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Joint Venture Agreement – Complete Guide for Huge Success

July 24, 2019

No discussion of real estate deals would be complete without a full review of the joint venture agreement (JVA). In fact, a real estate joint venture is one of the most popular modes for developing new projects. Accordingly, in this article on joint venture real estate deals, we’ll examine the real estate joint venture agreement. Specifically, we’ll define a JVA and who the joint venture real estate investors are. Furthermore, we’ll dive into the structure of a joint venture agreement and cover the secrets to a good deal. Finally, we’ll close with the pitfalls of a bad real estate joint venture and answers some frequently asked questions.

What is a Joint Venture Agreement?

A real estate joint venture agreement is a deal between two or more parties to work together on a real estate development project. Indeed, a JVA brings together the people who will manage the project with those who will fund it. That is, a JVA provides an avenue to bring capital and management together to construct, redevelop and/or purchase real property.

Parties to Joint Venture Real Estate

Normally, there are two types of parties to a joint venture real estate agreement. Explicitly, they are the capital member and the operating member.

JVA Capital Member

The capital member enters-into a JVA to participate in a real estate deal without having to manage it. That is, its job is to provide capital (i.e., equity) to help finance the project. Also, it may provide some or all of the debt finance, or simply put in (invest) the down payment. Naturally, the capital member is looking for a handsome return on its financial contribution to the project. Therefore, a joint venture agreement specifies, among many things, how to distribute the project’s profits and revenues among its members.

JVA Operating Member

The operating member has expertise in real estate projects. Accordingly, it is responsible for the overall project management and day-to-day operations. Specifically, the operating member of a joint venture agreement can identify, acquire, finance the debt, develop and/or manage properties. Furthermore, the operating member often specializes in particular real estate classes or geographic regions. It needs a JVA with a capital member to obtain the capital it requires to develop a project.

How to Structure a Deal

There are many ways to structure a deal among joint venture real estate investors and developers. Typically, the members are liable for any losses on the project. But the liability doesn’t extend beyond the JVA.  In other words, the Joint Venture Agreement is separate from the other business interests of the members.

Video:  Setting Up a Real Estate Joint Venture

Organizational and Management Structure

Usually, the structure of choice for a JVA is a new, limited liability company (LLC). However, you can organize a JVA as a partnership, corporation or another arrangement. As you’d expect, the JV structure reflects the relationship between the members. Then, once they form the organization, the members sign an operating agreement that specifies the deal terms. Specifically, those terms cover several broad areas, including:

  • How to distribute profits
  • How to specify who makes the decisions
  • Exit and transfer rights
  • Other rights and remedies

If appropriate, the members must choose a jurisdiction state that approves the LLC structure of the joint venture agreement.  More often than not, that state is Delaware because of its business-friendly attitude.

The JVA will specify the management structure within the organization. These might include one member managing the project, joint control, restriction of certain major decision rights, or a board of managers. Naturally, the more the capital member contributes, the bigger say it will have in the management structure.

Typically, the members enter-into thorough negotiations to hammer out the components of a JVA. Therefore, the following sections outline the considerations built into the JVA and operating agreement.

Capital Contributions

The JVA specifies how much capital each JVA member will initially contribute. Naturally, this figure can be whatever the members negotiate. Typically, the capital member will contribute 90% to 95% of the initial capital, with the operating member contributing the remainder. However, these numbers can vary greatly. For example, if the operating member is relatively flush with capital, it might contribute up to 50%. Of course, this allows the operating member to maintain more control over the JVA.

In addition, the JVA specifies any mandatory, secondary capital contributions the members must make. Normally, the capital contribution requirements reflect the type of property the members will buy or build. Sometimes, the capital member will insist on not contributing additional capital in excess of their initial percentage. Clearly, that might apply for a stabilized transaction, where members don’t plan to further develop or improve the property. Naturally, the opposite is true for a transitional property that contemplates to further develop or improve the real estate. That is, the JVA specifies which additional contributions are mandatory. Specifically, for new construction, the JVA will address budgeted amounts, cost overruns and unforeseen costs.

Provisions for Additional Contributions

The joint venture agreement can distinguish between additional discretionary and non-discretionary costs. Non-discretionary expenses include:

  • Legal compliance costs
  • Real estate taxes
  • Insurance
  • Safety issues

The JVA calls out these expenses to so that it can support practical processes for both parties to fund them. In other words, the JVA can include remedies available when one party objects to the specified funding. One such remedy is to assign a loan to the non-funding party and charge it interest. Additionally, the remedy might dilute the non-funding party’s membership interest in the project.

The JVA can clarify certain considerations regarding capital contributions, including:

  1. Capital Calls: Whether each member can call for more capital from the other member.
  2. Notifications: Specifying the timing of a notice for additional capital contributions.
  3. Member Loans: How much interest to charge a party triggering a member loan due to failure to fund a mandatory contribution. The member that does fund the contribution can collect interest and gets top priority when collecting project distributions.
  4. Dilution Formula: How much to dilute a member’s interest in the project due to not funding a mandatory contribution.
  5. Default: Whether failure to fund can result in a default by the non-funding member.

Waterfall Distributions

The JVA provides rules for waterfall distributions. That is, the rules for distributing to members portions of net operating proceeds or capital returns from the property.

