The Basics of a Real Estate Partnership
Real estate partnerships are best understood within the context of the most basic investment structure, the partnership. A partnership can be defined, in a broad sense, as a relationship between two or more persons to conduct and share in the profits and losses of a trade or business. An investment partnership is similar to the basic partnership, however the trade or business in an investment partnership is related to passive investment, specifically, the investment is typically in real property (although not necessarily). Essentially, the partners contribute cash or other assets, an investment partnership purchases property and shares in the profits generated from passive investment activities. Technically, whoever has rights over the management of the partnership is a General Partner; those who are just investors are Limited Partners. For the General Partners, risks may involve personal liability on the amount of capital contribution. For the Limited Partners , risks typically are limited to the extent of their contribution.
The success of an investment partnership depends greatly upon such factors as both the amount of capital contributed as well as the scope of the activity involved with the project. The main advantage of this type of investment is the absence of direct responsibility over the properties or any active management of the partnership. Essentially, the General Partners manage the properties and the Limited Partners finance the project in return for the same benefits. From a financing perspective, this type of investment allows a Limited Partner to financially benefit from a real estate development and or ownership without the risks and costs associated with direct investment within the project. In other words, a Limited Partner can theoretically be a passive investor of a real property development and earn whatever profit arises in the project without ever getting his or her hands dirty. This is the essence of a real estate partnership.
Components of a Real Estate Partnership Agreement
There are several key elements to memorialize in a real estate partnership agreement, including the following:
1. Roles:
Many partnerships begin informally, over drinks. As the projects get more serious, or the money more difficult to come by, having a clear understanding of roles can avoid confusion, and even disaster. A typical partnership arrangement would clearly exude respect and recognition of each party’s "specialty". This can be useful when seeking bank financing, and in understanding who is responsible for what.
2. Contributions:
What is each partner going to contribute? Is it cash, expertise, ideas, development, marketing, or other effort? Be clear.
3. Profit Sharing:
Who gets what? Will it be by percentage? By contribution? By effort? By experience? This can be one of the more important issues to work out in advance, if only to avoid disappointment later.
4. Dispute Resolution:
Any dispute resolution procedure must be carefully constructed, flexible, and balanced for both parties. Typical examples could be mediation, reference to a third-party advisor or decision maker. A good practice would be to include a list of specific individuals to be consulted first.
Important Considerations When Drafting an Agreement
Many of the agreements related to the partnership have tax or other legal consequences if the terms of the partnership agreement do not comply with the governing statutes or other applicable laws. For example:
- Does the partnership have a stated business purpose, and does the partnership have a term?
- Are there limitations on partner liability (keeping in mind that the liability of partners to third parties – such as creditors – will depend upon the manor in which a partnership is formed, the subsections of the Uniform Partnership Act that apply and other factors, notwithstanding the terms of the partnership agreement)?
- Is there an agreement concerning withdrawal of partners and does the partnership continue after withdrawal of partners?
- Is there an anti-dissociation statute and will the non-dissociating partners need to buy out the dissociating partner?
- Are amendments regulated by a statute such as the Partnership Tax Act?
- Must there be written agreement, as with a limited partnership?
- Must the limited partners remain passive investors?
- Must certain votes be taken in order to approve certain matters?
- Is a certificate required to file with a state authority such as the Secretary of State?
For these reasons, it is generally advisable for a real estate services firm to retain legal counsel to advise it on matters relating to the drafting and implementation of any partnership agreement. The advice of a qualified attorney is often invaluable in preparing an agreement that accomplishes business and tax purposes and avoids problems that could not only disrupt the business, but also could result in extensive legal and accounting costs to fix.
Types of Real Estate Partnerships
The following is an overview of the most common types of real estate partnerships: general partnerships, limited partnerships, joint ventures and limited liability companies. A business partnership can be formed for many different reasons, such as: sharing liabilities or profits; sharing in management of a business or investment; or diffusing ownership of a single home or several homes, especially for estate planning purposes. The following sections give an overview of the four different types of business partnership in which real estate can be held.
For many general partnerships with more than two partners, it can be beneficial to draft a formal Partnership Agreement to address the various issues that can arise, such as contributions, allocations of profits and losses, distributions, buyout rights and exit strategies.
In a limited partnership, the General Partner acts as the manager and is personally liable for the obligations of the partnership. The Limited Partner is not actively involved in the day-to-day management of the business or assets, and is usually only at risk for the amount of its contributions to the partnership. Limited Partnerships are typically used to manage real estate investments in a tax-efficient manner where the income or loss passes through to the Partners, but regular tax filings are not required with a Limited Partnership.
A joint venture is generally a business partnership with an identifiable project or outcome and a fixed duration. Joint ventures are typically used for real estate development deals, where a developer and lender enter into a single transaction on a specific piece of real estate. Joint ventures can take the form of an LLC or an entity foreign to the state where the real estate investment is located.
A limited liability company (LLC) is a hybrid entity that combines the liability protection of a corporation with the tax-efficient structure of a partnership. For investment properties, an LLC usually has a single purpose. LLCs do not pay tax on earnings or distributions and directly pass through tax consequences to the members (especially advantageous for tax-sensitive investors), but require some tax filings.
Potential Issues with a Real Estate Partnership
There are potential risks and challenges inherent in partnerships, including financial risks, partnership disputes, and market forces. A clear, comprehensive real estate partnership agreement can help address many of these issues.
