses from the partnership will be allocated, such as a percentage based on the amount of capital contributed or customized to meet the financial needs of each individual partner.
  5. Decide which partner (or partners) shall have the authority to make decisions, execute contracts, or otherwise bind the partnership. 
  6. Elect a general partner who will be responsible for management duties, including negotiating a purchase contract for the real estate acquired and overseeing the local property management company.
  7. Form partnership rules that determine what happens to a partner’s shares in the case of death or withdrawal and whether the real estate partnership shall have a right of first refusal to buy shares.
  8. Establish mechanism for resolving disputes if the partners are deadlocked on a decision like  whether to sell the property for a profit (or loss) or continue holding and collecting rental income.

 

Is a Real Estate Partnership a Good Idea?

Here are some of the pros and cons of a real estate partnership to consider, to help decide if forming a partnership is right for you:

Pros of a Real Estate Partnership

  • Pooling investment capital allows for larger, more complex investments than a single investor may be able to do on their own.
  • It may be easier to diversify a real estate portfolio by investing in multiple real estate partnerships instead of one or two wholly-owned rental properties.
  • Partnerships can provide flexible pass through distributions, allowing one partner in a high tax bracket to receive a larger share of the property’s depreciation expense.
  • Partnerships can serve as a good vehicle for investors seeking passive income streams as a limited partner.
  • Beginning investors can gain hands-on experience through partnerships  by watching how more experienced real estate investors work.

Cons of a Real Estate Partnership

  • The potential profits must be shared with other partners, which in turn limits the potential returns for any single investor.
  • Capital calls that require each partner to contribute more money into the partnership can occur if the investment does not perform as expected.
  • Misalignment of investment objectives may occur if the partnership agreement does not adequately outline the goals of the real estate investment, such as buying and holding until a specific ROI is achieved.
  • Failure to clearly delegate the responsibilities of each limited partner and the general partner can lead to conflict among the partners and the investment potentially underperforming.

 

Things to Consider When Choosing Investing Partners

Even though real estate is known for being a people business, the truth is that not every investor is someone you may want to partner with. 

Here are a four things to think about when choosing potential real estate investing partners:

  1. Identify what each partner will bring to the table, such as capital, contacts, or skills that the other partners may not have.
  2. Make sure each partner is “on the same page” by discussing the business philosophy and goals guiding the real estate investment partnership.
  3. Choose partners who have an investment horizon that matches the real estate partnership, such as buying and holding for the long term.
  4. If you are the general partner, describe your past successes to potential limited partners so that they are comfortable investing in your real estate limited partnership.