At High Peaks Capital, we take pride in our ability to organize joint ventures for all types of commercial real estate deals. We work with deal sponsors and operators throughout the country to capitalize projects. Specifically, we connect these individuals with both institutional investors and family offices to capitalize deals with limited partner (LP) and/or general partner (GP) equity. 

While each joint venture is unique, our deals generally share the following characteristics:

Equity Contributions from $3 Million to $40 Million+

Our capital partners typically require a minimum of $3 million in contributed equity per deal. While many of our deals entail capital contributions in the $30 to $40 million range, we have no hard upper limit. 

Maximum 90% Contribution of Required Equity

For example, if a deal requires $30 million in total equity, our capital partners will contribute up to $27 million. Frequently, the deal sponsors we work with syndicate the remaining 10% of contributed capital.

Preferred Returns Combined with a Sponsor Promote Waterfall Structure

The details of each deal will dictate its unique equity waterfall structure. However, most deals involve a minimum required return for LPs combined with a promote system for the sponsor/GP. 

Flexible Hold Periods

Most of our joint ventures have hold periods from three to five years. However depending on the particular deal and projected returns, we will structure deals with longer hold periods. Bottom line, we have flexibility if the numbers make sense. 

LP or GP Equity Options

While most of our capital contributors join deals in an LP capacity, we can structure deals with GP contributions, as well. 

Ground-up Development and Value-add Deals

Our capital partners seek both ground-up development and acquisition/value-add deals.

National Market

Rather than limit our deals to a particular region, we raise equity for deals throughout the country. Our extensive network of partners provides us on-the-ground knowledge across the United States. 

Multiple Commercial Property Types

We have experience funding deals across the commercial real estate spectrum, from multifamily to office to industrial and everything in between. If the sponsor, asset, and strategy are all sound, we will help facilitate the deal. 

Want to learn more about our joint venture and capital services? Contact us to schedule a call now. 

Still have questions about joint ventures in real estate? In the rest of this article, we’ll provide an in-depth review of this deal structure. Specifically, we’ll cover the following topics: 

• Joint Venture Definition
• Advantages to Joint Ventures
• Potential Drawbacks
• Establishing a Real Estate Joint Venture
• Equity Waterfalls in Joint Ventures
• Final Thoughts

Joint Venture Definition

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. 

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. 

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. 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. 

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. However, 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 cost, 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. 

Advantages to Joint Ventures

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

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. 

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. 

Potential Drawbacks 

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. 

Establishing a Real Estate Joint Venture

Step 1: Find a Partner and/or a Deal

In a real estate joint venture, this first step can occur in either sequence. In some situations, multiple parties (e.g. a developer and a family office) may decide to establish a joint venture then seek a deal. Alternatively, one party could find a deal and then solicit other entities to form a joint venture. 

Step 2: Confirm Your Legal Structure and Operating Agreement  

After agreeing, in principle, to form a joint venture, the parties need to agree on the legal structure and operating agreement. As discussed above, most joint ventures operate as either corporations or LLCs, but other options exist. Next, the operating agreement serves as the legal document that outlines the functioning of the joint venture. While not an all-inclusive list, some of the more important elements of any operating agreement include:

• The members of the joint venture (basic info and equity percentages)

• Management structure 

• Member responsibilities

• Capital contribution requirements

• Distribution of cash

• Allocations of profits and losses

• Accounting policies and responsibilities

• Overall objectives of the joint venture 

Step 3: Complete the Deal

Lastly, the joint venture completes the deal – whatever that may be. Some real estate joint ventures plan on developing, building, and immediately selling a project. Alternatively, the goal of the venture may be holding and managing a property for an extended period of time. Regardless of the overall deal objective, it should be clearly outlined in the operating agreement. 

Equity Waterfalls in Joint Ventures

The concept of equity waterfalls confuses many new investors. While these cash distribution structures can become complicated, their underlying purpose proves quite simple. In the next few sections, we’ll provide an overview of equity waterfalls and how they relate to a joint venture. 

An Overview of Equity Waterfalls

Unfortunately, experienced commercial real estate investors have a way of overcomplicating industry concepts. And, equity waterfalls absolutely fall victim to this phenomenon. To novice investors, understanding these tools can seem like a daunting task. 

Quite simply, an equity waterfall outlines how a deal’s cash flows will be distributed to investors. That’s it. Yes, how you structure a particular deal’s waterfall can become quite complicated, as you can distribute cash flows in countless ways. But, at a basic level, these tools just explain to investors how they will receive cash flows from a deal. Accordingly, a well-structured waterfall will attract investors to a deal. Conversely, a poorly structured one can dissuade potential investors. 

IRR vs. Cash-on-Cash Return

Before diving into equity waterfalls, we need to outline two related concepts: internal rates of return (IRR) and cash-on-cash return. Both serve as metrics for analyzing a deal’s performance, and either can be used in building an equity waterfall. Consequently, if investors don’t understand these concepts, they will struggle to properly interpret a proposed waterfall design. 

