This article is the first in a series exploring joint ventures in real estate transactions. A joint venture, generally speaking, is any combination of two or more parties for the purpose of pursuing a common investment or investments. In real estate, any particular such combination often involves, on the one hand, a developer or operator and, on the other hand, one or more sources of equity.
For purposes of our discussion, we are making two assumptions. First, the project for which the venture is created is a single development project (as opposed to a stabilized property or multiple projects). Second, we assume that the joint venture will include only two parties – a developer and an investor equity partner.
Finally, while tax considerations are beyond the scope of this series, note that the economics of a joint venture can be, and often are, informed by tax considerations. Any party entering a joint venture should consult its tax advisers to ensure that it will obtain the intended tax treatment.
Formation and Organization of the JV
While various choices are available for the form of a joint venture, a discussion of the variables that inform a choice of entity determination is beyond the scope of this article. A limited liability company (LLC) is the most prevalent form of entity chosen. LLC statutes provide the most flexibility among the different types of entity in terms of governance and equity structure. Participants in the joint venture – who become the “members” of the LLC – essentially can agree on whatever terms they see fit. In addition, each member in an LLC has limited liability. As opposed to a limited partnership, however, in which a general partner is liable for the debts of the limited partnership, the liability of every member in the LLC is limited to the amount of such member’s contributed capital.
Once the parties settle on the form of entity, they must negotiate and enter into a joint venture agreement. For an LLC, this would take the form of a limited liability company agreement (or “operating agreement”). In this article, we will refer to the agreement executed among the parties as the “JV Agreement.” The JV Agreement is the main document by which the parties memorialize their relationship.
Economic Features of the JV
Fundamentally, parties enter into a joint venture when there is a shared belief that, as between such parties, the whole is greater than the sum of the parts. The parties presumably believe that the potential returns are greater in the relationship than if each party proceeded alone. The parties’ interests at the outset of the relationship generally are aligned, but relative to the economics, will be competing. How or what a party contributes to the joint venture and how and when the parties receive their return, probably are the core issues for the two joint venture participants.
Contributions – Placing One’s Bets
At the outset of the joint venture, the parties will determine who is contributing what to the LLC. The developer wants to receive proper credit for what it has done prior to the venture. The investor wants to ensure that its capital is being deployed as intended, and that the project costs will be in line with the investor’s underwriting. Contributions can take several forms such as cash, real property or other assets.
Each party will have an initial required contribution. For the developer, this can include the real property for the project, if it is already owned,1 as well as any “pre-development” costs (such as the cost of obtaining entitlements or financing costs), and any costs and expenses such as legal fees that the developer has paid already but which benefit the joint venture. The investor’s initial capital contribution may include some amount to reimburse the developer for the investor’s pro rata share (based on the parties’ respective interests in the newly formed entity) of the pre-development costs, all or a portion of the purchase price of the real estate (whether or not already owned by the developer) and other closing costs.
The JV Agreement also should address when additional capital contributions will be required from either party. In our case, the developer typically will not have ongoing contribution obligations, except in specific circumstances (like cost overruns). The investor, on the other hand, likely will not fund all of its required capital contribution at closing. Most of the time, the JV Agreement will include a business plan approved by the members that, among other things, outlines the timing of the investor’s additional capital contributions. The investor will be required to make any additional contribution to the extent consistent with the business plan. Much like a construction loan from a senior lender, the investor’s additional capital would be contributed against presentation of invoices for materials or completed work, a calculation of remaining capital due, and/or an inspection of the work completed. The business plan should include other nondiscretionary items, such as taxes and insurance premiums, that must be paid during the course of construction even if the property is not yet stabilized.
What if additional capital is required for items not in the business plan? The investor’s liability for mandatory capital contributions is capped, and additional capital contributions will require investor consent. If cost overruns arise, the developer may be obligated to cover those out of its own pocket, or to pay a disproportionate amount of the same.2 The parties might negotiate specific circumstances where both parties cover their proportionate share of cost overruns, if the same occur through no fault of the parties, like a sharp increase in commodities pricing or property taxes. However, in most cases the investor will have significant negotiating leverage, and will require the developer to pay for the overruns (and may even require a guarantee of payment by a principal).
The JV Agreement should address a party’s failure to fund additional capital in accordance with its terms. First, the JV Agreement might permit the non-defaulting member to make a loan to the defaulting member and, if that loan remains unpaid at some later date, to convert that to an additional capital contribution. Conversely, the JV Agreement may provide that the non-defaulting member can make a loan to the LLC itself. In either case, such a loan typically would accrue interest at a very high rate (say, 20 percent) and receive a senior position in the distribution waterfall. A non-defaulting member may contribute additional capital to the LLC; in this case, the members’ pro rata interests in the LLC can be adjusted on an overall basis, or there might be so-called penalty dilution, in which case, the defaulting member’s percentage interest would be reduced on an accelerated basis relative to the parties’ overall contribution. Finally, a defaulting member may lose its voting rights in the LLC.
