Successful real estate investments require two basic ingredients: capital, and the skills and knowledge to put that capital to good use. While a handful of individual investors might have both the financial wherewithal and the knowhow to venture out on their own, the vast majority probably have only one of those basic ingredients to work with. Thankfully, real estate investment partnerships offer the opportunity for investors to “offset [their] area of lack,” Mike Mortimer, CEO of the real estate firm Abner Group, which is experienced in such partnerships, said.
Real estate investment partnerships or joint ventures normally involve a single real estate asset and usually consist of “passive” owners, who generally provide the funds for the investment operation, and “active” owners, such as construction companies or land developers, who execute the business.
Found a partner? Find a lawyer
Although the concept of forming an investment partnership is simple, outlining specific terms in structuring a partnership is not a do-it-yourself process. Hiring a legal professional who specializes in real estate law is a critical first step.
“You really need to be able to…pay an attorney to help you through the process or else there’s going to be holes in your documentation and your structure,” Mortimer said. “If you can’t afford an attorney, then you can’t afford to be in a partnership.”
Real estate investment partnership structures vary widely, but the most common structure is a limited liability company (LLC). Similar to a corporation, LLCs provide liability protection for the “members,” or owners, of the company; however, other features of LLCs provide management flexibility and the benefit of pass-through taxation, according to the Internal Revenue Service website.
In many states, members can create an LLC online for a nominal fee but enlisting the help of an attorney in putting together a detailed operating agreement is a must. Although investors may be reluctant to foot the bill for an attorney’s services, upfront legal fees are a small price to pay for the proper protection of each member’s interest.
“A lot of investors are very conscious about funds and don’t want to spend any money over and above putting it into the investment property,” Traci Ellis, president and principal attorney at Traci D. Ellis, Esq. LLC, said. “But things can go so sideways without [an] operating agreement [that is] drafted in such a way that protects each person’s interest. It’s money well-spent, because it definitely costs more to clean up the mess afterwards.”
Operating agreements include terms such as the amount of the company owned by each member; the amount of capital, property or services provided by each member; how profits are divided; and how to manage the addition or departure of members, according to Ellis.
Another important issue to address in an operating agreement is tax responsibility, which is “difficult to manage” in a partnership, Mortimer said. Taxes are determined by two parts: the income generated and the expenses that went into the project. While the income generated can be easily defined by sales, expenses are almost solely determined by the active side of the investment.
“The partner that represents the money side usually wants to take advantage of the taxable benefit that comes through real estate,” Mortimer said. “[But] usually only the active partner is managing the day-to-day operations [that] affect the bottom line of the taxes.”
Putting a real estate investment partnership together
Individuals with money to invest might consider partnering with a real estate firm that has experience and extensive knowledge in managing the real estate development process, according to Mortimer. An experienced company will most likely be able to provide proper paperwork in evaluating and structuring partnerships, presenting a significant advantage for an investor who is new to the process.
Individuals who are involved with the active side of the investment may need to start their search for a partner among friends and family. However, it is important for investors to keep in mind that the presence of a pre-existing relationship does not trump the need to have good paperwork.
“You just can’t kid yourself into thinking [that] because you know somebody and you’ve got a pre-existing relationship with them, you’re going to be able to work everything out,” Mortimer said. “When it comes to money and [having] very difficult…decisions to make, you need to get paperwork set up for the worst-case scenario at the onset [of the partnership].”
The money that enters a partnership can be structured as debt, which is secured against the real estate, similar to a bank; or as equity, which comes in as cash and is normally not secured against the real estate, Mortimer said. Furthermore, an equity partner is often asked to sign a guarantee on any new debt that enters the partnership.
Finally, according to Mortimer, it is important to distinguish real estate investment partnerships from pooling money from several investors into a single fund, which requires specific documentation from a specialized attorney to create a formal Reg D offering.