Internal Rate of Return. IRR is the discount rate where the present value of all cash inflows equals the initial cash outflow (i.e. the initial investment). In other words, if you invest $1,000,000 in Year 0, it’s the discount rate where the sum of all future cash inflows – discounted to Year 0 – equals $1,000,000. The higher the IRR, the higher the return for investors. 

This metric has the advantage of assessing a deal’s total cash flows. But, it has the associated disadvantage of being a slightly more complicated metric for potential investors to grasp when analyzing a deal.  

Cash-on-Cash Return. Whereas IRR looks at total cash flows, cash-on-cash return looks solely at annual inflows. Continuing the above example, if an investor contributed $1,000,000 in Year 0 and received cash of $50,000 in Year 2, she would have a 5% Year 2 cash-on-cash return. The Year 3 return would ignore these results and focus only on Year 3 cash inflows relative to the initial investment. 

Cash-on-cash return has the advantage of simplicity. But, it also has the disadvantage of ignoring overall investment performance and exit cash flow upon selling a property. 

A Basic Equity Waterfall Scenario

We’ll use the next two sections to provide a basic example of how an equity waterfall could be built. As stated, a given deal may have a far more complicated structure. But, this example will demonstrate the foundational concepts of equity waterfalls in commercial real estate. 

Assume a commercial real estate developer approaches a family office with a joint venture investment opportunity. He wants to develop and operate an apartment building, and he will invest $2,500,000 of his own money in the project. But, with $40,000,000 in projected development costs and 75% loan-to-cost financing, he needs another $7,500,000 to meet the $10,000,000 equity requirement. Enter the family office as a potential investor.

In this particular deal, the developer will serve as the general partner (GP), develop the project, and operate the stabilized property. The family office will be a limited partner (LP), only investing money – not responsible for any development or operations tasks. Equity will be divided pro rata based on initial investments: 

• LP: $7,500,000 investment for 75% stake in the deal. 

• GP: $2,500,000 investment for 25% stake in the deal.

Using the Waterfall to Define Deal Returns

At this point, we have the basic equity structure of the deal. Now, we need to decide how the deal’s cash flows will be distributed to the GP and LP. That is, we need to build the equity waterfall. To reiterate, this example is just one way – not the only way – to structure a waterfall. 

Assume the LP and GP decide that IRR makes the most sense as a measure of deal performance. As a starting point, the GP will likely ask the family office what sort of IRR it would require for a deal of comparable risk and duration. Both parties decide 10% is reasonable. 10% now serves as the first tier of the deal’s waterfall:

• Tier 1: Until the deal’s cash flows reach a 10% IRR, the family office and developer will split cash flows based on contribution, that is, 75% to the LP and 25% to the GP. 

But, in developing and operating the property, the GP also does essentially all of the work on the deal. As a result, he requires an additional return above the LP’s return. In commercial real estate terms, this extra cut is referred to as a deal’s promoted interest, and it serves as the equity waterfall’s second tier: 

• Tier 2: Once cash flows exceed 10% IRR, the GP takes an extra 50% of the LP’s cash flows in addition to his original 25%. That is, for every dollar above the 10% IRR, the GP receives 62.5% (25% original split plus 50% times your 75% original split). The family office will receive the remaining 37.5% on every dollar received above the 10% IRR threshold.

In this example, the deal’s cash flows “waterfall” from the first tier to the second one. And, this multi-tiered system provides two related advantages. First, the promoted interest compensates the GP for the work he’ll put into developing and operating the project. Second, the additional tier further incentives the GP to efficiently and effectively manage the project, as he’ll receive amplified returns for increased performance.

Adding Layers to an Equity Waterfall

While we outlined a basic equity waterfall example above, many joint venture deals use a slightly more complicated, four-tier structure. However, it’s important to note that the below model simply builds upon the above foundation. 

• Tier 1, Return of Capital: This tier allocates cash flows based on equity stake until all contributed capital has been returned. In the above example, the first $10,000,000 in cash flows would be divided 25% to the GP and 75% to the family office as the LP until both parties recouped their initial investments. 

• Tier 2, Preferred Return: In this tier, the LP would receive all cash flows until meeting its required return on investment – 10% IRR using the above example. 

• Tier 3, Catch-up: Frequently, deals have what’s known as a catch-up provision. In this tier, all cash flows go to the GP until he reaches a certain return, frequently the above preferred return. 

• Tier 4, Carried Interest (aka “Promotes”): In this final tier, the GP receives his promoted interest, that is, a larger percentage of all remaining cash flows. From the above example, this is the tier in which the GP would receive 62.5% of every dollar of cash flow, and the LP would receive the remaining 37.5%.  

Final Thoughts

At High Peaks Capital, we’re committed to meeting your real estate joint venture needs. We have a proven track record of connecting deal sponsors with equity partners. Regardless of the deal’s unique nature, we will work with you to raise the necessary capital via a tailored joint venture structure. 

– Franklin D. Roosevelt