About the Author : Domenic Romano, founder and managing partner of Romano Law, is a leading corporate and entertainment lawyer in New York.
Real estate development can be a profitable investment, but it presents unique challenges and risks. Effective construction management is very important to the success of the project, but the development business also involves areas such as corporate law, marketing and finance. It is unlikely that a single company will have expertise in all of these areas, which is why real estate projects are typically developed as joint ventures.
Business partners in real estate projects can be classified into general and limited partners, based on their responsibilities and obligations:
- Limited partners are only liable up to the amount they invested, while limited partners are fully liable for liabilities even if they lose personal assets.
- In exchange for taking on greater risk, the general partners decide how to develop and manage the project. On the other hand, limited partners have a passive role and delegate all decisions to the general partners.
General partners are typically experienced developers who can manage risk. With commercial agreements and limited partner investments, real estate developers can complete projects that would otherwise be beyond their means.
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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 of each other, even if the same promoters and investors are involved in many of them. If multiple projects are managed by a single company, they will all be threatened when a large liability affects one of them.
Limited partners assume less risk than general partners and their liabilities cannot exceed the capital invested. However, they cannot withdraw their capital on request – a common condition is to require limited partners to commit their capital until the project is completed. This ensures that general partners do not run out of funding mid-project.
In this aspect, real estate development is very different from investing in the stock market, where shares can be bought or sold at any time. Because limited partners do not have management responsibilities, they can make profits even if they have no real estate development experience.
The commercial agreement must make all legal and financial aspects of the project clear.
Starting a Real Estate Project
Creating a business agreement between general partners and limited partners is just one step towards a successful real estate project. Developers and investors must also ensure that the following requirements are met:
- Planning the project and defining its scope
- Due diligence: When purchasing land or an existing building, developers must check whether the property has legal, environmental or financial problems.
- Meet local regulations: building codes, zoning rules, environmental requirements, project approval, construction permits, etc.
- Hiring all necessary services during the project: architects, engineering companies, general contractors, legal services, accounting, etc.
- Secure sufficient funding to complete the project according to scope and plan.
- Marketing and sales.
The project developer usually brings some of the necessary skills. For example, many large contractors enter the development business to take advantage of their construction experience. A project can also have many general partners who bring complementary skills.
Forming an LLC
In addition to forming a limited 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 or debts incurred by the LLC. Just as they do in a partnership structure, real estate developers can create separate LLCs for each project to protect themselves against cross-liability arising from other projects.
The LLC structure protects its members from personal liability, offers tax flexibility, and does not require the same rigorous 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 distinct name for your LLC.
- Compose a Custom LLC Operating Agreement , which defines aspects such as the obligations and rights of LLC members, establishes 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 intention to establish an LLC.
- Apply for and obtain an LLC EIN through the IRS.
By combining effective construction management with an appropriate legal structure, risk can be minimized in the property development business.
