Most real estate investors begin on their own. However, due to financial, experience, and time limitations, many investors look to join forces, especially in the commercial real estate world. While several structures exist to combine your real estate efforts, joint ventures provide some of the most flexibility, making them an extremely popular option. As such, we’ll use this article as a guide to real estate joint ventures.
Specifically, we’ll cover the following topics:
- What is a Real Estate Joint Venture?
- Common Joint Venture Legal Structures
- Real Estate Joint Venture Pros and Cons
- Final Thoughts on Joint Ventures in Real Estate
What is a Real Estate Joint Venture?
Joint Venture Overview
Many business opportunities require more resources than a single firm can provide. Joint ventures provide a solution. With a joint venture, two or more businesses pool their resources to pursue a single project while still retaining their separate business identities.
For example, say an established manufacturing company wants to expand into an overseas market but lacks access to a local distribution network. In this new market, a logistics company has an established distribution network but wants to expand its operations. The two firms could form a new business as a joint venture, separate from the firms themselves. With this structure, both entities work together – under the joint venture – towards the common goal of manufacturing and distributing goods in this new market. The manufacturing firm would provide the manufacturing expertise and plant management, and the logistics firm would provide the local distribution support.
Depending on the joint venture’s operating agreement, the two parties would both likely contribute an agreed-upon amount of capital. Similarly, this agreement would dictate the allocation of profits and losses from the joint venture.
Real Estate Joint Ventures
A real estate joint venture operates in much the same fashion as the above manufacturing/distribution example. Especially with particularly large real estate deals, single firms lack A) the capital, or B) the expertise to single-handedly execute a deal. Instead, two or more firms form a joint venture to pool capital and skills in pursuit of a single deal.
For instance, say a real estate development firm has a plan for a new mixed-use community, Lifestyle at Midtown. In underwriting the deal, the developer realizes it lacks the necessary funds. Rather than over-leverage, the developer approaches a construction firm and a private equity group and offers to form a joint venture.
All three parties agree to form Lifestyle at Midtown, LLC as a joint venture. The developer structures and oversees the project, the construction firm contributes its services at a reduced fee, and the private equity firm provides the necessary capital. All three entities have an equity stake in the joint venture and share in its profits and losses.
As a joint venture, all three of these entities would retain their individual businesses. That is, they are not merging operations. Rather, they are pooling resources in pursuit of a single project, to be executed under the auspices of a joint venture – Lifestyle at Midtown, LLC.
Common Joint Venture Legal Structures
IRS Treatment of Joint Ventures
Of note, the IRS does not recognize joint ventures as a formal tax designation. Rather, businesses forming joint ventures typically form a separate legal entity (e.g. LLC or corporation). This separate entity would then receive tax treatment in accordance with IRS guidelines. Normally, joint ventures are taxed as either partnerships or corporations.
Limited Liability Companies (LLCs)
Most real estate joint ventures are established as LLCs. This organizational structure provides four key benefits. First, LLCs are extremely flexible. As long as the LLC members craft a thorough operating agreement, an LLC can be structured to fit the needs of the joint venture. Second, LLCs have very limited administrative requirements, making them easy to start and renew on an annual basis. Third, as the name suggests, LLCs limit the liability of the individual members to assets held within the LLC (barring gross negligence). Lastly, as pass-through entities, LLCs are not taxed twice. That is, the income/loss from the LLC is passed through to the individual members’ tax returns, where it is taxed once.
Though real estate joint ventures can take the form of corporations, they rarely do. While providing similar liability protection as an LLC, corporations have a far higher start-up and annual administrative burden. Furthermore, corporate shareholders are taxed twice. A corporate income tax is applied at the corporate level, and any shareholder distributions are taxed at the individual level.
Real Estate Joint Venture Pros and Cons
Pro #1: Pool Capital
The primary advantage of a real estate joint venture is the ability to pool capital. Costs for large-scale commercial deals can total in the tens to hundreds of millions. Most individual investors will struggle to come up with the cash requirements for these sorts of deals. With a joint venture, though, multiple firms can pool their resources to meet the cash requirements for a particular deal.
Pro #2: Leverage Someone Else’s Experience
Related to pooling capital, joint ventures allow you to leverage someone else’s experience. In commercial real estate, very few firms specialize in all aspects of a deal. With a joint venture, a developer can partner with design firms, private equity groups, construction companies, etc. to take advantage of their respective specialties and experience in pursuit of a common project.
Pro #3: Minimize Time Commitments
Many developers and investors don’t want to handle the day-to-day operations of a project – either in the construction or stabilized phase. By forming a joint venture, a development entity could structure a deal while allowing a construction company to handle the daily management of the construction portion. Similarly, a real estate company with a property management arm could enter a joint venture to take responsibility for the management of the stabilized property. This approach allows entities to optimize their time by focusing efforts where they can add the most value.
Pro #4: Promotes
Even developers who can contribute the full equity amount for their projects, often don’t want to. Promotes are the reason. In a typical Joint Venture a developer might contribute 10% of the required equity while the joint venture partner contributes the remaining 90%. If a project goes well then promotes and waterfalls outlined in the joint venture agreement can allow for a developer to receive 50% of the cash flow after certain returns are met. The outsized returns (getting 50% of cash flow in return for only contributing 10% of expenses is why many of the largest developers in the country still bring on equity partners for their deals.
Con #1: Diminished Deal Control
Joint ventures inherently reduce your control in a deal. If you enter a deal as the only equity member, you have 100 percent control. But, when you form a joint venture, you cede a portion of that control to each additional member of the venture.
Con #2: Potential for Conflict
A poorly structured operating agreement can create significant conflict in a real estate joint venture. If each member of the venture doesn’t clearly understand its rights and responsibilities, disagreements will likely occur. Consequently, a well-crafted operating agreement is a must in any joint venture – far better to address potential sources of conflict before a deal than during it.
Con #3: Share the returns
When you form a joint venture, you reduce your pro rata returns. That is, you won’t receive all of a deal’s return on equity, as you won’t contribute all of the capital. However, by pooling capital, a joint venture can also provide access to far larger deals than you could potentially close solo. In this fashion, you may forfeit a pro rata share of a deal but reap greater total returns due to deal size and economies of scale.
Final Thoughts on Joint Ventures in Real Estate
Joint ventures offer tremendous flexibility in deal structure. If multiple entities want to combine forces in pursuit of a single real estate deal, they can organize a joint venture to meet their unique objectives. Especially in larger commercial deals, joint ventures allow investors to pool capital, expertise, and time, making deals happen that one member couldn’t do on its own.
If interested in forming a joint venture, a variety of strategies exist for finding other deal partners. Networking at local real estate investment group events, introducing yourself to general contractors in your area, and asking your CPA about any high-networth individuals interested in deals are just a few of the strategies for building a joint venture team.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities.