August 17, 2016
U.S. News & World Report
By Dennis Cisterna
Investing with a partner in real estate, especially residential properties, can often be appealing as a business venture due to the inherent benefits, like mitigation of risk and shared responsibilities.
But proceed with caution. Real estate investing partnerships are like any other business undertaking, and should be treated as such. This is even more important to consider when potentially partnering with friends or family.
Before entering a partnership on a real estate investment opportunity, ask yourself, “Why am I doing this?” There should be an easily identified, tangible benefit to investing with a partner versus investing on your own. It could be any number of items, but if you can’t pinpoint what it is, maybe adding a partner is not right for the specific opportunity you have in mind.
Why Go Into It Together?
While some partnerships are based on relationships and convenience, partnerships built on necessity and practicality have a much greater chance for success. Most partnerships should have some type of financial or operational consideration as a driving force behind their formation.
Financial considerations. When investing in real estate, capital constraints are usually the single largest obstacle to overcome. There are many opportunities in the market, but not enough people to fund them. Should you let a great opportunity pass you by just because you do not have enough money? Chances are that if the opportunity is as good as you think, then the potential partners may be readily available.
Additionally, even in scenarios where an investor has enough capital to fund an investment on their own, partnerships can mitigate the risk of going “all in” on an investment by defraying the cost with the help of a partner.
Operational considerations. Perhaps you’ve stumbled across a hidden gem in your neighborhood but you don’t have the practical skills to manage the permitting, construction or sales process of the investment. While there is great truth in the idea that you may learn a lot by failing, you can also learn a lot by taking on a partner who has been there and done that. Amateur investors can save time and money by partnering with an experienced professional.
What Types of Partnerships Are Most Common?
The structure of the partnership is critical and you must clearly outline roles and responsibilities, look for someone who complements your needs and understand that partnerships must be equitable for both parties. These are some of the keys to sustainability and success in both the investment and your business relationship. Each partnership is unique, but they usually consist of a couple of key factors such as who has the money and who has the experience.
Fifty-fifty. The simplest kind of real estate investment partnership is an even split where each party invests equal money and effort into the investment and gets the same rewards. This scenario provides an ideal alignment of interest where both partners are committing to put the same amount of capital and effort into an investment.
Real equity and sweat equity. More often than not, one party might have the necessary experience but not enough money to pursue his or her ideal opportunity, so they partner with a like-minded equity partner. The investment manager, also known as the general partner, handles the day-to-day operations while the other person, also known as the limited partner, puts up the bulk of the funds. The payout structure between parties can range from a simple 50-50 split to something more frequently seen on Wall Street, where the LP is paid a preferred rate of return and the subsequent profit split escalates for the GP as profits increase, incentivizing the GP to work efficiently and under budget.
Formalize the Partnership to Limit Regrets.
As in any venture, it is important to analyze your risk. One area that can be critical to safeguarding your investment, but is often overlooked, is the actual partnership agreement. This legally binding document should clearly outline the rules, responsibilities and rights of each partner. It may seem obvious, but when push comes to shove, the partnership agreement is your only lifeline should things take a turn for the worse.
For example, if one partner is responsible for contributing capital but is consistently unable to pay, the other partner should have the right to replace such partner. Conversely, if one partner is clearly missing predefined budgets and schedules due to negligence or incompetence, the other partner should be able to rectify the situation through a buyout provision or penalties.
While many real estate partnerships do not require a lawyer to negotiate contracts, it’s a best practice that any partnership with money at stake be reviewed by an attorney to ensure that terms are fair and legally enforceable.
Some investors may prefer “handshake” agreements because they’re partnering with friends, family or colleagues. They think: “We are best friends, so what could go wrong?” That mindset is ground zero for an ineffective partnership.
There are a host of reasons to invest with a partner, but it’s imperative to always understand your risk. While it may seem appealing to invest with family members or friends, investments do not always perform as expected, and all members of a partnership need to be aware of and be prepared for this kind of situation from the start.
As it’s important to research the markets and properties you plan to invest in, the same is true of entering into a real estate investment partnership. The bottom line is that you are risking more than just your money when entering into an investment with a partner.