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.
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.
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.