A couple years ago I started reading up on real estate years ago. I picked up a few comprehensive books and went through them like they were picture books.
I’ve been hooked on real estate investing ever since.
And as ironic as it may be, I broke one of the cardinal rules of real estate investing – or at least according to the authors of the first two books that I read.
What is that rule? I’m glad you asked.
Both real estate investment books that I read both STRONGLY advised against investing in a real estate limited partnership. Despite this advice, over a year ago I was presented with a unique opportunity. Because of a number of reasons, which I will explain in detail in this post, I decided to take advantage, and I am glad I did. Not only did I stumble across a great investment, I also found one of the two truly passive ways to invest in real estate.
What is a Limited Partnership?
For those of you who are unfamiliar with what a limited partnership is, it’s actually quite simple. A limited partnership is like any other partnership (i.e. business with more than one person), with one exception. There are two groups of people: (1) general partners and (2) limited partners. General partner(s) are the ones who manage or run the business, while the limited partner is a purely financial partner. They are not allowed to play a role in the day-to-day business.
This may sound like a disadvantage, but it comes with its benefits too. Limited partners, as the name suggests, have limited liability for the business. That means if things were to go sour, I would not be on the line for any type of debt or legal consequences, other than the amount that I originally invested.
Not all limited partnerships are real estate – but that is the type of partnership I invested in. As such, here is how the company would work, it was presented to me:
- Invest any amount of money over $10k and receive a proportional amount of this real estate company
- There would be an initial period of raising funds, from a number of parties. After this 4 month period, no additional funds would be raised (to avoid diluting portion of ownership on all parties).
- Starting in January 2013, the company would start purchasing properties. This initial accumulation of properties would continue for a period of two years.
- After the initial period to acquire properties, the dividend payments would begin and early estimates suggest that the dividends would be around 17% each year going forward.
- Depending on inflation and property values, somewhere between 6-10 years, the general partners would re-finance the properties, taking out a lot of the equity and issuing it as a huge dividend payment.
- Overall, the goal and estimates were to recover the initial investment of all parties by year 7 or 8.
Why “Experts” Advise Against Limited Partnerships
Given that information, there are a few reasons why the experts advise against real estate limited partnerships (RELP’s going forward).
First Objection – Your Investment Isn’t Liquid
The first disadvantage to investing in a limited partnership is that is often, if not always, NOT a liquid investment. In other words, if you find yourself in a situation where you need the money that you invested 2 years ago, that’s too bad. The money that you invested in the company is not easily sold or transferred, as it would be if you were investing in the stock market. In my situation, I think the earliest that I can sell my portion of the company, assuming there was even an interested party, would be seven years.
This is not the worst objection, but it is one to be aware of when investing in a limited partnership.
Second Objection – YOU Can’t Make Important Decisions
The next objection, which I have already hit on is the fact that you have no say in the day-to-day operations. As a limited partner in any business, you are not legally allowed to make any decisions. Which 3rd parties you partner with, what properties you purchase, how much cash you keep in your accounts to cover the monthly expenses, which properties are financed and which are not. The list of things you CANNOT do goes on and on.
As far as I understand the reason behind this, it’s quite simple: since you are receiving certain benefits as a limited partner, it wouldn’t be right if you really acted as a general partner.
The concern, with this objection from the “experts”, comes from the fact that the general partners could make bad decisions. They could choose to buy a bad property, over-leverage the money and put the company in a bad position, etc. Ultimately, as a limited partner, you could lose all of your money simply because the general partners made a bad decision (or multiple bad decisions). This is certainly something to consider.
Third Objection – You are PAYING the General Partners
The third concern that the “experts” typically raise is the fact that general partners are receiving a portion of the profits prior to any dividend payments to the partners. This is often the case (if not always) as a way to motivate general partners to increase profits and to reward them for running a successful business. If the business profits, the partners get paid. If it is successful, they get paid even more.
Depending on the amount, this could significantly reduce the return on your investment as a limited partner. In particularly bad situations, it could also mean that the general partners are profiting and you are not. I’m not even suggesting that the general partners would intentionally cheat the other partners (although that could happen too), but what happens if the actual returns are lower than expected? If profits are lower than the original projections, you might find yourself in a bad situations where the general partners are still getting paid by the management fees AND there is not enough cash left over to issue dividend payments.
Reasons Why I Bought 8% of a Limited Partnership
Given the potential of these disadvantages to cripple my return or worse, lose my investment altogether, I’m sure many of you are wondering why I would invest in such an investment. I’m glad you asked!
There are a couple of reasons that pushed me over the edge.
