A joint venture can get complicated. The easiest way to break it down is that a joint venture is an arrangement where two investors create a partnership to purchase an asset.
In terms of commercial real estate, the joint venture typically consists of two main partners: a general partner (GP) and a limited partner (LP). The GP is usually the developer of the asset but can sometimes be a local investment group. In contrast, the LP is the person or group of people with the capital. LPs usually have billions of dollars that are backed by some sort of fund, sovereign and pension funds being the most common. Although the members of a venture are often referred to as partners — and can even have a legal structure as a partnership (though LLC is most common) — they are not partners in the classic business sense. Business partners work together toward achieving a successful company and have many goals in common.
Joint venture partners join forces to accomplish one specific task. All members of the joint venture must contribute to the costs of achieving the specified task and are responsible for any losses or profits. The joint venture is its own entity, separate from all the business activities of the partners involved in the arrangement. When it comes to commercial real estate finance, the specific task can have many facets. It can be to develop land, repurpose a building, refinance a property’s existing capital stack, and more. For the investors in a joint venture, the end goal for taking on these projects is always the same: to earn a significant return on their investment and increase profits.
Other than simply seeing sizable investment returns, joint ventures have other appealing advantages for investors. In commercial real estate specifically, these ventures enjoy the following benefits.
As we just mentioned, returns are at the forefront of the minds of the JV partners. With their powers combined, they work together toward the primary goal of increasing profit. A joint venture can be structured in dozens of creative ways so each partner sees the returns that are most beneficial to them. However, ventures are designed so each partner receives the same returns relative to their investments. To sweeten the deal for the GP, promote structures or “waterfalls” are written into the deal. Promote structures are added pay-outs that GPs can enjoy if they reach an agreed-upon return specified in the joint venture contract. A common waterfall hurdle is earning an increased rate of return over a certain level of return
Let’s look at an example.
Say you’re a GP who strikes a 90-10% deal with your LP, and the required investment from joint venture equity is $10 million. That means the GP’s investment is one million and the LP’s investment is nine million. If the return on equity (ROE) is estimated to be 8%, the GP and LP see an $80,000 and $720,000 return, respectively. An example of a GP waterfall would be an additional 15% return on everything over the 8% benchmark. Also, GPs often include fees that are charged to the LP throughout the course of the venture to cover operational costs.
If it seems like the GP (sponsor) is doing most of the work in a joint venture agreement, it’s because they are. The sponsor comes to the capital partners with the business plan, proforma models, case studies, and everything else that will make the LP jump at the investment opportunity. The GP also acts as the “boots on the ground” for the project managing day-to-day operations. It’s why they are often called the “operating partner.”
However, the hard work is worth it for the GP. They gain a massive amount of capital from the LP, making it possible for them to close on one or multiple big-money deals. The LP gains value from the GP because they provide property management expertise that the LP may not have. Also, as we just mentioned, the limited partner doesn’t have to be weighed down by daily operation management decisions of the investment, which is a very beneficial opportunity cost of their large investment of capital.
However, the most appealing aspect of an experienced GP to any capital partner is their local market knowledge and execution of a business model which they have successfully pulled off for years.
An example of this could be a GP that has been specializing in multi-family developments in Dallas, Tx for the past 20 years. LPs look to partner with many different operating partners with this type of experience so they can invest across all kinds of markets and asset classes.
Waterfall hurdles for GPs are not the only enticing aspect of a JV agreement in commercial real estate. Suppose market conditions fluctuate, resulting in the joint venture agreement’s terms becoming unattainable and thus dissolving the general partnership. In this unfortunate case, the net returned investment — less the senior debt — is repaid pari passu. This term means the loss-sharing is equal between the two parties, allowing for some money back. It also means shared upside when the project is successful. In a general partnership, the GP would be responsible for the debts.
Unlike senior debt from financial institutions, there is no regulating body overseeing the terms of a joint venture in commercial real estate. Because of this freedom, deals between GPs and LPs can be brokered in countless ways. The terms of the JV can be set up to cover one or multiple assets, and the returns can be reaped or reinvested to other deals by the parties involved. It all depends on how the deal is structured.
