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Oct 1989

Real estate limited partnerships after TRA 86. (Tax Reform Act) (Personal Financial Planning)

by Bell, Evan R.

    Abstract- The emphasis of real estate limited partnerships has shifted towards the deal's fundamental economic basis since the Tax Reform Act of 1986. Certified public accountants evaluating the soundness of real estate limited partnerships should analyze a variety of factors, including: the general partner; the economics of the deal; and the fee structure. When analyzing the general partner, the CPA should evaluate experience and knowledge, involvement, and availability. A CPA should also review the financial information contained in a prospectus closely. Any deals should be structured to show current returns and general partners should justify reasons for increased property value and cash flow.

In reviewing the soundness of an investment opportunity in a real estate limited partnership, the investor should be concerned with who the general partner is, the fundamental economics of the deal, and the fees being paid. What to Look for in a General Partner

When reviewing the credentials of a general partner, an investor must place heavy reliance on success in prior deals. In reviewing the prospectus, it makes sense to talk to limited partners from prior projects.

Experience and Knowledge. The general partner should be experienced in the particular type of real estate involved, i.e., residential or commercial, multi-family or single family, investment or development. The general partner should also be familiar with the particular location and the trends in the area in which the property is situated. He or she should be familiar with the rental market, the past appreciation statistics, the current market trends, and local statutory rent laws and zoning regulations.

Involvement. The general partner should be involved in the management of the property. He or she does not have to manage, but should personally oversee the way the property is being handled. Personal and periodic on-site visits are invaluable. Nothing substitutes for physical presence at the property and involvement in the area, including contact with area residents, local merchants and other real estate professionals.

Availability. The general partner should be available for questions from any of the limited partners or their advisors or professionals. He or she should encourage participation. The general partner should know much more about the real estate business than the investors, but should welcome comments, questions and suggestions. The general partner should periodically inform the limited partners of the status of their real estate. Financial statements are important, but partner update letters in layman's terms telling the investors exactly what is happening, are extremely valuable and informative. The general partner should encourage the limited partners to see the property when practical. Nothing spurs partner interest in a property more than actually touching the bricks and seeing the transformation of a well-managed property.

Keeping an Eye on Projections. The general partner should demonstrate a track record of meeting projections. A review of the general partner's projections in a prior deal should determine if, for instance, scheduled cash distributions have been met with relative consistency. If not, there should be an acceptable reason. If the explanation demonstrates poor planning or failure to anticipate a major expense (that should have been expected or planned), it can be taken as a danger sign. In a real estate limited partnership there is, of course, less risk of total loss because the investment is backed by the real estate. However, the bottom line for a successful investment is the general partner. The limited partner must investigate and satisfy himself that the general partner has the experience and savvy to make the venture successful. The Real Estate Deal Economics

A limited partner's objective should be to earn a profit on his or her investment. The partner must avoid the self deluding temptation to "romance the deal." Romancing the deal, simply put, is being distracted by items that do not affect the overall bottom line and investment objectives.

The financial information in the prospectus must be carefully reviewed. Are the cash flow budgets realistic? The reviewing professional should have some knowledge of the costs of managing property. Once again, reliance on the general partner's experience and past results should play an important role in the evaluation of the financial presentation.

Be wary of negative amortizing mortgages; mortgages that grow because payments are less than the cost of interest. These mortgages are attractive, because during the life of the investment they provide more cash flow for operations and distributions. The danger, of course, is a false sense of prosperity.

Pay special attention to the overcall provision. AU limited partnerships have them. They outline what happens when the partnership has to turn to the limited partners for additional funding. The provisions of the overcall should give the limited partner the opportunity to refuse to participate even if thereby faced with a dilution of partnership interest. If this option is not granted, the limited partner must meet additional funding requests. The limited partner may wish to make an additional contribution, but without the nonfunding option, he or she may have no choice but to fund a property that no longer has his or her confidence.

There Should Be a Current Return. The deal should be structured to show a current cash return. Real estate deals that show current cash returns may be difficult to find, but cash distributions are an important indication of a sound investment.

