This is the second part of my 3-piece blog on raising capital for real estate investing. This piece covers some key aspects of the partnership agreement. My third installment will address alternative financing strategies to be used in place of raising capital.
Assuming you have decided to proceed with raising capital, a common question you will ultimately face is, “What terms should I offer my investors?” It is a question that does not have a right or wrong answer because several items will ultimately influence the offer, e.g., your past performance, the risk of the project, time until completion, projected returns, etc. However, any offer you put together will most likely be premised upon the following assumptions:
- The choice of entity will be a Limited Liability Company or a Limited Partnership
- No one investor will be able to demand terms more favorable than those offered to all investors
- You will be the sponsor, a.k.a. manager, of the project
- You will not hire people to promote your offer
- Economics of the Structure
At the end of the day it all comes down to putting an agreement together that will attract potential investors and provide ample reward for all those involved.
Most LLCs are set up where the first profits are dedicated to repaying the investors until they are repaid in full. After the investors have received their initial investment the sponsor will typically be entitled to an increasing share of the profits as the return to the investors increase. The following is an example of such a clause:
The Manager’s interest in the Company’s Net Profits allocated to the Manager pursuant to Section 3.3, calculated as follows: (i) if the Realized Investment Gain on any Portfolio Investment is greater than zero percent (0%), but less than twenty percent (20%), of the Basis of any Portfolio Investment, then the Manager’s Carried Interest shall be equal to two percent (2%) of the Net Profit attributable to such Portfolio Investment and (ii) if the Realized Investment Gain on any Portfolio Investment is greater than or equal to twenty percent (20%), but less than or equal to one hundred twenty percent (120%), of the Basis of any Portfolio Investment, then the Manager’s Carried Interest shall be equal to the sum of (A) ten percent (10%) of the Net Profit attributable to such Portfolio Investment plus (B) two percent (2%) of the Net Profit attributable to such Portfolio Investment for every ten percent (10%) increase in Realized Investment Gain of such Portfolio Investment over twenty percent (20%); provided that the maximum Carried Interest shall be thirty percent (30%) of the Net Profit attributable to any such Portfolio Investment.
A simpler method might provide that after the investors have received back their principal, plus a preferred return of 10%, the remaining profits will be split as follows:
Until the investors receive a total return of 25%, distributions will be split 80:20; thereafter, all distributions will be split 65:35.
Simply stated, as the investors earn a greater return so will the sponsor. However, as the sponsor you have additional options to earn money from the project such as an Asset Management Fee on rentals typically in the 2% to 3% range of gross rents, or a Rehab Fee on the total cost of improvements. I have reviewed agreements containing Acquisition Fees, Disposition Fees, Leasing Fees or Financing Fees all aimed toward compensating the promoter for his time managing various aspects of the project.
Besides coming up with a fee structure satisfactory to all parties, certain non-economic terms should be incorporated to ensure maximum flexibility in the overall project. Some of these are as follows:
Control Over The Partnership
All day-to-day and big picture decisions should be left to the sponsor (typically the sponsor). Decisions concerning the project should take place without the need to consult or obtain approval from the investors.
I Need More Money Provision
The agreement must address what happens if the partnership is in need of more money. Will the sponsor be allowed to request additional capital from the investors? If so, will there be any cap on how much additional capital the sponsor can seek from the investor? In most agreements this is usually prohibited. If the investors do not want to provide the sponsor the prerogative to raise additional capital from new investors, then a model that offers a preemptive right is typically agreeable.
Tax and Distribution Issues
The sponsor will generally control whether distributions of cash are made to the investors and to what extent. This is typical because the sponsor needs the flexibility to control cash flow. However, it is good practice to commit to providing annual distributions to cover tax liabilities associated with ownership. This will alleviate some investors concerns regarding phantom income without the cash to pay the associated tax liability.
If the sponsor is planning on running more than one project with different investors or he has his own investing projects, a clause should be included that permits competing ventures. Ordinarily a sponsor owes a fiduciary duty to the partnership to work in its best interest. Without a clause permitting competing ventures, the sponsor may be liable to the investors for any outside projects producing a more favorable return.
Where to Create Your Company
You do not have to organize the LLC in the state where you plan to conduct the project. It is actually preferable to choose a state that offers limited fiduciary duties. As the sponsor, you will owe the investors a duty of care and loyalty. In states such as Nevada or Delaware, sponsors can contractually eliminate all fiduciary duties other than the implied covenant of good faith and fair dealing. These as well as other protections afforded by these states make them the preferred choice for organizing your LLC if you desire the most protection as a sponsor. (Bear in mind, you must file your LLC as a foreign LLC in any state where you will be conducting your project.)
Overall, sponsoring a real estate project is a great way to earn attractive returns. However, some sponsors lose sight of the yield to investors by becoming overly focused on the incentive to create deals for personal enrichment. Creating a true partnership relationship with your investors is a recipe for success and will make future fundraising easier, thus paving the way to larger deals.