Limited partnership is the most common business framework to do large scale real estate development. Keep in mind that while this concept is widely used globally, specific laws and regulations may vary by jurisdiction. Before delving into the details, it's important to consult with a legal professional when considering the implementation of this business structure.
The limited partnership structure allows for a separation of management responsibilities and investment capital,
which can be advantageous in certain business contexts.
A limited partnership structure is a business arrangement that involves two types of partners: general partners and limited partners.
On the other hand, limited partners are passive investors who contribute capital to the business but do not partake in its management or decision-making processes.
Their liability is limited to the extent of their investment, shielding them from personal responsibility for the partnership's debts beyond their initial contribution.
Liabilities within a limited partnership are distributed unevenly between general and limited partners.
General Partner (GP)
General partners assume unlimited personal liability for the partnership's debts and legal obligations.
This means that their personal assets can be used to satisfy any outstanding debts of the business, even if it leads to bankruptcy or financial ruin.
In terms of responsibilities, general partners play a pivotal role in running the partnership's operations. They make strategic decisions, manage day-to-day activities, and are accountable for the partnership's financial health.
Their active involvement exposes them to the partnership's liabilities, making it essential for them to exercise prudence in decision-making.
Limited Partner (LP)
Limited partners, however, enjoy liability protection. Their exposure is limited to the capital they invest in the partnership.
This separation of liability encourages investors to participate as limited partners, as it mitigates their risk and safeguards their personal wealth.
Limited partners, conversely, have a more passive role.
They primarily provide funding to the partnership and share in the profits, but they do not engage in managerial decisions or have direct control over the business.
This segregation of roles allows individuals or entities with specific expertise or resources to invest without necessarily being burdened by operational responsibilities or extensive liability exposure,
fostering a balanced and efficient business structure
Example
Let's consider a scenario where a partnership has a debt of $10,000,000 and comprises 5 limited partners. Among these partners, one individual also assumes the role of the general partner.
Each of these limited partners, including the one with dual roles, has invested $1,000,000. As a result, the liability for the four remaining limited partners is capped at the extent of their investments, which is $1,000,000 each.
Conversely, the individual acting as the general partner holds accountability for the remaining debt, which totals $5,000,000 in this specific case.
It's important to note that this individual also possesses some limited shares. This ownership structure contributes to the overall liability of the individual, which aggregates to $6,000,000.
Limited Partner Qualification
Generally, the security authorities in different jurisdictions have laws in place detailing the disclosure and reporting requirements when it comes to signing up limited partners in a limited partnership. The idea is that the general public needs to know the risks. The prospectus offering for securities (LP shares) often requires disclosure of very detailed and sensitive information about the issuer's financial condition, operations, management, risks, and other material information. This level of transparency may reveal sensitive or proprietary information to competitors. These prospectus offering can also be very expensive and time consuming to produce. For these reasons, limited partnerships often avoid filling the prospectus and rely on private placement instead. Thankfully, most jurisdictions allow certain accredited investors to sign up as a limited partner without requiring a full prospectus offering. The limited partner is required to sign a form confirming that they qualify as an accredited investor. The definition of an accredited investor is different from jurisdiction to jurisdiction, but in essence, an accredited investor is an individual with certain threshold of asset, financial means, and/or income. It is important that you consult with your legal counsil to prepare your firm prior to engaging individuals as limited partners in your partnerhsip.
GP's compensations
In a limited partnership, the general partner (GP) receives two kinds of compensations:
GP Fees
management fees for a General Partner (GP) in a limited partnership structure can vary widely based on the specific terms negotiated in the partnership agreement.
These fees are intended to compensate the GP for their efforts in managing the construction project. Here are some common types of management fees that might be associated with
ground-up construction projects. For a detailed explanation of these fees, please visit the blog post Development Management Fees
| Management | Purpose | Timeline | Fee |
| Acquisition Management | Strategizing & acquiring one or more adjacent properties | Initial concept to the completion of the property transfer | 3% to 4% of the land purchase price |
| Development Management | Securing development permit while preserving project viability | Property transfer completion to receving of development permit | 3% to 8% of the total project cost |
| Construction Management | Managing trades and constructing the project | Starts when the development permit is obtained and ends when the occupancy permit is received | 2% to 5% of the total construction cost, depending on project size and complexity |
| Financing Management | Arranging required land loan and construction loan | Both when the land is purchased (land loan) and when the construction is starting | 0.5% and 2% of the total financing amount |
| Sales & Marketing Management | Unit-mix design, marketing, and selling the building or individual strata units | Starts when the Develpoment Permit is obtained and ends when the sale is completed | 1% to 5% of the total sales revenue |
| Asset Management | Maintaining the building | Starts when the construction is complete and ends when the building is sold | 1% to 10% of the property's gross annual income, depending on the project size |
GP Compensation: Profit Sharing
Limited partnership distributes the earnings according to an agreed profit sharing schema. This is sometimes called a waterfall distribution model.
Principal Pay-out
The LPs receive their 100% of original investment amount. As Waren Buffet famously said, rule no. 1: never lose money.
So, the original investment payout is the first priority and step in this model
Preferred Return:
LP receives the profit based on a predetermined rate of return. The rate itself is referred to as preferred return or "pref rate". The amount of profit in this step is typically called "preferred return". The rate is usually expressed as a percentage of the initial investment, and it serves as a sort of "hurdle rate" that needs to be surpassed before the next step in the profit-sharing distribution model come into play.