Financial Risks; Debt and Guaranteeing Financing While joining efforts to purchase a property can have obvious financial benefits, adding multiple owners can also multiply the risk. When one partner defaults on financing, for example, others may be called to make up the difference. If an obligation is guaranteed by more than one partner , the risk of loss can expand exponentially. A couple additional notes about financial risks: Confidence in Partners; Partnership Disputes Although financial security is a key goal of going into business together, confidence in partners is equally crucial. Among the questions to answer: Market Forces; Common Forces Affecting Real Estate Partnership Because markets go up and down, a real estate partnership should have some foresight and planning to account for shifts in the economy that may produce negative effects on goals or funding. Partners should be aware, for instance, of: Although there can be many rewards to real estate partnerships, it is important to address the risks in a realistic and objective way.
Tips for a Successful Real Estate Partnership
Establishing and maintaining a successful partnership requires a proactive approach to organization and communication. Before entering into a partnership, both parties should conduct thorough due diligence for any possible red flags. This means looking into the individual partners’ financial, credit and legal histories, as well as conducting research into the proposed deal or property. Whenever possible, tour the property and meet with buyers. A real estate partnership agreement should clearly define each partner’s roles, responsibilities and contributions to the partnership. To ensure that responsibilities are met, the agreement should include deadlines and a process for ensuring compliance. In addition, the agreement must include guidelines for making partnerships decisions, such as when partners must agree unanimously, and when a simple majority is sufficient. Clear and consistent communication is also essential for success in real estate partnerships. Partners should hold regular meetings to provide progress updates, discuss obstacles, and suggest solutions to existing problems. By addressing these issues early on and providing potential solutions, partners can work together to overcome problems and maintain good relationships. If conflict arises, the partnership’s dispute resolution procedures should be followed until a resolution is reached. Monitoring each partner’s progress is also key to ensuring a successful partnership. The partnership should regularly review its financials to ensure that incomes and expenses are in line with expectations, and that each partner is adequately funded. Setting up a system for tracking daily, weekly, monthly and yearly reports can help partners gather this information and assess trends. Promptly following up on any discrepancies will foster transparency and teamwork, while allowing the partnership to remain on schedule.
Examples of Successful Real Estate Partnerships
To further illustrate the value of real estate partnership agreements, consider the following successful real estate partnerships.
Success in The Finger Lakes
When we talk about real estate in upstate New York, we have to mention the Finger Lakes region. The area is famous for its wine and vineyards, and it’s perhaps the most popular tourist destination in upstate New York. But it’s also home to many highly successful downstate families who have partnered with Finger Lakes farmers to create profitable businesses based on growing wine grapes. Many of those partnerships are formalized via written partnership agreements negotiated by our office, and each of them is successful in its own way. These marriages of land and money have guaranteed long-term, year-round work and income for the farmers and financial security for the investors. And, whether the grapes are for making wine or table grapes for sale at the nearby Great New York State Fair, through these partnerships both parties have benefited from the hospitality industry of the Finger Lakes.
Success in The Hudson Valley
Closer to New York City, other successful partnerships are taking place in the Hudson Valley. The best example is the story of Aaron and David Koller, local partners in an organic farm called Roller Coaster Farm. Aaron grew up on this 30-acre farm, whose former owner had made a fortune selling roller coasters. The owner had hired his son, David Koller, to oversee the carefully-tended farm, and David discovered that he enjoyed farming and excelled at it. David encouraged his partner to put the farm into a Limited Liability Company (LLC). That was brilliant because the owner had grown accustomed to business, but he was getting older and did not want to run the farm day-to-day anymore. The LLC was set up so that David, working on the farm full-time, could buy out the shares of his partner slowly and take over the business. That was five years ago, and David is now 50 percent owner of the farm, on his way to 100 percent ownership. David also introduced the idea of selling directly to consumers through a web-based site called "Local Dirt." This site sells produce every single week throughout the year to local customers, keeping the money in the Hudson Valley community rather than sending it elsewhere, as happens when produce is sold by the national chain stores. The Local Dirt website has involved other farms in the Hudson Valley as well as Roller Coaster Farm, including The Green Thumb Organic Farm, M & A Berry Farm and Sky Farm with its awesome blueberry crop .
And there’s one more reason why the Local Dirt website is brilliant. The site is well-promoted all over the region, and is the go-to source for chefs at the many fine restaurants in the area. The locals know that if they want to eat organic and local, they can go onto the Local Dirt website and find what is available locally, or visit one of the Farmers’ Markets in Putnam, Dutchess, Orange, or Westchester counties every season of the year.
Now Aaron and David are expanding into small fruit and vegetables as well as mushrooms, and in the winter, Chicken and Turkey sales are always just around the corner. They have become the go-to farm for the local restaurants and grocery stores for the freshest food produced in the Hudson Valley. Some of the restaurant owners in the fine dining places visited by my family have even mentioned that they have found that in addition to the tastiest food, they get the best customer service and the freshest produce when they call on Roller Coaster Farm.
Success in The Capital Region
Just off down the Thruway in Latham is another of our favorite success stories. Two young women shared the dream of having their own farm, and they considered whether to do it by themselves or to do it as a partnership. They decided to make a partnership agreement and do it together. They rented a small house on 25 acres, unable to afford to buy farmland yet. In that house they set up a community supported agriculture business called a CSB, which is as close as you can get to being in an organic farming commune. Carpet over the hardwood floors kept the house toasty warm as they started an organic vegetable garden and sat down with all their neighbors to have dinner together. They decided that they would be self-sustainable on donations from those dinners, and slowly they saved up enough money to buy 50 chickens and a dozen goats. They made their first investment into the farming business and have never looked back.
All three of these partnerships are localized – Hudson Valley, the Finger Lakes, small-town Latham. Some real estate partnerships have a global reach, and a few come from far, far away. But for the most part, the successful partnerships that we see around us, in all sorts of real estate ventures from commercial real estate to recreational properties, are centered close to home. Some are second-generation owned, with the first generation reminding us how important partnerships were for them in building wealth and prosperity for their families.