Joint Venture Types in Commercial Real Estate
When real estate developers find promising deals, they often don’t have the capital necessary to execute. As a result, these developers turn to outside investors to raise the required funds, frequently through a structure known as a joint venture, or JV. Numerous variations on the JV structure exist, and we’ll use the rest of this article to discuss joint venture types in commercial real estate.
Specifically, we’ll cover the following topics:
- What is a Joint Venture?
- JV Types in the Commercial Real Estate World
- Joint Venture Pros and Cons
- Final Thoughts
What is a 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 entities 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.
JVs in Commercial Real Estate
With particularly large real estate deals (e.g. developing a 500-unit apartment building), individual firms generally lack A) the capital, and/or B) the expertise to single-handedly execute a deal. Instead, two or more entities form a joint venture to pool capital and skills in pursuit of a single deal.
With the JV structure, the members retain their separate business identities; they don’t merge into a new firm. For instance, say that a real estate development firm finds and underwrites the above apartment building deal. But, this developer lacks the funds to make the deal happen. As such, the firm approaches a private equity group to form a JV and join the deal. After agreeing on terms, the developer and the private equity group form a new entity to pursue the apartment project while still continuing to function as separate entities. That is, the developer and private equity group don’t dissolve; they form a JV in pursuit of a single deal while continuing their other business operations.
Common JV Structures in Commercial Real Estate
A tremendous amount of flexibility exists in structuring joint ventures. Depending on the deal, partners will tailor the JV terms to most effectively meet the partners’ individual investment criteria while accomplishing the goals of the venture (e.g. developing an apartment building).
Having said that, the most common real estate JV model involves two players: a deal sponsor (the developer or entity finding the acquisition) and the investors (the entities providing the bulk of the deal capital). The sponsor typically contributes 10-20% of the capital, with the investor contributing the other 80-90%.
Legally, this sponsor/investor model normally functions as limited partnerships (LPs) or limited liability companies (LLC). In the former, the sponsor acts as the general partner, and the investors act as limited partners. In an LLC, the sponsor serves as the managing member and the investors as investor members.
JVs and Tax Considerations
The IRS does not recognize joint ventures as a formal tax designation. Rather, businesses establishing joint ventures form a separate legal entity (e.g. corporation, LP, or LLC). This separate entity would then receive tax treatment in accordance with IRS guidelines. Normally, real estate joint ventures formed as LPs or LLCs are taxed as partnerships.
JV Types in the Commercial Real Estate World
As discussed above, most real estate joint ventures involve two parties. The deal sponsor finds, vets, and executes the deal. The capital partner contributes the bulk of the deal’s cash while having limited (or no) role in day-to-day operations. Developers and real estate investment firms generally serve as the sponsors. Far more diversity exists on the capital partner side of the JV. As such, the JV type is largely determined by the capital contributor.
While not an exhaustive list, the following types of entities often join JVs as capital contributors:
Private Equity (PE) Firms. These firms, as the name suggests, do not trade on public exchanges. Instead, they include finance and investment professionals focused on a particular industry who A) raise capital from other investors, and B) invest and manage that capital on behalf of their investors. Many PE firms focus on commercial real estate and join deals as the capital contributor in a JV structure. A portion of the returns on these joint ventures are then passed through to the PE investors, with the PE firm collecting a fee in that process.
Family Offices. Many ultra-high-net-worth families have in-house finance professionals who handle their investments via a “family office.” These offices rarely lead their own real estate deals, instead connecting with sponsors and establishing JVs for individual projects.
Pension Funds and Endowments. Traditionally, pension funds and endowments invested solely in stocks and bonds. Recently, though, many have diversified into alternative asset classes like real estate. These funds are managed by finance and investment professionals – not real estate developers. Accordingly, they typically invest in commercial real estate via JVs as the capital partners.
Sovereign wealth funds. Particularly large commercial real estate deals may even attract capital from state-owned investment funds known as sovereign wealth funds. Many of these overseas funds see the United States as both a source of financial stability and long-term growth, which makes joining a commercial real estate JV appealing.
Joint Venture Pros and Cons
JV Pros
Pool Capital. The primary advantage of a commercial 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.
Spread Capital Across Multiple Deals. Related to pooling capital, JVs also allow entities to spread capital. For example, say a private equity firm focused on investing in commercial real estate has $100,000,000 in assets under management. In theory, the firm could invest this sum in a single, non-JV deal. But, that would A) consolidate risk, and B) prevent leveraging that capital in other deals. On the other hand, forming JVs allows firms to contribute smaller sums to individual deals (as they’re not the only capital contributors), while leveraging their funds across multiple JV deals.
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. In addition to pooling upfront capital, these professional service providers may waive or reduce their fees in return for an equity stake in the JV.
Minimize Time Commitments. Many 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.
JV Cons
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 returns on a pro rata basis. 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
Commercial real estate joint ventures solve two problems. First, they allow developers and other deal sponsors to connect with sources of capital to make deals happen. Second, JVs allow various investors to generate strong returns, despite having limited experience executing real estate deals. And, for sponsors looking to form JVs, numerous types of capital partners exist, providing a wealth of potential investors.
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