In addition to finding and underwriting deals, real estate developers spend a significant amount of their time raising capital for projects. Due to the size of most commercial real estate deals, developers rarely have the cash to cover all of a project’s equity requirements. Instead, many developers seek outside capital through a joint venture model, allowing for pooling of resources and expertise. As such, we’ll use this article to outline how joint venture equity for multifamily deals work.
Specifically, we’ll cover the following topics:
- What is a Joint Venture?
- Joint Venture Equity for Multifamily Deal Example
- Final Thoughts
What is a Joint Venture?
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. These shared resources often include capital, technical expertise, and contributed services (aka “sweat equity”).
Depending on the joint venture’s operating agreement, the separate parties would likely contribute an agreed-upon amount of capital and commit to deal-specific roles and responsibilities. Similarly, this agreement would dictate the allocation of profits and losses from the joint venture.
With particularly large real estate deals (e.g. an apartment building), single firms generally lack A) the capital, and 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.
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. corporation or LLC). This separate entity would then receive tax treatment in accordance with IRS guidelines. Normally, joint ventures are taxed as either partnerships or corporations.
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.
Leverage Someone Else’s Experience. 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.
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.
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.
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.
Reduced 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.
Joint Venture Equity for Multifamily Deal Example
Assume that a real estate development firm has a plan for a new multifamily project, Towers on Broad. In underwriting the deal, the developer determines the below numbers:
|Hard Costs (110 Units x $150,000/Unit)||$16,500,000.00|
|Soft Costs (Estimated at 10% of Hard Costs)||$1,650,000.00|
|Total Costs Minus Interest||$19,150,000.00|
|Construction Loan Loan-to-Cost Ratio||75%|
|Estimated Construction Period Interest||$359,062.50|
|Total Cash Required:||$5,146,562.50|
The deal requires over $5 million in contributed cash, but the developer only has $1.5 million available. To bridge this cash gap, the developer approaches a construction firm and a private equity group and proposes a joint venture.
All three parties agree to form Towers on Broad, LLC as a joint venture. The developer structures and oversees the project while contributing $1.5 million, the construction firm serves as the general contractor and contributes an additional $1.5 million, and the private equity firm provides the remaining capital.
In this particular deal, the three entities decide to allocate equity, profits, and losses pro rata based on cash contributed, creating a roughly 30/30/40 split, with the private equity group having the larger share. Of note, it’s also not uncommon to see situations where the general contractor provides its services at cost, receiving an additional equity stake based on cash saved.
As a joint venture, all three of these entities 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 – Towers on Broad, LLC.
Successful multifamily real estate deals typically require a significant amount of cash and expertise. When a developer or deal sponsor lacks the resources to single-handedly execute a deal, joint ventures offer a potential solution.
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