As Vince Lombardi once said, “Individual commitment to a group effort – that is what makes a team work, a company work, a society work, a civilization work.” That’s true of most things in life, including college football and real estate investing.
The fact is that almost every successful real estate investor has gotten where they are today teaming up with other people to do bigger and better deals.
In this article, we’ll take an in-depth look at forming a real estate partnership and buying property with other partners.
What is a Real Estate Partnership?
A real estate partnership is formed by two or more investors who combine their capital and expertise to purchase, develop, or lease property.
Also known as a real estate limited partnership (RELP), the partnership agreement can require each investor to be actively involved in the partnership as equal members.
However, it’s more common for a real estate partnership to have a general partner who assumes more responsibility and liability, usually in exchange for a bigger share of the profits, with the other members being limited or passive partners.
Real estate partnership entities
Although real estate partnerships can be formed a variety of different ways, the three most common entity partnerships are:
- LLC or Limited Liability Company
- LLP or Limited Liability Partnership
Known as “pass-through entities”, each of these three types of business partnership formations provide investors with dual benefits.
First, income or losses are passed through to each investor for reporting on a personal tax return, which eliminates taxation on both a corporate and personal level. Second, real estate partnership entities provide an extra layer of legal protection from claims against each investor’s other business or personal assets that are not part of the partnership.
Active vs. passive real estate partnerships
Partnership agreements can be customized in a nearly unlimited number of ways to meet the unique needs of a specific real estate investment. However, for most practical purposes, partnerships for real estate investing generally fall into one of two categories:
- Active real estate partnerships are ones where each member of the partnership actively works on the project on a daily basis.
For example, an active real estate partnership could consist of two investors in a portfolio of single-family rental houses, where one partner takes care of property management tasks such as rent collection and bill paying, and the other partner personally takes care of maintenance and repairs.
- Passive real estate partnerships are typically formed to raise capital or to leverage the unique skill set of one partner that the other partners don’t have.
For example, many people today are looking for ways to diversify a retirement portfolio away from traditional investments such as stocks and bonds. They want to invest in real estate, but don’t have the time, expertise, or in-depth market knowledge.
By forming a passive real estate partnership, an experienced real estate investor can raise capital from passive partners to scale up his business while handling the day-to-day property tasks. Income and equity are then split based on the specific terms of the real estate partnership agreement.
Reasons for Forming a Real Estate Partnership
A real estate partnership can be formed for a unique reason, such as gaining access to a partner’s contact at the local planning and zoning department, or for more general reasons such as putting bigger – and potentially more profitable – deals together.
While every real estate partnership is different, some of the key reasons investor work with other people include:
- Contributing capital to put large transactions together than would be outside the reach of any single partner
- Generate additional income from asset management fees, usually found in real estate partnership where the general partner assumes more of the risk in exchange for more money
- Liability of limited partners in real estate partnerships is generally limited to the amount of money invested, helping to reduce risk and protect other business and personal assets outside of the partnership especially useful in more complicated investments
How to Structure a Real Estate Partnership
Partnerships are built around the partnership agreement, with agreements different from one real estate investment to the next.
In this section we’ll discuss the process to follow when setting up a real estate partnership, and then describe some of the differences between a general partner and the limited partners.
However, before forming a real estate partnership, it’s a good idea to involve a trusted professional who is familiar with corporate formations and partnerships, such as your real estate attorney or financial advisor, to help avoid problems once your real estate partnership is up and running.
Process of setting up a real estate partnership
- Decide if a partnership is really right for you, or if you’re more comfortable working alone without having to report to other people
- Take a cold, hard look at your strengths and weaknesses, as if you were preparing for a job interview
- Search for potential partners who can fill the gaps where you are weak while allowing you to magnify your strengths
- Once you’ve identified potential partners and received a verbal commitment, evaluate the expected success of the partnership once your key players are in place
- Create roles and expectations that are clearly defined by talking to other investors who have formed real estate partnerships or working with your real estate mentor
- Construct a written partnership agreement with the help of your real estate attorney or financial advisor who has experience in corporate law and finance
- Use a corporate entity structure such as an LLC to protect and your other partners from potential liability
- Have a meeting of the minds with all partners to ensure everyone has the same expectations and goals for the investment
General vs. limited partners
Although it’s possible for every member of a partnership to be active, it’s more common for one member to serve as the general partner, while the other members act as limited or silent partners.
