05 May Provisions That Should Be Included in Operating Agreements for Rental Property LLCs

During the last two weeks, Edwards Law has been focusing on limited liability companies—why you want them, how you form them, how to make your LLC bullet proof; and how to protect them when a member of your LLC files for bankruptcy.  This week’s focus is the real estate LLC, and some of the provisions you should include in operating agreements for rental property LLCs.

Real Estate LLCs

The limited liability company or “LLC” has become a popular vehicle for real estate investment and development.  The principal advantages of forming an LLC, as opposed to a different form of business entity, include:

•the flexibility to describe the entire relationship of the parties by contract, without being governed by a mandatory statutory scheme;

•the benefit of the same limited liability as is available to a corporation’s stockholders; and

•for US tax purposes, the opportunity to be treated as a partnership or pass-through entity, which avoids taxation at the entity level and passes the company’s profits and losses through to the members.

What Provisions Should Be Included in Operating Agreements for Rental Property LLCs?

Along with the typical provisions included in any standard operating agreement, you and your LLC should consider including the following provisions in operating agreements for rental property LLC:

Purpose of the Company

Under the Act, an LLC can be formed for any lawful purpose, and the business of the company can be defined as broadly or narrowly as the members want or need.  However, in most real estate ventures, the purpose is usually defined narrowly because the members are generally forming the company for a specific purpose and to own a specific property.

A narrow definition of the LLC’s business can protect the LLC from any actions taken on behalf of the LLC by the managing member or a manager that is not related to the stated purpose of the company, because such actions would not be authorized under the LLC agreement, and thus the LLC is not then liable for those actions.

Also, limiting the purpose clause to creating and maintaining the real estate venture as “a single purpose entity” or “SPE” could protect and benefit the LLC in the following circumstances:

• Liability and bankruptcy protection. Because an SPE is formed for the sole purpose of owning and operating a single property (or a group of real properties), it typically cannot incur liabilities unrelated to that property.  This prevents creditors of other properties or businesses from attacking the assets of the SPE for debts unrelated to the property, so long as certain operational formalities have been complied with.
• Financing requirements. Most lenders require that the borrower be an SPE and meet the lender’s SPE requirements. To comply with the lender’s requirements, the borrower’s LLC agreement usually must include SPE provisions. These provisions can be included in the original LLC agreement or an amendment to the LLC agreement.

A good example of a purpose provision is as follows:

Purpose of the Company. The Company shall engage solely in the business of, directly or indirectly, through one or more entities (a) purchasing, owning, financing, refinancing, rehabilitating, operating, leasing, managing, holding for investment, exchanging, selling and disposing of [PROPERTY] located at [PROPERTY ADDRESS] (the “Project”); (b) acquiring, owning, holding for investment and disposing of ownership interests in entities that directly or indirectly own the Project; and (c) such other activities as are related to or incidental to the foregoing.

Management

Another important consideration for operating agreements for rental property LLCs is the management structure and allocation of control among the members of the venture.  A benefit of using an LLC as the venture entity for real estate is the flexibility it affords in structuring the management of the venture.  Management can take many forms, depending on the structure of the venture; the experience of the members; and the negotiating leverage of the parties.

The typical LLC for a real estate venture is managed by a managing member. In this structure, one member, which has real estate expertise, handles general daily management of the venture, and specified major decisions require the approval of all or a specified percentage interest of all the real estate venture members.

Your LLC could also appoint a non-member as manager. This may be used when none of the members have sufficient real estate expertise to manage the real estate venture and the members wish to engage a manager experienced in the operation of real estate; or there are a large number of members.  Although management by non-member managers is permitted, it is not often seen in real estate ventures.  It is more common for an experienced real estate operator or developer to act as the managing member of the venture.  If there is no member with real estate expertise, the venture often separately contracts with an experienced property or asset manager to manage the property for a fee or nominal interest in the LLC.

Restrictions on Authority of Managing Member Concerning Major Decisions

The major decisions involved in managing real estate LLCs should be expressly set out in operating agreements for rental property LLCs.  Major decisions often require unanimous approval, unless a super majority percentage threshold for major decisions is preferred so that one or a few minority owners cannot force a deadlock (which can lead to a disruption of the business and loss of value in the real estate project).

A few of the major decisions requiring member approval in a real estate joint venture are: (i)  the sale or exchange of all or substantially all of the assets of the Company (including the Project or any portion thereof); (ii) the acquisition, by purchase, exchange, lease or otherwise, of any real or personal property by the Company (other than acquisition of the Project); (iii) the entering into or modification of any lease for the Project (except in the ordinary course of business); (iv) the borrowing of any money by the Company or the granting of any lien, claim, encumbrance or security interest by the Company with respect to any asset of the Company, as security for the debts and obligations of the Company or otherwise or the modification, extension, renewal or prepayment in whole or in part of any borrowing; and (v) entering into material service or construction contracts, including property management and leasing management agreements.

Right of Partition

Partition is an equitable remedy that can be voluntary or involuntary (compulsory).  If co-owners of real or personal property cannot agree on the use, disposition, or other material matter affecting a property, an owner can apply to a court for partition to divide title to the property or compel a sale of the property.  Thus it is common to include in operating agreements for rental property LLCs a provision requiring members to waive their right to partition as a remedy in the operating agreements.  However the LLC operating agreement should provide appropriate remedies or exit strategies for potential deadlock situations, avoiding the need for any court-ordered partition.

A good example for such a provision is as follows:

The interest of each Member in the Company shall be personal property for all purposes.    No Member shall have any right to partition the Property or any assets of the Company and each Member hereby irrevocably waives any and all right to partition, or to maintain any action for partition, or to compel any sale with respect to its interest in any assets or properties of the Company except as expressly provided in this Agreement.

Protecting your real estate LLC via the operating agreement is critical.  Call Edwards Law today to get advice on the drafting process.