Let’s face it: Only a small percentage of us have the capital to swing a multi-million dollar commercial real estate deal. So what are we to do if we come across an excellent opportunity for commercial real estate investment but can only afford a percentage of the cost? That’s where joint venture equity comes to the rescue.
What Is Joint Venture Equity?
JV equity stands for joint venture equity and is also known as common equity. JV equity is the capital that gets invested into a commercial real estate deal to cover the portion of the capital stack a lending institution deems too risky to cover. Typically, most lenders will not cover more than 70–75% of the asset’s total value.
Here’s a simplified example. Say you’re an aspiring real estate developer and have enough cash on hand to purchase a sizable piece of land in an up-and-coming part of town, which you think will be a great spot for a mixed-use building. However, you don’t have near enough money to cover the development of said building.
Instead of giving up on the dream, you get in contact with a commercial real estate brokerage firm. The brokerage firm then connects you with a sponsor or an investor (usually a private equity or family office group) they think would be a good fit. The deal gets struck, and a joint venture is born. Joint ventures come in all types and no two are the same.
Because you are the one calling the shots and managing the property, you’re known as the “operating partner” or “general partner.” The providers of the capital are known as the “sponsor,” “capital member” or “limited partner.” The limited partner may be one company or many shareholders that operate within an asset management group. Regardless of the capital partner’s make-up, the money derived from them — combined with your contribution — is known as joint venture equity.
What’s the Difference Between Joint Venture and Preferred Equity?
To understand preferred equity, you must first understand the capital structure or “capital stack,” as it’s usually called when it comes to a commercial real estate investment.
Mike Holman of Overland Capital does a great job explaining the CREF capital stack, if you want to dive deeper. In short, the capital stack breaks up the relationship between debt and equity.
A good visualization is to think of the capital stack as a layer cake. Senior debt (the loan from the financial institution) resides at the bottom layer of the cake and commonly covers 65–70% of the asset’s value. JV equity lies at the top of the cake and is responsible for 30–35% of the asset’s worth, but that percentage can vary if there are other layers of debt and equity in between. The layers between (mezzanine financing and preferred equity) are blends of debt and equity.
The payment structure of the capital stack flows from bottom to top, meaning senior debt is paid first, followed by mezzanine financing, and then preferred equity. Joint venture equity investors are the last to be paid off. At this point, you may be wondering why anyone would want to be a joint venture partner.
It’s because the risk/return model flows opposite to that of the payment structure of the capital stack. At the top, Joint venture equity sees the most return on investment because it has the highest exposure to risk and in the most junior position. Senior debt gets paid first, which makes it less risky, yielding the lowest return.
Above senior debt, you have subordinated debt, often referred to as mezzanine financing. This type of debt is used to bridge any funding gaps between the senior debt and the preferred and common equity agreements. Subordinated debt gets repaid at a higher return than that of senior debt.
Getting Deeper Into Preferred Equity
Finally, we get to preferred equity.
Preferred equity lives senior to JV equity in the capital stack and junior to the first mortgage, and it usually enjoys a 9–13% return. The big difference between JV equity and preferred equity lies in the different levels of risk.
Leverage.com reached out to Sammy Greenwall, Co-Founder and Chief Strategy Officer at Lev Capital, to clarify preferred equity.
“Preferred equity is a blend of debt and equity that’s riskier than senior debt or a mezzanine loan but less risky than JV equity because the LP is not in a first loss position,” Greenwall said.
Typically, it’s viewed as a more secure, shorter-term investment because it has payment priority over JV equity and expiration date. Preferred equity investors aren’t as concerned with the venture’s unlimited upside, as their return is pre-determined and capped.
Joint venture equity is in it for the long haul of the venture, whether the end goal is to earn continued revenue or sell the property at a target date. Preferred equity’s primary concern is to see the return of the principal at the agreed-upon return.
4 Advantages of Joint Venture Equity
As we just mentioned, the first and most attractive advantage of JV equity is the returns to the partners. However, there are several others that make this partnership a go-to source of capital in high-priced CRE deals.
1. Uncapped Profit Potential
Although it takes some time to get there, once all of the capital stack’s participating agents have reaped their benefits, then the common equity partners get to shine. Whether the operating and capital partners decide to sell their investment for a profit or continue to manage the property for another 10 years, all profits after repayment of debt go to the JV partners.
2. Promote Structures and Fees
Management fees and developer fees are often negotiated in the JV agreement so the operating partner can keep the lights on while executing the business plan. Depending on the asset, the payments can be set up in many ways, with varying percentages of return.
Promote structures are, in essence, performance bonuses for the general partner. They are success benchmarks written into the partnership agreements.
“The economics of a commercial real estate deals are a lot more lucrative for a GP when you bring in a JV partner,” Greenwall said. “OPs can charge a management fee and set up a favorable promote structure once certain IRR hurdles are met.”
These management fees and promote structures are an added bonus for general partners that incentivizes them to work hard toward the desired goal of the JV partnership. Let’s look at an example.
Say you’re a GP, and you’ve only put in 5% of the equity. Your deal’s promote structure says that if you hit an 8% return on investment, you’re entitled to 15% of the total return above the 8% benchmark.
Promote structures like these are common in JV partnerships. Such an incredible return rate for such little equity invested is why joint venture equity is so appealing to GPs.
