In previous articles, we’ve gone into depth about the types of joint ventures and joint venture equity. Now let’s discuss the ins and outs of joint venture agreements as they relate to commercial real estate and financing.
What Is a Joint Venture Agreement?
In the world of joint ventures, commercial real estate stands apart. The key difference within the CRE realm is that a joint venture is always established with the goal of seeing a return on investment (ROI).
It’s not used to enhance or broaden the overall business of either party; this is where strategic alliances and joint ventures get confused.
How a Joint Venture Agreement Works
However, what remains the same, regardless of industry, is that the key players in a joint venture must ensure their best interests are considered. Each member of a joint venture creates an agreement that is binding by law. They share an obligation to one another within the venture that is outlined in the agreement.
For some industries, joint ventures can resemble partnerships or mergers of companies. In commercial real estate, joint ventures are always set up as their own entity, outside of any other business activities or entities in which the members might be involved. CRE joint venture agreements commonly take the form of a limited liability company (LLC), but they can take other forms if there is a perceived advantage.
In commercial real estate, the primary players in a joint venture agreement are a general partner (GP) or sponsor and a limited partner or capital partner (LP, CP).
The GP is more often than not a local developer or investor with fixed capital who’s trying to get into one or multiple big-money real estate deals totaling up to and over hundreds of millions of dollars. An LP is the source of the additional equity, which can come from several different sources.
4 Benefits of a Strong Joint Venture Agreement
A strong agreement is essential in a commercial real estate deal. If the deal is sound, it will operate like a well-oiled machine and benefit all parties involved.
However, if a joint venture agreement is rushed and not thought through, it can have devastating consequences for the venture and the partnership. Although there are many benefits of a joint venture agreement, there are four main benefits.
1. Performance Incentives
Every strong partnership agreement is set up with performance incentives for the general partner called promote structures or carried interest. Including incentives like these in the agreement is essential for any venture to function smoothly. It also ensures all joint venturers meet their obligations. It benefits the GP because they have the opportunity to get much more significant returns relative to their initial investment. Also, it benefits the LP by giving them peace of mind that the GP, who manages the assets, will hold up their end of the deal.
2. Pre-Determined Exit Strategies
A solid contractual joint venture is never in jeopardy of dissolving because it can’t, by law. When drawing up agreements, the members include detailed buy and sell agreements should one member decide they want out of the investment, or dies.
Also, exact expiration dates are written into the contract, which typically revolves around when the asset is slated to deliver the agreed-upon returns for both parties. The contract is typically set to expire after the full agreed-upon/estimated return is delivered, therefore partners don’t have the option of exiting the partnership until this time.
3. Clear Management Parameters
When the entity is set up correctly, neither partner is unclear about their duties in the agreement, nor do they try to overstep boundaries. In a classic commercial real estate joint venture agreement, the GP is the operating partner actively managing the asset.
At the same time, the LP, who is responsible for capital contributions, usually has more say in how the deal’s finances are structured because they have the most capital at stake. They also have more say in the overall business plan and when to sell.
4. No Unexpected Expenses
Most LPs will never even think about entering into a partnership agreement with a GP unless every investment point is meticulously detailed in a well-thought-out business plan with multiple case studies and proforma models to support the numbers.
However, no matter how much detailed planning there is on the GP’s end, things sometimes go sideways. That’s why there are capital call provisions written into an agreement for unforeseen circumstances when more money is needed.
We’ll cover capital calls a bit later under the duty of parties section below.
What Must Be Included in a Joint Venture Agreement for Commercial Real Estate?
The beauty behind joint venture agreements is that they can get very creative and come with hundreds of terms and conditions, as long as they are agreed upon by all parties. However, there are fundamental aspects of a joint venture agreement that must be present to be economically sound and legally binding.
A joint venture agreement has two primary concerns that both parties must agree upon: economics and managing control. Because the LP has more money at stake, they like to call the shots financially. On the other hand, the GP wants to have more managing control over the venture because they are in charge of day-to-day operations.
Both partners should understand it’s in their best interest to give full operational control to the GP. If every decision had to be approved by the LPs, the development process would get bogged down.
In every JV agreement, there are many rounds of negotiations that must take place before both parties feel like the deal is fair.
Below are the basic inclusions in a joint venture agreement.