Considerations include:

  1. Priorities: Often, JVAs specify that capital members receive return of capital ahead of operating members (the “pref”). Also, JVAs may specify the priorities for distributing a return on capital, often using an internal rate of return (the “hurdle”). Alternatively, JVAs may allocate distributions using the relative membership interests until members receive full returns of and on capital. Thereafter, the JVA might require higher-percentage distributions (the “promote”) to the operating member.
  2. Member Loans: Typically, the JVA will require repaying member loans with interest ahead of waterfall distributions.
  3. Dilution: Also, the JVA may specify percentage membership interest adjustments because of member loans.

Economic Percentages, Control and Fees

The JVA should clarify the correlation between each member’s capital contribution and its economic interest in the deal. The operating member may receive a capital contribution credit based on any property it contributes to the deal. This is important for the operating member in order to withstand the demands of the capital member. Additionally, the operating member may receive certain fees for services it performs. Those services include sourcing and managing the JVA property.  The joint venture agreement should clearly and succinctly clarify the type, recipient, amount and timing of these fees. JV fees include:

  1. Acquisition Fee:  Recognizes the operating member’s sourcing the property, usually paid at the real estate closing. Frequently, the fee is 1% of the property’s purchase price, perhaps including any additional capitalization.
  2. Financing Fee: Typically, about 1% of the mortgage and/or mezzanine loan. The sourcing member (i.e., the member that arranges the debt financing) receives the fee at property closing. This fee is much less common than it once was.
  3. Asset Management Fee: The operating member collects this fee for managing the property and the investment. Management duties include overseeing operations, creating budgets and business plans, mortgage compliance, bookkeeping, and handling tax payments. Normally, this fee is about 1% per year of the initial invested equity.
  4. Property Management: The operating member may hire a property manager or an affiliate for the property. Impressively, the JV pays about 3% to 4% per year of the property’s gross revenues to the property manager.
  5. Leasing Fee: A market-rate commission that the JV pays for a leasing manager or affiliate. Importantly, the venture might split the fee between the operating member’s leasing manager and an outside third-party broker.
  6. Development Fee: The operating member may receive a fee for managing construction and/or development services. Typically, the fee is about 3% to 5% of hard construction costs.
  7. Disposition Fee: Typically, a 1% fee the operating member collects when selling the property.

Secrets to Highly-Successful Deals

Highly successful deals hinge on how well the parties negotiate the JVA.  That is, the agreement should be as explicit and transparent as possible.  Therefore, a successful JVA will specify these points:

  1. The organizational and management structure of the joint venture.
  2. The exact timing and amounts of contributions from all parties.
  3. What form each contribution it will take. Contributions could include capital, services, letter of credit guarantees, existing property and other items of value.
  4. How to value any property a member transfers into the JVA.
  5. Treatment of taxes on contributions, including built-in tax gains or losses. Also, how to treat the tax issues arising from a member contributing services.

Additional Secrets…

  1. What fees the JVA will pay for which services.
  2. How and when to split the profits and other cash flows. This should take into account the structure of management and contributions other than capital.
  3. Clarifying Issues surrounding control and management. These include management centralization, minority protections, voting rights, veto rights and conflict resolution procedures. The JVA should specify how to replace underperforming management.       Conflict resolution should minimize economic harm to the joint venture.
  4. Enumerating which decisions require a super-majority vote. These include amending documents, requesting additional capital, property purchase and sale, distributions, and taking on additional debt. In addition, it includes issues regarding nonstandard leases, budgetary deviations, approval of contractors and contracts, and approving large expenses. Also include decisions regarding lawsuits, conflicts of interest, adding partners, dissolving JVs, and changes to accounting, taxes, and insurance.

Lessons from Joint Venture Agreements Gone Wrong

A JVA can look great on paper but fail in execution. In examining deals gone bad, we suggest the following hard-won lessons:

  1. Explicitly nail down the duties and rights of each partner. This includes who will contribute what, who will run the project, and how to dissolve the JVA.
  2. Ensure each partner has a strong interest in success. That means each partner must be willing to experience real financial pain for a bad deal. The JVA should motivate each partner’s cooperation.
  3. Get to know your partner before signing the JVA. It requires interactions to size up a partner, and you should take your time before taking the plunge. Moreover, understand your potential partner’s ethics and capabilities. In fact, don’t be afraid to visit their office and watch how they operate. Do they pay their bills on time or offer up lame excuses?
  4. Watch out for conflicts of interest, real or potential. For example, suppose your partner earns fees for the services it renders. Frankly, it might object to selling the property in order to preserve its income. Unfortunately, that might be bad news for you.
  5. Enforce your business plan. That means, managing your partner like a new hire. Truly, the plan should describe what you expect from your partner and how you’ll monitor its performance. Furthermore, schedule regular meetings and address all problems openly and honestly.

Frequently Asked Questions: Joint Venture Agreement

A JV deal helps to allocate available capital to projects that will return a profit. It helps developers who lack sufficient capital. It also helps investors who are looking for a good return on their money.

Many things can go wrong with a JV deal. For example, a partner might fail to fulfill its obligations or refuse to make additional commitments and/or capital contributions. Also, conflicts of interest can cause partners to act selfishly instead of in the JV’s best interests.

A partnership is a single ongoing business where all partners are liable for the organization’s debts. A joint venture is a temporary relationship between multiple entities. The JV partners are only responsible for the debts of the JV.

Joint ventures do not necessarily need a tax identification number. That’s because the IRS does not require joint ventures to file separate returns. However, if the joint venture incorporates, it will need a tax id number.

JVA terms are situationally dependent. Some might last only a few years, but many last 10 years or more. Really, there is no reason to terminate a JVA as long as the members find it beneficial to continue. Indeed, JVAs should always specify an exit strategy and procedures to end the agreement.

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