LP vs. GP in Commercial Real Estate Investing
Investors are routinely encouraged to diversify their portfolios beyond traditional stocks and bonds. This includes investing in a variety of alternative investments, including but not limited to private equity real estate.
Co-investing in commercial real estate is a great way to get started. Investing as a limited partner in a real estate deal is especially attractive to those who want to be hands-off and have no prior experience investing in real estate.
Real estate funds and syndications are an increasingly popular way for individuals to invest in private equity real estate. Private equity real estate transactions are generally structured to have two key partners: the general partner (or GP) and the limited partner(s) (or LPs). The GP and LP take on very distinct roles in private equity real estate, so it is important to understand the distinction between each.
The general partner is the person, group or entity charged with spearheading all investment activities on behalf of the passive, limited partners. The general partner may also be referred to as the GP, the “sponsor”, the “key sponsor,” the “promoter” or the “developer.”
The responsibilities of the GP are vast and include, but are not limited to: identifying potential deals, underwriting and conducting all due diligence on deals, putting deals under contract, lining up the debt and equity needed to finance the deal, crafting the business plan for the deal, overseeing any necessary construction activities, property management, asset management, lease-up and stabilization of the property, refinance and/or eventual disposition of the property.
Another way to think of the GP is as the “quarterback” of the real estate deal. All of the day-to-day operations will be overseen by the GP, with the GP calling the shots on behalf of limited partners. This last point is especially important: the operating agreement associated with the deal will outline the roles and responsibilities of both the GP and LPs. In this document, you will find that the GP generally has sole decision-making authority except in otherwise extenuating circumstances (which will be outlined in the operating agreement).
Any liabilities associated with the deal generally fall to the general partner. For example, the GP is typically responsible for any personal guarantees required by lenders when financing the deal. Therefore, whereas LP investors only have their equity investment at stake, the GP is said to be taking on substantially more risk in the GP/LP arrangement.
The limited partners, or LP investors, are passive investors who contribute capital (debt or equity) to real estate private equity deals. LP investors range can range from institutional investors (e.g., traditional banks, life insurance companies, endowments, hedge funds, pension funds, etc.) to family offices and high-net-worth individuals.
LP investors may or may not have any real estate experience. They are investors that are otherwise relying on the expertise of the GP to execute the real estate deal on their behalf.
Limited partners generally have less at stake than general partners. They are not required to personally guarantee loans or put up any other collateral in exchange for the debt being used to finance a property. Their “risk” is limited to the amount of equity originally invested in the deal (and any subsequent equity as may be required through capital calls).
In exchange, limited partners also have very little, if any, say in the decision-making process. LP investors rely on the general partner to manage to the business plan as originally intended, making smart, thoughtful course corrections as needed to preserve investors’ capital.
The backbone of any GP-LP structure in real estate is what’s called the “Limited Partnership Agreement”.
The Limited Partnership Agreement essentially outlines the conditions by which the GP and LPs are agreeing to create a private equity real estate fund (or syndication). That fund or syndication is established for the sole purpose of investing in real estate.
In the case of a fund, the specific real estate assets may or may not have already been identified. This is especially true in an open-ended real estate fund, in which properties may be purchased and sold from time to time as long as the transactions otherwise meet the fund’s parameters.
With a real estate syndication, the Limited Partnership Agreement outlines the details pertaining to the syndication’s purchase of a specific asset – such as a multifamily or office building the sponsor has already put under contract.
No, the GP does not own the LP. The partnership is co-owned between the general partner (GP) and limited partners (LPs). Ownership of the partnership will be outlined in the Limited Partnership Agreement, a document that governs the partnership and is required to be filed with the state in which the partnership is created. The percentage of ownership is generally based on how much equity each partner has contributed to the deal.
The primary reason an LP needs a GP is for their experience in managing large, complex real estate deals. As noted already, limited partners can take a truly hands-off, passive role. They do not need to have any prior real estate experience in order to contribute to a successful investment. The GP will oversee all of the deal’s activities on the LP’s behalf.
In a real estate partnership, the GPs and LPs should both expect to earn a predetermined share of the cash flow and sales proceeds. The partnership agreement will include an overview of the “real estate waterfall” which shows how cash flow distributions are made to various partners, in what increments, and when.
For example, a real estate waterfall might stipulate that LP investors earn a 7% preferred return before the GP earns any cash flow distribution. If the asset only generates enough to cover a 5.5% return that year, then this cash flow goes to the LP investors and the outstanding 1.5% return is tacked on to their next payment as carried interest. Conversely, if the asset earns an 8% return, the first 7% will go to the LP investors and the remaining 1% will be split between the GP and LP investors according to the profit split outlined in their agreement.
