Partnerships can be disastrous, but they can also open the doors to investing for many individuals, who could not otherwise invest. Personally, I think many investors are too eager or not eager enough to partner with like minded individuals. On one hand, everyone has a friend who always has that “great idea” (you know the liquor store across from the church or the ice cream store in Antarctica). These people should clearly be avoided. But what about people who actually have good ideas or have found good investment properties?
A good partnership begins with common goals. Each partner should have a clear expectation of the investment type, expected return, and reinvestment rate. If the goal is to get a better understanding of the real estate investment process, the partnership should focus on smaller, easier to manage properties. If maximizing return is the goal, everyone should be clear about their risk tolerance. Partnering on a land development deal might not be appropriate for someone with a lower risk preference. More importantly, everyone should understand the risk of every investment. This is easier said than done. Many real estate deals seem simple, but can get very complicated very fast. Keeping everyone well informed of the details is a must.
After common goals have been established, a clear investment strategy should be laid out in writing. It is important this is in writing because it should be referred back to as each investment is considered by the group. It is very dangerous for the group to stray away from their investment philosophy. When things go well this is typically not an issue, but when things go poorly this can be an issue of contention (outside and inside the courtroom). Additionally, by putting the investment strategy in writing, the group is forced to flesh it out. This process will often eliminate extraneous ideas or bring out ideas that people may not have been comfortable with. Either way, it puts everyone on the same page.
Next, bring in the legal and the accounting team. For smaller, less complicated partnerships this step is as simple as paying a lawyer to draw up a partnership agreement. The accountant for these deals really acts as a consultant for tax implications of the partnership and the investments. If anyone has an accountant they use for their taxes, (and has done real estate with him/her in the past) this individual will suffice. Typically, the accountant will give you advice free of charge if you use them regularly for your taxes. If no one has an accountant, look for an accountant that specializes in real estate accounting. This is important because there are many things that should and should not be deducted from your personal taxes. At your first tax return, the additional savings will cover the cost (which will be steeper than you are use to) of the services.
For the larger partnerships, consider forming a Limited Liability Corporation. Many people question the purposes of incorporating because of the tax/legal issues. Read more from the linked site above for tax questions. The biggest benefit to the LLC is the liability issues. Under an LLC, no member has liability for anything that goes wrong in the partnership (except some forms of fraud, which that member clearly should be liable for). This is helpful as the partnership takes on larger deals and more risks. When you get to this step, ensure that you have a lawyer knowledgeable about the formation of LLCs. This is a very simple process, but there are some finer points you want to make sure are included.
Last and most importantly, the group should have a clear exit strategy. Perhaps it is some number of investments or some dollar amount, but it should be clearly defined in the partnership agreement. Additionally, there should be an exit strategy for each property the group chooses to invest in. A major issue in partnerships always occurs around when to get out of a property. This should be defined as a fixed time (5 years) or a fixed return (15% IRR). Again, the return goal should match the risk of the project; otherwise, the group might be holding the property forever.
I could write at least ten more blogs about different aspects of partnerships (and I probably will), but I want to leave you with some key learnings I have had from my partnership days…
- Know your partners. Never partner with someone on recommendation or just because they have money unless you get to know them very well.
- Make it clear how partners can exit the partnership before the end date or closing return. This should have some kind of penalty attached because it will be a hardship for the other partners. For example, a partner may only get 65% of fair value if they need to exit early or they may only be allowed to exit early by super majority vote. The lawyer can help with language here.
- Partners should try to do equal work. If one partner knows everything, he/she should teach others and let them add value. No one partner should be doing the lion’s share of the work unless he is getting compensated fairly for that work.
- Always consult a lawyer to start and end the partnership. Yes it cost money, but it will save you thousands in court cost. Court is never fun or cheap.
- Partner for the right reasons. Either to spread risk if you are a beginner or to invest in larger properties if you are more experienced. Don’t partner with someone just because they promise you an unbelievable return or because they ask.
Joel Carignan says:
>”Partners should try to do equal work.”
No matter what, the 80/20 rule will apply. 80% of the work, will be done by 20% of the people. In a 50/50 partnership, one partner is really getting hosed with extra work.
I think it is imperative in a partnership to spell out the tasks each partner will handle. If you don’t know what the tasks are, you need to do more research into the project and better understand what you are getting into. If you find you both want to complete the same tasks, now is a good time to decide who will do the “dirty work,” long before it becomes “dirty work”. The worst thing you can do in a partnership is step on each other’s toes. Time is too valuable to do the same job twice. As the WWE’s famous entertainer, The Rock always says, “Know Your Role.” Nowhere is this more true than in a partnership.
February 6, 2007 — 2:49 pm
John Thieszen says:
Thanks for the great post.
I’ve been struggling to come up with a partnership agreement that will work. The partners are cooperative, and a real estate lawyer and accountant are involved, but it seems to be real flog getting it together. Interestingly, the real estate lawyer, who has a very good reputation, doesn’t seem to put much stock into LLC’s as a form of asset protection. He says that our assets would not be protected from a personal lawsuit (if we were in an accident, or sued at work), nor would they be protected if a renter sued us for personal negligence. It seems that he feels the best protection is adequate liability insurance and avoiding personal negligence (of course).
From the accountant’s standpoint, sharing the profits based on the amount of appreciation of the property is not favorably viewed by the IRS. In other words, we can’t be managing partners doing all the work, and have financial partners investing the downpayment, and then split the profits at the time of sale.
Anyhow, I’m slogging through this (and have been for several months). I’m reading all I can find on partnerships, and will closely watch for more posts. If anyone has any thoughts, I’d appreciate them.
Thanks again.
February 7, 2007 — 1:50 pm
Michael Cook says:
John,
First, your lawyer gives great advice. I was writing with the assumption that your company would have liability insurance. This is imperative for the assumptions you mentioned. Importantly, this insurance only covers a certain amount of damages. It is very important to know and understand this number because there are things that could happen that could be well beyond it.
There is no insurance that will cover personal negligence. If you fear that, go with the C-corp because I believe that does remove some of that liability from you. While it is still possible to go to jail, it is harder for people to get your personal assets. I would try to avoid this at all cost, however, because the tax implications are really not worth it. Simply avoid doing anything wreckless and you should be ok.
If you have investors and workers, consider a JV structure with a waterfall structure. This can help with some of your tax issues. If you are unfamilar with these types of structures, ask your lawyer about partnership/payment structures that provide a General Partner and Limited Partner structure. This should solve some of your tax issues.
February 7, 2007 — 3:53 pm
John Thieszen says:
Michael,
I’ve been meaning to thank-you for your detailed response. I’m going to look into the JV structure and Limited Partnerships.
Thanks again,
John Thieszen
April 15, 2007 — 4:43 pm