How Commercial Real Estate Investors Use Holding Companies to Reduce Risk
Holding companies help reduce a commercial real estate investor’s risk profile and the potential liabilities they could incur as a result of owning an investment property. In order to minimize risk, a holding company isolates one or more properties from an investor’s other assets, making it harder for a creditor or a plaintiff to repossess (or be awarded) their property. In addition, the separation that a holding company provides often makes things easier from a financial reporting and taxation standpoint. From a liability perspective, it’s almost always a good idea for an investor to start a holding company, rather than to personally own a piece of real estate or to hold it in a company with a variety of other assets.
Corporate Structures for Real Estate Holding Companies
Real estate holding companies can be organized in a variety of different ways, but LLCs are one of the most common ownership structures. Other popular options include C corporations, S corporations, and LLPs (limited liability partnerships). Limited partnerships or LPs are also a common ownership structure, but are generally only used in real estate syndications or joint ventures.
LLCs are generally easy to set up and can have an unlimited number of shareholders (though LLCs with less than 100 members can be taxed as if they were S-corporations, which can sometimes be beneficial). Like other types of corporate structures, LLCs insulate their shareholders from personal liability; while someone can sue an LLC for business-related activities, they are less likely to be able to sue the owner individually, which provides some degree of asset protection. However, if the managing shareholder(s) of an LLC commit fraud or engage in serious wrongdoing, the “corporate veil” may be pierced, allowing aggrieved parties to directly bring lawsuits against an LLC owner/shareholder. This phenomenon is not unique to LLCs and is also the case for most types of corporate ownership structures.
Operating Agreements for Real Estate Holding Companies
Whether you choose an LLC, a C corporation, an S corporation, or something else entirely, it’s essential to have an ironclad operating agreement before signing the papers on your new real estate holding company. If you choose an LLC or another type of corporation that will have one or more members, it’s especially important that your operating agreement has several key elements, including:
Percentage ownership interests for each member. So there is little to no confusion, each owner’s percentage stake should be clearly defined.
Members rights and responsibilities. The rights and responsibilities of members should also be carefully defined, as well as any general corporate rules.
Delegation of management responsibilities. While an LLC has more of a ‘flat’ or ‘circular’ ownership structure when compared to other types of ownership structures, such as an LP, there are still typically certain members which will take on more of an active role, and whom will be compensated for their additional efforts. An operating agreement should detail specific management expectations, and may also want to mention how and under what circumstances management responsibilities should be transferred to different members.
Voting. A larger real estate LLC or corporation may have several investors, who may wish to vote on issues relevant to their investment property. The operating agreement should detail exactly how this voting process will work.
Special Purpose Entities and Real Estate Holding Companies
In many cases, a real estate holding company, such as an LLC or S corporation will also be a special purpose entity (SPE). This generally means that it will only hold one asset, a piece of commercial real estate, and will typically not get financially involved with other assets or corporations. SPE status affords a real estate holding company an additional degree of financial and legal protection against creditors and other liabilities. In order to be classified as a single purpose entity, an SPE will need to state its purpose in its operating statement, as well as provide a series of operating covenants (or rules) which demonstrate how it will isolate itself from any other potentially affiliated entities. Common stipulations include:
The SPE will have a separate tax identification number (TIN)
The entity should have a separate bank account or accounts
The SPE cannot guarantee the obligations of other entities (such as using a property held by an SPE as collateral for a separate loan on a different property)
The entity cannot mix its assets with those of any other entity
In many cases, such as with CMBS loans, agency loans, and HUD multifamily loans, lenders actually require a borrowing entity to be set up as a special purpose entity. That way, if a borrower or a borrower’s business runs into financial difficulties or declares bankruptcy, their commercial real estate is less likely to be taken by a creditor.