This is the first in a three-part series of posts on partnerships. In this series I’m going to talk a little bit about partnerships, go into the legal structures, the different types of partnerships, and how to model each type.
Partnerships
People who are just starting out in real estate (like most of us), who have no track record or reputation, often have to call upon friends, family members, or clients to act as partners in their first deals. Or FFF as it’s often referred to – friends, family, and fools. One of the selling points to potential investors is the structure of the proposed deal. The deal that you ultimately strike is represented in a document known as the partnership agreement. It identifies the general partner (GP) (you) who is responsible for managing the partnership and the property, and the limited partners (LP), who play the role of passive investor. The GP can either be an individual or a corporation (the corporate approach helps limit personal liability). An individual or corporation can be both the GP and LP in the same deal. Most deals are done using a limited liability corporation (LLC).
Limited Liability Corporation (LLC)
The LLC provides better liability protection, more flexible capitalization opportunities, and more latitude for control being exerted by the managing partner. Lots of questions need to be answered in the partnership agreement such as: How will cash flow be distributed? What happens if more money is needed? Can the GP sell the property without the approval of the limited partners? Do the limited partners get the tax and depreciation benefits? What happens at the end of the deal? How is the timing of the sale determined? When the property is sold, do the limited partners get their capital back first, or does the GP get fees or some kind of guaranteed return first? All of these questions need to be answered.
From an investors stand point, it’s crucial to realize that the GP has very limited personal exposure in the transaction. Therefore, it’s imperative to ensure interests are generally in alignment. It’s important to go through what Bill Poorvu calls, Follow the Cash. Learn exactly who gets what, in what order, for assuming what level of risk.
Your first deals are likely to be in the forms of partnerships. In the next installment of this series I’m going to walk through some of the basic partnership structures and how they’re modeled looking in particularly at the country club model, the wall street model, and catchups and clawbacks.
What are some important things to keep in mind while structuring partnership deals?
The IRR is a useful metric to compare returns on projects with different funding, holding, and distribution patterns. However, there is a common mistake people make when converting monthly or quarterly IRR’s to annual. Simply multiplying by 12 or 4 understates the actual IRR and doesn’t take into account reinvestment. I’ve posted a brief article written by my Real Estate Finance Professor and Principal of Caramoor Capital, Robert Ginsberg, about how this miscalculation may cost you or your company money. I’m going to walk through 2 basic examples that he mentions in the article.
Passing on a good deal:
Suppose you are considering the purchase of a 3-lot parcel for $1 million. You believe you can sell each individual lot for $5550,000. Your company only does land deals that underwrite to 35% IRR or higher. Your analyst underwrites the investment with an initial investment of $1 million and sales proceeds of $550,000 at the end of the 16th, 20th, and 24th month. This cash flow indicates a 2.55% IRR per monthly period and says the investment will generate a 30.6% IRR (2.55 *12). Do you pass on the transaction? I hope not because the transaction actually offers a 35.3% IRR, if calculated properly.
(click to enlarge)
You now invite some limited partners to invest in this deal. The GP will contribute 10% of the equity while the LP contributes the remaining 90%. Proceeds from sale will be distributed pari passu (at the same time) until the capital partners have all their capital returned and have realized a 20% IRR. Additional proceeds will be split 55/50 (a 30% promote to you the sponsor). What will happen in this situation if the IRR is miscalculated? Well, you’d personally be leaving a lot of money on the table. See the write-up for details.
Simply multiplying the monthly IRR by 12 underestimates the actual IRR. That’s because multiplying by 12 only adds up the monthly receipts and does not recognize the potential to re-invest those receipts received during the year. The calculation should be IRR = (1+PIRR)^n-1. This is something very basic, but it’s a mistake I see all the time and one that could end up costing you money.
The USGBC recently posted a list of pending green legislation, most of which is still in the House or Senate. The unprecedented amount of pending legislation can/will have a huge impact on the commercial real estate industry. With this comes huge opportunities. I wanted to delve into that list in a bit more detail and think about the potential opportunities these new bills could create. I’ve re-posted the list below as well as a few interesting thoughts from Shari Shapiro of the Green Building Law Blog:
1. It’s all about incentives – With the exception of Waxman-Markey, the bills selected by the USGBC are all incentive based, providing funds for energy efficiency, water savings, etc.
