A real estate joint venture (“Real Estate JV” or “Joint Venture”) is a strategic partnership between two or more companies that pool their resources, expertise, and capital to achieve a common goal. These Real Estate JVs are often used for the purpose of buying, developing, leasing, operating, managing, and ultimately selling real estate assets for a profit. Joint Ventures differ from the typical business partnership because unlike formal partnerships where each party come together under a new distinct identity, in a Joint Venture each investor maintains their own individual business identity while working together. As with any business endeavor, it is crucial to evaluate the performance and success of a Real Estate JV to ensure that it is delivering the expected results.
In this blog, we will explore the key considerations when evaluating whether to enter into a Real Estate Joint Venture.
The Parties to a Real Estate Joint Venture:
A Real Estate JV typically consists of two types of business partners: (a) the “operating partner” and (b) the “capital partner.” Real Estate Joint Ventures are frequently used by real estate operating partners or real estate sponsors to obtain the capital they require for their projects.
The role of the capital partner, as the name suggests, is to provide the bulk of the equity capital that the Real Estate JV requires. In a typical JV, the capital partner provides between 30% and 90% of the total equity required to fund the deal. The remaining capital is obtained through debt financing from a bank or other lender. In most cases, the capital partner remains passive for the duration of the Joint Venture and is not involved in the day-to-day management of the underlying real estate asset. However, since such capital partner generally provides the majority of the capital to the Real Estate Joint Venture, they are likely to negotiate certain control rights over “major decisions” in the operating agreements related to the deal.
The operating partner is usually an experienced real estate investment individual or firm that will be responsible for the daily operations and management of the underlying real estate asset. An ideal operating partner is a highly experienced professional from the real estate industry with the ability to source, acquire, manage, and develop a real estate project successfully. Given its active role, reviewing the operating partner’s experience and track record related to the targeted strategy and market are crucial to the success of the Real Estate Joint Venture.
Main Considerations when Entering into a Real Estate Joint Venture:
Real Estate JVs are typically struck up when each of the parties needs something that the other party has to get a deal done. That could be a number of things, such as cash, credit, experience, and assets. Since each party’s role is important to the success of the Real Estate Joint Venture, it is important for each of the parties to conduct a due diligence on the other party and vet them to determine if there is indeed a good fit that will contribute to the success of the Joint Venture.
Here are some of the aspects a party to a Real Estate Joint Venture should be looking for in a prospective party:
Complementary skillset and temperament
Shared vision
Similar risk tolerance and target hold period
With respect to the operating partner, ability to execute the strategy, strong track record related to the specific market and real estate strategy, adequate team in place, turnover, length of time in which the business has been in operation, sufficient liquidity, resilience of the investment activity through different business cycles, transparency, reporting, and the team availability, credibility and professional backgrounds. A separate due diligence should be conducted on each of the key personnel employed at the operating partner, and reference calls with pervious or existing capital partners are recommended
With respect to the capital partner, ability to fund the deal on time, time horizon tolerance, risk tolerance, length of time it takes to approve a deal, desire to do a “one off” Joint Venture or create a more programmatic relationship, sources of funds, and others. Conducting reference calls with current or previous operating partners with which such capital partner entered into a Joint Venture is recommended.
Defining Clear Objectives of the Joint Ventures and Key Performance Indicators (KPIs):
Before assessing the performance of a Real Estate JV, it is essential for the parties to establish clear objectives and KPIs that align with the venture's strategic goals. These objectives can include financial targets, project costs and budget, targeted hold period, operational efficiency, and more. By defining these parameters upfront, the parties can effectively evaluate the Real Estate Joint Venture's progress and success.
We will explore these further below:
(a) Determining the Targeted Returns in a Real Estate Joint Venture:
One of the most important things to consider when entering into a Real Estate Joint Venture is the risk reward potential. Typically, opportunities will be presented with a base case return that assumes that the project costs and sale values are achieved. When investing equity into a Joint Venture opportunity, base case returns will usually stand at around 1.5x multiple, although this does vary from project to project.
It is important to understand that, as with all investments, returns are not guaranteed and performance can vary. Therefore, it is common to expect investment opportunities to be presented with three scenarios: a base case, a downside case and an upside case. The downside case would typically assume an increase in project costs and a decrease in sale values. This would lead to a decrease in the Joint Venture profits and therefore, the final distribution to the capital partner is likely to be reduced. Conversely, the upside case assumes that costs remain within target and sale values are ahead of target. This would mean an increase in the overall profit of the Joint Venture and, therefore, an enhanced final distribution to the capital partner.
(b) Agreeing on the Target Timeframe and any Extensions:
Real estate is considered an illiquid investment, meaning money invested in this asset class is usually tied up for a considerable period of time. Therefore, it is very important for both the operating partner and the capital partner to agree on the length of time of the Real Estate Joint Venture. Furthermore, returns are directly impacted by the length of the hold period. For a Joint Venture opportunity, a 1.5x money-on-money return may sound attractive, however the time frame of the investment will impact the Internal Rate of Return (IRR).
Most Real Estate Joint Ventures have a hold period ranging from three years to seven years, depending on the risk reward and hold period tolerance of the capital partner. Typically, capital partners that invest in development opportunities are targeting shorter hold periods of three to five years. Capital partners that invest in cash flowing properties generally target longer hold terms of five to seven years.
