A commitment to a real estate partnership isn’t something to be taken lightly, but rather as an integral component to a successful real estate business. At the very least, aligning yourself with the right partner could very easily be the best decision you ever make. However, it’s just as likely that poor real estate partnership structuring can cripple growth. With that in mind, it’s in your best interest to mind due diligence and take your time vetting potential candidates. Only then will you be able to realize the true value of a great partnership.
With so much money on the line in your typical real estate deal, how do you go about determining the best real estate partnership structuring? The answer is relatively simple: do your homework and don’t rush into anything without being certain of your decision. If that’s not enough to get the ball rolling, however, there are a few more things you should do (and not do) to make sure your real estate partnership structuring will work in your favor. Let’s take a look at some of the most important do’s and don’ts when it comes time for you to consider real estate property partnership structuring.
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What Is A Real Estate Partnership?
A real estate partnership refers to the business structure between two real estate entrepreneurs who have decided to work together in a professional environment. In its simplest form, a real estate partnership is exactly what it sounds like: two or more people working together in the real estate industry to accomplish a single goal.
Real Estate Partnership Entities
A real estate partnership can be formed through a variety of “pass-through” entities. Each of these real estate partnership formations provides dual benefits to investors. The 3 most common entity partnerships are:
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LLC or Limited Liability Company
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LLP or Limited Liability Partnership
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S-Corporation
Taxation is eliminated on a corporate and personal level since income or losses are passed through to each investor for reporting on a personal tax return. These entities also provide legal protection from claims against other business or personal assets belonging to each investor that are not part of the partnership.
What Is An RELP?
A real estate limited partnership, or RELP, is the legitimate classification of a real estate partnership. According to Investopedia, a RELP is “an entity that provides an opportunity to invest in a diversified portfolio of real estate investments.” A real estate limited partnership will determine how the business runs and is ultimately taxed by the government. While the structure of a RELP may differ, they are comparable to other real estate portfolio options such as REITs and managed real estate-focused investment funds.
Expected returns often measure significantly high. However, they also carry high risks. RELPs are marketed by defining the terms of the entity, detailed partnership agreements, and the overall investment opportunity. In general, RELPs target institutional investors or individuals with a high net worth.
Many limited real estate partnerships possess a specifically defined focus on the business structure, whether it be for constructing a residential neighborhood or business and commercial buildings. Often RELPs specialize in specific real estate projects such as high-end commercial real estate or retirement homes.
Is An REIT A Limited Partnership?
A real estate investment trust (REIT) is not a limited partnership, though they are treated similarly for taxation purposes. REITs and limited partnerships can both avoid double taxation due to their respective business structures. However, the two entities differ in most other ways, including their investment focus. While REITs are typically in the financial sector, limited partnerships focus most on energy or natural resources. Yet another difference can be found by looking at the distribution requirements for each: REITs must pay out 90 percent of their earnings. Limited partnerships, on the other hand, have targets, but they are not compulsory.
Commercial Real Estate Partnerships
One of the best ways to break into the commercial real estate world is through a successful partnership. Essentially, commercial real estate raises the stakes when compared to residential investments. This is because commercial properties are larger, require more financing, and demand more responsibility. However, the right commercial real estate partnership can allow two or more investors to combine their strengths (and capital) to achieve the high profit margins these properties can provide. In addition, real estate partners can share the debt, equity, and even workload required to get a commercial property off the ground—allowing them to get one step closer to the many benefits these investments can provide.
Real Estate Partnership Taxation
The real estate limited partnership structure undergoes a similar taxation process to that of a directly-owned real estate business. In some cases, an RELP could be viewed as a corporation, leading to a different tax structure. Although in most cases, these partnerships see the same pass-through benefits regarding income, losses, deductions, and credits. One of the many benefits of a partnership agreement is that it does provide all parties more flexibility in deciding how to split various gains and losses.
Active vs. Passive Property Partnerships
Partnerships can be structured in a number of creative ways that suit the needs of each individual involved. There are two key types of partnerships: active and passive partnerships.
In an active partnership, each member takes on a part of the workload and has an active role in contributing to projects on a regular basis. All tasks could be split up equally, or perhaps tasks could be split up based on each member’s level of experience and skillset. However, the idea is that each person involved in the partnership is putting in a direct effort into the collective work.
