The Complexity of Real Estate Investment Partnerships

How to Invest in Property Through a Partnership or Real Estate Sponsor

Real estate can be a valuable part of your investment portfolio. It provides asset diversification, a hedge against stock market and interest rate fluctuation, an opportunity for appreciation and, potentially, some tax benefits. However, owning investment real estate can be a complicated undertaking. Add in a real estate investment partnership structure, and the complexity only increases.

Putting aside the work that goes into selecting and acquiring a property and the capital (or debt) required to pay for it, you have to lease and maintain your property, pay bills for all taxes and operating expenses and keep accurate books and records for the project. While the difficulty of these tasks varies based on the nature of the property and your personal skills and finances, many people choose to partner with others to share the responsibilities and benefits of owning real estate.

If you decide to invest via real estate partnerships, selecting whom to work with and how you will invest with them is of critical importance. A strong partner can help boost the profitability of your investment, while a poor one can cause you monetary damage, anxiety or stress, and may also jeopardize your reputation or credit.

Real Estate Partnerships with Friends and Family

One of the most common types of real estate investment partnerships are formed when friends or family members decide to pool their resources to buy and manage property together. This enables people to buy assets of greater value than they would be able to afford independently.

Operationally, the investors will often divide the work based on their respective skills and resources. For example, one person may perform or oversee maintenance and repairs, while others are responsible for leasing and dealing with tenants, maintaining the books and records, making distributions of income to the partners, and preparing tax documents. The various tasks can be allocated evenly or unevenly among the parties, or hired out to third parties for a fee.

There is a certain innate appeal to working with people you already know and trust. However, real estate partnerships with friends or family members often puts strain on the relationship. This is particularly true if someone fails to properly handle the tasks assigned to him or her, if the investment does not perform as anticipated, if additional capital is needed post-closing, or if the parties have different expectations about the timing and nature of the exit strategy.

Real Estate Investment Partnerships with Operational Partners

In another common form of real estate partnership, one party will be the majority owner of a property, and another party will have a smaller percentage equity interest, but will be responsible for property management and operations. The operational partner will typically receive a management fee for those services, in addition to distributions on account of their ownership interest.

The operational partner’s “skin in the game” distinguishes this situation from the case where an owner simply hires a professional manager for a fee. In the latter situation, the manager is an outside professional with no stake in the outcome of the investment (beyond getting hired again the following year).

Operational real estate partnerships are common for investments that have more than a handful of tenants, for “value add” projects where renovations are made up front to upgrade, repurpose, or reposition the property in the marketplace, and for operational real estate such as hotels, nursing homes and self-storage facilities. These types of real estate partnerships may also be used to make single-tenant properties that require renovation or other capital improvements more akin to “armchair investments” from the majority owner’s point of view.

The operator is usually a real estate professional with direct experience managing the type of asset in question. Accordingly, the operator will have discretion to handle the day-to-day management of the property, while the majority owner will retain control over major decisions such as lease terms or budget, the scope of renovations and the sale or refinance of the project.

Passive Real Estate Investments

There are also a number of passive real estate investment opportunities available where investors can contribute capital, and a sponsor (generally a professional real estate operator) will manage all aspects of the investment, including major decisions. The sponsor may or may not contribute their own equity to the project. These investments are usually structured as either a limited partnership or limited liability company, and the partners or members do not necessarily know one another.

Regardless of the type of partnership you choose, there are several steps you can take to help ensure that your investment is handled according to your expectations.

1) Put your agreement for all real estate investment partnerships in writing.

• Identify who will be providing specific services (e.g. legal, financial, operational), what fees, if any, will be paid for the services, and how those fees will be calculated over the holding period.
• Identify who is responsible for decision-making, and what percentage of partners must consent to take different types of action (i.e., day-to-day versus major decisions). Include a procedure for dispute resolution.
• Specify what happens if a partner dies, becomes incapacitated, or wishes to exit the investment ahead of the other partners. A provision that substitutes a partner’s heirs in the case of death or incapacity may be workable for a passive investor, but could prove problematic if that partner was integral to operations, or had decision-making authority, especially if the heirs lack the original partner’s sophistication or skills.
• Memorialize the parties’ initial capital contributions, and how future capital calls will be treated.
• Identify the frequency and manner of distributions of cash flow and capital event or refinancing proceeds.
• Provide for cash reserves for unforeseen expenses.

2) Know your limitations and goals.

• If you are taking on management responsibilities, make sure you have the ability to fulfill them, or that you have a backup plan for times when life gets in the way, or you may jeopardize the investment for the entire partnership.
• Discuss the intended exit strategy for the property with your partners before you buy. If you want a short-term investment while your partners are thinking of a long-term hold, you are setting yourself up for some heartburn.
• Think about your risk tolerance, and compare it to the overall risk of the particular investment. Consider what could possibly go wrong, and whether you and your partners have the financial and emotional capacity to address those situations. If the fit is uncomfortable from the start, it will not likely improve over time.
• Consider your relationship with your partners. Have you worked well together in the past, particularly with matters that involved money? Is your relationship strong enough to withstand an investment disruption or failure? Does the investment agreement protect you (and the property) from a fellow investor’s bad acts?

3) Conduct as much due diligence on your partners as you do on the property.

• If you are investing with a professional sponsor, do your own research to assess that party’s experience, credibility, personnel, and track record. Ditto if you are working with an operational partner. Ask for references. Understand what fees you will be charged and when, and if there are economic hurdles or benchmarks that must be satisfied for the professional to earn those fees.
• You must also perform due diligence if investing with friends and family. At a minimum, make certain that all parties involved have the financial wherewithal to weather a total loss of principal, and to cover their share of “worst case scenario” capital calls. If a friend or family member is handling any operational issues, make certain that he or she has the experience and time to do the job properly (see bullet point above). Delegating some tasks to professional contractors or managers can provide peace of mind and will inevitably cost less than a fractured relationship.
• It is also extremely helpful to have a trusted outside professional, such as an attorney, accountant, or financial advisor who can impartially advise the venture in the event of a dispute.

4) When in doubt, use professionals.

• Using outside professionals may cost more in the short term than doing everything yourself, but good ones are frequently worth the price. In addition to having expertise in real estate matters, they are often better equipped to treat property related issues as business matters and not as emotional ones. Further, many commercial real estate professionals, such as property managers, can provide cost savings through economies of scale, greater knowledge of the applicable market and rental rates, and a deeper network of firms in the industry to call on for assistance or third-party services.
• Outside professionals are especially helpful if your property is not local, if you travel frequently, if your property or tenants are likely to require significant maintenance or repairs, or if it is not practical for you to be accessible 24-7 in case of a building or tenant emergency.

No matter how you decide to proceed, documenting your understanding in advance with your partners and outside professionals is critically important. It is easy to correct or forgive mistakes or deviations from the parties’ agreement when the investment is performing as expected. The bigger test is how your partners behave when something goes awry. Doing your homework to prepare for the worst in advance will help manage expectations.

Following these tips cannot guarantee that your real estate investment partnership will be as profitable and seamless as you might like, but it will improve your chances that you will have a positive investment experience with your partners.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Due Diligence in Real Estate Deals, Investing in Commercial Real Estate and Investing in Residential & Multi-Family Real Estate. This is an updated version of an article originally published on January 10, 2018.]

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