Making The Most Of Real Estate Limited Partnerships
Bob Mangat and CEO & Founder of the 1440 Group, a real estate investment and development firm in Vancouver, BC Canada.
For individuals who want to invest in commercial real estate, but may lack the stomach to go all-in individually, or even to have the bulk of liability for a new entity, a real estate limited partnership may offer the right risk-reward ratio—keeping more cautious investors excited and engaged in a potentially profitable opportunity, yet still able to sleep at night. Essentially, a RELP occurs when a group of investors goes in together to build, purchase or develop a property, usually a commercial space such as a shopping center, multi-family apartment unit, mixed-use development or business plaza.
When thoughtfully considered and carefully agreed upon with trusted partners, a RELP offers an excellent opportunity for investors to earn passive income while incurring a more moderate risk than those wherein they bear the entirety or the bulk of the exposure. Here’s how these partnerships work, and what to watch out for.
Who’s In The RELP?
Usually there is one general partner who assumes full liability for the investment; the GP is generally not one individual, but rather, a real estate development firm, a corporation or a property management company. The GP, in addition to controlling the lion’s share of the investment (and assuming the greatest financial risk in the partnership), also takes on day-to-day responsibilities for the project’s execution.
The limited partners, or LPs, usually are not involved in the day-to-day project development and in most states have no voting power over project decisions. (LPs are sometimes called “silent partners” for this reason.) They make smaller contributions to the overall pool and, resultantly, have more limited liability—only up to the amount they’ve invested in the project. Essentially, they have one job: Show up with the money.
RELPs are carefully defined and delineated, with the roles and responsibilities of each partner—including the level of their investment—clearly outlined in a partnership agreement. In some cases, RELPs can involve several smaller-scale investors, each kicking in a few thousand dollars to a project and pooling their money. But in the bulk of such agreements, certain types of investors are sought out in advance by the GP: high-net-worth individuals, institutions that have portfolios of such investments and individuals with SEC-accredited investor status. Relying on these trusted silent partners mitigates risk for everyone involved.
Benefits Of RELPs
Obviously, any investment carries some risk. LPs carry a share of the risk limited to their investment, with a given partner’s exposure being the amount they’ve committed to the project; in return, there is the potential for high returns, particularly for certain types of commercial real estate. Additionally, maintaining LP status allows partners to limit their day-to-day involvement in the project, allowing them to eventually generate passive income while focusing on other business. Particularly for partners who have limited knowledge of real estate development (and prefer to delegate this business to a more experienced general partner), but are curious and interested in investing in a space rife with opportunity, RELPs can present an ideal framework for a foray into real estate.
From a tax perspective, RELPs have some significant benefits, most notably that income is passed through the partners; thus, RELPs themselves are not required to pay taxes. In America, the partnership itself declares its income to the IRS with a Form 1065. Then, individual partners receive a form called a K-1 that details distributions of income (or losses) throughout the year; each investor then pays their individual income taxes to the IRS, as usual. This is beneficial, as it keeps the income from the property taxed at individual rates instead of (much higher) corporate rates.
The same taxation scheme occurs in Canada, with some minor differences: Canadian residents, as in America, pay personal income taxes on the profits received from the RELP. Non-residents have no tax liability in Canada (except on profits of the partnership that are derived from Canadian sources), but LPs that have non-resident partners are not exempt from withholding tax. This occurs in the form of the Part XIII tax, accompanied by form NR302 of the Canada Revenue Agency (CRA).
Potential Pitfalls
Not doing due diligence on partners can be a significant problem with RELPs, specifically with the general partners, who are in charge of day-to-day project management. Having an inexperienced or simply incompetent GP can doom a development project from the start. This can be incredibly frustrating to LPs, who have their hard-earned money invested in the project and yet have limited to no decision-making authority.
LPs should also be carefully vetted, particularly if the project necessitates not just one lump-sum investment, but contributions as called upon, or on a schedule over time. As with any investment, silent partners’ financial woes should not become a problem of the partnership.
Moreover, LPs’ investments in these projects tend to be illiquid, meaning they cannot be pulled out whenever the investor feels like it—even if the investor has lost confidence in the project, in their partners, fears that they will never recoup their monies or needs them immediately for personal reasons. Investors will instead have to wait at least until the property sells to get their money back, assuming of course that the project at least breaks even and they are able to do so.
Some Final Thoughts
RELPs afford partners a level of purchasing power that would be out of reach of each of them individually, with the potential for some incredibly high returns: In boom years, these investments have been known to realize as much as 30% gains on initial investments. However, like every such partnership—particularly in real estate—they’re subject to partners’ trust issues, mismanagement and market fluctuations, including “act of God”-type events (such as the pandemic, which initially caused a sharply reduced demand for commercial real estate). Potential investors should do due diligence on their partners, and on the project itself, but should not be afraid to engage if the right opportunity comes along.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
Source: https://www.forbes.com/sites/forbesbusinesscouncil/2022/10/12/making-the-most-of-real-estate-limited-partnerships/?sh=54f97042702f&fbclid=IwAR32QDmgOlKP_SDkkaXwJV2szt7B86jQCRLY7gqWVpTIW8PXbLyDExPMpHc
Tags: limited partners or LPs real estate limited partnership SEC-accredited investor status types of commercial real estate Business