Developing a strong relationship with your JV partner is vital to not only the success of your current deal but also your continued success down the road. Forming multiple, fruitful ventures is no different than building a career resume. As a developing GP partner, you can scale your commercial real estate portfolio exponentially fast using JV equity.
Joint ventures are utilized across almost every industry. Real estate joint ventures are a category in and of itself within the five different types of joint ventures. However, because we’re here to teach you about commercial real estate joint ventures, we won’t go into the others used in other industries. CRE joint ventures are like snowflakes. There will likely never be any two deals that are exactly the same. For that reason, there’s not a clearly defined “type” of commercial real estate joint venture. To better understand these types of agreements, it’s better to look at the resources the GP turns to for securing their financing. We turned to Avi Zukerman, Director of Capital Markets at Lev, to help us out.
“The business model of the general partner is to take a very limited amount of their capital and stretch it across many deals,” Zuckerman explained. There are a vast array of investment options when it comes to who is actually acting as the capital partner. It could be one person or group, or a broker could assist a GP in securing many different deals from multiple sources of equity. There are four most common sources of equity in commercial real estate joint ventures.
Private equity (PE) is typically managed by groups of finance professionals that acquire and manage the capital of many different investors and often turn that capital into private equity funds. These funds are deployed to invest directly into companies and aren’t listed on a public exchange. The Blackstone Group is an example of a private equity group and is one of the largest in the world. GPs tend to turn to private equity when they’re seeking out capital on their own behalf but don’t have access to other sources of equity that a broker would. Private equity is a popular source of capital for CRE ventures. However, the deals that are structured between GPs and private equity groups aren’t always favorable, as the PE funds only have their best interest at heart.
Family offices are, in a nutshell, exactly what they sound like. It’s a group of wealth-management professionals that represent a single, high-wealth family. Family offices are appealing for CRE investors and brokers because they’re much easier to negotiate with and have fewer gatekeepers than PE groups. According to Campden Research, in 2019, there were an estimated 7,300 family offices worldwide that had $5.9 trillion in managed assets and $9.4 trillion in available overall assets.
An opportunity fund is a business entity (usually set up as an LLC or Corporation) that must invest at least 90% of its holdings into an opportunity zone. An opportunity zone is a locale defined by the IRS as “An economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment.” Opportunity funds are generally raised by PE groups as one of their many buckets of capital. According to Equity Multiple, there are over 8,700 opportunity zones across the United States and its territories. To see an example of an opportunity fund, check out the Detroit Real Estate Opportunity Fund.
When it comes to investing in commercial real estate in the United States, there are tons of overseas groups that express interest in becoming capital partners in JV arrangements. This term is more of a catch-all term for any of the above-described equity sources, but are generally PE or Family offices not located in the U.S. The common advantage among them all is that they don’t have representation in the U.S. to find, negotiate, and underwrite joint ventures. GPs love being able to be paired with overseas investors of this nature because it’s more of a passive investment partnership.
So, you now have a better understanding of what a joint venture is, why they’re beneficial, and who is behind them. Before you rush out to strike a JV deal, consider these three very important points Avi Zuckerman mentioned.
“Using more than one broker to strike a deal is understandable when faced with a short timeline,” Zuckerman said. “But GPs diminish the value of their deal in the eyes of prospective investors when the same offer is presented to them multiple times. Even if it’s a great deal, it brings into question who is in control and dilutes its values in the eyes of the investor.”
“There are many benefits working with an intermediary who can handle both the debt and equity portions of your joint venture, ”Zuckerman said. “When you have one professional handling both areas, GPs can speak to questions from either lenders or investors with a lot of confidence.”
“Any GP can come to JV investors with business plans and proforma models. But if you really want to show your worth as a JV partner, be prepared to show comparables,” Zuckerman advised. “Meaning, have rent comparables, sales comparables, and be able to defend all your assumptions of the investment.”
There’s no doubt that joint ventures are complex, no matter what industry, and have an array of benefits and disadvantages to forming one. For commercial real estate, fruitful returns on investment, shared expertise, hedged risk and the ability to leverage capital are what draw in investors. However, they’re not something to be entered into lightly, and there are many considerations each partner should take into account before forming one.