3. More Upfront Cash
Both the operating and capital partners enjoy not having to pay the total cost of the asset. Though it may seem like the capital partner is getting the short end of the stick because they are floating a significant portion of the cost, both parties benefit.
The operating partner invests much less capital into the asset but sinks much more of their time in the day-to-day management. The capital partner is responsible for securing most of the funds, but that’s typically the only aspect they’re responsible for.
“With JV equity, you can close almost the entire cash gap between the OP’s investment and the senior debt,” Greenwall said. “With more cash upfront, OP’s can charge higher fees, make bigger returns, and the promote structure is far more superior because it’s based on a larger dollar amount.”
The bottom line is that if you’re a common equity investor in a 30-million-dollar commercial real estate deal (for example) and only responsible for 30%, that means other lenders/investors in the capital stack are covering 21 million. Meaning, over time, you’ve paid significantly less money for a high-value asset.
4. Relationship Building and Scaling Your Business
When you prove to private equity groups that you know your stuff, your chances of securing the subsequent deal increase significantly. It’s a quick and easy way to build your commercial real estate portfolio and expand your reach outside of your hometown.
When Using Joint Venture Equity Makes Sense
JV equity has huge upsides for both the general and limited partners. However, the benefits of JV equity lean heavily in favor of general partners looking for leverage. Below are some examples of how this type of shared risk investing does just that.
When Trying to Scale Your Real Estate Portfolio
As we mentioned, when you prove yourself to be a valuable operating partner, it becomes much easier to secure more private equity investors. This status can grow your business to a degree where you can become an investor.
When You Want to Go Big
Whether you’re a seasoned developer or just starting, you don’t have to set your sights low with JV equity. As long as you’ve done your research and present a solid case to investors, nothing is stopping you from a multi-million dollar deal.
When You’re Light on Cash Flow
In the real estate game, a smart investor always uses as little of their own money as possible. By leveraging JV equity, you can get excellent compounding returns with very little up-front investment as long as you can meet your IRR hurdles.
When You Should Try a Different Equity Position
Like with any type of investing, joint ventures come with some form of risk and downside. It might make more sense to try a different equity position in these scenarios.
If You’re the Limited Partner Trying to Hedge Risk
Many times the capital partner will enter into an agreement at the preferred equity position. Because preferred equity gets paid out before JV equity and has a lower return rate, preferred equity can sometimes make more sense for investors.
If You Want Complete Control
Although the operating partner has much of the say on how the asset is managed, a joint venture is still a partnership. The capital provider still has a voice regarding when to sell or refinance the asset or exit from the agreement.
If You Can’t Get Favorable Terms
It’s common for private equity groups to cut the standard operator fee from 3% to 1% and make the IRR hurdles very unfavorable, especially for new developers. If you’re getting stonewalled by PE groups, you may want to turn to a brokerage firm for help or acquire funding elsewhere.
Joint Venture Equity: Best Practices
If you ask any broker, lawyer, or experienced investor, they’ll say that striking a successful JV equity deal is no small task. Below are some tips on how to get your ducks in a row to ensure you and your partner have your best interests at heart.
1. Get Representation
Establishing a joint venture is not something you want to do alone. Having a professional with the relevant expertise by your side can ensure crucial aspects of the transaction aren’t overlooked. New developers often don’t think of all the taxes, fees, and other hidden costs that go into a joint venture.
The points mentioned below are key touchpoints that should be considered in every joint venture agreement. Having someone who knows the ropes and has your best interest in mind is a sound investment in and of itself.
2. Establish a Track Record
The best thing you can do to secure a capital partner is to have a strong track record in JV equity. For seasoned developers, that means having a strong portfolio with no questionable assets. For new developers, you’ll want to highlight your experience and business acumen. Highlighting success in smaller ventures before trying to tackle multi-million dollar projects is expected.
3. Be Extraordinarily Organized
When asking equity groups to invest millions in your venture, being meticulous is vital. Understanding how the process works from an institutional perspective, having models structured out, presenting third-party reports, establishing REO (Real Estate Owned) schedules, and having case studies are essential to strike a favorable deal.
4. Clarify the Timing of Payments
When forming the agreement, the capital and operating partners need to understand when funds will get dispersed. This knowledge will reduce the risk of the development process being hindered or causing the OP to take on unnecessary management costs.
5. Choose the Correct Business Entity
It’s important to keep in mind that, depending on the location of your corporate entity, there might be tax advantages to forming one type of business over another. While LLCs are common in most jurisdictions, in some it makes sense to go with a limited partnership, as stated by the Association of Corporate Council (ACC).
6. Establish the Waterfalls and Exit Strategies
Probably the most critical part of JVs is setting transparent, fair and realistic waterfall benchmarks. Also, each party involved should have a documented exit strategy before entering into the agreement in case either member chooses to dissolve the partnership.
7. Define Each Member’s Boundaries
The authority of both the capital and operating partners should be clearly defined when it comes to approving budgets, sale of assets, refinancing, and the admittance of new members. However, you can still expect disputes no matter what lines are drawn.
The Bottom Line
JV equity is an extremely attractive option when it comes to high-priced commercial real estate deals. Although all parties benefit from a successful JV partnership, the upfront cost of equity and returns definitely favor the operating partner. However, any partnership can be hard to navigate. Both sides need to thoroughly examine all aspects of the deal and deeply consider if the members involved will work well together. Having the right representation broker deals and write-up contracts is vital for a long-lasting business relationship.