Blog Posts
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Look Closely at Real Estate Partnership Agreements
Many investors didn’t know what a “capital call” was just a few years ago, but today they’re pretty common with real estate investments and have become the source of numerous partnership arguments and break-ups.
A capital call occurs when a property investment, like a retail strip center, runs short of operating capital sufficient to cover all of its obligations. How can this happen? Simple, (1) a tenant or two relocates from the property; (2) income falls below scheduled operating expenses; (3) extended vacancy eats up any excess operating account balances; and then (4) additional capital is needed to cover monthly shortfalls, or even to fund property improvements required to secure a new replacement tenant.
This may not seem like a big issue, but if the property is owned by a partnership with multiple investors, especially now while money is tight and when not all of the investors have the same liquidity, problems begin to crop-up. This is further complicated when market values of these investment properties drop 35% to 60% and the value of the specific investment property is arguably less than the existing debt.
No problem yet? OK, now let’s assume that one or more of your partners refuse to participate in funding their share of a significant capital call - can you see the remaining partners having difficulty funding more than their share of this event in order to protect the investment, their loan guarantees, and/or maintain their credit ratings? How about when they have to fund this capital call for an investment property that is valued significantly lower than the mortgage?
I could complicate this scenario significantly further with other real world challenges, but you probably get the idea of just how stressful this can be on a real estate partnership trying to make effective decisions in a difficult economy, while balancing these decisions with the added personal conditions of select partnership members. In summary, it can be a real mess!
In many cases, issues like these are addressed in painstaking detail in the partnership operating agreements, especially dealing with the death of a member or how to handle members that default in their obligations to the partnership. However, if you’re involved in an older, more closely-held, real estate partnership, you may be surprised to learn just how poorly these scenarios may be addressed and the actual financial exposure than poor partnership agreements can have on their investment members.
By and large, my real estate partnerships have been a very positive experience and have afforded me an opportunity to meet and form relationships with a number of wonderful individuals. Like with anything, the devil is in the details, and you need to make certain that your agreements (i.e. operating agreements, loan agreements, lease agreements, construction agreements, etc.) are worded and structured properly. In addition to the agreements, you need to manage your group’s affairs professionally and maintain a high level of transparency and communication in the management of the partnership. Like in marriage, even this will not solve every issue that comes up, but it does provide a great foundation to effectively deal with problems when they occur.