Alternatively, one or more members could be a silent partner. This means that they are providing capital to fund a project instead of actively participating, thus the name “passive partnership.” A real estate investor could raise capital from partners who want to reap the financial benefits of investing in real estate without having to directly involve themselves in a project.
Real Estate Partnerships Pros And Cons
A real estate partnership is a great idea for those who may have some gaps in their real estate knowledge or experience. If for nothing else, a truly great partnership can easily be the one thing new investors need to get started off on the right foot. According to Hutch Ashoo, founder and CEO Pillar Wealth Management, LLC, “The opportunity to raise funds and scale your real estate investment business is a benefit of joining a real estate partnership. This is especially true when collaborating with a passive investor to support your entire company or certain deals”. Here are just a few of the many benefits associated with real estate property partnerships:
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The right partner can bring extra resources to the table, including capital or an extensive network.
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A real estate partnership structure allows both parties more flexibility when it comes to distributing profits and losses.
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Partners can provide another perspective when analyzing potential deals and investments.
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The combined portfolios from real estate partners can help bring the “wow” factor to meetings with prospective lenders.
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Partnerships revolve around balance, allowing both parties to divide and conquer responsibilities and workload.
Essentially a good partner can bring something to the table you may not have at the moment, whether it’s access to capital or market experience in your preferred investment area. That said, partnerships are not meant for everyone. Consider the following challenges associated with real estate investment partners:
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Earnings must be split between the partners, undermining profit totals.
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Real estate partners may have very different management styles, leading to organizational conflict.
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If the partnership agreement is not entirely clear there may be issues delegating responsibilities (or losses).
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Partnerships could place an unnecessary strain on an otherwise healthy friendship.
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In some cases, one partner may bring more to the table creating a disparity in equity or skills.
Real estate industry expert Emily Cooper suggests that “differing strategies and having different levels of risk appetite can prove to be detrimental in the long run. It is so important to partner with someone who you can fully trust and be open with. Loyalty, honesty, and hard work are just some characteristics you should look for in a business partner”.
The best way to mitigate these potential conflicts is by establishing a clear agreement before you start doing business together. Keep in mind a successful partnership does not happen overnight; successful business relationships may take time to develop. While they can be highly beneficial for some, partnerships are not necessary to run a successful business. Weigh the pros and cons before committing to a real estate partnership and choose what is right for you.
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How To Structure A Real Estate Investment Partnership
The way investors structure a real estate partnership can directly lead to its success or failure. Therefore, this portion of the process should not be taken lightly by either business partner. Read through these steps on partnerships structures, and follow this process when you get started:
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Determine if a partnership is right for you
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Review your strengths and weaknesses
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Find someone who compliments your skills
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Evaluate the potential of the partnership
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Establish clearly defined roles and expectations
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Create the terms of agreement
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Keep the process simple
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Protect yourself from potential challenges
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Review business goals together
Decide If You Need A Partner
Determine, beyond the shadow of a doubt, that you actually need a partner. Far too many real estate investors are enamored by the prospects of partnering with someone else before they even consider the alternative. And while I will never entertain the idea that partnerships can’t be extremely beneficial, they require careful consideration before committing to one. That said, I maintain that the only reason you should partner with another individual is that they bring something new to the table that you are currently missing. Perhaps they have access to capital or are more in touch with the local community. Whatever the case may be, identify what you gain from partnering up and determine whether the benefits outweigh the negatives.
Conduct A Self Evaluation
Real estate partnership structuring has more to do with matching qualified candidates than anything else. However, far too many real estate investors spend too much time evaluating their potential partners and not enough time evaluating themselves. As it turns out, both are incredibly necessary. In fact, I maintain that an unbiased self-evaluation is just as important as an interview with a candidate, if not more so. A self-evaluation will identify the areas you currently lack and those considered to be strengths. At the very least, doing so will give you a great starting point when trying to find a partner. Only once you are confident in what you currently bring to the table can you be certain of what to look for in a partner. It’s worth noting, however, that this only works if you are completely honest with yourself. Set aside some time to map out your strengths and weaknesses, and use what you learn to start real estate property partnership structuring.
