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How a Real Estate Limited Partnership (RELP) Works

A real estate limited partnership is a popular way for investors to combine their resources, knowledge, and capital to scale their real estate business.


[Updated: Apr 14, 2021 ] May 07, 2020 by Kevin Vandenboss
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Some of the most successful real estate investors have built their wealth by leveraging other investors to partner with on deals. With the right structure, a partnership can open up several new opportunities that may not be available otherwise. Real estate limited partnerships are one way that investors have been able to take advantage of these opportunities.

What is a real estate limited partnership?

A real estate limited partnership (RELP) is a type of real estate investment where multiple investors pool their money to purchase or develop real estate. The RELP has a general partner who manages the investment and assumes the liability and limited partners who are just passive investors.

A real estate limited partnership is a popular method for developing and investing in larger projects. Multiple investors are able to combine their resources to complete a deal they may not be able to afford or manage on their own.

An investor with management experience that secures a deal on a great investment property, but with limited funds, can partner with investors with the capital. These investors may not have the management experience or may just want to invest in a deal without having to worry about the day-to-day operations.

Real estate limited partnerships are common structures for real estate syndication and equity crowdfunding.

How is a real estate limited partnership structured?

Real estate limited partnerships are structured based on the partnership agreement. This agreement can be quite different from one deal to the next. However, these agreements share the same basic format, which gives them their limited partnership status.

A RELP has two types of partners, a general partner and limited partners. Each type of partner has equity in the deal, but the contribution, responsibilities, and liabilities are different between the two. The investment returns are also distributed differently between the two in most cases.

General partner (GP)

The general partner is responsible for setting up the partnership, handling the transaction, securing the financing, and managing the investment. The general partner is usually the one who finds the deal.

While the general partner may be one person, they normally set up a separate entity that will be the actual partner in the agreement. This helps protect the partner's other assets and allows them to participate as a limited partner through another entity or personally.

The general partner is given equity for securing the real estate deal and for the work they put into it. The amount of equity the general partner receives varies but is often somewhere between 20% and 35%.

General partners often earn money through fees charged to the partnership as well. Common fees that a general partner receives are:

  • Acquisition fee: 1% to 5%.
  • Asset management fee: 1% to 3% annually.
  • Refinance fee: 1% to 3% of the loan amount.
  • Loan guarantee fee: 0.5% to 3.5% of the original loan amount.
  • Construction management fee: 5% to 10% of the renovation budget.
  • Disposition fee: 1% to 2% of the sale price.

Not all general partners charge all of these fees, and the actual amount of the fee can vary depending on a number of factors. Usually, the more work and risk involved for the general partner, the higher the fees will be.

Some GPs also handle the property management themselves. In this case, they may also charge the management fee that would otherwise be paid to the property manager. This can range from 5% to 10%, depending on the property type.

The general partner also receives a profit split. There are several ways this is handled, and we'll discuss that in more detail below.

Limited partners (LP)

The limited partners in a real estate limited partnership are the passive investors. They contribute capital to the partnership to earn a return on their investment. These partners benefit from having limited liability in the investment.

The limited partners have little to no involvement in the daily operations of the investment. They're considered "silent partners." However, limited partners may have certain voting rights based on the partnership agreement. While they can be given voting right on all matters, they're usually limited to major decisions.

Some of the decisions limited partners commonly vote on are capital expenditures, refinancing, and how to handle financial problems.

Some limited partners may have expertise in certain matters that can benefit the partnership, but they have to be careful with how much time they spend working in the RELP. Any limited partner that spends more than 500 hours in a year engaging in operational activities of the partnership can lose their limited partner status and liability protection.

Distributions

Profits are distributed among partners based on how the partnership agreement is structured. Profits will be shared at regular intervals if the partnership has invested in an income property. If the partnership was formed for a development that will be sold or refinanced upon completion to return the partners' investment, the profits will be distributed when the deal is completed.

It's common for a real estate limited partnership to offer a preferred return to the limited partners. This means that the limited partners have to receive a minimum return on their investment before the general partner can share in the profits.

There are a number of ways this profit split can be structured. It's often structured in a way that gives the general partner more incentive to increase the profits by offering a larger split as the return increases. This split may start out as 70% to the limited partners and 30% to the general partner and increase to 50/50 if the total return hits a certain milestone.

A simple example of a preferred return structure:

Preferred return: 6%

If the total return during a period is 5.5%, all of the profit will be paid to the limited partners.

If the total return during a period is 7%, then 6% will be paid to the limited partners and the other 1% will be split between the general partner and limited partners according to their agreement.

How is a real estate limited partnership deal financed?

