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‘Tis the Season for Trending Topic Tuesday. Get current on trends in real estate joint venture agreements with Thomas G. Maira of Reed Smith LLP.
Interview with Thomas G. Maira on current trends in real estate joint ventures
1. What is a typical management arrangement for a real estate joint venture?
A common structure is the operating member managing the day to day affairs of the property and the capital member having various degrees of major decision approval rights and negative control rights. Typically, the higher the overall percentage of the capital that the capital member funds, the more control they obtain or require.
Typical examples of joint venture major decisions, that with respect to such decisions, no act will be taken without the express approval of the capital member or both members, as applicable, are:
The list above is not exhaustive but rather should serve as a starting point. Certain important issues to address in drafting major decision provisions include:
2. What is the most heavily negotiated part of the real estate joint venture agreement? Any tips on getting through such provision?
In my experience, one of the most heavily negotiated parts of the real estate joint venture agreement is the scope of major decision rights touched on above. The capital member often proposes a lengthy and detailed list of major decisions in the interest of protecting its investment which the operating member often feels is excessive and limited its ability to effectively operate the property. Striking a balance between these competing interests often requires a great deal of time and experience in order to reach an agreement among the parties.
I would advise anyone struggling with the scope of major decision rights to cover the major issues such as approval over sale, refinancing, major leases, capital expenditures, operating budgets and capital calls first, then think through the other items the client wants to be involved in (in the case of the capital member) or does not want to seek approval for (in the case of the operating member). A good approach is to find a reasonable balance commercially and practically as to how asset level decisions and actions need to be made, but that a capital member with a high percentage of the equity has adequate rights and protections.
Liquidity (e.g., the options the parties have to exit the joint venture, what triggers such rights, the specific details of such rights) is similarly often heavily negotiated.
3. In your opinion, what is the most important exit right to have in a real estate joint venture agreement?
In my opinion, the most important exit right to have in a real estate joint venture agreement is a Buy/Sell.
In a typical buy/sell, one or both parties may have a right to trigger a process whereby one party will buy the other out of their interest in the joint venture. The party triggering the buy/sell is typically required to send an offer that simultaneously acts as an offer to either buy the other member’s interest in the joint venture or, alternatively, sell the triggering member’s interest in the joint venture, in each case, for the consideration set forth in such offer. The party receiving the buy/sell offer then has the option to either (1) sell its interest to the triggering partner or (2) buy the triggering member’s interest, in each case, for the consideration set forth in the offer. This process incentives the triggering party to make a fair offer and provides for some flexibility to exit the joint venture.
4. In recent transactions, how are development deals being structured? Specifically with respect to cost overruns – who typically bears the risk?
More typically the operating/developer member bears the cost overruns as the capital member is relying on and investing in the transaction based on the budgets and projections presented by the operating member/developer member. An important issue to address is how much this risk can be assessed and mitigated (e.g., guaranteed maximum price (GMP) contract where the general contractor takes most of this risk).
5. What hurdle and promote levels are you seeing in waterfall provisions?
As part of the waterfall provisions, the amount of proceeds distributed to one party (usually the capital member) before and in priority to the other member (usually the operating member) is often referred to as the preference or pref. The aggregate amount of such pref is often based on a stated internal rate of return (IRR) percentage amount (e.g., a pref is paid to the capital member until the capital member receives the return of its capital and a return thereon such that the capital member has received a 7% IRR thereon). In that example the 7% IRR is often referred to as the hurdle. Once the hurdle is met, the operating member may catch up on any unreturned portion of its capital as well as an agreed IRR thereon, and/or the operating member is often entitled to receive an increase in the percentage of the distributions it gets above the operating actual percentage interest in the joint venture. This increase is often referred to as the promote.
The level of hurdles and promotes are very asset class and deal specific. Development deals will typically have higher preference hurdles for promotes as compared to stabilized assets to account for the increased risk of development projects. A typical range seen recently is 7% - 15% hurdles for 15% - 25% promotes, but again, this is very deal and asset specific as to what is viable.
6. How is increased foreign investment in US real estate affecting the joint venture agreements?
As more foreign capital is seeking US real estate investment opportunities, and such capital is frequently interested in high quality lower risk assets (such as Class A Office properties in major cities), it has driven prices on those assets up and capitalization rates down, resulting in US real estate investors having fewer real estate investment opportunities at satisfactory pricing and capitalization rates and such investors have thus been exploring higher risk or more complicated transactions in a search for sufficient yield.
7. What practical tips would you give to attorneys tasked with negotiating and drafting real estate joint venture agreements?
I would advise attorneys negotiating and drafting real estate joint ventures to focus on the following:
Additional value that attorneys can add to the process include thinking about what is missing from the form being drafted that ought to be there in this specific transaction and thinking through the particular asset class and asset in terms of what might be unique or that needs to be dealt with on a much more deal specific basis then might be provided for in a more basic form that is used as a starting point. An attorney that has a deep understanding of the clients goals and desires for the asset and overall investment will go a long way to shape the legal documents surrounding the deal in a way the provides substantial practical value to the client.
8. Any current trends, changing market provisions or anything else to be aware of that is a hot topic in real estate joint ventures?
Foreign capital continues to invest in US Real Estate through joint venture structures. As such, tax structure and tax issues are extremely important to address in that context, particularly as to minimize total tax payments and to comply with tax withholding and US reporting requirements.
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