Necessary Components for Successful Commercial Real Estate Joint Ventures
The old adage that two heads are better than one applies to commercial real estate, today more than ever.
As land and construction costs rise alongside development risks, joint ventures offer companies an opportunity to pool financial resources and management skills. The end result is often a successful and more profitable experience.
In the Washington, D.C., area, Baker Tilly partners James McCann and Randy Barrus see JV partnerships as the norm rather than the exception. With cap rates low and real estate expensive, JVs offer a way to spread risk and take advantage of a partner’s assets. A joint venture presents an opportunity to merge together available property, like land parcels, with a partner’s track record for development and management.
But pulling off a successful JV requires two parties with a strong relationship and complementary strengths.
“In a good partnership, you have folks that will complement each other,” McCann said. “One will have a strength in one area and the other side will have strength in another. You have folks with different skill sets that can come together, and the whole is greater than the sum of the parts.”
Joint ventures in commercial real estate will often divide responsibilities between an equity partner and a developer partner. Typically, one party provides the majority of the equity needed for the project, while the other controls the day-to-day financial and operational management. The equity partner will receive regular reports and have input and rights regarding certain decisions with respect to the project.
While the division of responsibility allows the partners to focus on their respective strengths, gaps can occur in communication.
Communication is key, and it starts with the JV agreement. Both parties need to identify when to file financial and property performance reports, schedule meetings and plan for unexpected expenditures.
“JV partners want to get the deal done, and they have a term sheet, but they often don’t take the time to get the JV agreement properly documented, vetted and understood,” Barrus said. “It can be a problem down the road. Time and time again, that JV agreement is what people go back to when mending a relationship.”
McCann and Barrus work with their clients to address their tax and advisory needs. Discussing the financial aspects of a partnership early can prevent tension down the road. Both parties need to be aware of each other’s needs when it comes to specific tax provisions and the flow of capital. Agreements should address cost overages, funding sources, the possibility of loans and shifting interest rates, to name a few concerns.
Partners should also understand how to exit the JV. Both parties should discuss when a property can be sold, and whether one partner can buy out the other’s interest in the project. Keeping tabs on the internal rate of return ensures the developer partner receives its promote, the share of profits in a real estate deal in addition to a predetermined return threshold.
“How the cash goes out, and how the taxable income is allocated, is really important,” McCann said. “How much equity are we putting in to start, how much equity will be needed in the future, how do we divide the profits of the underlying assets, how do we resolve disputes, what are the financial reporting requirements?”
Once a strong agreement is in place, having a management team that understands the local market and the asset class of the project can ensure future success. The management team needs to understand its responsibilities and have a certain level of autonomy making day-to-day decisions, McCann said. McCann and Barrus’ clients also stick to their strengths, whether that involves developing Class-A multifamily buildings or value-add office properties.
A successful partnership can also come down to complementary personalities.
“There’s a bit of a relationship-building process. It’s figuring out what are the relative strengths of each party that they are going to bring to the table," McCann said. "How is each partner going to maximize their contributions? It is a matter of finding partners who have a track record of success with these particular skills.”
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