Somebody will have to sign on the loan if the partnership is using leverage to finance the investment. This responsibility will fall on the general partner. Unless they're able to secure a nonrecourse loan, the general partner will have to provide the guarantee for the loan.

Since the general partner signing the guarantee is the only one liable for the loan, the loan will be approved based on the general partner's creditworthiness and experience. Even if all of the limited partners have excellent credit and high net worths, the lender will only be able to look at the GP's ability to pay the loan.

In many cases, the general partner will raise enough investments to limit the amount of leverage needed in the deal. The lower the loan-to-value (LTV) ratio required, the better the chances are of the general partner being able to get a nonrecourse loan or only having to provide a limited guarantee.

Investors who want to limit their risk may also be more interested in an investment that is using less leverage. Having more equity in the real estate offers protection if the real estate market goes down. Also, the lower debt payments can make a big difference if the property goes through a period of low occupancy.

RELP taxes

Real estate limited partnerships don't pay taxes. Instead, the net losses or gains are pass-through income to each partner.

The partnership is required to file Form 1065, which reports the net income or losses after all deductions. The partnership is required to provide each partner with a schedule K-1, which shows the income they received throughout the year.

Investors in a RELP are able to enjoy the same tax benefits as if they were investing in real estate on their own. Depreciation and interest expense can be deducted to reduce each partner's tax liability.

A real estate limited partnership can do a 1031 exchange for another like-kind property to defer capital gains. However, partners aren't able to exchange their partnership interest. This means that the investors will have to pay capital gains tax when the partnership is dissolved, even if they intend to reinvest the money.

Benefits of a real estate limited partnership

There are many benefits to a limited partnership for real estate investors as the general partner as well as for the limited partners.

The main benefits to the general partner in a real estate limited partnership are:

  • The ability to invest in larger deals by partnering with other investors.
  • Additional equity for putting the deal together.
  • Income from asset management fees.

The benefits to limited partners include:

  • Liability limited to the amount invested.
  • Passive investment.
  • Real estate tax benefits.
  • Pass-through entity.
  • Preferred return in many cases.

There may be additional benefits to investing in a partnership as a limited partner depending on the exact terms of the partnership agreement.

Risks of a real estate limited partnership

Real estate limited partnerships come with their risks, just like any other investment. General partners and limited partners share certain risks, and they also have their own separate risks.

Both types of partners are at risk of losing the capital they've invested. However, general partners have the added risk of being liable for the loan. The general partner's other assets may be at risk if the partnership defaults on the loan.

Limited partners are taking a risk by trusting the general partner with their investment. Once the money is invested and the partnership agreement is signed, the limited partners are relying on the general partner to make the investment successful and earn a return for them.

Investments in a limited partnership aren't liquid. It can be extremely difficult to find somebody to purchase limited partner interest, especially at its full value. In some instances, other limited partners may be willing to purchase the interest. Anyone investing in real estate through a limited partnership should plan on staying invested through the planned investment timeline.

RELP vs. LLC

Another common method for investors to pool their money into a deal is through a limited liability company (LLC). In many ways, a RELP and an LLC operate in the same way.

Instead of general partners and limited partners, all investors in an LLC are members. There still may be different classes of members, however, similar to a GP and LP structure.

An LLC has a lot of the same flexibility as a limited partnership in terms of who will manage it and how distributions will be made. LLCs are also pass-through entities for tax purposes, just like a limited partnership.

One advantage of an LLC over a limited partnership is that an LLC offers all of its members limited liability, no matter how much involvement they have in the operations. With a limited partnership, limited partners can lose their liability protection if they spend more than 500 hours in a year assisting in operational tasks.

One of the benefits to a limited partnership over an LLC is that the general partner can also deduct health and 401k benefits.

RELP vs. REIT

Real estate investment trusts (REITs) are corporations that invest in various types of real estate. Investors in a REIT are purchasing shares in the corporation instead of partnership interest like in a limited partnership.

Publicly traded REITs are regulated by the Securities and Exchange Commission (SEC) and have certain rules and restrictions. Real estate limited partnerships have far less regulations, since they are a type of private equity.

Below are the main differences between a REIT and a real estate limited partnership.

Category REIT Limited Partnership
Taxes Pass-through income Pass-through income and losses
Investor requirements None Minimum income and net worth
Liquidity High if publicly traded Low
Minimum investment Low High
Risk Moderate High
Build equity No Yes
Value Tied to stock market Tied to real estate market

Starting a real estate limited partnership

Setting up your own real estate limited partnership is a great way to grow your portfolio as a real estate investor. Being a general partner in a limited partnership can give you the ability to make larger multifamily and commercial real estate investments.

