For better or worse: how to give your real estate joint venture the right start
Published on 16th Oct 2020
The first of our two-part series on real estate joint ventures looks at the structuring, funding and exit considerations that can help to set the venture off on the right track.
Joint ventures (JVs) in real estate have long been an attractive proposition due to the ability to combine assets and expertise and share the burden of project finance costs. As uncertainty continues through the Covid-19 pandemic, we expect joint venture opportunities to increase across all asset classes as stakeholders seek to mitigate risk across their businesses.
Joint ventures can involve a pooling of assets or expertise – or a combination of the two. Often a property owner may enter a joint venture with a developer to enhance the value of their asset in return for an equity interest in the land and therefore a share in the upside.
Our role as lawyers is to ensure the parties are protected throughout the length of the relationship and the governance provisions are clear and practical. While the parties will be hoping for a long and happy marriage, it is important that the pre-nuptial terms are sufficiently clear to avoid an acrimonious divorce if things do not work out as planned.
In this Insight series, we will outline the some of the main considerations that parties should have regard to at heads of terms stage and when drafting the JV agreement.
This Insight summarises the structuring considerations that go to the heart of the economics of the JV. The second article in this series focusses on the day-to-day management and control of the JV.
Form of the JV
The term 'joint venture' has no specific meaning in English law. It describes a commercial arrangement between two or more independent parties for the purpose of executing a particular business undertaking. This can either be:
- a contractual joint venture, through an agency, collaboration or consortium agreement; or
- a corporate joint venture, through the formation of a limited company, limited liability partnership (LLP), limited partnership (LP) or an offshore structure.
The choice of vehicle will depend on the requirement of the parties and tax planning should always be sought prior to heads of term stage. LLPs are often used on real estate JVs where the parties require a tax transparent structure.
Business of the JV
Ensuring both parties clearly understand the common objective of the JV is the first step. Divergence of plans for the JV can be catastrophic for the JV and if the "business" of the JV and the first business plan cannot be agreed at the outset this should ring alarm bells.
For example, is the venture primarily aimed at developing a property to be sold on; have the parties identified an under-performing asset that can be made more profitable and then exited; or is the intention to provide steady revenue over a longer period.
How will the JV be funded? The parties need to consider when funding is required (including upfront acquisition costs or ongoing developmental / working capital) and how it will be provided – through either equity or loans.
This will depend on the specifics of the projects and tax advice but where the JV parties choose to fund the JV by way of loans then they should agree the key terms up front. These can include whether:
- the loans will be capped;
- interest will apply; and
- they will be secured against the underlying property or any other assets of the JV vehicle.
If the JV is also obtaining third party funding then that funder will usually expect repayment ahead of the JV partners receiving any profits or loan repayments from the JV. However, there may also be circumstances where one JV partner wants repayment ahead of the other; for example, for the repayment of development land transferred into the JV at incorporation.
One area that can lead to a dispute between the parties is how any additional project costs over and above the budget are dealt with. The JV agreement can require further funding from the JV partners to manage overruns on either a compulsory or optional basis. Again, the parties should consider the terms for any additional funding (including whether it takes the form of equity or loans; any enhanced returns; whether any interest or priority repayment should apply if only one party is capable of plugging the funding gap).
The parties need to agree how cash proceeds generated by the JV are applied to its costs and subsequently made available as distributable profits. The JV agreement would typically include the following 'waterfall' for the use of proceeds:
- payment of any tax due;
- repayment of any third party debt
- payment of third party creditors of the JV;
- repayment of loans from the JV partners;
- making provision for working capital; and
- any balance being made available as profits for the JV partners.
The parties will need to agree whether profits should be shared equally, proportionally to their equity contributions or if more complex profit sharing provisions are appropriate for the JV.
These provisions can take different forms, including a priority return for one party. For example, a developer JV partner may be due a promote payment, with that party receiving a certain IRR (internal rate of return) threshold and profits then allocated to both parties once the threshold is exceeded. Promote calculations are complicated and we would recommend preparing worked examples to ensure parties agree how they will work in practice. Alternatively, the priority party can receive a guaranteed fixed return and the other party not participate in profits until this return is met.
Parties to a JV will have taken a lot of time and consideration in choosing to partner with each other so they will usually want some control over whether the JV partner can exit and sell to a third party, potentially undermining the viability of the venture. This is particularly relevant where one of the parties is providing services to the JV or developing the underlying asset.
The parties should agree at the outset whether either of them can transfer their interests in the JV. It is common for minimum lock-in periods to be agreed before a transfer can be made to a third party (if at all), but for transfers to group companies to be automatically permitted.
Where transfers are permitted in any form, the parties should consider what is capable of being transferred and whether both equity and debt interests should be transferred at the same time.
Specific transfer mechanisms should also be considered, including pre-emption or right of first offer rights in favour of the non-transferring JV partner, along with drag-along and tag-along rights.
Entering into joint ventures take time and planning. The merits of the joint venture may be clear but scenario planning and crafting the specific terms can lead to extensive debate. The partners need to fully understand their own position, particularly around any future funding obligations, for example to fund the next phase of development or acquire adjoining assets. Think carefully about how the joint venture can proceed without more capital and whether the relationship can continue if the parties' positions change. We have seen a development joint venture fail as the initial funding dries up and the default funding scenario kills any prospect of the JV remaining solvent. Keeping a focus on the aim of the JV whilst protecting all parties' financial position can be a balancing act.