2. They’re not very innovative – There are only two bills on the list which I consider to be innovative or interesting. The Federal Personnel Training Act of 2010 (yet to be introduced) which focuses on training federal personnel to operate and maintain high performance buildings, and S. 1619, the Livable Communities Act of 2009 which seeks to establish an Interagency Council on Sustainable Communities and provides $4 billion in grants to incentivize integrated community planning and implementation of sustainable projects.
3. Building Codes are not addressed – Waxman-Markey, and its Senate counterpart The American Clean Energy And Leadership Act, both have some provision for creating a national energy efficient building code. The other bills, however, do not attempt to address the key policy lever of building codes to enhance sustainable construction and save resources. This is probably because of the enormous political fight involved, both in wresting control of building codes away from states and local governments, and with the private interests involved in the building industry.
House The American Recovery and Reinvestment Act (aka The Stimulus Bill) – Public Law – Spurred green jobs across the country with the most funding ever dedicated toward clean energy and energy efficiency projects in a stimulus package. Contained over $80 billion in funds for clean energy, including over $22 billion for energy efficiency
programs. Signed into law on Feb. 17, 2009
The American Clean Energy and Security Act – (aka Waxman Markey) – Spurs widespread modernization and renovation of existing building stock in America by establishing incentives for efficient building retrofits (the REEP Act introduced by Rep. Welch), incentivizes energy-efficient home mortgages and utilizes basic green building standards for public housing projects (the GREEN Act introduced by Rep. Perlmutter), improves building efficiency codes, establishes a building energy performance labeling program, creates a rebate program for water-efficient products and properties and moves the U.S. to a low-carbon future by setting targets for greenhouse gas emission
reductions, renewable electricity use, and industrial efficiency. Passed the House on Jun. 26, 2009
The 21st Century Green High-Performing Public School Facilities Act – Ben Chandler (D-Ky.) – Authorizes $6.4 billion annually in 2010 for critically needed K through 12 school modernization, renovation, and repair; and ensures the best learning environments for America’s children by requiring 100% of funds be used to meet green building standards by 2015. Passed the House on May 18, 2009
The Expanding Building Efficiency Act – Dave Reichert (R-Wash.) – Makes efficient homes and buildings more achievable by increasing and extending the new energy-efficient home tax credit and improving financial incentives for energy efficient commercial buildings. Increases consumer energy awareness by establishing a tax credit for home energy ratings for the first time ever, and grows the green job market by providing financial assistance for home-performance auditor training and certification. Introduced on Dec. 8, 2009
The Property Assessed Clean Energy Tax Benefits Act — John Sarbanes (D-Md.) – Allows American home owners to finance cost-saving energy- and water-efficient retrofits with minimal upfront costs by enabling State and local property assessed clean energy (PACE) programs. Introduced Nov. 19, 2009
An Act to Enhance Private Financing for Clean Energy Technology Deployment – Steve Israel (D-N.Y.) – Unlocks private financing for clean energy by authorizing government credit support for state, local, and private entities that enable building owners and users to significantly increase energy efficiency and generate on-site clean, renewable electricity. Introduced Oct. 15, 2009
The Energy Efficiency Modernization Act of 2009 – Mary Jo Kilroy (D-Ohio) – Improves the energy efficiency of federally assisted housing by an estimated 25 to 40 percent by enabling and incentivizing private affordable housing owners to finance efficiency and green building improvements, increasing the job market for energy retrofits. Introduced on Nov. 18, 2009
The Water Accountability Tax Efficiency Reinvestment (WATER) Act – Michael Coffman (R-Colo.) – Increases efficient use of freshwater resources and saves energy by creating a tax incentive of up to $1,500 for purchase of WaterSense labeled products and property. Introduced Apr. 2, 2009
The Livable Communities Act of 2010 – Ed Perlmutter (D-Colo.) **pending introduction** – Promotes the linkage of transportation, housing, and energy and resource use in American communities by establishing an Interagency Council on Sustainable Communities; funds the Office of Sustainable Housing and Communities within HUD, and authorizes over $4 billion in grants to incentivize integrated community planning and implementation of sustainable projects.
The Federal Personnel Training Act of 2010 – Russ Carnahan (D-Mo.). **pending introduction** – Ensures the effectiveness of federal high-performance green buildings and protects tax dollars by investing in the training of federal personnel to operate and maintain high-performance buildings at peak efficiency, and promotes federal leadership in defining core skill sets for green jobs that can be replicated in the private sector replication.
