The old adage “there’s more than one way to skin a cat” is especially true when it comes to real estate investing. Although most people understand that investing in real estate is a good idea, the high initial cost means a lot of capital is needed to close deals. One way to overcome this obstacle is to pool investor funds through a real estate limited partnership (RELP).
RELPs offer investors a low-cost way to buy real estate without having to buy or manage entire properties themselves. If you’ve been thinking about investing in real estate but aren’t sure how to go about it, read on to learn more about how RELPs work and if they’re right for you.
How do real estate limited partnerships work?
RELPs work similar to a traditional business partnership. You get a group of like-minded investors who will contribute money and create a limited partnership that exists for real estate investment purposes. Each of the partners receives shares in the properties purchased by the RELP at a rate proportional to the size of their investment.
For example, if there were five investors who all invested $200,000 to buy $1,000,000 of real estate, each of them would have a 20% interest in the property. However, before the RELP actually buys any property, it must have a partnership agreement to define its structure and operating procedures.
How are RELPs structured?
RELP agreements can be structured in different ways depending on the investment objective of the partners. Each RELP agreement establishes standard modes of operation, which include:
- names of investors
- Amount of capital committed by each investor
- Plan the distribution of investment income or capital
- Date of surgery for partnership
- Amount of equity for each partner
In addition to the basic design of the RELP, the articles of association must also name the general partners and limited partners of the RELP. Limited partners have equity interests but do not participate in the management of the investment or make decisions for the fund.
General partners are responsible, among other things, for ensuring that the investment is properly managed, including maintenance, renovation, direct management of the assets or direct management supervision.
They sign the checks and have the primary responsibility for making the RELP profitable. The limited partners of a RELP place enormous trust in the general partner. For this reason, the general partner of a RELP should be someone with extensive experience in managing real estate assets.
What do RELPs invest in?
Most RELPs focus on commercial real estate, as undervalued commercial real estate can yield huge returns under intelligent, proactive management. Examples of the types of commercial real estate that RELP targets are:
- apartment building
- mixed-use developments
- office parks
- Medical Centers
The high cost of buying and renting single-family homes in some of America’s largest cities has resulted in RELPs buying multiple single-family homes rather than just focusing on traditional commercial real estate.
How are prizes distributed?
Profits from RELPs are distributed according to the operating agreement. If the RELP is invested in investment properties such as apartment buildings or commercial properties, the distribution is usually monthly or quarterly. Of course, the distributions are made after expenses like property taxes, debt service, maintenance, and insurance are deducted from the gross receipts.
In cases where the RELP has acquired a property with the aim of rehabilitating it and selling it at the end of a certain period, profits are usually paid out after the asset has been sold. RELP distributions are made to individual investors based on the size of their stake in the partnership.
How are RELPs taxed?
RELPs are pass-through units, meaning that any revenue generated by the RELP is distributed to the affiliates, leaving the RELP with no taxable profits. However, each individual partner in the RELP pays tax on the pass-through income it receives from the RELP.
Partners also have limited liability for the losses or expenses of the RELP based on their equity share. If a five-person partnership spent $100,000 on expenses in a year, each partner would be entitled to write off $20,000 against their distributions. For this reason, one of the most important responsibilities of a general partner of a RELP is to ensure that the partnership completes IRS Form 1065 each year.
Form 1065 is a tax form that tells the IRS how much money the RELP distributed to each affiliate. In addition, RELP provides affiliates with a K-1 form detailing their individual payouts and cost shares. RELP shareholders are also entitled to a proportional write-off along with the 20% pass-through income tax credit enacted under the Tax Cuts and Jobs Act 2017.
Benefits of investing in a RELP
RELPs offer several significant benefits to real estate investors. They provide investors with syndication opportunities that allow them to buy more properties as a group than they could individually and provide real estate investors with an opportunity to generate passive income for themselves.
The nature of RELPs, established as pass-through units, allows individual partners to benefit from a variety of tax breaks, most notably the 20 percent write-off on pass-through income. Finally, and perhaps most importantly, the ultimate payout for investors from a RELP value-added stock sold in a hot market can be tremendous.
Possible risks of investing in a RELP
While RELPs offer investors significant upside potential, they are not without risks and downsides. RELPs are private partnerships, meaning your investment is likely to remain illiquid for the duration of the partnership. Most RELP agreements provide for a multi-year partnership, and the private nature of RELP partnerships means there is no secondary market in which to liquidate your shares.
A RELP is only as good as the general partners who manage it. As a limited partner, you are essentially a passenger in a car driven by the general partners. They are responsible for management decisions and the execution of the RELP’s business plan. If your RELP is mismanaged by its general partners, your investment is unlikely to pay off. Conducting proper due diligence before investing is crucial.
Finally, there is an element of timing that is beyond your control. Although real estate investments typically do well over the long term, the timing of your RELP investment and how it fits in with market trends is important. If your RELP’s investment period ends in a down cycle, or if interest rates rise when the RELP needs to borrow money, you could be in trouble.
How to invest in RELPs
Investors have a variety of ways to invest their money in RELPs. In theory, you and a group of your friends could set up your own RELP and start making your own investments. However, this requires an incredible amount of footwork, research and, most importantly, experience. Unless you and your potential partners are experienced real estate investors, starting your own RELP is probably more liability and hassle than it’s worth.
A much more practical way to invest in RELPs is through online investment platforms. In this list of the best online real estate investment platforms from Benzinga you will find a number of exciting RELP opportunities.
Investing in RELPs vs Real Estate Investment Trusts (REITs)
Although both RELPs and REITs offer investors an opportunity to invest in limited liability real estate and earn passive income, they have some key differences. RELPs are not publicly traded and come with high buy-ins that typically limit participation to accredited investors. In contrast, numerous REITs allow unaccredited investors to buy in for less than $500 per share.
REITs are formed to acquire assets and generate nearly unlimited revenue. Most REITs make their biggest payouts through monthly or quarterly distributions. RELPs are typically set up to add value to an undervalued asset and then liquidate it, meaning the large payout of RELPs usually occurs at the end of the partnership when the asset is sold.
Unlike REITs, RELPs are non-public, meaning shares cannot be sold on public exchanges, making RELP shares almost entirely illiquid for both general partners and limited partners. The distinct differences between RELPs and REITs and your investment goals play a big part in deciding which is right for you. The good thing is that both investors offer different opportunities to grow wealth through real estate.
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