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					The Economics of Real Estate Joint Ventures
               By Richard R. Spore III
                   J
                       oint ventures (meaning an entity         Carving Up the Pie: Structuring               parties structure the deal. For example,
                       formed for co-investment by multi-       the Economics of a Successful                 the extent to which a project is financed
                       ple parties, including general                       Joint Venture                     with debt versus equity significantly
                     partnerships, limited partnerships,       The threshold issue for the joint ven-         affects risk. Obviously, the greater the
                   and limited liability companies) are a      ture partners (as used in this article,        leverage, the greater the risk for every-
                   common vehicle for providing equity         “partners” refers to the holders of inter-     one, although this risk probably bears
                   funding for real estate projects. They      ests in any type of joint venture entity)      most heavily on capital providers who
                   are popular at all levels of the real       is how they should carve up the eco-           face the potential loss of their capital if
                   estate “food chain,” from mega-deals        nomic pie if the project meets cash flow       a highly leveraged project goes
                   involving institutional, publicly traded    expectations. At a minimum, this               through foreclosure proceedings.
                   firms down to smaller transactions          would mean that the project generates          Furthermore, the nature of the joint
                   between local developers and                sufficient cash flow to pay operating          venture project obviously affects the
                   landowners. Regardless of their size        expenses and meets scheduled debt              risk calculus. For example, an income-
                   and complexity, however, real estate        service payments, so that the owners           producing property that has already
                   joint ventures ultimately involve a         do not have to contribute additional           been stabilized (that is, leased up, with
                   marriage of some kind between               capital to keep the project afloat. The        positive cash flow) entails less risk than
                   providers of capital and providers of       related underlying question for the            a troubled property that must be
                   real estate services.                       capital and service providers is: what         turned around. If a project is a new
                      Every joint venture structure must       are appropriate risk-adjusted economic         development, the attendant risk will be
                   address three economic concerns:            returns for their respective contribu-         less if it is anchored with a major ten-
                                                               tions to the project?                          ant as opposed to being a purely spec-
                     1. providing the partners with                Answering this question requires           ulative development. Of course, all
                        appropriate risk-adjusted returns      the partners to assess two factors: first,     project-specific risks must be viewed in
                        if the deal is successful,             the relative value of their contributions      the context of larger macroeconomic
                     2. providing a mechanism for              to the joint venture and, second, the          developments in local, national, and
                        restructuring and salvaging the        risks associated with the project. The         global markets, which, in turn, can
                        deal if things do not go as well as    first assessment is typically (but not         affect project costs, leasing, and interest
                        expected, and                          always) more objective and therefore           rates. All of these factors affect the par-
                     3. ensuring that technical tax and        simpler than the second. For example,          ties’ risk and must be taken into
                        accounting matters do not have         if a capital provider simply writes a          account because they determine what
                        an unintended and unanticipated        check to the joint venture, there should       return will be required to induce the
                        effect on the parties’ negotiated      be no issue about the economic value           parties to commit their resources—
                        business deal.                         of the contribution. But, if the contribu-     whether financial capital or real estate
                                                               tion is in-kind—for example, a contri-         services—to the joint venture.
                       Not surprisingly, businesspeople        bution of land—a valuation issue                   One particularly important ele-
                   typically focus on the first concern of     exists. For a service provider, the valua-     ment of risk in structuring joint ven-
                   determining appropriate returns for         tion of the contribution will necessarily      ture economics is the extent to which
                   the parties if the venture generally per-   be more subjective. Although the mar-          the partners’ economic returns are
                   forms as expected, because this is          ket for almost any conceivable package         contractually “guaranteed” (at least to
                   almost purely a business issue.             of real estate services should provide         the extent of available joint venture
                   Businesspeople, however, tend to leave      good information about the value of            cash flow) as compared to “at risk”
                   the second and third concerns to the        those services, the value of services is       returns that are based on overall proj-
                   lawyers to “parade the horribles”           nonetheless inherently more subjective         ect profitability or the achievement of
                   about what might go wrong, propose          and thus more likely to be “in the eye         certain other performance thresholds.
