Not to point out the obvious, but there are pros and cons with investing in any asset class. There are specific pros and cons when investing in various asset classes whether those are stocks, bonds, REITs, private equity, venture capital, businesses, debt, or real estate.
Whether investing directly or indirectly in real estate in different asset types and geographies, there are also unique pros and cons to those investments. And this article will specifically discuss Real Estate Limited Partnerships.
Real Estate Limited Partnerships are investments where you invest as a limited partner in a Limited Partnership (LP) or as a member in a limited liability company (LLC). Investments in Real Estate Limited Partnership also have their own pros and cons.
In this article, I will address the pros and cons as well as the benefits and risks of investing in Real Estate Limited Partnerships, and the ways to invest in Real Estate Limited Partnerships.
Pros of Investing in Real Estate Limited Partnerships
There are a number of benefits to being invested in Real Estate Limited Partnerships.
One benefit of Real Estate Limited Partnerships is that these investments give you access to deals that you otherwise would not have had access to.
Another benefit of Real Estate Limited Partnerships is that many of these investments give you current cash flow.
Real Estate Limited Partnerships also provide upside potential, which gives you the chance to earn higher overall returns.
Yet another benefit of Real Estate Limited Partnerships is that they provide you with diversification. If you allocate your capital wisely, you have the ability to sprinkle your net worth around multiple deals that can give you much needed diversification that will enhance your overall returns over time while shielding you from unnecessary risks. One type of diversification that Real Estate Limited Partnerships afford you is product type and asset class diversification. A second type of diversification that Real Estate Limited Partnerships provide you is geographic diversification. A third type of diversification that real estate limited partnership provide is sponsor diversification. A final diversification that Real Estate Limited Partnerships provide is that these investments can give you access to deals in other countries should you be so inclined, which gives you exposure to multiple currencies.
A fifth benefit of Real Estate Limited Partnerships is that you get tax advantages related to limited partnerships. With Real Estate Limited Partnerships, not only do you have the chance to earn capital gains on any profits, but you also have tax shelter in the form of depreciation on your current income. As such, much if not all of your current income that gets paid out as preferred returns can be partially or fully sheltered in a lot of cases especially in the early years of an investment. The benefit of depreciation is that you can have a situation where you have positive cash flow on your investment while having tax losses that you can carry forward onto your personal tax return.
Another advantage that you get, in addition to having long term capital gains on your profits, is that you also have the ability to do what is called an IRS 1031 exchange. A 1031 exchange will allow you to defer your profits for an even longer time period assuming you reinvest in like-kind investment property.
As an example, let’s assume that you bought a property for $10 million and you initially invested $3 million in the property. Let’s also assume that you placed a $7 million loan on the property that was interest only, which means that the loan did not carry any amortization and the loan balance remained the same when you sold the property. In our example, you sell the property for $13 million. Your debt is still $7 million. The balance between $13 million and $7 million is $6 million, which means that you got back your original $3 million investment and you made $3 million of profit from the sale.
For the 1031 to work, you would have to reinvest in an investment property or properties in which the acquisition price for the property is valued at least $13 million. You would need to obtain at least a $7 million loan and re-invest the $6 million of equity in order to not pay boot, which is a tax on the equity you take out of the real estate deal for personal use. We will get into 1031 requirements in a future article.
A final benefit I will address in this article related to Real Estate Limited Partnerships that was set up as part of the 2017 Tax Cuts and Jobs Act are Opportunity Zones. The IRS defines Opportunity Zones as economically distressed communities that may qualify for tax deferment.
Opportunity zones are areas that the US government has defined as places that need rehabilitation, gentrification, job growth, and general investment. And so, the US government is providing preferential tax benefits to these areas. If you hold the property for 10 years, you can have a situation where your profits are not only tax deferred, but also where those taxes can be significantly reduced or negated. In those situations, you would have no capital gains on those opportunity zone investments. You can find opportunity zones all across the country including the territories like Puerto Rico, Guam, and Washington D.C.
Cons of Investing in Real Estate Limited Partnerships
In addition to the pros of investing in Real Estate Limited Partnerships, there are also a couple of disadvantages or things to consider when investing in Real Estate Limited Partnerships.
The first con of investing in Real Estate Limited Partnerships is control, as a Sponsor controls the destiny of the deal. Every deal is dependent on the Sponsor of the property regardless of whether the investment is a friends and family deal or whether the deal is sponsored by a larger organization that is overseeing the transaction. In a Real Estate Limited Partnership, there is a company or a group of Principals that are responsible for the outcome of that property.
Another con of Real Estate Limited Partnerships is that Real Estate Limited Partnerships are illiquid. Real Estate Limited Partnerships can either be set up for a certain amount of time or they can be set up for an indefinite period. The most common practice now is to set up an entity that has an indefinite time period even if the business plan for the Real Estate Limited Partnership only calls for a shorter time horizon to execute the business plan. Often times, a Fund structure for a Real Estate Limited Partnership may be set up for 10 years with extension options.