The GP will also generally charge certain fees to compensate them for their role in overseeing and managing the deal on investors’ behalf.
Real estate sponsor fees can include, but are not limited to, an acquisition fee (1-5% of the purchase price), asset management fee (1-3% of gross annual revenue), capital events fee (0.5-2% of the loan amount), project management fee (5-8% of the construction costs), and a disposition fee (1-2% of the sales price).
The GP may also be eligible for certain “promotes,” which are essentially bonus payments that become due if and when the sponsor exceeds return expectations. This is a way of incentivizing the GP to thoughtfully manage the project, to control costs, and to ensure interests remain aligned throughout the lifecycle of a deal.
The primary distinction between a general partnership and limited partnership pertains to liability.
In a general partnership, all GPs are considered “owners” of the partnership and are equally involved in decision-making processes. In a purely general partnership, the owners all take an active role in the deal.
One of the primary benefits to forming a general partnership is that it is easy to set up and has a low cost of operation. A general partnership can be formed between as few as two people. There is no state filing paperwork required. The partnership takes effect when the GPs begin business activities. Moreover, there are few proscribed duties of a general partnership. They are not required to hold annual meetings, issue investor reports, hold funds in escrow separately from their own personal assets, and more.
The downside to investing in a general partnership is that all owners are held equally liable if one partner is sued.
For that reason, most commercial real estate partnerships are structured as limited partnerships. Limited partnerships are the preferred investment vehicle for CRE because it reduces the risk and liability of the LP investors, who can otherwise be hands-off and passive in every regard. With a limited partnership, the LPs are only liable for the partnership’s debts and obligations up to the amount of capital they have personally invested. If something were to go awry, and the GP is for some reason sued, nobody can come after the LPs’ other assets.
To memorialize this arrangement, most commercial real estate limited partnerships are structured using what’s known as a “limited liability partnership,” or LLP. An LLP functions much like an LLC in that it protects the personal assets of the partners. The only time an individual in an LLP can be held personally liable in excess of their capital contribution is if that individual is deemed to have committed some wrongful or negligent act on behalf of the partnership. All other partners will remain insulated from this wrongdoing when invested in an LLP.
Individuals can invest in real estate as either a general partner or limited partner, and there are certainly pros and cons to each. Most individuals will opt to invest as a limited partner, as this is the best way to earn truly passive income.
Other benefits to investing as an LP include:
Greater deal exposure. Since LP investors are not responsible for managing the day-to-day of a real estate deal, they can invest smaller sums in more deals across asset types and geographies. Someone can invest $50,000 apiece into four deals whereas a sponsor with $200,000 to invest would likely contribute that entire amount as equity into the deal they are overseeing.
Less personal liability. As passive investors, LPs are not required to sign personal guarantees or take on other liabilities associated with any specific deal. This is important to any LP who may need to secure financing for another deal (real estate or not), as lenders will look to see what sort of liabilities are outstanding as part of that individual’s portfolio. To the extent an LP investor can limit their personal liabilities, the better off they will be when trying to finance other investment opportunities.
No direct real estate experience required. Many people are interested in investing in real estate but, absent any prior experience, are unsure how to get started. Investing as an LP is a great way to gain exposure to real estate without having any direct real estate knowledge. By investing with a trusted sponsor, the LPs can learn about real estate while the GP takes the lead on the actual execution. Those who participate as LPs will often go on to participate in smaller deals as GPs, having learned from their experience as LPs over time.
Of course, those who want to have more control over a deal’s direction, or who want to be more of an active real estate investor, might instead consider investing as a general partner. To be a successful GP, though, an investor must have significant real estate experience and understand the complexities associated with bringing a deal through its full lifecycle. Few individuals are prepared to take on the role of a GP and instead, are better off joining a team of people who complement their areas of expertise.
On the surface, it may seem exhilarating to personally invest as an active partner in a commercial real estate deal. Many who do so will quickly find that there is a steep learning curve. In can take time—years even—for people to learn the basics needed to be even marginally successful when investing on their own.
This is what makes co-investing in commercial real estate deals so attractive. By investing as a LP in a real estate fund or syndication, individuals can gain access to institutional-caliber deals without shouldering the burden of deal execution. This is best left to the pros who live and breathe real estate for a living.
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