A massive influx of capital into the commercial real estate market has spawned a parallel growth in joint ventures to co-own and operate investors’ real estate assets. While these JVs can take many different forms, investors would be wise to understand the key factors common to most successful JVs.
A simple model JV — Super Profitable Partners LLC — will help illustrate some of the issues on which investors and their partners will need to agree when structuring a JV. We will assume that Super Profitable Partners is being formed to acquire a multi-tenant office building for $100 million, obtaining $70 million acquisition loan from a third-party lender and providing $30 million in equity (for the sake of simplicity we will ignore typical additional closing costs).
Super Investor — the investor (or capital partner) and Profitable Operations — the operator/developer (or operating partner) form a new single purpose limited partnership or limited liability JV company (Super Profitable Partners) to acquire, own, operate, and ultimately dispose of the asset. But before their success is guaranteed, the partners must ask and agreeably answer the following six questions:
1. Who Owns What and How?
How will Super Profitable Partners own the asset — directly or as a subsidiary? In some cases (e.g., if there is mezzanine debt or if the partners are acquiring a portfolio of multiple assets) a company may instead own and hold one or more subsidiaries, each of which may directly own an individual asset. Super Profitable Partners decides to acquire and own the office building directly.
2. Who Manages What and for How Much?
Super Investors needs Profitable Operations’ superior infrastructure and market presence to manage the day-to-day affairs of Super Profitable Partners’ office building, but Super Investors doesn’t want to give up control. So both partners agree that Super Investors solely will decide on a sale of the property of filing for bankruptcy and will be consulted on any “major decision” (such as approving major tenant leases, refinancing the asset, calling for additional capital, commencing or settling litigation).
Profitable Operations, like most operating partners, will be paid market-based fees for certain services, including asset management, property management, leasing, and development and construction management. Additionally, both of the partners agree to be paid an acquisition fee and/or a disposition fee as well as a fee for providing any guaranties the third-party financer requires.
“Profitable Operations, like most operating partners, will be paid market-based fees for certain services, including asset management, property management, leasing, and development and construction management.”
3. Who Contributes Capital and How Much?
Since typical real estate JVs require the capital partner to contribute between 80-95% of required equity, Super Investors will pony up $27 million (90%) and Profitable Operations will come in with the balance of $3 million (10%) at closing.
Since Super Profitable Partners has planned for renovations and capital improvements and may face unanticipated re-tenanting, the partners agree to provide additional capital in the same 90% / 10% proportions. If either party fails to do so, the noncontributing partner may face dilution or other punitive measures.
4. How Much Does Each Partner Earn in Distributions?
Super Profitable Partners’ office building generates net cash flow, or profits, which will be distributed quarterly (in the case of operating cash flow) or shortly following a capital event (e.g., a refinancing or sale of the asset) in the case of capital proceeds. The distributable cash goes through a “waterfall” — cash is distributed to each of the partners in accordance with their proportionate percentage interest (i.e., 90% to Super Investors and 10% to Profitable Operations) until each has recovered all contributed capital plus a negotiated preferred return or internal rate of return (IRR) (the partners agreed on a fairly typical 8%). In order to incentivize Profitable Operations, Super Investors agrees to distribute additional cash thereafter disproportionately in Profitable Operations’ favor. This increased interest, or “promote,” is tied directly to the success of the investment in the office building.
“In order to incentivize Profitable Operations, Super Investors agrees to distribute additional cash thereafter disproportionately in Profitable Operations’ favor.”
5. Can Partners Transfer?
As is fairly common, neither of Super Profitable Partners’ partners may transfer all or any portion of their interest in the JV to a third party without the prior consent of the other partner (with a few exceptions they have agreed upon such as a merger, IPO or for estate planning purposes).
6. How Can the Partners Fight or Break-up?
While Super Investors and Profitable Operations have a long and amicable history of working together, they have wisely included a “buy-sell” mechanism to allow one partner to establish a price at which that partner is willing to either sell its interest to the other partner or to purchase the other partner’s interest. The other partner then gets to choose whether to be a buyer or seller.
For JV formations, even those as fictionally simple as Super Profitable Partners LLC, both parties should consult seasoned counsel.