Legal Ownership Structures: Partnerships

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One of the most fundamental decisions that a real estate investor must make is the legal ownership form under which they invest in real estate. Each have their own unique characteristics and associated legal rights. It is crucial for investors to know the pros and cons of each in order to best determine the most advantageous based on their financial resources, goals, etc. Important factors to consider are ease/cost of formation, taxation, liquidity, survivability, etc. In this article, I will discuss the various partnership forms: general partnership, limited partnership, and limited liability partnership through the lens of real estate investment.

This content is meant to be informational and not advisory. Readers are encouraged to consult an attorney or CPA when deciding on how to structure their investment holdings.

General Partnership

The default form of partnership that exists when two or more persons (or business entities) operate a business for profit as co-owners, each member being a general partner. Partnership agreements, drafted by an attorney, address issues such as profit and loss sharing, management responsibilities, etc.

Pros

  • Ease/Cost of Formation – There are no formal costs to create a general partnership.
  • Taxation – General partnerships are pass-through entities; meaning all income, deductions, etc. are reported on each partner’s individual tax return and cash distributions are generally tax-free to the extent they do not exceed the partner’s basis in the partnership.

Cons

  • Liability – Each partner has unlimited liability for any legal or financial responsibilities of the general partnership. As a result, each partner is fully liable for all of the partnership’s debts whether or not that particular partner incurred or approved of those debts and regardless of the amount invested in the partnership.
  • Liquidity – Because the title to the property is held by the partnership individual partners do not have ownership interests of the property, itself, but rather in the partnership. This can create an issue when one partner wishes to “cash out.”
  • 1031 Exchange – Related to the issue of liquidity, because partners in a general partnership do not actually own a piece of the real estate their interests are not eligible for a 1031 Exchange.
  • Survivability –General partnerships terminate with the death or withdrawal of one of the partners. Partnership agreements should thus account for the survivability of the partnership during the holding period of the investment.

While many general partnerships are formed by business entities that already have some level of liability protection, they are not the ideal business structure in which to invest in real estate due to each partner’s unlimited liability.

Limited Partnership (LP)

Limited partnerships consist of one (or more) general partner(s) and one or more limited partners, which can be individual persons or business entities. Limited partnerships must register as an LP. General partners are responsible for all management of the partnership and thus have unlimited legal and financial liability while limited partners acting as passive investors with no say in the day-to-day management of the business. The partnership agreements are crucial and should be drafted by an attorney.

Pros

  • Liability – Limited partners in an LP are generally only responsible for the amount each invested and are not responsible for the actions of the general partner.
  • Taxation – LPs are pass-through entities; meaning all income, deductions, etc. are reported on each partner’s individual tax return and cash distributions are generally tax-free to the extent they do not exceed the partner’s basis in the partnership.

Cons

  • Ease/Cost of Formation – LPs must register with the state and partnership agreements should be drafted by an attorney.
  • Taxation – Because of the passive role of limited partners they are subject to passive loss rules, which do not allow passive losses to offset active or portfolio income. The tax implications of sale may be different for the general partner and select limited partners and when conflicts of interest arise, limited partners may have no say in the matter.
  • Liquidity – Because the title to the property is held by the partnership individual partners do not have ownership interests of the property, itself, but rather in the partnership. This can create an issue when one partner wishes to “cash out.”
  • 1031 Exchange – Related to the issue of liquidity, because partners in a general partnership do not actually own a piece of the real estate their interests are not eligible for a 1031 Exchange.
  • Survivability –General partnerships terminate with the death or withdrawal of one of the partners. Partnership agreements should thus account for the survivability of the partnership during the holding period of the investment.

Limited partnerships can be effective ownership structures for real estate investment where limited partners provide the capital and general partners provide the expertise and management. Partnership agreements are especially important because, as is the case in general partnerships, the general partner can be a business entity that already enjoys some level of limited liability, which can protect them from the liabilities of the LP. If general partners no longer have unlimited legal and financial responsibility the incentive to be good stewards of the investment is removed.

Limited Liability Partnership (LLP)

Consisting of any number of limited partners, LLPs are typically used by professional organizations such as law firms where each investor has management rights.

Pros

  • Ease/Cost of Formation – Conversion from a general partnership to an LLP is not a taxable event.
  • Liability – Liability is generally limited to each investors’ ownership interest.
  • Taxation – LLPs are pass-through entities; meaning all income, deductions, etc. are reported on each partner’s individual tax return and cash distributions are generally tax-free to the extent they do not exceed the partner’s basis in the partnership. Because of each limited partner’s management rights, they are subject to active loss rules.

Cons

  • Ease/Cost of Formation – LLPs must register with the state and partnership agreements should be drafted by an attorney.
  • Liquidity – Because the title to the property is held by the partnership individual partners do not have ownership interests of the property, itself, but rather in the partnership. This can create an issue when one partner wishes to “cash out.”
  • 1031 Exchange – Related to the issue of liquidity, because partners in a general partnership do not actually own a piece of the real estate their interests are not eligible for a 1031 Exchange.

