According to the Reserve Bank Data, credit approvals for construction over $2 million is as low as levels in 2002.* As everybody is aware, there is significantly less capital available to fund development projects, particularly in respect of higher risk profile developments.
Yet the market has shifted and responding accordingly. First, there has been an increase in foreign investors in the market filling the void left by domestic players. Secondly, there has been a significant increase in joint ventures and syndicates. Incidentally, a considerable number of joint ventures have emerged because foreign investors have recognised the value of local knowledge and have teamed with local developers.
When faced with an attractive investment opportunity but limited funding, teaming up with another party and combining resources and expertise has led to deals happening. In a more conservative post-GFC world, there is also a growing desire to "share the risk and the reward".
"Fund through" style joint ventures has also allowed investors to access high quality products in competitive markets (e.g. Sydney CBD Commercial Office).
However, like all things in life, benefits seldom come without complications. Legal documents relevant to a joint venture are usually complex, intensely negotiated and, almost always, there is unlikely to be a precedent that addresses the particular development project.
In this article, I summarise some of the common types of joint venture structures emerging in the current development landscape and the issues that need to be considered in a joint venture development.
Commercial compatibility, complimentary business culture and skills, shared vision and resolve, potential growth in relationships are all key relationship issues to consider in choosing a JV partner.
A successful joint venture, like all healthy relationships, will be centred around compatibility, trust and a shared vision and resolve.
Key issues to consider are:
- What is the vision of each party? What is each party seeking from the relationship? For instance, for one party it may be a final developed product and for the other, the development work pipeline – a perfect match!
- Can you grow the relationship with future developments?
- Are there cultural synergies?
- Can you leverage the relationship of the specific entities or divisions across the broader corporate group?
These are only some of many pertinent matters that potential joint venture suitors may need to consider during the "flirting stages" of their relationship.
I now turn to some of the more technical and legal issues that may need to be considered.
The two most common legal variations of a joint venture are the "incorporated" and the "unincorporated" joint venture.
Incorporated joint ventures
An incorporated joint venture usually exists in circumstances where the parties agree to set up a company or unit trust and channel the investment through that company or unit trust. The joint venture agreement in these circumstances is usually a "shareholders' agreement" or "unitholders' agreement".
An unincorporated joint venture is simply an agreement to co-operate without the use of any jointly owned or controlled corporate vehicle or trust.
Why do parties opt for one legal structure over another? Generally it does not have much to do with commercial imperatives. Usually the choice is driven by issues such as tax, partnership law and ease of transacting.
For example, where there are a number of parties who come together to purchase and develop a series of developments, it may be preferable to use an incorporated joint venture to simplify matters such as acquiring the property and dealings with third parties such as contractors and financiers (who will contract with the incorporated entity).
On the other hand, where the parties are a number of existing neighbouring land owners coming together for a single project, it may not be tax effective to transfer the land into an incorporated vehicle, and an unincorporated joint venture is usually the preferable way forward. In such a case, the parties may then appoint a nominee who will be given the power to bind the parties in order to simplify transacting with third parties.
Partnerships and its consequences
Tax, partnership law and ease of transacting are the main drivers for deciding whether to proceed with an incorporated or unincorporated JV structure.
One thing that all joint venture participants need to be aware of is that there is specific state based partnership legislation, which deems that a partnership exists where two or more parties conduct a venture with a purpose of sharing "profits". It does not matter how the parties seek to characterise their association – even if they expressly provide the joint venture documents that they are not partners – if they share profits then in all likelihood partnership law will apply to their association.
This has many consequences but the most profound is that the law will deem each party jointly and severally liable for all obligations incurred by any of the other parties, whether or not the incurring of those obligations is consistent with the provisions of the joint venture agreement.
There is an added complication, that the characterisation of the relationship as a partnership will have tax consequences including, potentially adverse income tax consequences. From a practical perspective, the parties will also need to reach agreement on how to treat GST, depreciation and the capitalisation of interest as it will not be possible that each can deal with these matters in isolation to other joint venture parties.
A joint venture may be deemed to be a "partnership" with implication on liability and unintended tax consequences.
There is any number of ways to commercially structure a joint venture and complexity increases with the number of parties involved.
The fundamental issue which impacts many of the matters addressed below is what will be the respective interests of the joint venture parties. In essence, what may be fair and reasonable for joint venture parties with 50% interest each may not be for a joint venture with a 10%/90% interest split. Similarly, what is acceptable or expected of a party will vary where there is more then two parties or where each of the parties has different expertise, experience or other contributions which they will "bring to the table".
