The Complexity of Real Estate Investment Partnerships

Investing in Property With a Partner or Real Estate Sponsor

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

Real estate partnerships can come in many forms, depending on why you’re investing with others. The reasons can range from needing additional capital to wanting a more passive role in property management. In addition, changes to the federal tax code have made co-investment in real estate syndications with professionals more accessible to the public, creating more investment opportunities.

If you decide to invest with others, selecting whom to work with and how you will invest is critical. 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 even jeopardize your reputation and credit.

Partnerships With Friends and Family

One of the most common types of investment partnerships occur when friends or family members pool their resources to buy and manage property together. This approach enables investors to buy more significant assets than they might be able to buy alone.

Operationally, the investors will often divide the work based on their respective skills and resources. One person may perform or oversee maintenance and repairs, while others may be responsible for leasing and dealing with tenants. Financial matters, such as paying bills for the property and maintaining books and records, and legal/administrative matters, such as securing insurance for the property and creating an LLC or partnership for the investment, will also need to be delegated to someone. 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 appeal to working with people you already know and trust. However, real estate partnerships with friends or family members can potentially put a strain on the relationship. This is particularly true if someone fails to properly handle the tasks assigned to them 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, especially if an investor’s financial circumstances change during the holding period.

The strain can increase if the parties’ individual investments or decision-making authority are unequal or if disagreements arise about operational matters.

Partnerships With Operational Partners

With operational partners, one party is the majority owner of a property, and another party has a smaller equity interest. The party with a smaller equity interest is the ‘operational partner’ and is 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.

What distinguishes this situation from hiring a professional is the manager’s equity stake. With a hired hand, the manager is an outside professional with no interest in the outcome of the investment beyond getting hired again the following year. This also differs from friends and family partnerships, where none of the partners need to be real estate professionals, and several contribute to the management of the property.

Operational real estate partnerships are most common with: real estate associated with an ongoing business enterprise such as hospitality, senior living, parking, or self-storage facility; properties with more than a handful of  tenants, such as residential buildings with 5 or more units, multi-tenant retail centers of offices; or properties of any type requiring significant renovations at the outset — so-called ‘value add projects.’

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

In these types of investments, communication is key. Operating partners must keep the other investors apprised of the status of the project, especially during critical phases of construction, leasing, and financing. As with friends and family partnerships, differing opinions about major decisions can derail the investment if they are not resolved satisfactorily. Though this type of arrangement poses its own challenges and requires diligent oversight, it is more likely to operate as an ‘armchair investment’ for the majority partner than a friends and family partnership where the investors are directly involved in the day-to-day.

Passive Real Estate Investments With Professional Sponsors

There are also a number of passive real estate investment opportunities available where investors can contribute capital, and a professional real estate operator, or sponsor, 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 a limited partnership, a limited liability company, a real estate investment trust (REIT), or a Delaware statutory trust (DST). The partners or members often do not know one another.

In these types of partnerships, the investors do not typically have any vote or input on how the property is operated. Additionally, there is little room for negotiation of the agreements governing the partnership. The investors rely on the sponsor to make prudent decisions regarding the project.  The lack of control at the investor level can be frustrating if the operator’s decisions are not consistent with your own priorities. However, a good sponsor will make informed choices based on knowledge and experience in the industry, communicate regularly with you and provide reporting, and will prevent your fellow individual investors from impacting the project.

Making Your Partnership Work for You

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.

Put Everything in Writing

Identify who will be providing specific services (e.g., legal, financial, operational), what fees will be paid for the services, and how those fees will be calculated over the holding period. Know 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. Substituting a partner’s heirs might be workable for a passive investor but could prove problematic if that partner was integral to operations, especially if the heirs lacked the original partner’s knowledge or  skills.

You should memorialize the parties’ initial capital contributions and how future capital calls will be treated. Ensure that the project has working capital or reserves to address unforeseen expenses. It’s also important to identify how cash flow and capital gains and losses will be distributed and at what frequency.

If professionally managed, there should be an offering memorandum with disclosures provided to investors before they fund their respective interests. The memorandum should include sponsor information, the due diligence conducted on the property and tenants, the investment strategy, financial projections, and the potential risks of the investment. There should also be a written agreement outlining the rights and obligations of the parties. It’s important to review and understand these documents before committing to the investment.

Know Your Limitations and Goals

If you are taking on management responsibilities, make sure you can fulfill them.  Have a backup plan for when life gets in the way, or you may jeopardize the entire partnership.

Discuss a potential exit strategy for the property with your partners before you buy. If you want a short-term investment while your partners are thinking more long-term, you are setting yourself up for heartburn.  Realize that people’s circumstances may change during the course of the investment.

Think about your risk tolerance and compare it to the overall risk of the particular investment. Consider worst-case scenarios 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 bad acts by management or fellow investors?

Conduct Due Diligence on Your Partners

If you are investing with a professional sponsor or an operational partner, assess their experience, credibility, and track record of the individual. Ask for references. Understand how, when, and how much they will charge you. Most larger sponsors make their money with a “promote” or “carried interest” where they reap significant benefits based on performance, but upfront fees and ongoing asset management fees are also common.

You must also perform due diligence with friends and family. At a minimum, confirm that all parties involved can weather a total loss of principal investment and cover their share of ‘worst case scenario’ capital calls. If a friend or family member handles any operational issues, ensure they have the experience and time to do the job properly.  Any party with a stake in the project can impact it, including through social media.

Delegating some tasks to professional contractors or managers can provide peace of mind and 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. This should be someone other than your own personal advisor in order to avoid conflicts of interest.

When in Doubt, Use Professionals

Using outside professionals may cost more in the short term, but good ones are frequently worth the price. They are often better equipped to treat property-related issues as business matters rather than emotional ones. Further, many commercial real estate professionals can provide cost savings through economies of scale, greater knowledge of the market and rental rates, and a deeper network of firms to call on for assistance or third-party services.

Outside professionals are especially helpful if your property is not local, if you travel frequently, or if your property or tenants are likely to require significant maintenance or repairs. Even if your lease makes tenants responsible for building maintenance, you should still keep an eye on the building, otherwise known as ‘your investment.’

No matter how you decide to proceed, having a clear understanding of the people you work with is critically important. It is easy to forgive mistakes or deviations from the 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 you 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.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Property/Business Interruption and Cyber Liability
2. Complex Financial Litigation / Common Issues and Strategies in Business Breakups
3. Ethical Issues In Real Estate-Based Bankruptcies / Insider Lease Agreements

This is an updated version of an article published January 10, 2018, and updated  May 26, 2020.]

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