As we mentioned before, a joint venture is formed outside of the usual business activities of both partners with the goal in mind of achieving high returns on their investment. However, it must be specified what path they are taking to reach that goal.
Is it a new development project with the intention to sell within ten years? Is it a property flip and refinance? The end goal of the venture must be explicit and not be a loose “play it by ear” sort of arrangement.
After agreeing, the two members (companies) form a sister/child company with its own classification. In commercial real estate, joint ventures are usually set up as LLCs to limit liability, but they can take any form.
Contributions & Ownership
This portion details all forms of debt and equity in the form of a capital stack. It also outlines the amount of capital required from both the general partner and the limited partner to fulfill the common equity requirement of the capital structure. Deals between LPs and GPs can be anywhere from 50/50 to 95/5%. Whatever each member agrees upon investing, they own that much of the asset.
Distribution of Profits
Other than why the joint venture is being formed in the first place, how and when the profits will be distributed is perhaps the most critical portion of the agreement. Many numbers have to be crunched here to figure out agreeable internal rates of return (IRR), promote structures, operating fees, potential for profit, and many more economic factors relevant to the venture.
Because the GP is the “boots on the ground” calling the day-to-day shots, they typically want more say regarding how the asset is managed. Although they’re the experts in this area, that position doesn’t mean the LP has no voice. After all, their capital contributions are floating a large portion of the investment.
Conversely, the LP can’t control every financial aspect of the deal. The members must find a middle ground, and they must clearly express it within the agreement.
Duty of Parties
The duty of parties section of a partnership contract relates closely to the management section, except it covers many different contingencies for unforeseen circumstances.
One example is the need for capital calls. Capital calls allow the GP to go back to the capital partner and request more capital be dispersed. Capital calls usually happen under unforeseen circumstances like drastic market shifts (recessions) or miscalculated expenses. In this instance, it would be the fiduciary duty of the LP party to release the funds.
Capital calls can also be on a pro rata basis, meaning if the original contribution split was 90/10, the capital call could be at that same split as well. By utilizing a pro rata basis, no dilution or change in ownership percentages occurs.
Although a capital call is unforeseen, the joint venturers must try to account for as many contingencies as possible when forming the contract.
Additionally, the parties involved must include penalties if the other is not fulfilling their duties. Penalties of this nature most commonly apply to the GP not performing or managing as expected. The incentive for the GP to earn more return on their investment through promote structure waterfalls sometimes isn’t enough. If either party isn’t performing, there must be clear buy/sell agreements in place.
In a perfect world, everything goes according to plan, and the venture ends when its initial goal is achieved: profit. But things go wrong sometimes. There have to be explicit terms on how and when a member can buy out the other or sell their investment if something happens.
Common reasons for a joint venturer taking advantage of the buy/sell agreement are if the other member dies, is underperforming or in breach of contract, or the investment clearly won’t deliver its expected returns.
Handling of Disputes
Sometimes, disputes within a JV agreement don’t necessarily mean it needs to be dissolved, but there should be clear avenues of resolution. Under certain circumstances, partners may agree to solve disputes through mediation or arbitration.
Even though commercial JV partners aren’t technically business partners, meaning they haven’t formed a business entity or partnership from a legal standpoint, they see a lot of each other’s proprietary information that wouldn’t be good if shared.
Both parties should sign a confidentiality agreement to avoid this.
A statement that the JV partners are not in direct business with one another should be in the contract, just so that one party doesn’t take liberties with being associated with the other. Meaning, one JV partner can’t act as a business representative of the other under any circumstances.
Often, GPs and LPs are not in the same state. Consider which state laws and regulations the JV agreement should follow. This issue is also important for tax considerations.
Sometimes throughout a JV partnership, the agreement must be changed or amended. They can make changes if both parties sign off on them.
Examples of a Joint Venture Agreement in Commercial Real Estate
In terms of commercial real estate, most joint ventures follow the same formula. A developer or a commercial real estate company is looking to move on from managing small projects and wants to graduate to properties worth hundreds of millions of dollars. Typically, joint ventures are formed for properties starting at around $5M and go up from there.
Since they have a good track record, they seek out a JV partner to dramatically increase their equity. JV agreements are seen in association with single-family housing developments, office buildings, and large-scale retail or event spaces. However, these are only a few examples and can exist in virtually any commercial real estate scenario.