Simple Development Agreements
Where a land owner teams up with a developer, with the developer receiving a fee for its development expertise, the joint venture may in fact be documented as a simple "development agreement". In such a case, the agreement will set out the obligations of the developer in procuring the development in return for its fee.
"Fund Through" and Sophisticated Development Arrangements
A joint venture may be a simple development agreement where a developer obtains a development fee in return for its expertise.
A more sophisticated structure where a developer/builder "packages" a development with an investor or what is known as a "Fund Through" may resemble the following:
- the investor, who is usually the ultimate owner of the property following the project, buys an interest in vacant land;
- on completion of the purchase, the investor enters into a development agreement with the developer to procure the development;
- the developer may then enter into a construction agreement with its own intra-group construction company; and
- the payment under the development agreement may be in the nature of "coupon payments" or otherwise arranged, such that the investor essentially funds the construction.
These arrangements have been an effective alternative to third party financing allowing a developer/builder to secure the necessary financing to get projects out of the ground. At the same time, they offer the investor/ultimate owner some development risk and return and potential stamp duty saving. In a competitive investor market with limited stock, it may also give the investor market access.
In the remainder of this article we will discuss a number of specific issues which arise as part of the process of documenting what we would describe as more a conventional joint venture, where the parties have decided to opt for an unincorporated joint venture.
How will decisions be made?
"Fund through" and sophisticated JVs may provide ultimate investor access to stock in competitive markets, higher returns and stamp duty savings.
The parties need to identify the matters which require unanimous decision making (unanimous matters may be referred to as Reserve Matters) and those that simply require a majority decision.
Looking at this in the context of joint venture with the single purpose of developing a property, typical Reserve Matters may include:
- increases to the maximum contributions of parties;
- incurring debt on behalf of the joint venture;
- substantial transactions involving the property (e.g. sale of the hotel or major pre commitment);
- the identity of the builder and main terms of the building contract;
- transactions ancillary to the development (e.g. acquiring adjoining land for the purpose of expanding the development); and
- winding up the enterprise.
JV parties need to consider which matters require unanimous resolutions and which a majority only.
Initial contributions and return
The contribution/return settings need to be properly aligned to reflect the desired behaviour of JV parties.
This is probably the most important issue and it often requires a great deal of time to determine the approach each party wishes to take on funding its participation in the joint venture. Ultimately, if the contribution/return settings are not aligned properly to reflect the desired behaviour of the joint venture parties, friction and dislocation will occur, despite the terms of any agreement.
For example when one party is contributing "in kind", such as, providing the land, the benefit of a development consent, and/or other intellectual property such as designs and consultants reports, a value will need to be attributable to these contributions for determining the respective contributions of the parties.
Similarly, the parties need to carefully consider what each party will receive when the development is complete. Where the project is a residential or commercial development with the sale of apartments or units, normally, agents commissions and GST will need to be paid first followed by repayment of project funding and then payment to participants in their respective portions.
The matter becomes complex if some parties prefer to retain a portion of the development (e.g. some lots in the development) rather than proceeds.
When the joint venture is incorporated, the choice in how the joint venture is funded is basically between equity and debt. Debt usually affords better protection for investors than equity (and secured debt is even better), though taking on debt from the joint venture parties may limit the joint venture's ability to borrow externally. Tax issues are also a relevant consideration as interest on debt is usually tax deductible however dividend payments on equity are not.
Whether any debt provided by a party is to be secured or unsecured is another significant point. If secured, consideration needs to be given to the security arrangements of any third party financier (either existing or proposed). The general rule is that the senior secured financier will generally be comfortable provided it is clear that it is first ranking in all respects and has sufficient control rights.
The parties will also need to consider how they will deal with practical issues that will emerge during the project life to ensure there is a careful balance between control and the flexibility needed to ensure timely completion of the development. The following issues may need to be considered:
- Responsibility for maintaining records and accounts of the joint venture;
- Signatories and execution of documents;
- Any specific obligations of the joint venture parties, i.e. conditions precedent such as the removal of existing encumbrances on land; and
- The scope of sub-delegating authority.
Securing third party finance
In dealing with "day to day matters", there needs to be a careful balance between control and sufficient flexibility needed to ensure timely completion of the development.
The intention of joint venture participants is usually to secure third party funding that covers the project costs as far as possible. Where possible, the facility sought should be limited recourse, limiting the parties' exposure to the joint venture assets.
In a residential or commercial development where units are to be sold or offices to be leased, typically, third party financiers are seeking a sufficient level of pre-commitment as a pre-condition to any drawdown and will carry out a thorough due diligence of the terms of any off-the-plan sale contracts, agreement for leases and construction contracts. In the later case, third party financiers will ordinarily seek to ensure as much of construction risk is passed on to builder as possible, so as to minimise their exposure in the event of foreclosure.
Failure of a party to contribute
Where possible, third party financing should be limited to recourse. Expect third party financiers to have certain levels of pre-commitments (depending on the market) and to pass as much development risk onto the builder.
Invariably there are times where significant capital may be required during the life of the development to fund the aspirations of a joint venture, particularly where third party finance will not cover all project costs.
It is important to consider early on what the consequences of a failure of a participant to make their contribution should be – in particular, because it is likely to lead very quickly to trigger defaults for non-payment under major project contracts, such as the building contract.
Common in joint venture agreements are mandatory notification processes to give a non-contributor a chance to rectify an administrative oversight, but after that, possible consequences include:
- an ability for other joint venture parties to fund instead of the defaulter, in return for equity enhancements (where the defaulter's interest will be diluted);
- an ability for other joint venture parties to cover the funding shortfall by making a loan to the joint venture, usually on preferential terms, and often combined with a suspension of some or all of the voting rights of the defaulting party; and/or
- rights for the non-defaulter to buy-out the defaulting party at a preferential price.
Ensure you have mechanisms in place to deal with the failure of a party to contribute capital when required to avoid triggering defaults in major project contracts.
The terms on which parties should be a key focus of negotiations on joint venture agreements. Where one party wishes to sell its interest, it will usually be required to first offer that interest to the remaining joint venture parties, usually on terms no less favourable than the exiting party would offer to any third party buyer.
Important issues on these pre-emption rights are:
- for the seller – the pre-emption process needs to be clear, especially in terms of when it is triggered, what the timetable is, and overall to ensure the process does not in practical terms hinder or frustrate the eventual sale of the relevant interest; and
- for the non-selling joint venture parties – to have the opportunity to acquire the selling party's interest for market value or better, and the ability to control or influence the identity of any incoming joint venture party.
In the event that one party holds project assets in its own name, such as the land, off-the-plan contracts and/or IP, the joint venture agreement should contain a mechanism for these assets to be novated to the party that retains the interest in the development.
All JVs should have carefully thought out exit mechanisms to deal with the JV relationship becoming sour.
In my experience, most disagreements or disputes are best dealt with by elevating the issue above those with day-to-day control of the matter and on to divisional or CEO level decision makers. If that does not produce an acceptable outcome, then the joint venture agreement will usually nominate a dispute resolution forum – usually expert determination or arbitration. Careful thought should be given to the choices here – including the forum, particularly with a view to costs, enforcement and the speed with which a determination can be effected.
Where there are only two joint venture parties with equal interests, the role of expert determination is best limited to determining technical or construction matters only or where the matter for determination is less than an agreed capped amount. This forces the parties to compromise to reach a practical solution on major issues without having that matter determined by a third party outsider.
Consider the choice of forum. Try elevating disagreements above those with day to day control of matters.
Valuation methodologies, and particularly the appointment of specific valuers, becomes significant in relation to buy-out rights in the joint venture agreement. Wherever there is a right to buy out another party's interest for market value (or an amount less than or greater than that number), typically that value will be determined either by the agreement of the parties or, where such an agreement cannot be reached, as determined by a third party valuer.
Any property developer will understand the importance of having input on the identity of the valuer appointed for this purpose, including the importance of the underlying assumptions of any valuation, and the leverage that may be obtained by being able to drive that appointment (and payment of fees). Applicable assumptions need to be carefully considered, and are often set out in a schedule in the joint venture agreement.
Summary and conclusion
Valuation methodology and the identity of the valuer are critical.
Limited access to financing, whilst challenging the real estate industry, presents an opportunity for industry players to work together to share risk reward through joint ventures.
Joint ventures are commercially and legally complex. Whilst a successful joint venture will be centred around compatibility, trust and a shared vision and resolve, almost every joint venture will experience challenging times, and it is critical to protect against downside risk.
Issues often arise in the course of joint ventures where the legal documentation in place does not provide a pre-agreed solution, usually to the detriment of one of the parties. A thoroughly considered and well drafted joint venture agreement is a surer step forward to all parties achieving their mutual and independent aspirations.