We typically underwrite our real estate holdings for 4- to 7-years. Some of our business plans only call for a 2- to 3-year business plan while some of our assets we are looking to hold over the long-term to benefit from cash flow and upside potential. There are some assets that my partnerships have held for 7- to 10-years, and the plan is to hold those assets even longer. While the cash flow and upside is a benefit, the illiquidity is a con.
Another con related to illiquidity is sale-ability. If you end up needing liquidity at some point in your life during the hold period, you may be forced to sell your limited partnership interests through the Sponsor, and you would likely get a discounted valuation on your investment if they even allow you to sell your limited interest.
Another con of Real Estate Limited Partnerships is the tax rate on ordinary income. If part or all of your income is not sheltered, then your Preferred Returns will be taxed at ordinary income levels. Ordinary income tax rates carry higher rates than capital gains rates. As such, tax rates can be a con of investing in Real Estate Limited Partnerships. Ordinary income tax rates and capital gains rates are shown below from the Tax Foundation’s 2022 Report:
Tax Brackets and Rates, 2022
Tax Rate For Single Filers For Married Filing Joint For Heads of Households
10% $0 to $10,275 $0 to $20,550 $0 to $14,650
12% $10,275 to $41,775 $20,550 to $83,550 $14,650 to $55,900
22% $41,775 to $89,075 $83,550 to $178,150 $55,900 to $89,050
24% $89,075 to $170,050 $178,150 to $340,100 $89,050 to $170,050
32% $170,050 to $215,950 $340,100 to $431,900 $170,050 to $215,950
35% $215,950 to $539,900 $431,900 to $647,850 $215,950 to $539,900
37% $539,900 or more $647,850 or more $539,900 or more
Source: Internal Revenue Service
2022 Capital Gains Tax Brackets
For Unmarried Individuals For Married Individuals For Heads of Households
0% $0 $0 $0
15% $41,675 $83,350 $55,800
20% $459,750 $517,200 $488,500
Source: Internal Revenue Service
Another con of investing in Real Estate Limited Partnerships, is that you generally have a slow growth model. Real estate is not a get rich quick scheme, but it is a get rich over time model. What I mean by slow growth is that you generally put in a sizable chunk of your cash as an investment, and the returns come back slowly in the form of a preferred return over time.
Typical Preferred Returns are somewhere in the 5% to 8%. We will assume a 6% Preferred Return. If you invest $100,000 in a deal, you should normally expect to receive $6,000 in Preferred Returns per year.
Typical IRRs that Sponsors strive for over a 5-year hold period are 15% IRRs. What that means is that you receive a 15% annualized return. This is calculated over a 5-year hold period using the time value of money. The IRR calculation is calculated using your initial investment, the cash flow or Preferred Returns received each year, and the profit received when the asset is ultimately sold. In this example, you would be getting a cash return of 6% during each of the initial five years. This equates to $30,000 ($100,000 x 6% x 5 years). At the tail end of the deal, assuming the deal achieved a 15% IRR, you would make the equivalent of the difference between 15% and 6%, which equates to 9% per year. This equates to an additional $45,000 ($100,000 x 9% x 5 years). In addition to getting your initial $100,000 back, you made $75,000 in total comprised of $30,000 of cash flow and $45,000 of profit. A 15% IRR is effectively equal to a 175% return ($175,000 total return of principal, cash flow, and profit divided by your $100,000 investment multiplied by 100%).
Another metric that we look at is the equity multiple. The equity multiple shows the ratio of return to equity invested. By summing the return of your initial principal, cash flow, and profit, you get the numerator, which is our case is $175,000. Divide the numerator by the denominator, which is your initial $100,000 equity investment. By dividing $175,000 by $100,000, you get 1.75x.
Now you can see that while you had a 6% annual cash-on-cash return, you received at 15% IRR upon the sale of the property after 5 years, and that equates to a 1.75 x equity multiple. This all means that you would grow tour money by 75% over that 5-year period, which is a return of 15% per year.
As we stated, you have to be patient because the returns in the initial years can be slow, which is a con of Real Estate Limited Partnerships.
A final risk we will discuss is capital risk. Sponsors cannot legally guarantee a return of capital or a return on capital. This is a risk that you have to acknowledge and that you have to be aware of. You can’t just bank on a 15% IRR because Preferred Returns and IRRs in a deal are not guaranteed.
Preferred Returns are not guaranteed returns. Sponsors cannot guarantee Preferred Returns. Additionally, your capital is at risk, as are your preferred returns. It is not a guarantee of a return of capital or return on your capital.
There are obviously risks in every Real Estate Limited Partnership. There are many benefits to investing in Real Estate Limited Partnerships. There are some cons to investing in Real Estate Limited Partnerships too. There are market risks, governmental risks, property risks, tax risks, and tenant risks in every Real Estate Limited Partnership.
Good sponsors work towards preserving your capital, as well as growing the capital through Preferred Returns and cash flow distributions that are paid on a monthly, quarterly or annual basis. Real Estate Limited Partnerships also have the ability to increase in value thereby creating upside potential and profit potential for investors.
This article has detailed a number of the pros and cons related to Real Estate Limited Partnerships from a high level.
Until next time, let’s continue growing our cash flow and net worth together!