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John W. Hanley Jr. is a partner in the Seattle, Washington, office of Davis Wright Tremaine LLP.
The commercial real estate market enjoyed unprecedented expansion from the early 1990s until mid-2007. During those years, the market became more efficient, larger in scale, and more transparent, in part because information about properties and capital sources became much more available to potential buyers and sellers. Many classes of U.S. real estate assets became acceptable forms of investment for institutions and funds of all types. New sources of debt and equity liquidity, provided by a now-global capital market, drove record sales volumes and prices year after year. Near the market peak in mid-2007, commercial real estate assets were being purchased by new owners using a "capital stack" composed of (1) first mortgage debt underwritten at an 80%-90% loan-to-value ratio; (2) additional debt financing in the form of a higher risk, higher yield, "B piece" of the mortgage loan, a mezzanine loan, or subordinated second mortgage seller financing; and (3) a thin sliver of purchaser equity. Much of the debt financing provided for these purchases was underwritten based on projected cash flows from the property, rather than in-place, verified cash flows.
Today the commercial real estate market is different. Few commercial real estate loans are being made. The credit market for commercial real estate has been in near paralysis as the industry awaits an anticipated spike in commercial mortgage defaults in 2010 and 2011, the years in which many recent commercial mortgage loans will mature. The commercial real estate sector will go through a de-leveraging that is likely to be painful. Unable to refinance at current mortgage debt levels, owners will be forced to either sell their assets or restructure project ownership.
The current conditions in the credit and real estate markets, which may persist into 2011 and beyond, dictate that new first mortgage financing is based on a loan-to-value ratio of 60%-70%, and subordinate debt financing is very difficult to obtain. This situation creates a substantial "equity gap" of as much as 40% of the proposed purchase price for a commercial real estate asset. Only the rare investor with deep, deep pockets and a long-term horizon is willing to be the sole source of such a large equity investment in a single asset. The joint venture can be expected to be used more frequently as the preferred ownership vehicle, because owners will be forced to sell to joint venture entities that benefit from the combined equity of several joint venture owners or to restructure their ownership by the addition of new equity partners to refinance current first mortgages.
A real estate joint venture is a vehicle for co-investment in a real estate property or interest by two or more parties. Typically structured as a limited liability company (or, occasionally, a limited or general partnership), the real estate joint venture raises the equity capital needed to complete a purchase or investment. In the case of a development or redevelopment project, the joint venture may combine that capital with real estate industry services from providers that prefer to receive an ownership-like interest in the asset, on a tax-efficient basis, rather than fees for their nonmonetary contributions to the success of the development or redevelopment.
State laws governing formation and operation of limited liability companies and partnerships, especially the laws of Delaware, provide co-owners with great flexibility in creating a structure and setting terms and conditions to meet the goals and objectives of all the co-owners. See, e.g., Del. Code Ann. tit. 6, §§ 17-1101(c), 18-1101(b) (policies of Delaware Revised Uniform Limited Partnership Act and Delaware Limited Liability Company Act are to give maximum effect to the principle of freedom of contract). If the co-owners wish to have an investment vehicle that qualifies as a partnership for federal income tax purposes, and thereby avoid federal taxation of the venture's income and profits at the enterprise level, they can readily do so with only a small measure of complexity in their joint venture agreement.
The joint venture is often the preferred form of ownership structure for the purchase of a site and development of a new project or redevelopment of an existing property. The development company sponsor can use the joint venture to aggregate the required equity from other investors and to set the terms under which it will contribute to the enterprise its own expertise, contract rights, project entitlements, services, and, perhaps, a small amount of capital. A development joint venture agreement is typically more complex than the governing agreement for a joint venture whose sole purpose is to pool equity capital from similar investors and purchase a stabilized, income-producing commercial real estate property that will continue under third-party management. A greater number of all types of real estate joint ventures can be expected in the coming years, however, as current owners and prospective investors confront the reality of substantially restricted first mortgage financing and the prospect of compulsory de-leveraging throughout the commercial real estate market.
When credit markets finally thaw, the current owner or the prospective purchaser of commercial real estate may find that it has at least a few choices among capital sources to close part of the new equity gap. The choice may be among small and deeply subordinated second mortgage financing, expensive mezzanine debt financing, and additional equity raised in a joint venture from other like-minded investors. What are the advantages and disadvantages of using a joint venture to raise that extra measure of capital now needed to recapitalize or purchase commercial real estate?