Find The Right Partner
If for nothing else, a partner should be tasked with bringing something entirely new to the table. And while it’s perfectly acceptable for your prospective partner to share some of the unique skills you already exhibit, they must offer a complementary skillset. In other words, the partner you decide to align yourself with should fill a distinct void and meet a specific need. Only through the addition of a complementary skillset will your business become more versatile and better prepared to handle what the real estate market has in store.
Mind Your Due Diligence
Entering into a real estate partnership is nothing to take lightly, nor should you do so without thinking about things from an objective perspective. As I said before, you must be confident that you are entering into a partnership for the right reasons, but it’s equally important to choose the right partner. Not only should they complement your skills to maximize your usefulness, but they need to be someone you trust implicitly. In vetting your potential partner, it’s of the utmost importance that they can do their job well. What’s more, it’s up to you to make sure they can. You are the final gatekeeper, so make sure you are comfortable that your partner is competent.
Define Roles And Expectations
Before entering into a partnership, it’s in your best interest to identify what will be expected of each individual and the roles they will inherently fill. In doing so, you will mitigate the risk of running into significant problems down the road. It’s worth noting that the more clearly you can define each partner’s respective role, the better. There should be literally no discrepancies as to what role you will play over the course of your involvement in the business. Who is going to manage the finances? Who will be responsible for marketing? Which of you will be tasked with negotiating at the closing table? Partners will need to know who is doing what well before the situation ever arises. That way, you can set reasonable expectations each partner will be held to.
Set Terms
Once you decide how to delegate responsibilities, it’s time for a more complicated conversation: delegating profits and losses. All real estate investment partnership structures have a contract of some sort, dictating the exact terms of agreement for the business. A common structure will designate what portion of profits are given to the business and how the partners will divide leftovers. For example, the terms of your agreement could be to have 40 percent of profits remain in the business and then a 50/50 split between partners after that. There are endless possibilities for the terms of the agreement; be sure you find some that both parties agree on.
Keep It Simple
Avoid overcomplicating things as you get into the actual structure of your partnership. You need to anticipate business operations, but you do not need to set lunch breaks at this time. Remember to stay focused as you negotiate and keep things simple (yet thorough). At this time, it is also important to remember not to go overboard with the legal jargon. Both partners need to understand what they are getting into explicitly. Formality is important to maintaining professionalism; however, you need to understand exactly what you are getting into. Work with a real estate attorney or legal team and use language everyone understands.
Protect Yourself
At this point, you have worked to create an ideal business partnership, but that does not guarantee it will be safe from challenges. Both you and your partner should take steps to protect yourself if something goes awry in the future. This means setting up the proper business structure to protect your personal assets, whether that is through an LLC or something else. Protecting yourself also means you take time to discuss what would happen during any potential business disagreements. This includes designating how losses will be divided, what would happen if one partner wanted to leave the company, and the business dissolution process. Each of these terms should then be reviewed with a lawyer and placed in a binding contract. While no one wants the worst-case scenario to happen, you and your partner must be protected if it ever does.
Set Goals
Don’t neglect your potential partner’s long-term goals and aspirations. In fact, understanding what it is your partner wants out of this exchange is invaluable, especially to up-and-coming businesses. If for nothing else, gaining a clearer picture of what your partner wants out of the impending partnership could make or break things moving forward. That said, you need to be certain that each of your goals is in line with each other. There is no point in partnering up with someone that has different intentions. At best, you will be working towards different aspirations. At worst, you could jeopardize the entire company.
How To Pick The Right Partner
Above, we talked about finding a partner with a complementary skillset. While this is crucial advice, it is not the only factor to consider when forming a real estate partnership. If you are considering someone to go into business with, you need to understand their investment philosophy, business goals, and financial know how. You do not need to agree on each of these areas, but at the very least you should both come to a mutual understanding so that future decisions do not alienate one another or put the business at risk.
As you pick a real estate partner, also consider the timing of your business and investment. How much time will you realistically be able to work together? Would you be comfortable taking on meetings alone? Would you trust them to act in your place? As you can see, forming a business partnership relies on trust — which can take time to form. Do not rush into a partnership without learning each of these components and more.
Summary
A real estate partnership is a great way to get your business off the ground. If you hope to partner with someone to bring your career to the next level, you better be certain it’s with the right person. With the right partner, there is no reason you couldn’t expect your business to grow exponentially. So make sure you mind due diligence and, above all else, see to it that the right structuring is in place.
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