                   solutions for potential problems, and       of the beholder.” The valuation of serv-       For example, a developer/service
                   make sure that no tax or accounting         ices provided to the joint venture by a        partner may receive guaranteed pay-
                   “traps for the unwary” affect their         partner may, therefore, entail signifi-        ments in the form of development,
                   clients’ carefully negotiated economic      cant negotiation and ultimately conces-        construction management, leasing,
                   arrangements. This article examines         sions by the joint venture partner who         sales, financing, or property manage-
                   the role that each of these three funda-    most wants to do the deal.                     ment fees or commissions. A capital
                   mental economic concerns plays in               The second key factor in determin-         provider may receive minimum nego-
                   structuring real estate joint ventures.     ing the partners’ negotiated joint ven-        tiated financial returns on its capital
Andrew O. Alcala




                                                               ture returns is their assessment of risk,      in the form of interest on subordinat-
                                                               which can take many forms in a real            ed loans or minimum preferred
                   Richard R. Spore III is a member in         estate transaction. The same real estate       returns on its unreturned equity capi-
                   the Memphis, Tennessee, office of           project can entail significantly different     tal. In general, the greater the contrac-
                   Bass, Berry & Sims PLC.                     risks simply depending on how the              tually “guaranteed” payments or


                                                                                                            PROBATE & PROPERTY        JULY/AUGUST 2007 27
returns to a partner, the smaller its            arises when all partners provide guar-           overall returns should be. Stated
residual “at risk” profits interest              antees, but a particular partner                 a little differently, the more a
should be, and vice versa.                       nonetheless arguably bears more risk             partner has at risk financially—
   Another key element of risk that              because that partner has greater finan-          whether through a capital contri-
should affect the partners’ relative             cial strength and thus is more likely to         bution, under a guarantee, or in
returns is the effect of any guarantees          be called on to perform under the                terms of opportunity costs from
(or other credit enhancements) that              guarantee.                                       foregoing other projects—the
they provide to support any third-                  Ultimately, the economic model for            greater that partner’s returns
                                                 most joint ventures involves some                should be.
                                                 combination of the following elements:         • The greater a partner’s overall
                                                                                                  risk in a project (whether of loss
                                                   • a return of capital, typically with          of capital or failure to realize
                                                     some minimum threshold or pre-               anticipated returns), the greater
                                                     ferred returns, to the capital               that partner’s overall returns
                                                     providers;                                   should be if the project performs
                                                   • in certain cases, some guaranteed            as expected.
                                                     payments to service providers              • The greater a partner’s contractu-
                                                     depending on the nature of the               ally guaranteed returns, the
                                                     project and the scope of the ser-            lower that partner’s residual “at
                                                     vices provided; and                          risk” profits interest should be.
   The greater the value of a                      • negotiated sharing of the remain-
                                                                                               Planning for Trouble: Capital
   partner’s relative economic                       ing distributable amount among
                                                     the joint venture partners based               Call Provisions in Joint
    contribution to the joint                        on the relative risks they bear                  Venture Agreements
 venture—whether of capital or                       and the value they add through
                                                     their entrepreneurial efforts.