Typically, the sponsor's principal advantage in using a real estate joint venture to raise additional capital is that it promises a lower cost of capital than other sources. The joint venture agreement can and must meet the risk and reward expectations of each new investor. Frequently, that agreement can be structured to give the investor a preferred call on project net cash flow to a certain target rate of return; a pari passu return (that is, a call on equal footing with the rights of all other investors in the venture) to a second, higher target rate of return; and beyond that, a return that is often reduced to allow the sponsor to receive an additional amount based on its promoted interest. The cost to the sponsor of capital raised in this manner is more bearable than the financial burden of a market-priced subordinated second mortgage loan or a mezzanine loan from a third party, because joint venture capital becomes expensive only if the project is financially successful and the venture can afford to make premium distributions.
Frequently, another advantage of the joint venture is that it will be more likely to satisfy the requirements and expectations of the first mortgage lender. First mortgage loan documents prohibit or severely restrict the property owner's use of subordinated mortgage financing and mezzanine loans, but mortgage lenders are more willing to accommodate arrangements by a joint venture borrower that raises its additional equity capital internally. The economic terms of the relationship between a project sponsor and a new capital source, embedded in their joint venture agreement, can be similar to those that would govern a mezzanine loan or subordinated second mortgage loan. The first mortgage lender, however, is often more accepting of a new funding relationship "inside" a joint venture than a hard money loan to the borrower from an "outside" source, for at least two reasons. First, if the project fails to perform as expected and the investor never receives its expected preferred return, the investor may have remedies under the joint venture agreement, but exercise of these remedies usually does not require a foreclosure or other public proceeding that highlights the asset's financial distress. The investor's recourse is usually removal of the sponsor from management of the joint venture, further subordination of the sponsor's economic interest, or a call for additional capital, potentially leading to dilution of the sponsor's interest. From the mortgage lender's perspective, however, there is no interruption of its relationship with the borrower entity, even though the internal governance or economics of the venture have been altered. Second, historically capital market requirements for securitization of first mortgage loans have imposed programmatic prohibitions or limits on the use of second mortgage loans and management loans. These requirements impose fewer limitations on changes in governance or economics within a first mortgage borrower that is a joint venture.
In addition, in the case of a purchase transaction, when confronted by capital constraints or a hesitant project site seller, the new real estate project sponsor may find that under current market conditions the most effective way to complete the acquisition and launch its project is to include the prospective seller in the enterprise. This can be done by including the landowner in a new joint venture.
The principal disadvantage of using a joint venture to raise additional capital is the complexity and associated expense of structuring and documenting a joint venture agreement that will give the new funding source a preferred return, as well as protections and remedies, approximating the position typical of a junior lender.
Federal tax and state laws give the founders of a commercial real estate joint venture enormous flexibility in setting terms and conditions that will satisfy the competing objectives of the co-owners. This flexibility permits the prospective owners to establish an economic relationship inside the investment vehicle that has mutually accepted rules of capitalization, operation, governance, and liquidation. Flexibility breeds complexity, and a joint venture agreement often establishes intricate arrangements for capital formation and profit sharing. These agreements also address difficult issues and esoteric concepts arising from state and local laws governing limited liability companies (or partnerships), fiduciary duties, agency, commercial relations, intangible interests, contract rights, and real and personal property.
A real estate joint venture is typically structured to qualify as a partnership under Subchapter K of the Internal Revenue Code for federal income tax purposes. It will be subject to dense and lengthy partnership tax rules governing the use of capital accounts and the allocation of taxable income, gain, and loss among the partners in the venture. Typically, the joint venture agreement includes several pages of highly technical provisions intended to meet the requirements of, and select alternatives permitted in, these tax rules. Such provisions are complex, abstract, and difficult to understand. The prospective partners in any joint venture should engage partnership tax lawyers or advisors to craft and explain these terms. Federal tax laws affect every real estate joint venture in one way or another, and it is essential to ensure that federal tax requirements allow the parties to implement the business deal that they have negotiated without unexpected and adverse tax results.
Typically the joint venture agreement takes the form of a limited liability company agreement or operating agreement, which complements the entity's certificate of formation or organization (the filed public document by which a limited liability company is created). It is beyond the scope of this article to address every topic and element to be negotiated, or at least considered, in the formation of a joint venture to acquire commercial real estate. The two subjects that are of the greatest importance in framing the real estate joint venture, subjects deserving the earliest possible consideration by the prospective investors, are the economics of the business organization and its management.
Prospective joint venturers are eager to discuss the finances and anticipated profits of the proposed relationship—often well before they bring legal advisors to the table. Indeed, working alone, the principals may hammer out a preliminary term sheet that identifies the target real estate to be owned by the proposed venture, the anticipated capital structure of the enterprise, the projected financial results to the partners, and little else. Of course, the definitive joint venture agreement must fully and accurately describe all of the economics of the proposed joint venture relationship. This subject permeates many terms in the well-crafted joint venture agreement, including at least the elements discussed below.