Distributions – Cashing In
While the provisions around capital contributions are extremely important, the parties’ real interest likely lies in the distribution provisions, which set forth the terms upon which the parties will receive returns on their investments. The mechanics of how the parties receive their distributions are commonly referred to as the “waterfall,” and the waterfall can be very simple or exceedingly complex. In its simplest form, the waterfall will be “pari passu,” meaning each party’s return ranks equally, and “pro rata,” meaning each dollar distributed will be split relative to the parties’ split of the membership interests in the LLC. However, in most joint ventures, the waterfall will include some or all of a preferred return, an internal rate of return (IRR) hurdle and/or a promote. The economic structure of the waterfall is subject to the parties’ negotiations, and the following examples are meant to be illustrative, but are not exhaustive.
First, note that JV Agreements typically differentiate between returns of net operating income and distributions of proceeds from a capital event, such as a sale or refinancing of the project. Net operating income, or NOI, is the amount of cash flow the project generates after paying property-level, and often entity-level, expenses, such as taxes, insurance, general operating expenses and debt service. A new development probably will not generate substantial NOI for quite some time. The JV Agreement may specify when NOI is returned – typically on a monthly or quarterly basis or as otherwise decided by management.
What the parties really care about, though, is the distribution upon a sale or refinancing of the project, as this is where the money is made. The investor partner may want to receive its invested capital, often with interest, before the developer receives anything. The interest component is commonly referred to as a preferred return. The preferred return will be priced to pay the investor for putting its capital at risk and current “market” terms generally range from 8 to 13 percent. In many cases, the waterfall would distribute net proceeds of a capital event, first, to the investor until the investor has received all of its contributed capital plus its preferred return. In some cases, the developer also receives a preferred return on its contributed capital, in which case the investor and developer would receive pro rata distributions until both parties have received their respective preferred returns.
The waterfall may include a threshold that members must receive on contributed capital before returning other amounts. This is commonly referred to as the “hurdle,” and most often the hurdle is based on the IRR on the contributed capital. The JV Agreement will specify how the IRR is to be calculated, for example, using the XIRR function on Microsoft Excel. In a waterfall with an IRR hurdle, the investor and developer will receive pro rata distributions until the investor has (or, sometimes, both members have) received distributions sufficient to generate an IRR of some stated percentage. A typical IRR hurdle is 15 percent but may be higher or lower depending on market conditions.
Once the IRR hurdle is met, the distributions typically toggle so that the developer begins receiving distributions that exceed its membership percentage. This is commonly referred to as the “promote” or “profits interest.” The developer receives a promote to recognize that the developer’s expertise and ability add value to a project. The promote also incentivizes the developer; once the promote is being paid, the developer will receive a percentage of the profits that exceeds its relative capital contribution. As an example of a promote provision, the JV Agreement might say that net cash proceeds from a capital event will be distributed to the members, in proportion to their respective interests, until the investor has (or both members have) received a targeted IRR; thereafter, the remaining proceeds will be distributed 40 percent to the developer and 60 percent to the investor (the particular split will be subject to the parties’ negotiation). A developer typically would forfeit its promote upon its default under the JV Agreement or removal as the manager of the project.
In addition to the foregoing, the waterfall may include other provisions. These provisions can be subject to negotiation but often bear correlation to other settled economic terms. For example, if the JV Agreement permits a non-defaulting member to make member loans or shortfall loans upon a party’s failure to fund additional capital contributions, those might be repaid first in the waterfall. In a promote structure, any promote paid to the developer may be subject to a clawback in the event that the investor’s actual IRR is less than the targeted amount stated in the JV Agreement (as a result of the timing of prior distributions).
Other Economic Terms
While distributions are the means by which the parties receive return on their capital investment, they are not the only way by which the parties can make money. In particular, the developer often receives a contractual payment for developing the project, or a developer’s fee. The developer might also receive a construction management fee, in exchange for managing the project; a financing fee in exchange for finding debt financing for the project; and/or a fee for providing any guarantees to debt providers for the project. All of these are negotiable by the parties at the outset and, while pertinent to the JV Agreement, often are documented separately – for example, in a development agreement between the joint venture and an affiliate of the developer member. Like the promote, the investor may require also that fees paid to a developer are subject to clawback in the event the investor does not receive its contracted-for return.
There are myriad ways in which the parties to a joint venture can address the economics of the parties’ relationship. How the parties “split the pie” entering into, during and at the end of the relationship can take many forms.