Investing in commercial real estate can seem daunting. Between the capital requirements, the industry-specific jargon, and the sheer scale, the barriers to entry often appear insurmountable. Fortunately, joint ventures allow you to pool capital, time, and experience to invest in commercial deals. As such, we’ll use this article to answer the question, what does a real estate joint venture look like?
Specifically, we’ll cover the following topics:
- Joint Venture Definition
- Advantages to Joint Ventures
- Potential Drawbacks
- Establishing a Real Estate Joint Venture
- Final Thoughts
Joint Venture Definition
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
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.
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.
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 construction company) 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.
We’ve only provided a basic overview of joint ventures in this article. But, 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 joint venture opportunities.