                                                                                             It is a cliché that no war, marriage, or
                                                                                             partnership was ever started without a
  of services—the greater that                                                               good deal of optimism. Unfortunately,
         partner’s overall                           For lower risk projects (for example,
                                                 income-producing projects that are at
                                                                                             things do not always go as planned,
                                                                                             and this is certainly true with real
        returns should be.                       or near stabilization), this negotiated     estate projects, particularly those entail-
                                                 sharing of the upside may simply            ing significant risk. Costs overrun,
                                                 involve a modest “promote” fee for the      interest rates rise, tenants fail, and
                                                 service provider of a few extra percent-    neighborhoods decline—all these fac-
party financing for the project. This risk       age points of return over and above         tors, along with a host of others, can
can obviously vary greatly depending             the service provider partner’s baseline     result in a troubled project. “Troubled”
on the nature of the project and the             return on its invested financial capital,   in this context most commonly means
guarantee—for example, a guarantee of            if any. But, for development projects in    that the owners of the project must
“bad boy” nonrecourse carve-outs on a            which the service provider may be           arrange for additional capital infu-
nonrecourse loan secured by a stabi-             adding significant entrepreneurial          sions—whether of equity or debt—
lized property should entail much less           value and taking substantial risks          because the joint venture’s cash expen-
risk than full payment and perfor-               through exposure on loan and per-           ditures outstrip its cash receipts. The
mance guarantees on a construction/              formance guarantees, the service            question becomes whether (and to
development loan for a new project.              provider partner may receive a back-        what extent) the joint venture partners
The extent to which one partner                  end “carried” profits interest (after a     want to plan for this trouble on the
assumes more risk than other partners            return of capital and any additional        front end by providing in their joint
by exposing its other assets under a             preferred return to the capital             venture agreement for a negotiated
guarantee to support third-party joint           providers) in the 30–50% range.             mechanism for “feeding” the joint ven-
venture financing should be reflected                In summary, a few generalizations       ture with additional needed capital.
in the guarantor partner’s overall joint         emerge in analyzing real estate joint       The alternative is simply to deal with
venture returns. Compensating a part-            venture economics that are obvious          this problem when and if it ever arises.
ner for assuming this additional risk            but probably bear repeating:                    It should not be a foregone conclu-
can be accomplished through a sepa-                                                          sion that the partners will want to
rate guarantee fee based on the amount             • The greater the value of a part-        include detailed capital call provisions
guaranteed or by increasing a guaran-                ner’s relative economic contribu-       in the joint venture agreement. For
tor partner’s overall negotiated joint               tion to the joint venture—              example, with a stabilized, relatively
venture returns. Of course, a more sub-              whether of capital or of ser-           low-risk project, the joint venture part-
jective (and therefore thornier) problem             vices—the greater that partner’s        ners may well conclude that the risks



28 PROBATE & PROPERTY         JULY/AUGUST 2007
of having to infuse additional capital in      • Are there any limitations on the            the partners? For simple joint
the project in the future are so low as to       amount of the capital call? For             venture deals that do not involve
not justify the effort required to negoti-       example, can capital calls up to a          return preferences or “flips”
ate and agree on capital call provisions         certain amount be approved by               among the partners, this may be
in advance. Or, a partner may believe            the joint venture’s managers/offi-          an easy question to answer—each
that it will reap strategic or tactical ben-     cers, while capital calls over that         partner simply contributes in
efits by dealing with this issue only            amount require partner                      accordance with such partner’s
when and if it actually arises. For              approval? Perhaps this concept              partnership percentage owner-
example, a capital partner that has              might include additional refine-            ship interest. But with a more
relied on a developer/service partner’s          ments, so that capital calls over           complicated joint venture in
rosy projections regarding the joint             $x but up to $y can be approved             which returns to (and percentage
venture’s future performance may con-            by a simple majority of partners,           interests of) the owners may vary
clude that it will be able to extract more                                                   over time depending on the joint
pounds of flesh from the developer                                                           venture’s performance, at any
once the financial crisis actually arrives                                                   given point in time it may be
(if it ever does) than if it is negotiating                                                  more difficult to determine what
with the developer about hypothetical                                                        a particular partner’s percentage
problems that, in the first blush of opti-                                                   interest in the project is and there-
mism at the outset of the project,                                                           fore what percentage it should
appear unlikely to occur.                                                                    contribute of any required capital
    But the partners will often conclude                                                     call.
