Real Property Law

Taking the Plunge: Key Considerations for Joint Ventures with Developers

In this article, Andrea Saunders Rifenbark and Elizabeth A. Willes provide an overview of some of the matters investors should carefully consider before entering into a joint venture with a developer.

Andrea Saunders Rifenbark and Elizabeth A. Willes
Key Considerations for Joint Ventures with Developers

Key Considerations for Joint Ventures with Developers

Joint ventures between institutional investors and developers often present great opportunities for higher returns than stabilized properties.  However,  like all relationships, there are pitfalls and challenges of which to be wary and it is best to start the relationship built on a stable foundation of communication and trust, as well as an equitable spread of risk and reward.

The following is an overview of some of the matters investors should carefully consider before entering into a joint venture with a developer.

Choose the Structure

Unless there are particular tax concerns, the majority of joint ventures are structured as limited liability companies or limited partnerships. Limited liability companies are the simplest to form and provide the benefits of limited liability to its members while also offering flexible management and operation rights. Besides determining the best investment vehicle for a venture,  an additional threshold  matter to be decided is whether it will be a platform venture focusing on the acquisition and development of specified property types located in certain target markets or a venture for the development of an identified project or portfolio of related properties.

Determine Timing of Initial Investments and Contributions of Properties

It is not uncommon for a developer to acquire raw land or enter into a purchase agreement to acquire the land, and then attempt to bring in an investor to provide the capital necessary to complete the acquisition process and/or development of the property. As part of the discussion regarding the structure, the developer may suggest that it contribute a certain property or related group of properties as the initial investment(s) of the venture, which will impact the allocation of costs, risks and liabilities among the members upon the origination of the venture. For example, the developer may request  reimbursement and/or upfront payments from the investor to cover its due diligence expenses,  initial lender fees and other pre-development expenses. If the developer member has already entered into a purchase agreement, the investor must evaluate the risks of relying on the due diligence conducted by the developer during a time in which it was not subject to any standard of care set forth in the venture agreement.

If the developer already owns the property and desires to contribute the  property and/or its membership interest in the existing entity that owns the property, the investor should obtain certain assurances in the form of indemnities and representations and warranties to mitigate the risks associated with occurrences at the property and actions taken by the developer and the owning entity prior to the closing of the contribution. An investment into an existing entity adds another layer of complexity to the transactions since the investor will want entity-level as well as property-level representations and warranties, addressing matters such as pending litigation, financial status, tax payments, and other liabilities of the entity, so as to protect the investor from inheriting these pre-closing liabilities without any ability to allocate the responsibility to another party. Preferably, the entity-level representations and warranties and indemnities will have a sufficient survival period to mirror the long-term liability of acquiring an ownership interest and all  assets and obligations associated with the entity. The parties should also discuss how the property will be valued for purposes of determining the initial actual or deemed capital contributions of the members as well as any tax consequences associated with the contribution of property to the venture.

Address Cost Overruns

One of the most negotiated provisions in a venture agreement pertains to allocating responsibilities for costs that exceed the approved budget, commonly referred to as cost overruns. On the one hand, the developer does not want to be responsible for cost overruns outside of its control, and on the other hand, the investor does want to be obligated to fund more capital than what it allocated to the  project (and  may not be able to do so without receiving investment committee approval for an increase).

The investor will want any cost overrun incurred by the venture due to the developer’s failure to comply with the applicable standard of care to be paid 100% by the developer. Developers often push back on this, advocating for the venture to pay any cost overruns that were not due to the developer’s own gross negligence, willful misconduct  or other bad acts. However, this puts the venture at risk for cost overruns caused by mismanagement (i.e., simple negligence by the developer) and could result  in the investor funding much more than originally planned in order to have the project completed.

Another good position for the investor is when the developer takes responsibility for 100% of the cost overruns up to a fixed dollar amount, so that the initial cost overruns to be funded in excess of the budget are borne by the developer. This  approach incentivizes the developer to not exceed the budget since it alone must fund such initial cost overruns. Cost overruns due to force majeure are usually  excluded,  with the venture being responsible  for costs overruns  incurred  due to unforeseen  weather delays, labor strikes, etc. (although what is considered force majeure is also heavily negotiated).