Limited liability partnerships are rarely used for real estate investment despite the limited liability of its partners. One of the key characteristics of this ownership structure is the management rights of each partner which make it more suited for the operation of a professional business rather than a mechanism to passively invest in real estate.

 

Source: CCIM Institute, Investment Analysis for Commercial Real Estate, January 2, 2018

Tysons Corner Submarket Q3 2019

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“I’m the Juggernaut, @#$%&!”

RBA: 30,096,814 SF

Vacancy Rate: 14.4%

12 Month Net Absorption: 1,400,000 SF

Average Asking Rent: $35.41

12 Month Rent Growth: 3.8%

Tysons Corner is numero uno (sorry, Reston). This “edge city” is Fairfax County’s (and arguably Northern Virginia’s) central business district and a regional commercial center; boasting the largest concentration of office space in Virginia and 3rd in the DMV behind only DC’s East End and CBD submarkets. Many of the nation’s largest companies have their corporate headquarters in Tysons Corner; including Booz Allen Hamilton, Capital One, Freddie Mac, and Hilton Worldwide. The submarket is also home to two super-regional malls, Tysons Corner Center and Tysons Galleria, the former being the largest shopping mall in both the Commonwealth and Baltimore-Washington area. With over 115,000 office and retail workers, Tysons Corner is the 12th largest employment center in the United States. In short, Tysons Corner is a veritable juggernaut.

The delivery of the Silver Line in 2014 brought 4 metro stations to the submarket, which increased density based on proximity to the metro and spurred a flurry of development; delivering over 2,000,000 SF of office and nearly 3,000 multi-family units. The most significant new developments are Capital One’s new headquarters and Meridian’s Boro Tower. Strong demand has kept vacancy rates down, which are now at a 10-year low, and as a result rent growth has been strong at 3.8% over the past year.

Tysons is a tale of two cities or, perhaps more accurately, two tiers of office space. It seems odd that despite vacancy rates in the high teens rents have steadily and significantly risen since 2015. The answer lies in the breakdown of the rents and vacancy rates between 4 & 5 Star properties and 3 Star properties. The average rental rate in Tysons Corner is $35.41/SF/yr but is $39.97/SF/yr for 4 & 5 Star properties and $27.60/SF/yr for 3 Star properties. Along the same trend, the vacancy rate and net absorption for 4 & 5 Star properties is 16.8% and +35,335 this quarter and 20.4% and (61,850) for 3 Star properties. This flight to quality trend is most likely to continue; leaving many to wonder what to do with Tysons functionally obsolete office inventory.

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DC Metro Area Market

Semiannual Snapshot Q3 2019

 

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Rentable Building Area (RBA)

  • 4 & 5 Star: 247,814,496 SF
  • 3 Star: 189,929,408 SF
  • 1 & 2 Star: 61,972,441
  • Total: 499,716,496 SF

Vacancy Rate

  • 4 & 5 Star: 14.8%
  • 3 Star: 12.8%
  • 1 & 2 Star: 6%
  • Overall: 13.0%

Average Asking Rent

  • 4 & 5 Star: $44.79/SF
  • 3 Star: $31.78/SF
  • 1 & 2 Star: $26.16/SF
  • Overall: $37.70/SF

Under Construction

  • 4 & 5 Star: 10,948,687 SF
  • 3 Star: 293,425 SF
  • 1 & 2 Star: 0 SF
  • Total: 11,242,112 SF

12 Month

  • Net Absorption: 2,900,000 SF
  • Rent Growth: 0.9%
  • Vacancy Change: (0.2%)
  • Deliveries: 5,500,000 SF
  • Sales Volume: $7,200,000,000

Money for Nothing, Rent for Free

 

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Landlords and investors must make many decisions when leasing a property. Once they set their asking rate and have a tenant interested in the space, the negotiations process begins. Landlords must analyze each deal and determine what concessions they are willing and able to make. A tenant’s profile, i.e. financial strength, size, etc. heavily influences these decisions, but is not the only factor. In fact, there is a higher “power” under which all other factors fall: the holding period.

Holding period refers to the timeframe that an investor owns an asset/property or the period between the purchase and sale of an investment. When determining whether or not to purchase an asset and at what price, investors calculate the return the asset will produce over the holding period based on the acquisition basis and projected cash flows and disposition/sales price. While market conditions can change and alter the length of the holding period, investors make asset management decisions to maximize the performance of their investment and eventual sales price. This article will discuss how landlords can use free rent as a tool to increase a property’s return based on a 3 to 5-year holding period.

While “everything is negotiable,” landlords typically have a minimum base rent that they will accept for a property regardless of the tenant. Instead of agreeing to a lower rental rate, landlords may choose to offer additional months of free rents over what might be considered market. For example, in our current office market, tenants can expect around one month of rental abatement per year of term, i.e. 5 months on a 5-year term (65 month lease). If the tenant is unable or unwilling to pay the minimum base rent required for a particular property, the landlord may choose to offer an additional 2 months of rental abatement (7 months on a 67-month term) in order to lower the tenant’s average cost of occupancy and get the deal done.

