JOINT VENTURE DEFINATION
A Joint venture is an association between two or more participants for a specific business purpose and for a limited duration. A joint venture comes to an end once the business purpose is achieved. A joint venture is characterized by risk sharing, combining capital and expertise of the involved parties and speculative objectives.
A joint venture can be organized as a partnership firm, a corporation or any other form of business organization which the participants deem fit. A real estate joint venture is mostly organized as a limited partnership where limited partners are the ones who provide most of the equity capital. General partners are responsible for managing the assets while contributing a small portion of equity capital.
A joint venture is not a legal form of organization and hence a joint venture agreement needs to be created. A joint venture agreement includes details of construction, profit sharing in percentage, and time-frame. The land owner usually provides his land and provides no further investment. All other aspects of construction, investment and obtaining the required approvals is the responsibility of the real estate developer. Profit is shared such that it benefits all participants.
Factors to be reviewed while drafting a joint venture agreement
Capital Contribution: The capital to be contributed by all participants should be clearly specified. The agreement should specify the initial capital contributions to be made by all and how future capital contributions will be done.
Share in cash flows: There are two types of cash flows. One being annual cash flow obtained by operating the property and the other being cash flow received from sale of property. The participants’ share in both these types of cash flows needs to be specified.
Preferred Return: The type of cash flow to be used for paying the preferred return to the participants needs to be mentioned, if required.
Profit Sharing and risk sharing: Participants must share the profits and losses in proportion to their ownership interests. Proportion of sharing taxable income (or losses) and capital gain (or loss) may also be based on the proportion of distribution of annual cash flow. All participants must share the financial, legal and operational risks in proportion to their ownership interests. If risk is shared by all the participants, impact of risk on individual participants is reduced.
Management and control: Participants who control the property’s operation must be specified. Participants who will be involved in management decisions related to capital, leasing, financing and sale of property needs to be specified.
Tips for land owners while getting into a real estate joint venture agreement
1. Background check of developers needs to be done to verify their credibility and success rate in previous projects.
2. Register a new company as a private limited company and transfer your land to the books of this company. This needs to be done before entering into a joint venture agreement with the builder’s company so that the agreement is between two companies where one provides the land and the other provides investment and expertise.
3. Decide on the profit sharing ratio with your developer. Usually the percentage of profit sharing in India is 1/3rd and 2/3rd, where 1/3rd of the cash inflow from the sale of housing units is for the land owner and 2/3rd is for the developer. A better bargain is to get the appropriate number of housing units assigned to you in the joint venture agreement along with a clear mention of the number of units, floor and size of the units
4. Seek the services of a legal company with the right expertise to represent you.
Top Ten Considerations for Creating Real Estate Joint Ventures
Joint ventures are a time-honored structure through which to develop real estate. In their simplest and most typical form, real estate joint ventures combine the real estate expertise of a developer member with the equity of a capital member. Though this marriage of resources has obvious benefits, poor planning in the initial stages can lead to an ugly divorce. Careful attention to the following considerations increases the odds of a prosperous relationship.
1. Choose the Right Vehicle.
In recent years, most joint ventures have been formed as limited liability companies. LLC’s offer the benefits of limited liability to all members, simplicity of formation, and a potentially nimble management scheme. Some states and foreign jurisdictions, however, create adverse tax consequences for investors in LLC’s, which mandates the use of general or limited partnerships. Absent tax or other countervailing consideration, LLC structures are normally used.
2. Keep Financing in Mind
Almost all real estate projects require third party financing. Stabilized assets are often financed through non-recourse loans that will require a guaranty for certain recourse carve-out events, and construction lenders almost always require full completion and payment guarantees. In either case, a joint venture term sheet should allocate the guarantor obligations. Capital members generally expect their risk to be limited to their investment and will require the developer member or its affiliates to provide any guarantees, but some developers do not have sufficient net worth to satisfy lender requirements. A joint venture agreement should address guarantor obligations associated with the initial financing, guarantor requirements of future refinancings, and the treatment of payments made pursuant to guarantees.
3. Orchestrate Timing of the Initial Investment
Ideally (particularly from the perspective of the capital member), the following events will occur simultaneously: (1) acquisition of the land, (2) closing of the construction loan, and (3) the capital member’s initial contribution. In certain situations, the developer member may negotiate for access to the capital member’s cash earlier in the process to cover due diligence costs, pay up-front lender fees and provide other pre-development capital. In these situations, either the joint venture agreement or another binding document (as opposed to an expressly non-binding letter of intent) should be completed prior to the capital member’s funding any capital. Developer members often incur significant costs prior to a capital member’s initial investment, and sometimes own the land to be acquired by the venture. In such cases, the JV agreement should establish the capital contribution imputed to the developer member for those pre-formation costs and contributions.
4. Establish the Waterfalls
In terms of ultimate aims, the provisions governing distributions comprise the most critical section of a joint venture agreement. Real estate joint ventures typically establish a series of thresholds or waterfalls that provide a set percentage return to each member based on their capital contributions. After the members have obtained those returns and a return of their capital, there is often a “promote” (sometimes referred to as “carried interest”) that incentivizes the developer member by granting it a disproportionate share of distributions after the preferred returns are achieved. Following is a simple JV waterfall sample:
(A) First, to each Member an amount equal to such Member’s Preferred Return, to be shared by the Members in proportion to their respective Capital Contributions;
(B) Second, to each Member in an amount equal to the Unreturned Capital Contributions of such Member, to be shared by the Members in proportion to their respective Unreturned Capital Contributions (typically 95/5 or 90/10);
(C) Third, the balance, if any, 60% to the Capital Member and 40% to Developer Member.
5. Describe Management Responsibilities
The developer member typically oversees construction and manages day-to-day operations of a completed project through an affiliated management company, and the venture agreement should empower the developer member to fulfill those obligations. The joint venture agreement should also include a set of major decisions for which the capital member’s consent is required, including (1) admission of new members, (2) re-investment of proceeds, (3) confessing a judgment, (3) refinancing, (4) sale, and (5) approval of budgets. Many management issues are addressed by simply requiring the capital member’s approval of construction and annual operating budgets while prohibiting the developer member’s incurrence of fees in excess of the approved budgets.
6. Recognize the Potential Need for Additional Capital
Real estate developments often require more capital than is initially budgeted. Unexpected capital needs combined with a lack of clear language in the JV agreement can lead to major disputes between the capital and developer members. The operating agreement should both state which members are entitled to require a capital call and the consequences for a member who fails to provide the additional required capital. One common means for dealing with non-contributing members is to allow the contributing member to either dilute the non-contributing member’s capital by filling the defaulting member’s capital requirement, or loaning the required capital to the company with a priority distribution in the JV waterfall for repayment at a high interest rate.
During the construction phase of a real estate development, the developer member will often execute both the construction loan guaranty and a completion guaranty to the JV that requires the developer member to fund construction overruns. The members must decide how to treat any overrun payments. The three basic options are: (1) The developer member absorbs those costs, (2) the costs are treated as capital, or (3) the costs are treated as loans. One common approach is to treat the overrun payments as contributions, the return for which is subordinated to the equity member’s preferred return. This approach both creates some accountability for the developer member to work within the budget that is approved by the capital member, and avoids the potential inequity of a developer member receiving no return for funding reasonable overrun costs.
7. Disclose Fees to Affiliated Parties
Joint venture agreements should prohibit fees to members or their affiliates that are not approved by the other members. Developer members often receive acquisition fees, construction management fees, disposition fees, and refinance fees in addition to the fees payable to the developer member’s affiliated property manager and leasing agent. Capital members will often receive asset management fees and other fees connected with refinancings or dispositions. These fees should be delineated in the JV agreement.
8. Allow for Removal of Managing Member
In most joint ventures, the developer member is also the managing member. Once a project is completed and construction loan guarantees are released, the equity member normally carries the greater risk of loss. Joint venture agreements should define the circumstances in which a capital member may remove the developer member as manager and take over management responsibilities, including the power to sell, refinance, approve budgets and take similar actions without developer member consent. Capital members should carefully review property management agreements with companies affiliated with their developer member and require those companies to execute separate agreements permitting early termination if the property manager’s affiliated member is removed as managing member of a joint venture. Developer members often negotiate for their release as guarantors of third party loans as a condition to their removal as manager.
9. Provide an Exit Mechanism
Because a developer member and capital member may have disparate motivations as a project progresses, the JV agreement should provide a clear mechanism for either member to exit the company. To protect capital gains treatment on proceeds from sale, the agreement should have a minimum hold period following project completion, after which either party can initiate an exit. Agreements often provide for a traditional buy/sell where either member can set a price at which it will either sell its interest or buy the other member’s interest. Another approach is to allow either member to market the property for sale to third parties after the hold period. If one member approves an offer that the other member does not, the non-approving member is obligated to either acquire the approving member’s interest or sell its interest to the approving member using the valuation established through the third party bid. The members should negotiate for loan document provisions allowing for transfers among members to facilitate a buy/sell.
10. Anticipate Disputes
Clear language in the joint venture agreement is the best means by which to avoid disputes, but conflicts are sometimes inevitable. Though the exit mechanism described above can be an effective means by which a member can simply leave a contentious JV arrangement, a JV agreement should also provide for either arbitration or mediation and establish the jurisdiction and venue for the litigation of conflicts.
Joint ventures are an excellent means by which to combine the complementary strengths of a developer and equity source, but a JV’s success or failure depends not only on sound underwriting, but also careful preparation of the agreement that will govern the relationship of parties in an often high-stakes enterprise.
Joint venture real estate deals are a great way to grow your portfolio when you’re short of cash resources for down payments, struggle to qualify for financing, or want to work with other people who bring something to the table that you don’t have. They are long term business relationships, however, and need to be carefully considered to make sure it’s a fit and that the structure you select makes sense given what you are all bringing to the table. Hope this gives you a few new ideas.