A variety of options exist for organizing commercial real estate deals. Joint ventures represent one of the more common and flexible deal structures. But, as widely used as the joint venture model is, many investors lack a thorough grasp of how joint ventures work. As such, we’ll use this article to provide investors an understanding of joint ventures in real estate.
Specifically, we’ll cover the following topics:
- What is a Real Estate Joint Venture?
- Real Estate Joint Venture Structures
- Key Elements of a Real Estate Joint Venture Agreement
- Final Thoughts
What is a Real Estate Joint Venture?
The Deal vs. Capital Problem
In commercial real estate, developers and other real estate professionals often find great deals but lack the capital to make them happen. Conversely, many passive investors want a return on their investment but lack the time or expertise to find and execute a real estate deal.
Real Estate Joint Venture Overview
Real estate joint ventures solve both of the above problems. In this system, a developer (known as the operating member), finds, underwrites, and vets a commercial real estate deal. As part of that underwriting process, the operating member identifies the cash gap, that is, the difference between the cash required and the cash he plans on personally contributing.
With this cash gap and the deal’s projected returns identified, the operating member pitches the deal to potential investors (referred to as capital members). In a commonly-used joint venture model, the capital members receive a minimum required return – paid out prior to the operating member receiving a return on his equity investment. If the deal’s performance exceeds this minimum return, the operating member receives a disproportionate amount of that upside through his catch-up return and promoted interest distributions. This set-up A) protects the capital members, and B) incentivizes the operating member.
While joint ventures share many similarities to partnerships, one primary difference exists. In the joint venture model, the members retain their individual business identities. While joint venture members combine efforts in pursuit of a specific project (i.e. the joint venture), they continue to operate their individual businesses as separate entities.
Real Estate Joint Venture 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 (also referred to as a “joint venture 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.
Key Elements of a Real Estate Joint Venture Agreement
A joint venture agreement provides the legal basis for the venture’s operations. Agreed upon by the LLC members, at a minimum, the agreement should outline:
- Capital contributions required by all members
- How profits and losses will be distributed
- Management rights and decision-making authority within the LLC
- Exit and transfer rights pertaining to the sale or transfer of interests in the LLC
- Any other relevant rights, remedies and obligations granted to members of the LLC
Diving into a little more detail, we recommend that any effective joint venture agreement should, at a minimum, include the below nine elements. Conceptually, the agreement should address both how the LLC will operate when performing as planned and during poor operating performance. Addressing these potential negative situations before they occur helps avoid disagreements and, in a worst case scenario, costly legal fights in the future.
JV Element #1: Capital Contributions and Associated Failure-to-Fund Remedies
One of the primary objectives of a joint venture is to raise capital. As such, a joint venture must clearly state who contributes what amount of capital to the deal. In real estate, the operating member typically contributes 5% to 10% of the required capital, while the capital member contributes the remaining 90% to 95%.
However, due to the unknowns inherent to any real estate deal, a project may require additional capital down the line. A thorough joint venture agreement will not only include the initial capital contribution but also account for cost overruns and any other unexpected costs. Related, the agreement should address a member’s failure to fund these additional capital requirements. Frequently, when one member fails to fund a capital call, one of two options exist. First, the other member can provide a loan with priority repayment rights. Or second, the non-funding member can have his membership interest diluted (i.e. reduced) when the other member covers the entire capital call.
JV Element #2: Member Percentage Interests
Generally, membership interest in a joint venture relates directly to the members’ respective capital contributions. For instance, say a deal requires $10 million in contributed capital. If the operating member contributes $1 million and the capital member $9 million, the former would retain a 10% interest in the joint venture and the latter a 90% interest. Despite this frequently straightforward relationship between capital contributions and membership interests, the exact percentages still need to be clearly defined.
JV Element #3: Income Tax Responsibilities
As stated above, real estate joint ventures usually operate from a tax perspective as partnerships. Accordingly, no income tax exists at the joint venture level. Instead, the joint venture files a partnership tax return with the IRS, and the profit/loss from that return is passed through to the individual members via K-1s. In this environment, income tax responsibility doesn’t pertain to paying taxes. Rather, the joint venture agreement should clearly outline who is responsible for maintaining the accounting records, submitting a tax package to a CPA to complete the tax return, and distributing the K-1s to the joint venture members.
JV Element #4: Waterfall Distributions and Associated Hurdles
An equity waterfall outlines how a joint venture’s cash flows will be distributed to its members. 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, a waterfall just explains to members how they will receive cash flows from a deal.