While the exact steps may be different from one situation to the next, the main steps should be the same.

Find the right deal

The first step to creating a real estate limited partnership is to find an investment that other investors would want to be involved in.

If the partnership is being used to purchase an investment property, you'll negotiate the price and terms, then get the property under contract. Since the partnership isn't formed yet, you'll put it under contract in your name with the ability to assign the purchase agreement to the limited partnership.

If the partnership is being created to develop a property, you'll want to secure the land and get all necessary entitlements and permits.

Secure financing

You'll also want to have financing lined up. Knowing the amount of financial leverage you'll need will determine how much capital you'll need to raise.

Draft documents

You will need to draft the private placement memorandum (PPM) to provide investors when presenting the offering. You will also need a draft of the partnership agreement and the forms required for filing the limited partnership with the state, along with any other required documents.

It's important to use an experienced securities attorney to help you through this process. Raising capital from investors involves securities requirements that you want to be sure you're compliant with.

Find investors

One of the most important steps is to find the investors to be your limited partners. If you're marketing to the general public, you'll only be able to raise capital from accredited investors. You can only have limited partners that are non-accredited investors if you have an existing relationship with them.

Pool the investments

Once you've found enough investors, you'll execute the partnership agreement, collect the funds, and file the limited partnership with the state.

Apply for an Employer Identification Number (EIN)

You'll need to apply for an EIN from the IRS. This is the tax ID number you'll use when filing the partnership's taxes.

Close the deal

Once the partnership is formed, you'll close on the deal under the partnership with the limited partners' investments and the financing you arranged. If you raised capital for a development project, you'll start construction at this point.

These are just the basic steps to starting a real estate limited partnership. There are a lot of strict rules when it comes to using this structure to invest in real estate. You should consult with an attorney before you start the process of setting up a limited partnership. You can put yourself and your investors at risk if all of the requirements aren't met exactly.

Investing in a real estate limited partnership

Investing in a limited partnership is a great way to enjoy the benefits of real estate investing without the headaches of the day-to-day operations. Being an investor in a limited partnership with an experienced general partner can provide excellent returns.

Real estate limited partnerships do come with a higher level of risk than many other types of investments. However, you can reduce the amount of risk you're taking by doing your due diligence on the investment as well as the general partner.

Whether you find an investment opportunity online or through your own network, you'll want to consider several things before committing to the deal.

Investment strategy

Does the partnership's investment strategy fit with your investment goals? Many real estate limited partnership investments have a target timeline of five to 10 years or more. You'll have to be ready to let your investment sit for the full term.

Risk

How well does the deal fit with your risk tolerance? Some real estate investments have lower projected returns but are less risky because they're in a high-quality, stabilized property in a strong market. Others offer higher projected returns but rely on the occupancy rate to be improved and the rents raised.

Some investments offer a higher return because they're in a more volatile market or because the general partner is less experienced and needs to offer a higher incentive.

The general partner

The person or company managing the investment is just as important as the real estate itself. You will want to look at their experience, their track record, and how much of their own capital they're investing in the deal.

A lot of investors prefer to partner on deals where the general partner has a significant amount of their own money invested, or "skin in the game." A general partner with their own money on the line is going to be a lot more motivated to work hard to get the highest return possible. They also have a lot more to lose if the investment fails.

Investment performance

If you're investing in an income-producing property, you'll want to look closely at how well it has performed over the past few years. The general partner might have a pro forma that shows an excellent return, but you want to see how that compares to past performance.

If the pro forma shows higher income than the property has been producing, you'll want to see clear evidence that the general partner is going to be able to deliver the returns they're projecting.

If you're investing in a development, there obviously won't be any historical financial information. However, the general partner should be able to show you evidence that the property will provide the projected return. This could be based on the values of comparable developments and the market rents of similar properties.

Leverage

The amount of leverage on the property can play a large role in the level of risk you'll be taking on. Highly leveraged properties are vulnerable to changes in the real estate market. A low debt service coverage ratio (DSCR) can result in negative cash flow if the income is down for any period of time.

Real estate investments with less leverage and more equity provide more protection for investors.

Investing in a limited partnership carries a significant amount of risk. You should always consult with a professional who can help you evaluate the deal before putting your money at risk.

The bottom line

Investors have been using real estate limited partnerships for several decades. While they are one of the most popular ways to partner with other investors on real estate deals, they are just one way to structure a partnership. Whether you're considering starting a limited partnership or investing in one, look at all of the different options available before working with investing partners.

Whichever way you decide to structure the deal, partnering with other real estate investors can help you grow your investment portfolio much faster than you would normally be able to on your own.

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