While on the journey to a successful real estate deal, the contractual aspects of the deal, such as the operating agreement and the management agreement, are often overlooked.
The operating agreement serves as an official contract that binds the partners to its terms. There are many reasons why an operating agreement is an important aspect of a successful deal:
- It provides a layer of protection for the partners of the business from personal liability to the partnership.
- It legally formalizes agreements between the partners and can prevent miscommunication as a result.
- It designates who serves as management, the terms for removal or change in management, and management’s duties and limitations.
- It can delineate management’s compensation, be it an asset management fee, acquisition fee, disposition fee, construction management fee, or other type of fee.
- It defines how the distribution waterfall is calculated and how the sponsor earns its carried interest.
- It protects your business from state default rules that typically govern partnerships in the absence of an executed operating agreement.
Operating agreements should be thoroughly reviewed by both general and limited partners to ensure that all parties agree to the terms and understand the deal and parties understand their legal rights and obligations.
Many real estate deals, especially those involving residential properties, hire property management companies to handle the day-to-day operations, including billing and rent collection, leasing space, resolving maintenance issues, hiring and paying vendors, hiring and managing building employees, and bookkeeping for the property, among other responsibilities. Sometimes, real estate-owning companies will establish their own property management companies to self-manage their properties.
While self-management could provide real estate professionals with a new profit center, an outside manager could be more cost effective than internal management. By outsourcing, the company can save on payroll and overhead costs needed to setup internal management operations. However, determining the cost effectiveness of outsourcing is directly tied to the management fee charged by the third party, which is stated on the related management agreement.
A management agreement is a contract that documents the obligations of the parties, various legal provisions, terms and conditions, and maybe most importantly, the management fee. When reviewing the management agreement of a servicer, it is important to consider the following:
- The method of calculation and fee percentage
- The scope of reimbursable expenses, such as payroll and related costs
- Each party’s responsibilities, deliverables, and obligations
- The termination conditions
- The reputation and history of the service provider
All the above should be considered when in the process of examining a management agreement and should be analyzed for appropriateness based on the type of property, expected revenue and net operating income, competitiveness of the management fee, and how these impact future cash flows of your deal.
As a general rule, it is important to involve your lawyer and accountant in the drafting of operating and management agreements. An operating agreement serves as the written understanding of each partner’s rights and obligations in the deal. It is important to involve your accountant in management agreement review process, as they shed light on your decision and provide analysis to help you protect your company while obtaining the best agreement for your deal.
Citrin Cooperman’s Real Estate Industry Practice’s professionals are here to help the next time you are reviewing an operating agreement or management agreement. With extensive experience in the industry, our professionals have the knowledge and tools to assist you on your journey to a successful deal.
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