The question remains: Why would the landlord simply not lower their rental rate? The answer can be best viewed through the lens of the holding period and desired/required sales price for the investment. It takes time to lease a property. Theoretically, the higher the occupancy level the higher the gross and net operating income. Net operating income is what investors look at when measuring their return and sales prices are usually quoted in terms of cap rates, which reflect a property’s unleveraged return based on that net operating income. Time is money and landlords must constantly juggle the competing goals of leasing the property quickly and maximizing the gross operating income by leasing their property at the highest rental rate possible. Therefore, landlords have a powerful incentive to keep rents as high as possible. Free rent allows them to provide powerful economic concessions to attract tenants and achieve full occupancy quickly while still maintaining their required rental rates (those that were in their projections).

There are many old adages that help explain the underlying theory behind this strategy: taking one’s medicine, all good things come to those who wait, delayed gratification, etc. Investors can use rental abatement to attract tenants and lease up a property within their projected holding period all while maintaining the highest rents possible thus maximizing their net operating income. When it comes to sell the free rent has “burned off” and the investor is left with a property with long-term leases at strong rental rates; allowing them to sell for the highest price possible.

*Savvy investors will also structure their business holdings so that losses incurred during the rental abatement periods can offset active income elsewhere.

Rent Free or Die

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“Give me rental abatement or give me death!”

Rental abatement or free rent is one of the most powerful economic bargaining tools for both landlords and tenants. Free rent is quoted in terms of months and is a period of time in which the tenant can enjoy beneficial occupancy of a commercial space without having to pay base rent. These are important distinctions because the time provided to a tenant to build out their space is usually not considered free rent and based on the asset type and rental structure the tenant may have other occupancy costs during the free rent period.

Free rent is generally provided at the beginning of the lease term. For example, if a tenant has 3 months of free rent these would be the first 3 months of the lease term. Landlords require tenants to pay the first month’s rent at lease signing, which can cause some confusion. In the previous example the first month’s rent due at lease signing would be applied to the 4th month of the lease term. In rare cases, landlords may grant multiple months of free rent that are staggered throughout the lease term. For example, a landlord may agree to 5 months of free rent on a 5-year deal with the tenant enjoying one month of rental abatement at the beginning of each lease year. Landlords may choose to do this in order to begin collecting rent sooner and/or mitigate any perceived risk with the tenant’s financial strength.

Most free rent is “outside the term;” meaning that landlords will add the number of months of rental abatement to the overall term of the lease. For example, a 5-year lease in which the landlord agrees to provide the tenant with 5 months of free rent, the term of the lease would increase from 60 months to 65 months. At first glance this does not seem like a good deal for the tenant because the rent for the 5 additional months at the end of the term will have increased each year at the agreed upon escalation rate and thus have a higher dollar value than the 5 months at the beginning of the lease term when the rent is the lowest. The value of 5 months of free rent for a 1,000 SF space at a starting rate of $30/SF/yr equals $12,500 (1,000 SF x $30/SF/yr = $30,000 / 12 months = $2,500/month x 5 months). Based on a 3% annual escalation the rental rate for the final 5 months would be $34.78/SF/yr; resulting in a value of $14,490.93. So, what gives?

There are a number of reasons that this structure still benefits the tenant. First, rental abatement at the beginning of the lease term provides the tenant with a “ramp up” period in which to get their business going and start generating revenue. Second, there are costs associated with leasing space including but not limited to furniture, moving expenses, cabling/wiring, etc. Rental abatement frees up cash for tenants to purchase and pay for necessary infrastructure, equipment, etc. Third, the time value of money states that money today is worth more than money tomorrow. In theory, the landlord is having to wait 5 years to make that money back and with annual escalations around 2-3%, that money could have been more profitably invested in an asset or instrument with a much higher return.

Finally, the value and power of free rent can be best displayed when calculating the average cost of occupancy. In the case above, the total lease value for the 5-year, 5-month lease with 5 months of rental abatement equals $161,265.00. On a 5-year lease with no free rent the total lease value is $159,274.07. While the 5-year lease has a lower dollar value the average monthly cost of occupancy is $173.57/month higher! This is because you’re dividing the lease value by 60 months instead of 65 months. This leads an average annual rent of $31,854.81 for the straight, 5-year deal and $29,772.00 for the 65-month lease. That’s amazing when you consider the fact that the average annual rent for the 65-month lease is lower than the annual rent in the 1st year of the lease term (1,000 SF x $30/SF/yr = $30,000/year) and over $2/SF lower than the lease in which no rent was provided ($29.77/SF/yr vs. $31.85/SF/yr).

If free rent is placed “inside the term” its effects are magnified. Using the previous example, if a landlord were to agree to 5 months of free rent on a 60 month/5-year term the total lease value would decrease to $146,774.07; resulting in an average annual/monthly cost of occupancy of $29,354.81/$2,446.23 and average rental rate of $29.35/SF/yr. What’s striking is how relatively small the difference is between the free rent inside vs. outside the term (only $0.42/SF/yr)!

I will elaborate on the difference between build out periods and free rent as well as other potential costs that tenants must pay during the rental abatement period in subsequent articles; breaking down the discussion based on asset class (office, industrial, retail, etc.) and how each treat “free” rent.