Beginner's Guide to Real Estate Limited Partnerships

The old saying that there’s more than one way to skin a cat is especially true when it comes to real estate investing. Although most people understand investing in real estate is a good idea, the high acquisition cost means a lot of capital is needed to get deals done. One way to navigate this obstacle is pooling investor funds through a real estate limited partnership (RELP).

RELPs offer investors a cost-effective way to buy real estate without having to buy or manage entire properties themselves. If you've been thinking of investing in real estate but aren’t sure how to do it, keep reading to find out more about how RELPs work and whether they are right for you.

How Do Real Estate Limited Partnerships Work?

RELPs work a lot like a traditional business partnership. You get a group of like-minded investors who contribute money and form a limited liability partnership that exists for the purpose of making real estate investments. Each of the partners receives equity in the properties purchased by the RELP at a rate proportional to the size of their investment.

So, for example, if there were five investors who all put in $200,000 to buy $1,000,000 worth of real estate, each of them would have a 20% equity share in the property. However, before the RELP actually purchases a property, it must have a partnership agreement to define its structure and operating procedures.

How are RELPs Structured?

RELP agreements can be structured in a variety of different ways depending on the partners’ investment goals. Every RELP agreement will establish standard modes of operation that include:

• Names of the investors
• Amount of capital pledged by each investor
• Plan for distribution of investment income or capital
• Date of operation for the partnership
• Amount of equity for each partner

Along with the RELP’s basic set-up, the partnership agreement also needs to name the RELP’s general partners and its limited partners. Limited partners have equity shares but don’t participate in managing the investment or making decisions for the fund.

General partners will be responsible for things like making sure the investment is properly run, including maintenance, renovations, direct management of the asset or direct supervision of management.

They sign the checks and bear the most responsibility for making sure the RELP is profitable. The limited partners in a RELP place an enormous amount of faith in the general partner. That’s why the general partner in a RELP should be someone with extensive experience in managing real estate assets.

What Do RELPs Invest in?

Most RELPs are focused on commercial real estate because undervalued commercial real estate assets can generate huge profits under smart, proactive management. Examples of the kinds of commercial properties RELPs target include:

• Multi-family residential
• Industrial
• Mixed-use developments
• Storage facilities
• Office parks
• Medical centers

The high cost of buying and renting single-family homes in some of America’s largest cities has led to RELPs buying multiple single-family homes instead of just concentrating on traditional commercial real estate opportunities.

How Are Profits Distributed?

Profits from RELPs are distributed in the manner dictated in the operating agreement. If the RELP is invested in income property such as apartment buildings or commercial real estate, distributions are usually made on a monthly or quarterly basis. Distributions are made after expenses like property taxes, debt service, maintenance and insurance are taken out of the gross revenue.

In cases where the RELP has purchased a property with the goal of rehabilitating it and selling it at the end of a defined period, the profits are usually paid out after the asset is sold. RELP distributions are made to individual investors based on the size of their equity share in the partnership.

How Are RELPs Taxed?

RELPs are pass-through entities, meaning all the revenue generated by the RELP is distributed to the partners, which leaves the RELP without profits to be taxed. However, each individual partner in the RELP will pay taxes on the pass-through income they receive from the RELP.

Partners also have limited liability for the RELP’s losses or expenses based on their equity share. If a five-person partnership spent $100,000 in a year on expenses, each partner would be entitled to write off $20,000 against their distributions. That’s why one of the most important roles that a RELP’s general partner performs is making sure the partnership completes IRS Form 1065 each year.

Form 1065 is a tax form that informs the IRS how much money the RELP distributes to each partner. Partners receive a K-1 form from the RELP that breaks down their individual distributions and expense shares. RELP shareholders are also entitled to take a proportional depreciation write-off along with the 20% tax break in pass-through income that became law under the Tax Cuts and Jobs Act of 2017.

Benefits of Investing in a RELP

RELPs offer several significant benefits to real estate investors. They give investors syndication opportunities that allow them to buy more property as a group than they could individually and offer real estate investors the chance to generate passive income for themselves.

The nature of RELPs being set up as pass-through entities allows individual partners to benefit from a host of tax breaks, most notably the 20% pass-through income write-off. Last and perhaps most importantly, the end pay-off to investors from a value-add RELP asset that gets sold in a hot market can be huge.

Potential Risks of Investing in a RELP

Although RELPs offer investors significant potential profit, they are not without risks and downsides. RELPs are private partnerships, which means your investment will likely remain illiquid for the duration of the partnership. Most RELP agreements call for the partnership to last for several years, and the private nature of RELP partnerships means there is no secondary market where you can liquidate your equity shares.

A RELP is only as good as the general partner who manages it. As a limited partner, you’re basically a passenger in a car being driven by the general partners. They are responsible for management decisions and executing the RELP’s business plan. If your RELP is poorly managed by its general partners, it’s unlikely you will see a return on your investment. Conducting proper due diligence before investing is critical.

Finally, there is an element of timing that is beyond your control. Although real estate investments typically perform well over the long haul, the timing of your RELP investment and how it fits into what the market is doing is important. If your RELP’s investment period ends in a down cycle or interest rates go up when the RELP needs to borrow money, you could be in trouble.

How to Invest in RELPs

Investors have a variety of options for putting their money into RELPs. Theoretically, you and a group of your friends could form your own RELP and begin making investments of your own. However, that requires an incredible amount of legwork, research and most importantly, experience. If you and your would-be partners are not experienced real estate investors, forming your own RELP is probably more liability and trouble than it’s worth.

A much more practical way of investing in RELPs is through online crowdfunding investment platforms. You will find a number of exciting RELP opportunities in this list of Benzinga’s Best online real estate investing platforms.

Investing in RELPs vs. Real Estate Investment Trusts (REITs)

Although both RELPs and REITs offer investors the chance to invest in real estate with limited liability and earn passive income, they have some significant differences. RELPs are not publicly traded and come with high buy-ins that typically limit participation to accredited investors. In contrast, numerous REITs allow non-accredited investors to buy in for less than $500 per share.

REITs are set up to acquire assets and earn revenue almost in perpetuity. Most REITs make their biggest payouts through monthly or quarterly distributions. RELPs are usually set up to add value to an undervalued asset and then liquidate it, which means the big payout from RELPs typically comes at the end of the partnership when the asset is sold.

Unlike REITs, RELPs are not public, which means shares can’t be sold on public exchanges, making RELP shares almost completely illiquid for both general and limited partners. The differences between RELPs and REITs and your investment goals will play a large role in determining which one is right for you. The good thing is they both offer investors different ways to grow wealth through real estate.

Collaborative Ownership

RELPs allow investors to pool resources and enter the real estate market without sole ownership. Through RELPs, investors can acquire and manage properties for potential profits and passive income. However, investors must carefully assess partnership agreements and the expertise of general partners. Risks, such as illiquidity and market timing, exist and require due diligence.

RELPs differ from REITs in terms of value addition and eventual liquidation. The choice between RELPs and REITs depends on individual goals and circumstances. RELPs offer versatility in real estate investment, but thorough research and prudent decisions are necessary for success.

Frequently Asked Questions