Reason #1 – Large, Dependable Income Investment
When I got the early projections, I was very skeptical. The first projections were, as I mentioned earlier, 17% after year 2. Any experienced investor know that a 17% annual return is a good return. This year, the market is up almost 30% YTD and that rarely happens. To get 17% each and every year for what I expect to be decades to come would be a GREAT investment. So, is it too good to be true?
I spent the next week preparing for a call with one of the general partners. There was no way I was going to invest without knowing more specifics. While I don’t remember the specifics of that conversation, I do know that I was completely satisfied after this conversation. One of the biggest reasons I was satisfied after grilling the general partner is the perfect market for real estate investing – I share more about this in the conclusion of this post.
The early projections were to buy single family units/homes for $30,000-$40,000, fix them up a little, and then rent them for anywhere from $600-$750. That is a rough average of 2% ratio of rent to home value, which is one indication of a great real estate investment.
I came to find out in that conversation that 17% was by all standards conservative numbers, and I wouldn’t be surprised to see 20% dividends in the future. (At the end of this post I share the anticipated 2014 dividends)
To summarize this reason for investing, the potential earnings (and the likelihood of it actually happening) was too great to turn down. While most young adults are typically not looking for income investors (as much as people approaching retirement), I’m really excited for this extra income that will likely continue for decades to come.
Reason #2 – Trust in General Partners
The second reason that I overlooked the disadvantages of investing in a limited partnership is trust in the general partners. I only knew this general partner as a friend of a friend, but I learned that he had been investing in real estate for several years. Not only did he have several more years of experience in this real estate market, but in another conversation (prior to this opportunity, so I knew he wasn’t trying to sell me anything), I learned that he had a real estate mentor who managed a real estate portfolio that has six-figure gross rents. Yes, that means that all of her properties’ rents totaled over $100k each month – or another way of putting it is gross income from her properties exceeds $1 million annually.
While previous experience and an awesome mentor does not guarantee success, it does give a pretty clear projection. To reassure me even further, I learned that the general partners were also investing in this partnership because they believed in this that much. I don’t remember the exact percentage, but I think the general partners contributed 25% of the total money raised. Again, this doesn’t guarantee success, but it does tell me that they are more motivated to earn money and make sure not to lose our initial capital.
Results & Takeaways from 1 Year of Ownership
While there are a number of other reasons why I invested money in this RELP (including having some extra money that I wanted to put into real estate), I wanted to get to the conclusion, because it really excites me. I expect that I’ll be able to give a more valuable recap on the success (or failure of this investment) next year, because I still have yet to receive one cent in dividends – but that is consistent with what I was told when I invested 1 year ago.
About two weeks ago, I got an informal progress update from one of the general partners, and here is what he shared:
- I own about 8% of this real estate limited partnership
- In the past year, the company has acquired 6 single family properties and a 6 unit property. All but 2 of those 12 are currently rented out, with one of them being renovated. All of them should be rented out by end of November.
- Four of the properties are mortgage-free, thereby reducing the leverage, but also increasing the current cash flow. This also makes it easier to acquire new properties with cash.
- The company is producing approximately $6,400 per month in rents, and about half of that is net income or profit.
- The plan, as of right now, is to continue to use a portion of the profit to increase the number of properties. This means to acquire 1 additional property every 1-2 months for the next year.
- The general partners did not plan on distributing any dividends this year, but were considering about 5% at the end of Q4. If they decide NOT to issue dividends this year, they would issue quarterly dividends in 2014 with the annual dividend equal to about 15% of the original investment. (Again, this is 1 year earlier than they were projecting).
Overall, I am VERY satisfied with the progress that the company is making. Not only is it exceeding the conservative projections, but is has been truly passive. Other than two 30 minute conversations asking an update, I have done NO WORK. People often claim that real estate is passive, but this is one of the two ways that real estate investing is truly passive. The other would be REITs, that are traded like stocks (but from what I’ve seen only produce a fraction of the projected returns of this partnership).
I’ve also come to realize that this partnership has allowed me to invest in a more profitable market in a safe way. Despite paying a small portion of returns to the managing partners, I am still in a much better situation than what I would be if I tried to invest the same money in the market that I live (or will be living in 1 month). The partnership that I am currently invested in is earning the same return in rent while having less than 1/5 invested. To put it simply, I couldn’t come close to earning same return in the market that I am familiar with as the partnership that I invested in. (Now you can understand why I am so excited about this partnership!)
Of course, I could try to do it all myself in order to keep more of the profits. But that would require a lot more work and definitely a lot more risk. While I may not be maximizing my profits in real estate, it does look like I will get a great return without having to do any work.
This goes to show you that while you need to perform due diligence, the experts are not always right and you shouldn’t be afraid to venture into other nontraditional investments. You never know when you could stumble across a prime opportunity.