Senate The Clean Energy and American Jobs Act – John Kerry (D-Mass.) and Barbara Boxer (D-Calif.) – Spurs widespread modernization and renovation of existing building stock in America by establishing incentives for efficient building retrofits (the REEP Act introduced by Rep. Welch in the House), targets improvements in building efficiency codes, establishes a rebate program for water-efficient products and properties, and moves the U.S. to a low-carbon future by setting targets for greenhouse gas emission reductions, renewable electricity use, and industrial efficiency. Reported out of committee on Nov. 5, 2009
The American Clean Energy and Leadership Act – Jeff Bingaman (D-N.M.) and Lisa Murkowski (R-Alaska) – Increases the sustainability of the built environment by establishing an energy efficiency building retrofit incentive program and improving building efficiency codes, and creates a building energy information program for energy data disclosure. Reported out of committee on Jul. 16, 2009
Energy Efficiency in Housing Act (EEHA) of 2009 – Sheldon Whitehouse (D-R.I.) – Transforms and modernizes the U.S. housing market by incentivizing GSEs such as Fannie Mae and Freddie Mac to use Energy Efficient Mortgages (EEMs) and Location Efficient Mortgages (LEMs); ensures that the benefits of green buildings are accessible to Americans of all income levels by utilizing standards for public housing projects, including green building standards for single-family or multifamily structures. Introduced Jun. 25, 2009
The Livable Communities Act of 2009 – Christopher Dodd (D-Conn.) – Promotes the linkage of transportation, housing, and energy and resource use in American communities by establishing an Interagency Council on Sustainable Communities; funds the Office of Sustainable Housing and Communities within HUD, and authorizes over $4 billion in grants to incentivize integrated community planning and implementation of sustainable projects. Introduced Aug. 6, 2009
The Expanding Building Efficiency Incentives Act of 2009 – Olympia Snowe (R-Maine) – Makes efficient homes and buildings more achievable by increasing and extending the new energy-efficient home tax credit and improving financial incentives for energy efficient commercial buildings. Increases consumer energy awareness by establishing a tax credit for home energy ratings for the first time ever, and grows the green job market by providing financial assistance for home-performance auditor training and certification. Introduced Aug. 6, 2009
The School Building Fairness Act – Tom Harkin (D-Iowa) – Promotes green schools by directing $6 billion dollars in competitive matching grants to local educational agencies across the country for school repair, renovation, and construction with prioritization for local agencies that will use green building standards. Introduced on May 21, 2009
Clean Energy for Homes and Buildings Act of 2009 – Jeff Merkley (D-Ore.) and Richard Lugar (R-Ind.) – Creates clean energy capital by funding a $2 billion dollar Clean Energy for Homes and Buildings Program in the Department of Energy, which will make loan guarantees, financing, and credit support available to states and local governments for enabling energy-efficient home and building retrofi ts and on-site renewable energy production. Introduced Aug. 4, 2009
The Energy Efficiency Modernization Act of 2009 – Michael Bennet (D-Colo.) – Improves the energy efficiency of federally assisted housing by an estimated 25 to 40 percent by enabling and incentivizing private affordable housing owners to finance efficiency and green building improvements, increasing the job market for energy retrofits. Introduced Dec. 17, 2009
The Water Accountability Tax Efficiency Reinvestment (WATER) Act of 2009 — Mark Udall (D-Colo.) – Increases efficient use of freshwater resources and saves energy by creating a tax incentive of up to $1,500 for purchase of WaterSense labeled products and property. Introduced Jun. 23, 2009
The Federal Agency Energy Efficiency Improvement Act of 2009 – Susan Collins (R-Maine) – Promotes federal leadership in sustainability by directing federal agencies to collect data on building energy consumption and develop and implement policies for agencies to minimize energy use; authorizes a renewable power purchase agreement pilot program for federal agencies. Introduced Dec. 16, 2009
As a student of the real estate game I’m thinking about all the opportunities that may be created through the passing of this legislation. What do you think?
This is the first in a three-part series of posts on partnerships. In this series I’m going to talk a little bit about partnerships, go into the legal structures, the different types of partnerships, and how to model each type.