that the advantages of providing for a                                                     • What are the consequences of a
previously agreed-on method for rais-                                                        partner’s failure to meet a
ing at least certain amounts of addi-                                                        required capital call? Can other
tional needed capital are compelling.               The riskier the project,                 partners essentially “oversub-
Such advantages include, for example,                                                        scribe,” meeting the defaulting
greater certainty for the joint venture        the greater the potential need                partner’s contribution obligation,
and its partners if trouble does arise;          for additional capital in the               and, if so, what is the effect of
lower transactions costs in obtaining                                                        that? Is it treated as a forced loan
capital if it is needed; and reduction of         future and the greater the                 from the other partners to the
the risks associated with one of the               need for the partners to                  defaulting partner, and, if so,
partner’s trying (perhaps inappropri-                                                        what are the terms of that forced
ately) to turn the crisis to the partners’      consider including capital call              loan? Can the other partners elect
advantage by engaging in tough                      provisions in their joint                to treat the oversubscription as
retrading of the partners’ original busi-                                                    additional equity, with a corre-
ness deal in the context of a workout                 venture agreement.                     sponding forced dilution of the
situation.                                                                                   defaulting partner’s interest in
    If the partners do elect to include                                                      the project? Does the failure to
capital call provisions in their joint ven-                                                  meet a capital call trigger a
ture agreement, those provisions                 but any capital call over $y                default under the joint venture
should address the following basic               requires a supermajority                    agreement, and, if so, what are
questions:                                       approval.                                   the consequences of that default?
                                               • What is the required form of the            A loss of management rights?
   • What approvals are required to              capital contribution by the part-           The triggering of a buy-sell right
     trigger the capital call? Approvals         ners? Can it be made in the form            to buy out the defaulting partner
     by a designated number of man-              of subordinated (that is, to senior         on less than favorable terms?
     agers, directors, or officers? Or, if       secured lenders) debt, and, if so,          Other bad consequences to the
     partner approval is required, is            what are the terms of that subor-           defaulting partner?
     the required approval threshold a           dinated debt? Or must the contri-
     majority in interest or, alternative-       bution be made in the form of             In preparing joint venture agree-
     ly, a supermajority in interest of          equity? Can it take the form of        ments, keep in mind a few final consid-
     partners? (If the required thresh-          guarantees of additional third-        erations about capital call provisions:
     old is unanimity, there is proba-           party financing and, if so, what is
     bly not much point in having a              the consideration to the guaran-          • The riskier the project, the greater
     capital call provision, because all         tor partners?                               the potential need for additional
     partners would have to agree to           • How is responsibility for meeting           capital in the future and the
     the capital call in any event.)             the capital call allocated among            greater the need for the partners



                                                                                       PROBATE & PROPERTY      JULY/AUGUST 2007 29
     to consider including capital call          U.S.C. § 704(b). Section 704(a) generally   real estate joint venture transactions so
     provisions in their joint venture           provides that a partner’s distributive      that they can help ensure that no dis-
     agreement.                                  share of partnership income, gain,          connect occurs between the business
   • Always consider the likelihood              deductions, or credits is determined by     deal the parties believe that they have
     that a particular partner may be            the partnership agreement. Section          negotiated and the deal they actually
     able to retrade the joint venture           704(b) provides, however, that if the       get after applying the relevant tax and
     deal to its advantage if a financial        allocation set forth in the partnership     accounting rules.
     crisis requiring additional capital         agreement “does not have substantial           Accordingly, although a detailed
     arises in the future, but negotiat-         economic effect,’” then the partner’s       discussion of the myriad tax and
     ed capital call provisions have             share shall be determined “by the part-     accounting issues affecting real estate
     not been included in the joint                                                          joint ventures is beyond the scope of
     venture agreement. For example,                                                         this article (and the expertise of its
     if a development/service partner                                                        author), this article will review a few of
     has provided an unlimited pay-                                                          these basic concepts, including
     ment and performance guarantee
     on a new development project,                                                              • the basics of how capital
     that partner obviously has signifi-                                                          accounts work,
     cant exposure if additional capital                                                        • the difference between cash and
     is required to prevent a loan                                                                net income, and
     default and that capital is not                                                            • why those hard-to-understand
     forthcoming. If there is no clear                                                            tax allocation provisions really do
     mechanism for calling for addi-                                                              matter.