- Finds the deal and runs due diligence
- Forms the real estate partnership
- Secure financing and closes on the sale
- Manages the investment
- Normally receives around 30% of the cash flows and equity in exchange for the additional work and risk involved
- Other common fees a general partner receives include acquisition, annual asset management, and disposition fees, usually in the range of 1% to 3% or more, depending on the deals and terms of the agreement
- Passive investors, perfect for people who want to invest in real estate but don’t have the time or experience to learn the trade
- Contribute capital in exchange for a return on the money invested, similar to buying shares of a REIT or investing in a crowdfund, but with much more control
- Limited partners have limited liability and little or no involvement in the daily operations of the property
- May be required to vote on major issues affecting the partnership, such as capital expenses, refinancing, or the need for additional capital
- Limited partners may receive a preferred return on their investment before the general partner gets paid his share of the profits
Pros and Cons of a Real Estate Partnership
The best real estate partnerships are like the four corners of a house, with each cornerstone helping to create a solid foundation. Partnerships in real estate are supported by the four key cornerstones of necessity, practicality, convenience, and relationships.
Take one of these away, and similar to a triangle, the real estate partnership can still function, although it won’t be sturdy. Take two of the corners away, and the partnership will always be on shaky ground.
Here are some of the biggest pros and cons of a partnering up to help ensure the one you create will be as powerful as possible:
Pros of a real estate partnership
- Partners always bring something extra to the table, such as capital, connections, project experience, or professional expertise such as legal or financing
- Distributions in a real estate partnership can be flexible, such as one partner receiving the majority of the tax benefits while the other partners receive a bigger share of free cash flow
- Real estate partnership structured as a pass-through entity – such as an LLC or S corporation – allow income and losses from the partnership to be passed through to each investor and claimed on personal income tax returns
- A real estate partnership can be the perfect investment vehicle for people looking for passive investments
- Preferred returns can be structured to pay certain partners first, before distributions are made to the remaining investors in the partnership
- By having “skin in the game”, each partner also has an extra motivation to share their unique perspective when analyzing acquisitions, development, and management of the project, and disposition
- Personalities of each partner can combine to a greater level of credibility in meetings with lenders, prospective tenants, and additional investors
- Real estate partners each carry their fair share of the workload, with one partner frequently handling the day-to-day responsibilities of the project, while other partners ensure longer-term strategies are being properly executed
Cons of a real estate partnership
- Benefits of the investment – such as monthly income, profits from the sale, and tax benefits – must be shared among the partners, limiting the potential profits for any one investor
- Personality conflicts can occur due to different investment and management styles, or partnership agreements that don’t clearly define who is responsible for doing what, where, and when
- Poorly written partnership agreements can also result in a good investment going bad if responsibilities aren’t clearly delegated
- Capital calls – or the need for partners to contribute additional funds – can occur if a project isn’t performing to expectations, or if one member wants to exit early and demands to be bought out by the other partners
- Strains in a real estate partnership can also occur if one partner feels they are doing a disproportionate share of the work without getting an equal share of the returns
Tips for Choosing the Right Real Estate Partner
You’ve probably heard the saying that, “Real estate is a people business.”
That’s especially true when it comes to forming a real estate partnership. After all, you can have a sure-fire business plan, only to see the partnership go south if you choose the wrong people as partners.
Here are some of the key criteria to look for when selecting potential members of your real estate partnership:
- Analyze the strengths and weaknesses of each partner, the same way that you evaluated your own
- Have a heart-to-heart talk with each partner about your business philosophy, investment goals, and the methods used to measure the success of the partnership
- Select partners who have a similar investment timeline as yours to ensure they don’t plan on retiring before the exit strategy of your real estate partnership can be fully executed
- Review your past deals with potential partners, and ask them to exchange their previous successes and failures with you, to understand how good a partner they will really be
Today, there are a growing number of people who have significant gains from investing in the stock market but are worried about what could come next. Many of these investors would like to diversify their portfolios by adding real estate to the mix, but don’t know how to go about doing it.
As an active real estate investor, forming a real estate partnership and buying property together can be a great way to scale up your own portfolio and take your real estate business to the next level. You’ll be able to raise more investment capital and do bigger and better deals while helping others profit from your experience.