Oftentimes, when investing in commercial real estate, a limited partnership can be the best way to go. For starters, a limited partnership is a good way to invest and profit without all of the responsibilities of a landlord.
A real estate limited partnership (RELP) is a legal agreement that lets you invest your funds with other investors to buy and sell buildings. Even though you passively own the company, you actively reap the profits. Every limited partnership includes a general partner (GP) who acquired the property and a limited partner (LP) who invests in the property.
In a Limited Partnership, Which Partner Remains Bound By All the Debts of the Business?
In a limited partnership, the general partner remains bound by all debts of the business. A GP finds the deal, as well as the investors — or limited partners — and is bound to the debts in a way that LPs are not. Both the general and limited partners have a stake in the equity, but their responsibilities and contributions vary. Just like if a general partnership fails, the general partner is responsible for the debts.
Responsibilities of the General Partner
The GP can either be one individual, also known as a sole proprietorship, or a larger entity like a real estate development firm or S corporation. The GP is responsible for setting up the partnership, acquiring financing, and managing the investments. At the end of the day, the GP is ultimately liable for the debts and obligations of the partnership. Because the general partner puts in all this work, they also retain an ownership stake in the partnership, and sometimes, they might charge fees to other partners.
The general partner receives equity for landing the deal and for the work they put into the real estate project.
That equity can fall somewhere between 20 and 35%. In terms of fees charged, depending on the general partner, they might charge for acquisition (1 to 5%), asset management (1 to 3% annually), refinancing (1 to 3% of the loan amount), loan guarantee (0.5 to 3.5% of the original loan amount), construction management (5 to 10% of the renovation budget), and disposition (1 to 2% of the sale price). Not all general partners charge fees, while some might charge for any or all of these.
As a general rule, the more risk and labor involved for the general partner, the higher the fees.
The profits are then split between partners, with amounts dependent on the agreed-upon deal.
What Are the 3 Types of Partnerships?
There are three types of real estate partnerships that a person might become involved in, all with varying liabilities and rewards. Note that there is some overlap with the various types of joint ventures.
1. General Partnerships
You’ve heard of general partners, but what is a general partnership? Unlike a sole proprietorship which only involves one party, a general partnership is a for-profit business entity that is created by mutual goals and complementary roles between two or more parties.
Put simply, a general partnership occurs when two or more people or entities invest in a property, putting in equal work and taking on equal responsibility. If something were to go wrong with that property — for instance, maybe a tenant is injured due to some faulty construction work — both partners are liable to be sued. And both partners are liable for the debt.
Because of this risk, many investors increase their protection from disaster or being sued by turning general partnerships into limited liability companies (LLCs). The formation of a limited liability company protects the partners’ personal assets from being a part of any lawsuit.
2. Limited Partnerships
On the other hand, we have a limited partnership that, as explained above, includes one general partner who is liable for everything, and one or more limited partners who invest in the property. A limited partner contributes capital and remains a silent partner.
Limited partners rely on the judgment of the general partner and are not involved in day-to-day operations. While they’ve invested in the property, they are not considered to be direct owners, which is why they are not liable for any of the debt or expenses.
Profits are shared between the general partner and the limited partner(s), but the split varies greatly from deal to deal. Sometimes limited partners even have a minimum guaranteed return before the general partner receives any profits.
3. Limited Liability Partnerships
Another common type of partnership in commercial real estate is a limited liability partnership, or LLP. The main benefit of a limited liability partnership is that it reduces a partner’s liability if anything should go wrong.
All partners in a limited liability partnership can participate in the management of the partnership, making it quite different from a limited partnership, in which the limited partners are silent and uninvolved. This shared responsibility means personal liability and debt are also shared.
Most of the time, LLPs consist of a group of people who have pooled their resources to invest in a property, but with the added advantage that partners can come in and opt out as they please. This added flexibility means new partners who might bring in more business can join the deal at any time, as long as the existing partners agree.
The limited liability part of the partnership comes into play as it relates to personal assets. When an LLP is formed, as per the terms of the contract, a partner’s personal assets are protected, similarly to a limited liability company, or LLC. However, only the partnership is liable in a lawsuit, unless of course one partner personally did something wrong.
3 Considerations Before Forming a Limited Partnership in Commercial Real Estate
There are various factors to take into account before forming a limited partnership, similar to when forming a general partnership. The terms between the general and limited partners are always agreed upon upfront, usually with a contract, in which limited partners agree to maintaining the partnership for a minimum number of years.
1. Make sure to agree on all terms and timelines upfront
Before entering a partnership, it’s important to be clear about the agreement upfront. Desmond Holzman-Hansen, a former member of Lev’s Capital Markets team, said, “When a general partner is looking to enter into one of these types of partnerships, the things that they should definitely be on the lookout for are, identifying a party that’s like-minded, that is aligned on the overall business plan, that understands the timeline, the holding period.”
Some limited partners enter an agreement hoping to immediately get a return on investments, but “the last thing you want to do is get into a partnership with someone who needs their money returned in three years,” said Holzman-Hansen.
Limited partnerships are usually intended to last longer, with more long-term profit.
Holzman-Hansen added, “I think the most important thing for the partners to consider is: am I working with someone who thinks similarly, and are we on the same page in regards to how the project is going to be built or how the returns are going to be paid off?”
2. Invest with people whose expertise you trust
In a limited partnership, the limited partners are dependent on the expertise of the general partner.
Once the LPs’ funds are invested and a limited partnership agreement is signed, the LPs are depending on the GP to earn them a return on the investment.
If a GP doesn’t have the adequate skills and management ability, then the property is likely to lose money. For that reason, it’s important to invest only with people who have a track record of successful and profitable deals.
3. There are no guarantees
As in any real estate deal, there is no guarantee of profit in a limited partnership. There is always fluctuation in the real estate market, and sometimes projects cost more than expected, whether that expense means construction fees, repairs, upkeep, etc. Something as simple as being unable to obtain the proper zoning permits may squash the partnership’s plans.
Both limited partners and general partners should go into the partnership knowing they are taking a risk, and that a return on profit could take years.
A Real Estate Limited Partnership Is a Way to Passively Invest Over Time
If you’re looking for a way to make money passively over time, then becoming a limited partner in a commercial real estate investment can be the way to go. As a limited partner, you’re not liable for debt, and you’re not responsible for any of the work that goes into the deal or the management of the property. Just make sure you’re investing with a general partner you can trust, agree on all the terms and timelines upfront, and be prepared for risk and long-term profit.