     tional capital (and remedies for a
     failure to meet such calls) in the
                                                          Real estate joint                      Capital accounts reflect and can ulti-
     joint venture agreement, the                      ventures are typically                mately drive joint venture economic
     other partners may try to lever-
     age this exposure to obtain
                                                    structured as pass-through               outcomes, and it is therefore important
                                                                                             to have a basic understanding of how
     greater concessions for their                  entities for federal income              they work. Capital accounts essentially
     agreement to provide additional
     capital to prevent the loan
                                                    tax purposes for a variety               are intended to reflect a partner’s capi-
                                                                                             tal in the joint venture. Therefore, capi-
     default.                                       of compelling tax reasons.               tal accounts are increased by items that
   • Also consider the degree to                                                             would increase partnership capital
     which the partners’ financial                                                           such as capital contributions and the
     strength will allow them to meet                                                        partner’s share of net income (which,
     future capital calls. If one partner        ner’s interest in the partnership.” Id.     of course, represents an increase in net
     is significantly stronger financial-        § 704(b)(2). The related Code § 704(b)      partnership assets). Likewise, capital
     ly than the others, it may affect           regulations to that section outline the     accounts are reduced by items that
     the drafting of the capital call            circumstances under which allocations       reduce partnership capital, such as dis-
     provision (or the decision of               will be deemed to have “substantial         tributions to the partner of property
     whether even to have such a                 economic effect” and include require-       and cash and the partner’s share of
     provision).                                 ments for a safe harbor for allocation      taxable loss (representing a decrease in
                                                 provisions. Treas. Reg. § 1.704-1(b)(2).    net partnership assets). Treas. Reg.
    Making Sure the Tax and                         Most real estate joint venture agree-    § 1.704-1(b)(2)(iv)(b).
 Accounting Tail Doesn’t Wag                     ments have pages of highly technical            The capital account rules help
      the Business Deal Dog                      provisions intended to address the con-     underscore the important difference
Real estate joint ventures are typically         cerns raised by these rules. These pro-     between a partner’s share of partner-
structured as pass-through entities for          visions are generally impenetrable both     ship income (as an accounting and tax
federal income tax purposes for a vari-          to the client and the nontax specialist     matter) and a partner’s share of distrib-
ety of compelling tax reasons. As such,          real estate lawyer alike, with the result   uted cash. Net income ultimately rep-
they are subject to the arcane partner-          that they both must rely on the high        resents an increase in a firm’s net
ship tax rules relating to the establish-        priesthood of the tax bar to interpret      assets, and allocations of net income to
ment and maintenance of capital                  their mysteries. It is helpful (if not      a partner therefore increase the part-
accounts and allocation of taxable               essential), however, for real estate        ner’s capital account. In contrast, cash
income, gain, and loss. Specifically,            lawyers representing parties in joint       withdrawals represent a decrease in
Code § 704(b) requires that allocations          ventures to have a rudimentary under-       partnership assets, and distributions of
of income and loss to partners must              standing of some of the basic tax and       cash to a partner therefore decrease the
have “substantial economic effect.” 26           accounting concepts that affect most        partner’s capital account. More impor-



30 PROBATE & PROPERTY         JULY/AUGUST 2007
tantly, from a practical perspective, a         would receive a $50,000 liquidating          will have to “earn” a positive capital
partner generally pays tax on its share         distribution), there has been a currently    account balance by having taxable
of net income but not necessarily on            taxable capital shift of $50,000 to the      phantom income allocated to the serv-
the partner’s share of distributed cash.        developer partner.                           ice partner without a corresponding
A partnership may therefore have tax-              The typical solution to this prob-        distribution of cash, and the capital
able income without having cash to              lem is to include distribution and allo-     partner will have to obtain the return
distribute to the partners, and vice            cation provisions in the joint venture       of its capital by having cash distrib-
versa. This phenomenon can make for             agreement requiring a return of capi-        uted in excess of the corresponding
unpleasant surprises.                                                                        allocation to the capital partner of tax-
    For example, a joint venture must                                                        able income.
