REAL ESTATE LAW
The Economics of Real Estate Joint Ventures
Capital accounts reflect and ultimately can drive joint venture economic outcomes.
Joint ventures are a common vehicle for providing equity funding for real estate projects. Every joint venture structure must address three economic concerns: (1) providing the partners with appropriate risk-adjusted returns if the deal is successful; (2) providing a mechanism for restructuring and salvaging the deal if things do not go as well as expected; and (3) ensuring that technical tax and accounting matters do not have an unintended and unanticipated effect on the parties’ negotiated business deal. This article examines the role that each of these three fundamental economic concerns plays in structuring real estate joint ventures.
Carving up the pie: Structuring the economics of a successful joint venture. The threshold issue for the joint venture partners is how they should carve up the economic pie if the project meets cash flow expectations. At a minimum, this would mean that the project generates sufficient cash flow to pay operating expenses and meet scheduled debt service payments so that the owners do not have to contribute additional capital to keep the project afloat. Because many joint ventures involve contributions of both capital and services, the fundamental question for capital and service providers is: What are appropriate risk-adjusted economic returns for their respective contributions to the project if it meets expectations?
The economic model for most joint ventures involves some combination of the following elements: (1) a return of capital, typically with some minimum threshold or preferred returns, to the capital providers; (2) in certain cases, some guaranteed payments to service providers depending on the nature of the project and the scope of the services provided; and (3) negotiated sharing of the remaining distributable amount among the joint venture partners based on the relative risks they bear and the value they add through their entrepreneurial efforts.
A few generalizations emerge in analyzing real estate joint venture economics. First, the greater the value of a partner’s relative economic contribution to the joint venture, whether of capital or services, the greater that partner’s overall returns should be. The more a partner has at stake financially—whether through a capital contribution, under a guarantee, or in terms of opportunity costs from foregoing other projects—the greater that partner’s returns should be. Second, the greater a partner’s overall risk in a project, the greater that partner’s overall returns should be if the project performs as expected. Third, the greater a partner’s contractually guaranteed returns, the lower that partner’s residual “at risk” profits interest should be.
Planning for trouble: Capital call provisions in joint venture agreements. Costs overrun, interest rates rise, tenants fail, and neighborhoods decline—all these factors, along with a host of others, can result in a troubled project. “Troubled” in this context most commonly means that the owners of the project must arrange for additional capital infusions because the joint venture’s cash expenditures outstrip its cash receipts. The question becomes whether (and to what extent) the joint venture partners want to plan for this trouble on the front end by providing in their joint venture agreement for a negotiated mechanism for “feeding” the joint venture with additional needed capital. The alternative is simply to deal with this problem when and if it ever arises.
If the partners do elect to include capital call provisions in their joint venture agreement, those provisions should address the following basic questions: What approvals are required to trigger the capital call? Are there any limitations on the amount of the capital call? What is the required form of the capital contribution by the partners? How is responsibility for meeting the capital call allocated among the partners? Finally, what are the consequences of a partner’s failure to meet a required capital call?
In preparing joint venture agreements, keep in mind that the riskier the project, the greater the potential need for additional capital in the future and the greater the need for the partners to consider including capital call provisions in their joint venture agreement. Always consider the likelihood that a particular partner may be able to retrade the joint venture deal to its advantage if a financial crisis requiring additional capital arises in the future but negotiated capital call provisions have not been included in the joint venture agreement. Also consider the degree to which the partners’ financial strength will allow them to meet future capital calls.
Making sure the tax and accounting tail doesn’t wag the business deal dog. Real estate joint ventures are typically structured as pass-through entities for federal income tax purposes. As such, they are subject to the arcane partnership tax rules relating to the establishment and maintenance of capital accounts and allocation of taxable income, gain, and loss. Code § 704(b) requires that allocations of income and loss to partners must have “substantial economic effect.” Section 704(a) provides that a partner’s distributive share of partnership income, gain, deductions, or credits is determined by the partnership agreement. Section 704(b) provides, however, that if the allocation set forth in the partnership agreement “does not have substantial economic effect,” then the partner’s share shall be determined “by the partner’s interest in the partnership.” The related Code § 704(b) regulations outline the circumstances under which allocations will be deemed to have “substantial economic effect” and include requirements for a safe harbor for allocation provisions.
Capital accounts reflect and ultimately can drive joint venture economic outcomes, and it is therefore important to have a basic understanding of how they work. Capital accounts are intended to reflect a partner’s capital in the joint venture. Therefore, capital accounts are increased by items that would increase partnership capital such as capital contributions and the partner’s share of net income. Likewise, capital accounts are reduced by items that reduce partnership capital, such as distributions to the partner of property and cash and the partner’s share of taxable loss.
The capital account rules help underscore the important difference between a partner’s share of partnership income (as an accounting and tax matter) and a partner’s share of distributed cash. Net income ultimately represents an increase in a firm’s net assets, and allocations of net income to a partner therefore increase the partner’s capital account. In contrast, cash withdrawals represent a decrease in partnership assets, and distributions of cash to a partner therefore decrease the partner’s capital account. More importantly, from a practical perspective, a partner generally pays tax on its share of net income but not necessarily on the partner’s share of distributed cash. A partnership may therefore have taxable income without having cash to distribute to the partners, and vice versa.
The complicated rules relating to the maintenance of capital accounts and the methods of allocating taxable income, gain, and loss ultimately have great practical significance because the final liquidating distributions in most real estate joint ventures will generally follow positive capital account balances. Not only is it intuitively obvious that the final distributions should reflect the partners’ respective capital positions at that time, but one element of the partnership tax safe harbor necessary for allocations to have substantial economic effect is that final liquidating distributions to the partners must be in accordance with their positive capital account balances. Therefore, when the joint venture’s assets are ultimately sold and the resulting cash is ready to be distributed, it is important that the partners’ capital account balances stand in a ratio that will force distributions that give effect to the partners’ original intent relating to their business deal.
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Richard R. Spore III is a member in the Memphis, Tennessee, office of Bass, Berry & Sims PLC. He may be reached at firstname.lastname@example.org.