How Joint Ventures Work in Commercial Real Estate
Many sizable commercial real estate projects are not simply purchased and developed by one firm; instead, they are structured as joint ventures (JVs), in which one party provides commercial real estate expertise and the other party provides capital. In essence, a joint venture is very much like a commercial real estate syndication, except it is generally between 2 or more large individuals or firms rather than one sponsor and a larger group of investors.
In general, the operating member (the one with commercial real estate experience) is often an experienced developer or property manager, who takes the lead on the management side of the project. In contrast, the capital member, who provides the money, generally takes a more passive role, but their level of activity can vary depending on the individual project.
Ownership Structures for Joint Ventures
A joint venture can be structured in several different ways, with a limited liability company (LLC) being the most common. Other options include partnerships, corporations, and other structures. However, it’s important to choose the right structure for a project’s individual needs, as the structure can have a big impact on the rights and responsibilities of (and the power dynamics between) members. For instance, an LLC puts the operating member and the capital member on relatively equal footing. In contrast, a limited partnership or LP (with the capital member being a limited partner) significantly reduces the capital partner’s control over the venture, though they would carry very little liability were the project to fail.
The Importance of Joint Venture Agreements
In addition to determining what type of corporate or partnership structure a project should have, the partners will also need to agree upon and sign a joint venture agreement. This document will generally state:
The plans and goals of the joint venture: This part of the agreement should detail the property that the JV plans to develop/acquire, and how will they do it.
How much each party will contribute to the venture: In most cases, a capital partner or partner(s) will contribute the majority of the capital to a project, while the operational partner will contribute a smaller stake. However, in some cases, the operational partner will not contribute anything, while the capital partner contributes 100% of the required capital. In addition, the joint venture agreement should clearly state if the venture plans to take out a commercial real estate loan, and, if so, for how much.
Profit splits/management responsibilities: The agreement should detail exactly how profits are split. In many situations, the operating partner will take in a larger share of the profits due to their additional management responsibilities. They will often be compensated in the form of a waterfall/promote structure, in which they will receive a proportionally larger share of the profits (called a promote) should the project exceed certain profitability hurdles. In addition, the operational partner will typically be awarded certain fees, which we’ll get into a bit later.
Long-term ownership rights: The agreement should also detail who will be able to own the property after the primary investment period is over. For instance, if the operating partner has a significant ownership stake, the capital partner may have the right to buy his stake after a certain period.
Exit strategies: The exit strategy should detail the estimated timeline for the project exit, how it will be done, and under which circumstances a party can exit the agreement early.
Contingencies and how various emergencies will be handled: Natural disasters, ‘acts of God’, lawsuits and other unforeseen events can easily derail a real estate investment or development project. However, having certain structures in place may be able to reduce risk and prevent a bad situation from getting worse.
Operating Member Fees
In addition to generally receiving a larger share of the profits through a promote, the operating member of a joint venture will often be rewarded for their work via certain fees. Like the other information mentioned above, the exact nature of these fees should be detailed in the joint venture agreement. Common fees include:
Acquisition Fee: Operating members put a lot of time and effort into purchasing the property itself, and this fee compensates them for that. Acquisition fees are generally set at 1% of the property purchase price.
Financing Fee: Sourcing debt for a commercial real estate investment can be time intensive, so many operating members are paid a fee of 1% of all the debt they source for a project. However, this fee is somewhat less common in today’s market.
Development Fee: If a project requires significant construction, an operating member will often be paid between 3 and 4% of hard construction costs in exchange for monitoring and managing the construction and development process.
Leasing and Property Management Fee: Leasing and property management are sometimes taken care of by an affiliate of the operating member. If this is the case, the operating member may be paid (albeit indirectly) as a result of the use of these services.
Asset Management Fee: Compensates the operating partner for managing the overall financial strategy of the investment property. Typically 1% of equity invested for each year of the project.
Disposition Fee: The opposite of the acquisition fee, the disposition fee is paid to the operating partner to compensate them for their role in managing the property sale process.
Joint Venture Best Practices
While joint ventures can be extremely rewarding for all parties involved, they aren’t without their risks. Without proper planning, a joint venture can easily be a sand-trap, in which one (or both) parties can lose valuable investment capital and even expose themselves to serious liability. To try to ensure that your joint venture partnership goes off without a hitch, you may want to consider following some of the best practices listed below:
Be careful when selecting a partner. Choosing the wrong partner can sink a joint venture, while choosing the right one can help it skyrocket to success. It’s essential to make sure that both partners are on the same page involving ethical business practices, risk tolerance, timeliness, and other important factors. Of course, you’ll also need to make sure that a potential partner (or firm) has the operational experience, manpower, and capital to get the job done.
Delegate responsibilities carefully. While we’ve already discussed the importance of having a detailed joint venture agreement, it’s still important to have a frank discussion with potential partners about who will do what and when. That way, there will be significantly fewer misunderstandings if you actually end up working together.
Be careful about conflicts of interest. In many cases, the operational member of a joint venture may also be a property manager or a general contractor, and, in many cases, they will be using their own company to do a significant amount of work involving the property. While this can lead to cost savings, in some cases, what benefits these affiliated companies may not be best for the performance of the investment. For instance, it might not benefit the operating member’s property management company if a property is sold, even though it would be best for the joint venture. Therefore, it’s important to stay aware of potential conflicts to make sure they don’t cause any serious issues.