repay the principal amount of its debts                                                          The complicated rules relating to
with after-tax dollars. Therefore, a joint                                                   the maintenance of capital accounts
venture that is generating significant                                                       and the methods of allocating taxable
taxable net income or gain (for exam-                                                        income, gain, and loss ultimately
ple, through outparcel sales or lease                                                        have great practical significance,
income) but using all available cash to                                                      because the final liquidating distribu-
retire joint venture debt will have                                                          tions in most real estate joint ventures
“phantom income”—taxable income                                                              will generally follow positive capital
allocated to its partners without accom-                                                     account balances. Not only is it intu-
panying cash distributions to those                  When the joint venture’s                itively obvious that the final distribu-
partners. The answer to this problem is           asset is ultimately sold and               tions should reflect the partners’
to determine, based on the joint ven-                                                        respective capital positions at that
ture’s business plan, whether this issue             the cash is ready to be                 time, one element of the partnership
is likely to arise and, if it is, to consider      distributed, it is important              tax safe harbor for allocations to have
providing for tax distributions in the                                                       substantial economic effect is that
joint venture agreement (and to make                that the partners’ capital               final liquidating distributions to the
sure the joint venture’s loan documents              account balances stand                  partners must be in accordance with
will accommodate such distributions).                                                        their positive capital account bal-
    Another situation underscoring the              in a ratio that will force               ances. Treas. Reg. § 1.704-1(b)(2)(ii)(b);
difference between taxable income and           distributions that give effect to            see also I.R.C. Reg. § 1.704-1(b)(2)(ii)(d).
cash can occur when a developer/ser-                                                         Therefore, when the joint venture’s
vice partner in a joint venture receives          the partners’ original intent              asset is ultimately sold and the cash is
a “promote interest” that, proportion-          relating to their business deal.             ready to be distributed, it is important
ately, exceeds that partner’s capital                                                        that the partners’ capital account bal-
contribution to the venture. A “pro-                                                         ances stand in a ratio that will force
mote interest” is incentive compensa-                                                        distributions that give effect to the
tion in excess of a distribution allocable      tal to the capital partner before the        partners’ original intent relating to
to an actual capital contribution, if any,      developer/service partner and capital        their business deal.
for achieving a stipulated economic             partner begin sharing upside profits
result. Unless the promote interest is          50/50. Note that these provisions will                     Conclusion
structured as a carried “profits” inter-        have to allocate at least some taxable       Real estate lawyers representing
est, which is triggered only after the          “phantom” income to the developer            clients in joint ventures cannot (or at
other partners have received a return of        partner, while providing for corre-          least should not) shrug off entire
their capital, it may result in a capital       sponding cash distributions to the           aspects of the transaction as consist-
shift to the developer partner. If that         capital partner, or there will never         ing of “business issues” or “account-
occurs, the developer partner would             really be a return of capital to the cap-    ing issues” or “tax issues.” Without at
have to pay tax on the amount of that           ital partner. If the capital partner is      least a basic understanding of the rel-
capital shift even though the developer         allocated (and pays tax on) $100 of          evant investment, accounting, and tax
partner did not receive a correspon-            taxable income for every $100 cash           considerations, the real estate lawyer
ding distribution of cash. For example,         that is received as a distribution, there    cannot provide effective counsel to
if a capital partner contributes $100,000       will never be any net decrease in its        clients involved in these kinds of
of cash to the joint venture and the cap-       capital in the partnership: the capital      transactions. An important part of the
ital partner and developer partner both         account keeps increasing by $100 of          lawyer’s role in these transactions is
receive a straight 50% interest in the          taxable income, only to be reduced by        to assist the client in anticipating and
partnership (so that if it were liquidat-       the $100 cash distribution, with no net      addressing various possible joint ven-
ed immediately after the initial capital        reduction in the capital account bal-        ture economic outcomes—good and
contribution, the developer partner             ance. The service partner essentially        bad. ■



                                                                                            PROBATE & PROPERTY        JULY/AUGUST 2007 31

				
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Description: Joint Venture Agreement Real Estate document sample