Current cash flow also indicates the availability of excess cash over operating expenses for use during troubled times. Real estate is like any other business, and a smaller than planned distribution may serve a business purpose on occasion. However, a regular cash distribution is a sign of a healthy property.

It is, however, important to recognize that a building that does not show positive cash flow upon purchase, while more speculative, could be a valuable investment for the medium to long term. However, greater care in the investigation may be prudent when considering such an investment.

Increased Value of Property. The general partner should be able to justify reasons for increased cash flow and equity appreciation. An example of projected increased cash flow would be correction of below market rents. Some placid owners do not know the market for the more attractive properties in their areas.

An increase in value may also result because of area appreciation or "gentrification." As areas become more desirable, the land owners profit dramatically. The general partner should know the area well enough to be able to point out area trends and show the limited partners progress in the area of the property.

Inflation is also a major factor. Real estate has kept pace with inflation, usually outpacing it. A good real estate investment should provide greater appreciation than staying even with inflation.

A word of warning about "romancing a deal." A beautiful building in a superb location does not necessarily make a good investment. Buying a property because it has beautiful detail or Georgian columns, without examining the underlying economics, is self deluding. On the other hand, one should not necessarily pass on a property because it is an ugly building or the amenities are lacking.

A mistake made by some investors is looking at real estate as if it were to become their personal residence or place of employment. An investment is not the investor's place of abode.

Blind Pools. Blind pools are created when funds are collected before a particular property has been selected. Blind pools make it easier for the general partner to negotiate a deal because there is cash on hand. However, blind pools put pressure on the general partner to find a deal. He or she has the limited partners' money, and no doubt numerous calls from them about progress. There is a temptation to hastily choose a property that might not meet the standards expected by the limited partners. Fees to General Partners

Fees to general partners are an important part of every deal. The fees are paid for finding the property, putting the deal together, evaluating the validity of the economics placing the mortgage, assembling the limited partners, managing the property, and ultimately, handling the sale. Fees generally fall into four categories: organizational fees, cash flow fees, management fees and back end fees.

Organizational fees are generally paid at closing. They ordinarily are a percentage of the equity capital raised and range up to 25%. Some general partners buy a property in a general partnership and then resell it to the limited partnership, thereby recognizing an immediate gain for the general partners. It is important for any limited partner to ascertain from whom the property is actually being purchased; i.e., is it an independent party or a party related to the general partner?

Cash flow fees are paid to the partners in the operation of the property. They are usually based on a percentage of what the limited partners receive. Cash flow fees may range from 10% to 25% of the limited partners' distribution. Often, the general partner gets no cash flow fee until the limited partners get a certain return, either stated in dollars or percentage; i.e., the general partners shall begin to share in the cash flow after the limited partners receive a 7% return on capital. The theory behind the cash flow fee is that it gives the general partner an incentive to manage the property efficiently and effectively, to generate higher cash flow to the limited partners.

A management fee may also be paid to the general partner. This is a fee for current services rendered and would be paid to someone in any event. A general partner should manage the property. It indicates that someone with a vested interest in the property is supervising the limited partners' investment. Management fees generally range from 45% to 7% of collected rent in residential property.

Back end fees may be paid to a general partner when a property is either sold or refinanced. The fee should always be based on the profit from the sale or refinancing, not the gross cash distributed. Back end fees range from 25% to 50% of the profit on the sale. After the limited partners have their investment back, this is the general partner's real fee for a job well done.

Organizational fees and cash flow fees generally cover overhead. The back end fee is the financial reward to the general partner for identifying a valuable property and managing it successfully until the ultimate realization in a profitable sale. Very often a general partner will wait five to 10 years for the fee. It is the incentive for a general partner to select only the properties with the most potential, to manage well and to wait patiently for appreciation. Effects of TRA 86

Real estate investments structured as limited partnerships have a long history. Since TRA 86, there has been a complete shift in emphasis. Limited partnerships quite appropriately now focus on the economics of the deal. They can be an excellent vehicle for the investor who does not have the expertise to select or the time to manage an investment, but seeks the opportunity that real estate offers. It also allows investors to diversify into various limited partnerships instead of putting all of their capital allocated to real estate into one venture.

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