Since it is such a hotly contested issue, and a sensitive one for developers who often have more limited access to additional funds, the cost overrun issue should be addressed at the term sheet stage.

Establish Investor Approval Requirements

Another issue to address early on is the approval rights, or “major decisions,” over which the investor can exercise discretion or control. Major decisions inevitably become more detailed with development projects.  There  will  be a push-pull  between a developer who is concerned about satisfying a completion guaranty to a lender and therefore wants the flexibility to take action with limited oversight, and an investor with 90% or more of the equity in the project who wants to be involved in decisions regarding how the project is built. There will also be a desire by the developer for as much

latitude as possible to incur costs, adjust the budget and schedule, and otherwise deal with contractors in order to complete the project in a timely manner.

Consider Default Remedies

In development ventures, investors and developers spend considerable time discussing and negotiating the ability of the investor to remove the developer as manager of the venture if the manager is in material default under the  venture  agreement  or fails to meet certain performance standards, in order to protect the investor’s investment.

However, investors should consider that  removal  of a developer mid-stream might  not be beneficial. Investor  will have  to provide substitute  guarantees  to a construction lender, and may not have the capability or the capacity to deal with contractors, lenders, etc. in order to complete the project.  Investors  should  consider penalties  for default other than removal (such as the right to offset losses against distributions and dilution of the developer’s interest in the venture), or otherwise establish relationship  with developers who might be willing to take over a project for a fee.

Limit Sale Rights

Most developers earn a “promote,” or carried interest, as compensation for a successful development after all investor capital and a return thereon  have  been paid to the investor. Therefore, most developers will look to liquidate a development  project as soon as possible after stabilization in order to earn that promote. For investors with a long-term hold strategy, selling the project after stabilization may not be desirable.

Therefore the investor should consider whether  to allow the developer to put its interest to the investor, force a sale to a third party subject to an investor  right of first offer, or stay in the deal with the promote being “crystalized” and paid by the investor to the developer in cash (and the developer otherwise leaves its capital in the project until sale).

Monitor Affiliated Transactions

Developers often have affiliated companies that perform specific services such as construction management, development management and property management, and the joint venture agreement should accurately reflect the expectation of the parties with respect to the developer’s ability to enter into contracts  with its affiliates to perform these services. Since developers often receive acquisition fees, asset management fees, construction/development management fees and disposition fees through the venture in addition to any fees payable to the developer affiliates, it is critical to clearly describe the fees in the venture agreement. At a minimum, the investor should have approval rights with respect to the form of the services agreement or there should be a pre-approved form negotiated in conjunction with the venture agreement, and if not set forth in any approved form of services agreement, the venture agreement should mandate that the compensation be consistent with market rates for such services or otherwise expressly approved by the investor. The investor will want the service agreement to provide that it may be terminated without cause at any time that the developer partner ceases to be the managing member of the venture. The investor may also want to require each affiliate to be subject to the same standard of care as the developer is under the venture agreement.

Conclusion

The above sets forth a sampling of issues that could arise when entering into a joint venture with a developer. It would  be difficult  to summarize  all potential pitfalls,  but these are some of the most prevalent complications as well as the strategies that an investor may employ when confronted with these challenges.  The  fate  of the relationship of a developer and investor does not need to be written in the stars, but rather the parties should take the time at the beginning of their relationship to carefully draft an agreement that anticipates the possible complexities down the road and clearly delineates the parties’ respective rights and obligations with respect to the venture.

Andrea Saunders Rifenbark and Elizabeth A. Willes are partners at Cox, Castle & Nicholson, LLP, a full-service law firm focused on real estate in the United States. They both specialize in advising institutional investors on joint ventures and other complex real estate transactions. Cox, Castle & Nicholson LLP is not engaged in rendering legal or tax counseling through this publication. No statement in this column is to be construed as legal, tax or investment advice.

This article was published in the May 2018 issue of Institutional Real Estate Americas, and is hereby used with permission from the publisher and copyright holder, Institutional Real Estate, Inc.