Nuts and Bolts of Real Estate Joint Venture Partnerships
By: Jonathan B. Farrell, CPA, a partner in the real estate group of DiCicco, Gulman & Co. LLP
With real estate markets across the country flexing their recovery muscles — and, in some cases, clearly booming — new cash is available for developers seeking joint venture (JV) partners to help finance their projects. But while this cash can make it easier to launch projects and attract high-quality tenants, developers need to pay close attention to the details of the partnership.
Vet Your Partner
Before inking any agreement, developers not only need to understand all the details, but must make sure the agreed-upon terms will work for them. That means doing their homework and paying attention to three aspects of any deal: control and reporting requirements, economics and tax implications.
While it may seem counterintuitive, all parties should start by looking at their exit strategy. Developers and JV partners need to agree on both when and how they will exit an investment. If you want to hold onto the property over the long term and your partner wants to sell in a couple of years, that can lead to serious conflicts.
Developers also need to understand who will be making which decisions. Both sides will want to hold the reins, so it’s wise to lay out the specifics ahead of time. A JV partner, for example, can paralyze operations by achieving absolute control over details ranging from individual leases to needed repairs. At the same time, developers need to understand that their partners require sufficient control to protect their own interests.
Don’t overlook reporting requirements, either. Joint venture partners will need financial reports, and often have specific requirements as to format, the kind of software used and timing. They may require formal audits, which can be both expensive and time consuming. Such items usually are not deal breakers, but it is important to understand these requirements before agreeing to any partnership.
Understand the Economics
When it comes to analyzing the economics of a partnership, both the developer and the JV partner are going to want to negotiate an agreement that benefits them. Make sure that the economics allow for enough incentive to make the transaction a benefit and not a burden for either party.
As a developer, you need to understand the key economic issues:
- What is the preferred return your JV partner will want on its equity? Is this return reasonable for this project?
- Will the developer equity be given the same preferred return as the JV equity?
- Will both the JV equity and developer equity be given the same priority?
- Is there a promote (a share of cash flow distributed to the developer that is not proportional to his or her cash investment in the project) for the developer? If there is, is the promote sufficient to incentivize the developer?
- Be wary of a JV partner that seeks a 15 percent priority return on contributed capital plus the return of its capital first. This is essentially a 15 percent mortgage that can leave little or no incentive for the developer. The numbers can be startling: With $10 million of contributed capital and a 15 percent preferred return, the required preferred return would be $1.5 million annually, which ignores the compounding of the preferred return.
Factor in Taxes
Developers can face a variety of tax concerns when adding a JV partner. These issues should be addressed in the JV agreement. With careful planning, developers can minimize the tax ramifications of a JV partnership.
Taxpayers must consider issues such as income allocation clauses, Internal Revenue Code (IRC) 704(c) depreciation allocation methods and lock-out periods on both the property’s sale and debt repayment. Joint venture agreements should be drafted carefully to help minimize these issues.
When crafting income allocation clauses in the JV agreement, the developer should avoid clauses that cause phantom income allocations (those without cash). These typically arise in promote deals. Phantom income can be avoided by carefully modeling the allocations or adding tax distribution clauses.
Developers also should determine the most advantageous IRC 704(c) method. The property owner should be aware that depreciation deductions could be stripped and sent to the JV partner in certain situations. Proactive tax planning and negotiations can greatly reduce the burden of such stripped deductions.
Lastly, negotiating lock-out periods during which the property cannot be sold nor the debt paid down can result in significant tax benefits. These might include delaying gain recognition upon sale until a more tax advantageous time or avoiding the recapture of large negative capital accounts as a result of a decrease in the debt that supports them. This is especially important if the equity partner has control over major decisions.
As with all property-related decisions, owners should seek the advice of tax and legal specialists before embarking on JV partnerships.