What are each investor's anticipated contributions to the capital or operations of the enterprise and when and how will each contribution be received and used? A contribution to capital may take the form of a transfer to the joint venture of cash or property. If the contribution is a transfer of property, secondary but important questions must be addressed. How will the property be valued for purposes of recognizing the transferor's investment in the venture? What are the legal requirements, formalities, and costs associated with transfer of the asset to the venture's balance sheet? Are there liabilities associated with the asset, and must the venture assume those liabilities? Does the asset have federal income tax attributes ("built-in" tax gain or loss, for example) that will carry over to the joint venture and be problematic?
A prospective venturer may be expected or required to contribute to the success of the joint venture in other ways. For example, a partner may be required to make its balance sheet strength available for the benefit of the joint venture by providing a limited or unlimited guaranty to the project's mortgage lender, or available to support the issuance of a letter of credit or other financial accommodation needed by the venture. How is the venturer that provides such credit support to be recognized or compensated for this financial support?
Finally, the sponsor of the joint venture may be planning to provide, or cause an affiliate to provide, services necessary to execute the business plan of the venture in exchange for an economic stake in the venture. These services might include real estate brokerage services related to acquisition of the real estate, consulting services to secure necessary development or construction permits and approvals, construction management services for new improvements or the redevelopment of existing improvements, mortgage brokerage services for the placement of the anticipated first mortgage debt for the project, or leasing brokerage services to obtain the tenants for the completed development or redevelopment project. How are such services to be described, measured, and rewarded? Thorny federal income tax issues relate to the receipt of an economic interest in a real estate joint venture in exchange for services. The draftsman of the joint venture agreement must proceed cautiously in these areas.
Once the parties have reached agreement on their respective planned contributions to the venture, they must establish the financial return that each contribution will earn if the venture is successful. This process requires the parties to reach a mutual understanding of the degree of risk of financial failure associated with their common enterprise—at each stage of acquisition, development (or redevelopment), and operation of the real estate asset. The redevelopment of an existing commercial property in a transitional neighborhood that will need both novel land use approvals and a new class of tenants to succeed will naturally bear a greater risk of failure than the routine purchase of a fully occupied and well-maintained apartment building in a community known for strong job growth and an attractive lifestyle. The sponsor must offer a greater financial return to attract equity to the more risky venture than to the safer, more established property.
Once they have agreed on the appropriate financial return for each equity investment in the joint venture, the partners must determine how those returns will be realized. They must set the formulas for periodic or special cash distributions to some or all of the joint venturers out of cash proceeds realized from operations or capital events (for example, refinancings, condemnations, casualty losses, partial sales, or a complete sale of the real estate). In establishing these formulas, the flexibility of the joint venture is an invitation for creativity—constrained only to some extent by the federal partnership tax laws. To meet their respective economic objectives, the prospective joint venturers can provide for different priorities and different formulas for determining distribution amounts to each partner under a variety of circumstances. Complex "waterfalls" of distribution levels can be devised. In this fashion, each significant equity investor can be given a priority right to certain kinds of distributions if necessary, until it has received (or made significant progress toward receiving) the projected risk-adjusted return on its investment.
Planning for the Unexpected
The prospective partners will also want to address the possibility that the venture will fail or stall. They should try to agree on procedures—and requirements—by which unexpected project difficulties will be confronted and (hopefully) overcome. Once launched, the venture may require more equity capital than was originally contemplated, and one of the venturers may be unable or unwilling to make further capital contributions. Will the joint venture agreement require all, or permit less than all, of the joint venturers to provide proportionate funding for unanticipated future capital needs? Will the contributing investors enjoy an added measure of preferred return on an additional investment made in these circumstances? Will a noncontributing venturer suffer an economic disadvantage or penalty if it is unable or unwilling to contribute to the capital shortfall? The parties can include a wide range of possible mechanisms by which the venture's future capital requirements can be satisfied.
The Ultimate Business Terms
By working through these topics, formally or informally, prospective joint venturers can establish the fundamental economic terms of their proposed co-owned venture. When fully developed, the financial terms will determine how each investor providing capital or services, or both, will be rewarded for its contributions if the venture is successful, and what the nature and potential extent of its financial losses will be if the venture fails. Of course, the exact formula for sharing the prospective profits and losses earned by the joint venture will depend on many circumstances, including property and market conditions, the availability of other capital sources to the sponsor, and the availability of other investment opportunities to the investor.