(c) Understanding the Investment Risks:
As with all investments, Real Estate Joint Ventures carry a degree of risk. Risk considerations can fall into a number of categories and should be understood clearly by the capital partner. These include:
Loss of capital: as with all investments, a risk to capital exists
Lack of liquidity: investments in a Real Estate Joint Venture are considered illiquid because there is a very limited secondary market that exists for the transferal of interests
Project Cost risk: unexpected delays may occur that could impact the project return, such as obtaining permits, complying with building regulations or other construction or contractual matters, resident turnover, and others. During renovation or construction, certain structural or other issues may come up that need to be rectified causing delays and increased project costs. Maintenance and taxes should also be understood clearly.
Sales risk: sales prices may be higher or lower than those assumed in the financial projections, which could increase or decrease investor returns. The same goes for assumptions related to rent increases, occupancy rates, resident turnover, cap rates, and others.
(d) Determining the Fees, Costs and Financial Incentives of the Joint Venture
Fees related to the purchase, operation, financing, and sale of a real estate asset can quickly accumulate to a meaningful portion of the overall project budget. Therefore, it is important for the parties to a Real Estate Joint Venture to clearly define any fees related to the project. Fees may include acquisition and disposition, debt procurement, equity capital raise, construction management, asset management, and property management in addition to organizational expenses and leasing commissions.
Any conflicts of interest should be clearly disclosed, meaning if the operating partner is using an affiliate to provide any services where such fees may be earned, it should be clear. Fees should be levied “at market.” Whether an affiliate is used or not, the operating partner should obtain bids or quotes from multiple sources to ensure all fees and costs are consistent with the local market for the asset size and type.
In addition, most Real Estate Joint Ventures will include some sort of economic incentive for the operating partner to achieve strong results, subject to returns meeting a certain hurdle (called the “preferred return”). This incentive fee, often referred to as “sponsor promote,” is designed to reward the sponsor for outperformance. This reward is probably the strongest mechanism in a Real Estate Joint Venture for aligning interests between the operating partner and capital partner.
(E) Ensuring Alignment of Interests and Protection of the Interests of the Capital Partner
As noted above, the operating partner will be responsible for the day-to-day management of the real estate owned by the Joint Venture. That said, the investor member should retain the final say over many major decisions. This is especially true in cases where the investor member comprises 50% to 90% of the total Joint Venture equity. Such control rights may include, but are not limited to, the following: approval of any major changes to the business plan, approval of annual budgets, ability to remove or replace the property manager or the operating partner itself in certain circumstances, ability to trigger or veto the sale or refinance of the property.
The capital partner may require the operating partner to have a meaningful “skin in the game.” To accomplish this, the operating partner typically contributes 5% to 10% of the total equity of the Real Estate Joint Venture.
Mitigating Factors to the Potential Investment Risks:
There are a number of ways to mitigate the investment risk of Real Estate Joint Ventures. As mentioned above, it is essential for each of the operating partner or capital partner to conduct a due diligence on the other party. In addition, both parties should conduct a due diligence at the property level that may include some of the following considerations:
Financial and operational due diligence: including: (i) real estate valuation by a certified appraiser, if possible, (ii) searching for rent or sale prices of similar properties in the chosen area (iii) calculation of all relevant fees and taxes, (iv) asking the seller for evidence of no debts on taxes or mortgage, no liens or other financial liabilities related to the property, (v) evaluation of project costs and rent or sale revenue, (vi) analysis of historical financial records to uncover any potential risk factors or inconsistencies, existing debts, financial position and cash flow information.
Legal due diligence: including title documents, encumbrances like mortgage or inheritance, ability to obtain appropriate permits, land usage and planning under public law, existing leases and agreements for the property, including any utility, maintenance or insurance contracts, permissions in case of property under construction, and other regulatory rules such as rent restrictions.
Environmental: environmental factors can harm the property’s economic viability. This review typically consists of a geologist, asbestos technician and a lawyer experienced in residential pollution issues.
Market Due diligence: review of the real estate market, location and corresponding marketability of the property. This review may include any appraisals from qualified real estate organizations, macro economic factors, demand and supply considerations, through a comprehensive analysis of the market. With a market analysis, the Due Diligence team has to consider the market trends, such as the demographics, unemployment trends and purchasing power trends.
Other due diligence items include taxes and structural or physical review.
Ongoing Monitoring of a Real Estate Joint Venture:
Financial metrics play a vital role in evaluating the performance of a Real Estate Joint Venture. Key financial indicators such as rent growth, profitability, return on investment (ROI), and cash flow should be tracked regularly. These metrics provide insights into the Joint Venture's financial health and its ability to stay on track and generate the targeted returns.
Communication and Collaboration:
Effective communication and collaboration between the parties to the Real Estate Joint Venture are critical for its success. Regular communication channels, reporting and shared information are essential for maintaining transparency and addressing any issues that may arise. Monitoring the quality and frequency of partner interactions can provide insights into the strength and health of the Real Estate Joint Venture.
Important Disclaimer: Enterstate Capital, Ltd. (“Enterstate”) published this article to convey general information about our services and not for the purpose of providing any investment, legal or tax advice. Strategies mentioned herein may not be appropriate for you. Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain. You should consult an investment professional regarding your own situation. Nothing in this article should be considered an offer of securities or the solicitation of an offer to acquire securities of any type.