In a common joint venture model, a waterfall will include multiple “hurdles,” that is, threshold rates of return (often measured by the deal’s IRR). For example, a common waterfall model includes the following hurdles:
- Hurdle 1, Return of Capital: This tier allocates cash flows based on equity stake until all contributed capital has been returned.
- Hurdle 2, Preferred Return: In this tier, the capital member would receive all cash flows until meeting an agreed-upon required return on investment.
- Hurdle 3, Catch-up: Frequently, deals have what’s known as a catch-up provision. In this tier, all cash flows go to the operating member until he reaches a certain return.
- Hurdle 4, Carried Interest (aka “Promotes”): In this final tier, the operating member receives his promoted interest, that is, a larger percentage of all remaining cash flows.
JV Element #5: Deal Fees
Due to the fact that operating members handle all of a joint venture’s operations, they charge certain fees related to these services. To avoid disagreements once these fees come due, a joint venture agreement should clearly outline the types of fees, how they’ll be calculated, and what will trigger their payment. Common fee types include:
- Development fees (for ground-up or redevelopment deals)
- Acquisition fees (for purchasing stabilized properties)
- Debt placement fees
- Property management fees (if not outsourced to a third party)
- Asset management fees
- Refinance fees
- Disposition (i.e. sale) fees
JV Element #6: Management and Control of the Venture
LLCs are state-level entities. As a result, a joint venture must ensure it complies with a given state’s rules and regulations dictating an LLC’s management. Within this state-level framework, a joint venture will typically employ one of the four following management models:
- Option 1: Manager- or member-managed joint venture with one manager
- Option 2: Manager- or member-managed joint venture with joint control
- Option 3: Manager- or member-managed with one manager subject to designated major decision rights
- Option 4: A joint venture board of managers
Often, the operating and capital members’ capital contributions to the joint venture will dictate a deal’s management structure. For instance, a capital member contributing 95% of a deal’s capital will likely want to have some sort of say in a joint venture’s major decisions, even if not responsible for day-to-day operations.
JV Element #7: Limitations on Transfers of Rights
When a capital member joins a deal, it does so relying on the expertise and daily responsibilities of the operating member. As a result, most joint venture agreements restrict an operating member’s abilities to transfer any of its rights or interests, as this change could materially alter the deal’s viability from the perspective of the capital member.
On the other hand, most capital members require more liquidity in a deal so have the ability – under certain circumstances – to transfer their interests in a joint venture. But, these transfers could also adversely affect the operating member, so the circumstances surrounding a capital member’s transfer interest must be clearly outlined in the joint venture agreement.
JV Element #8: Deadlock Scenarios and Exit Mechanisms
Deadlock refers to a situation when a joint venture’s members cannot agree on a major decision. To avoid an indefinite pause in a deal due to deadlock, the joint venture agreement should outline what steps should be taken in these scenarios. If a deadlock cannot be resolved, most agreements include exit mechanisms, that is, the means in which a member can leave the joint venture due to irreconcilable differences with the other member(s).
One such exit mechanism could be a buy/sell clause, which triggers a process where one member must buy the other out of its joint venture interest. Depending on the members’ preferences, a variety of exit options exist. The important takeaway, though, is that these options must be clearly defined in the joint venture agreement.
JV Element #9: Available Remedies to Default
Unfortunately, members can – and do – default on their obligations to a joint venture. Legally speaking, a default would make one member liable to the other, injured member for damages. From a practical perspective, this may not provide a reasonable solution, as the single-purpose LLC established to join the joint venture LLC likely has no assets besides its interest in that joint venture. Instead, other possible remedies include:
- Removal of the operating member from joint venture management and major decision responsibilities
- Reallocation of cash distributions to the injured member to offset damages
- Dilution of the defaulting member’s interest in the joint venture
- Termination of the operating member’s rights to previously agreed-upon fees (e.g. asset management fees, property management fees, etc) until the damages have been offset
Final Thoughts
A joint venture provides tremendous flexibility in pursuit of real estate deals. And, as an effective means of pooling capital, these structures allow members to execute deals collectively that they couldn’t individually. But, to avoid costly disagreements, a thorough joint venture agreement should, at a minimum, cover the above items. It’s far better to put in some up-front work hashing out these details than to face an otherwise avoidable disagreement during the deal.
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.