The other major subject that should be addressed, at least conceptually, before the partners embark on the details of a definitive joint venture agreement is the subject of governance. How will this co-owned real estate enterprise be managed?
This subject is addressed in depth in a companion article by Richard R. Spore III, which discusses several threshold choices that should be made by the founders of a real estate joint venture if they are to have a centralized management structure that gives them the best chance of economic success. See Management and Governance of Real Estate Joint Ventures: Avoiding Surprises and Resolving Conflict in Tough Times on page 33 of this issue. Just as they did in crafting their economic blueprint (capitalization and the sharing of economic gains and losses), so also do the prospective joint venturers have enormous flexibility in crafting a management structure that best meets their respective needs and concerns. No one approach to centralized management is required for all ventures, as illustrated by three points.
First, as noted by Mr. Spore, an initial threshold choice is usually whether the owners will co-manage the enterprise by means of a management committee or board of directors composed of representatives of all, or the primary, venturers; or whether, instead, they will concentrate management authority in a single designated manager, usually the sponsor or an affiliate, whose duties and authorities will be circumscribed in various ways. In the commercial real estate industry, the latter structure is more typical, but the management plan chosen for a particular venture will be determined largely by the facts and circumstances surrounding that particular opportunity. For example, in the case of a venture being formed by a sponsor to exploit a new construction or redevelopment opportunity, the management burden may be quite substantial until the project is finished and placed in service. The venture may need a nimble, decisive manager who can make many timely decisions and deal with the unexpected, as the venture passes through the high-risk phases of permitting, development, construction, and lease-up to a lower-risk phase. Certainly if the sponsor hopes to earn a large promotional interest for the successful development of the project, it will negotiate for a clear and broad delegation of management authority having few checks and balances. In all likelihood, the other principal funding source—the construction lender—will also prefer that kind of governance structure. By contrast, if a joint venture is being formed by several similar, experienced investors to co-own a stabilized multifamily asset being managed by a reputable property management company, they will probably gravitate to the use of a board of directors or management committee for governance. This is particularly true if no one investor will be asked to make a substantially larger investment than the others or to provide other unique financial support, such as a guaranty to the mortgage lender.
Second, Mr. Spore notes the two alternative or complementary means typically used to check the authority of a designated managing member, in order to protect minority interests in the venture: approval rights (sometimes called "veto rights") for various potential future decisions by the manager and the use of an approved annual budget to establish limits on spending authority and revenue-related decisions. Again, the extent to which prospective partners rely on each of these mechanisms will depend on a host of considerations unique to that particular venture opportunity. In a new construction or redevelopment venture, use of annual budgets may not be practical until after the project has been built and leased, although the investors will no doubt comb through the proposed development/construction budget, require approval of that budget before investments will be made, and tightly control subsequent changes to that budget. Much more typically, the prospective venturers will develop a list of approval rights tied very closely to the anticipated permitting, development, construction, and leasing process—for example, selection of the architect, selection of the general contractor, issuance of the notice to proceed, and material change orders. By contrast, a venture being formed to acquire a stabilized real estate asset with well-understood and measurable operating revenues and expenses (for example, a successful hotel or apartment building) may lend itself to use of a management structure heavily dependent on review and approval of annual operating budgets and other periodic financial measurements to confine management's authority.
Third, Mr. Spore describes the wide range of choices to be made concerning future removal of the initial managing member. Again, the circumstances surrounding each particular joint venture will guide the venturers to a set of accountability terms acceptable to both the manager and the other venturers. Most significant is the manager's own investment in the venture as an equity partner, if the manager makes a monetary investment. What are the potential sources of economic loss for the venture? Of these potential losses, which are appropriately attributable to bad management, in light of the scope of the manager's delegated authority, its professed expertise, and the rewards offered to the manager for successful avoidance of those losses? Which are more appropriately borne proportionately by all the members as an enterprise risk?
As Mr. Spore so ably demonstrates, careful and thorough advance planning is required to launch a joint venture with a governance structure that will enhance, rather than undermine, the chance for economic success.
In the new real estate and capital markets, there will be greater use of the real estate joint venture as a means of closing the "equity gap" created by substantially reduced mortgage lending. The real estate joint venture is a powerful and flexible tool to assemble equity capital, including land and other assets, and to attract the necessary real estate industry skills. Because of the great flexibility offered by this vehicle, the real estate joint venture is typically governed by a complex and dense joint venture agreement. Potential joint venturers should place their main focus on the economics and management of the enterprise to build the foundation needed for a successful real estate joint venture.