About the Author: Domenic Romano, Founder and Managing Partner at Romano Law, is a leading corporate and entertainment attorney in New York.
Real estate development can be a lucrative investment, but it comes with unique challenges and risks. Effective construction administration is very important for project success, but the development business also involves areas like corporate law, marketing and finance. A single company is unlikely to have expertise in all these fields, and this is why real estate projects are normally developed as joint ventures.
The business partners in real estate projects can be classified into general and limited partners, based on their responsibilities and liabilities:
- Limited partners are only liable up to the amount they have invested, while general partners are fully responsible for liabilities, even if they must lose personal property.
- In exchange for assuming a higher risk, general partners decide how to develop and manage the project. On the other hand, limited partners have a passive role and they delegate all decisions to general partners.
General partners are normally experienced developers who can manage risk. With business agreements and investments from limited partners, real estate developers can complete projects that are beyond their means otherwise.
Minimizing Risk in Real Estate Development
Real estate developers create a separate company for each project as a risk management strategy. This makes projects independent from each other, even if the same developers and investors are involved in many of them. If multiple projects are managed under a single company, all are threatened when a major liability affects one of them.
Limited partners assume a lower risk than general partners, and their liabilities cannot exceed their invested capital. However, they cannot withdraw their capital on demand - a common condition is requiring limited partners to commit their capital until the project is completed. This ensures that general partners are not left without funding halfway through the project.
In this aspect, real estate development is very different from investing in the stock market, where stock can be bought or sold at any time. Since limited partners have no management responsibilities, they can earn profits even if they lack experience in real estate development.
The business agreement must clearly all legal and financial aspects of the project.
Starting a Real Estate Project
Creating a business agreement between general partners and limited partners is just one of the steps for a successful real estate project. Developers and investors must also make sure the following requirements are met:
- Planning the project and defining its scope
- Due diligence: When purchasing land or an existing building, developers must check if the property has legal, environmental or financial issues.
- Meeting local regulations: building codes, zoning rules, environmental requirements, project approval, construction permits, etc.
- Hiring all services needed during the project: architects, engineering firms, general contractor, legal services, accounting, etc.
- Securing enough financing to complete the project according to the scope and plan.
- Marketing and sales.
The project developer often brings some of the skills required. For example, many large contractors enter the development business to take advantage of their construction expertise. A project can also have many general partners who bring complementary skills.
Forming an LLC
In addition to creating a general or limited partnership, business partners in real estate projects also have the option of forming a limited liability company (LLC). An LLC is a legal entity that insulates its members—and their assets—from personal liability for judgments against or debts incurred by the LLC. Just like they can under a partnership structure, real estate developers may create separate LLCs for each project to safeguard against cross-liability that originates from other projects.
The LLC structure shields its members from personal liability, offers tax flexibility, and does not require the same stringent formalities as a corporate structure.
When forming an LLC, be sure to:
- Comply with your state’s LLC formation regulations and requirements.
- File the “Articles of Organization” with your Secretary of State.
- Choose a distinctive name for your LLC.
- Compose an LLC Operating Agreement, which defines aspects such as your LLC members’ obligations and rights, sets out how your LLC will be governed and organized, and details the dissolution process.
- Determine whether your state requires you to publish in local newspapers a notice of your intent to establish an LLC.
- Apply for and obtain an LLC EIN number through the IRS.
By combining effective construction management with an adequate legal structure, risk can be minimized in the real estate development business.