For example, if a distribution model has a pref rate of 8% per annum compounded annaully with investment maturity duration of one year, the investor who has invested $1,000,000, will receive $80,000 at the end of the year.
Catch up:
Up until now, the LP has received their original investment amount plus a share of the profit based on the pref rate. GP has received no profit so far. It is now the GP's turn to receive
a portion of the profit based on a predetermined rate. The catch up amount is equal to the catch up rate multiplied by the whatever is left of the earnings from the above step.
Split:
In this step, the remainder amount is split based on a predetermined split rate. For example, a split rate of 30% (GP) and 70% (LPs) means that the
remaining amount will be split by giving out 30% to the GP and 70% to the LPs.
Many complex waterfall distribution models can be devised, and we have covered some
of these in our blog posts. Visit A Simplified Guide To LP-GP Waterfall Distribution for in-depth explanation of
waterfall distribution.
Dilution
Dilution occurs when the ownership percentage of LPs is reduced due to additional investments or other factors that increase the total ownership pool. In this scenario, the existing LPs' ownership becomes a smaller portion of the overall ownership.
For example, if the required capital increases based on increased costs, the additional investment amount from an outside source would dilute the percentage ownership of the original LPs.
To avoid the dilution, the LPs would need to contribute more capital. For example, if the bank is financing 60% of the $10,000,000 construction loan, and each LP is contributing $1,000,000
for the remainder of the amount, the LPs are each owning 10% stake. If the construction costs goes up and the total project expenses is now $11,000,000, to maintain the 10% stake, each investor has to contribute
$100,000. Note that we are still short $700,000 but the LPs percentage shares are now protected.
Cash Call
A "cash call" refers to a request, or a "call", made by the general partner (GP) of a limited partnership (LP) for additional capital contributions from the limited partners (LPs). This mechanism is commonly used in real estate limited partnerships to address unforeseen expenses, capital shortfalls, or to seize investment opportunities.
Cash calls are usually accompanied by terms and conditions outlined in the partnership or investment agreement, specifying how much each investor is required to contribute and by what deadline. Also, in a waterfall distribution model, the cash call may be paid with the initial investment and before any profit is distributed. Alternatively, cash calls may be structured as a loan which would reduce the total profit by the interest and fee of the loan. Again, it is crucial that sound financial planning is performed in a limited partnership to foresee and prepare for these scenarios and that all limited partners are aware of this.
When a real estate limited partnership is formed, LPs contribute an initial amount of capital to fund the project's acquisition and early development phases. However, ground-up commercial construction projects can be complex and subject to unforeseen expenses, such as cost overruns, design changes, or delays. As a result, the initial capital contribution might not be sufficient to cover all project-related costs.
When the GP determines that additional funds are needed to complete the construction project successfully, they issue a "cash call" to the LPs. A cash call is essentially a request for the LPs to contribute additional capital beyond their initial investment. The purpose of the cash call is to bridge any funding gaps, ensure the project's timely completion, and maintain its financial viability.
The terms and conditions of cash calls are typically outlined in the limited partnership agreement. This agreement specifies the circumstances under which a cash call can be made, the maximum amount of capital that can be requested, and the timeline within which the LPs must respond and contribute. It might also outline the consequences if LPs choose not to participate in the cash call, such as dilution of ownership or limited rights in the project.
LPs have the option to either contribute the requested additional capital or decline the cash call. If an LP chooses not to contribute, they might face certain consequences as outlined in the partnership agreement. The GP may have the right to seek alternative sources of funding or adjust the project plan to accommodate the funding shortfall.
The additional capital raised through cash calls can be critical to completing the construction project successfully. Adequate funding ensures that the project can overcome challenges, address unexpected expenses, and achieve the intended quality and timeline.
It's important for both GPs and LPs to have a clear understanding of the cash call process, as well as the potential risks and benefits involved. GPs need to manage cash calls responsibly to maintain investor trust and ensure the project's success, while LPs should carefully evaluate the financial commitments and potential returns associated with their participation in the limited partnership.
Taxation
A limited partnership operates as a flow-through entity, meaning it does not have a direct tax liability. Instead, all income and profits pass through to the individual partners or owning entities. These partners or entities are responsible for filing their own tax returns. Therefore, it's important for limited partners to engage in discussions and tax planning with their chartered accountant to navigate this aspect effectively.
Reporting
GPs typically owe fiduciary duties to the LPs, which include duties of loyalty and care. Providing timely and accurate financial and investment updates is often seen as a way to fulfill these duties. It helps LPs make informed decisions and assess the performance of their investment. Of course, if a prospectus is filled with the securities authority, the laws governing the reporting requirements would apply and supercede. As in any other investing ventures, transparency and communication will foster trust and repeated business.
Takeaways
Limited partnerships offer an efficient means of securing project funds from numerous investors while safeguarding them from the operational risks in which they play no active role. This business structure operates as a flow-through tax system, necessitating that limited partners devise their individual tax strategies and plans for handling profits. Moreover, the waterfall distribution system in a partnership agreement establishes an incentive framework designed to align the interests of both the fund operator (General Partner or GP) and the investors.