Joint ventures in context: Expert interviews - real estate

Overview

Andrew Davies is a Senior Associate in the Norton Rose Fulbright corporate team in London. His practice has a focus on the real estate sector with wide ranging experience of corporate transactions including complex joint ventures, domestic and cross border M&A and capital fundraisings. 

Recent real estate joint venture transactions have included advising:

• BentallGreenOak in connection with the establishment of a co-investment structure in respect of the development of a mixed-use property in North London; 
• InfraCo Africa on its investment into two real estate investment trusts in East Africa;
• Ivanhoé Cambridge in relation to its joint venture arrangements with Greystar in respect of, amongst others, the development of the Greenford Green multifamily project in West London; and
• Workspace Group plc on its entry into a 50:50 joint venture with Whitebox Creative Limited.

Further information about Norton Rose Fulbright’s global real estate practice can be found here.

1. Are joint ventures a common feature of the commercial real estate sector?

Yes, not least so as to ensure an appropriate spread of investment risk. Commercial real estate has proved to be one of the standout asset classes in recent years, providing impressive returns; however, individually, a development can be a fairly risky venture given the number of factors that need to come together in order to make it a success, and it would be rare for a developer to bear all of the execution, development and financing risks involved with a “big ticket” property. 

As such, joint ventures in the real estate sector effectively create a platform in which seasoned developers and financial investors come together to pool resources, complement each other’s skills and expertise and share risk in order to create a successful development.

We will talk about the typical life cycle of a real estate joint venture later on, but you would find joint ventures throughout the life cycle of a real estate asset. For instance, you may have a joint venture set-up for the initial development and stabilisation of the project, after which the risk profile of the asset changes, with a different form of joint venture being established for the initial operational life of the property.  If the asset later needs repurposing, refurbishing or redeveloping, that can lead to further joint ventures and the cycle can be repeated. 

Real estate investment trusts (also known as REITs), for instance, are a form of joint venture incorporating fund style characteristics that typically own, operate and finance income-yielding real estate, spreading risk across a number of real estate assets often across sectors and geographies.

2. Is there a typical profile of the different participants in a real estate joint venture?

Typically, real estate joint ventures are established such that financial backers are invested in the equity of the relevant vehicle which in turn appoints a developer or manager to develop and/or operate the asset and to take day-to-day decisions relating to the underlying property. A common feature is that the developer or manager is also invested in the equity of the joint venture to ensure it has some “skin in the game” but a significant part of its remuneration will derive, if the development is successful, from carried interest or “promote”. The promote is a key mechanism to ensure that managers are incentivised, in the context of a development, to keep the cost base low and, in the context of an operating asset, to generate the highest yield possible. The promote would only be payable where certain target thresholds have been achieved and they are often structured in tiers so that the reward becomes a larger proportion of the profit, the better the asset performs. For financial investors, a suitably invested and incentivised manager can give significant comfort that the joint venture’s assets will be developed and operated in a thoughtful and appropriate manner. Of course, the manager’s track record and reputation will also be significant factors in determining whether the proposed manager has the requisite level of experience and skill to act as a good custodian of both the joint venture’s assets and the investors’ funds.

In terms of investors, they come in all shapes and sizes ranging from institutional investors such as pension funds and insurance companies, to private equity and retail investors, and from passive financial investors to active stakeholder investors. Depending on the structure of the relevant joint venture, there may be legal requirements as to the type of investor which can invest in that venture; however, the main consideration in determining whether someone is a suitable investor often comes down to credit worthiness and reputational standing.

3. Is there a common structure used for real estate joint ventures - what are the initial considerations and motivations which may influence deal structure?

There is no single common structure used for real estate joint ventures and we see the full range of options being used, including limited partnerships, unit trusts, REITs and incorporated limited liability vehicles. The choice of structure – and the jurisdiction in which such structure is established – depends  on a number of factors, including the tax treatment applied to the particular structure, the stage of development of the relevant real estate asset, the type of investor and the breadth of the investor base and the management structure to be put in place.

Also, a structure may evolve over time to track the relevant stage of the asset’s life cycle, or so as to reflect the wider collaboration of the investors with the manager. For example, it is common for investors and managers with a long-standing relationship to establish a “master” joint venture through which they invest in a number of either wholly-owned or other joint venture entities, which allows them to react quickly to potential opportunities in the knowledge that they have a tried and tested structure in place to protect their investment.

However, in practically all scenarios, the principal considerations when structuring a real estate joint venture include: (a) the stage and risk profile of the venture, (b) exit opportunities; (c) management of the venture, including incentivisation, scope of authority, removal and approach to liability; (d) funding requirements and events of default; and (e) tax efficiency.

4. Is there a typical life cycle of a real estate joint venture?

You could find a real estate joint venture at any stage of a real estate asset’s life cycle; however, typically, a structure is established for the initial development and stabilisation of the asset, which is the riskiest point in the life cycle, with a new structure being adopted for the operational, income-producing phase which is more suited to the needs of a long-term investment.

As mentioned, the development and stabilisation phase is the riskiest phase of a project. It can take a considerable period of time to even get to the point at which construction can begin, taking into account the processes for acquiring land, carrying out market analysis, environmental assessments and surveys, and obtaining appropriate planning consent (which often comes with conditions) and financing. Thereafter, the construction works need to be undertaken which will invariably involve setbacks, cost overruns and unexpected challenges, following which the asset will need to be leased-up or stabilised for sale. Clearly, at this stage, the type of investor and the amount of capital at stake is likely to be very different to the position later on in the life cycle, and you typically see the developer taking on a greater share of the risk and having a larger share of the equity during this phase. 

Once the asset is developed and stabilised and has become income-producing or ready for occupation, this is usually the time at which developers and initial phase investors seek an exit, either by selling the property or the vehicle owning the property, possibly to another joint venture or REIT, or by bringing in fresh capital and diluting their stake in the existing vehicle. They will want to do this, of course, so as to realise some or all of the value created during this phase.

During the operational phase, the key will be to source long-term investors (typically institutional investors, such as pension funds or insurers) who are more likely to take a passive approach to the investment and allow the appointed manager to manage the asset and secure as large a yield as possible.

Once an asset has reached the end of its expected lifecycle, the asset will most likely be either redeveloped or demolished with the entire process starting again.

5. What are the issues that often require the most time to agree at documentation stage?

In my experience, the top 3 topics which require most negotiation as part of the joint venture documentation are:

• Value items – funding requirements, fee and promote structure, and investor distribution rights;
• Exit – lock-up, rights of first offer / refusal, drag and tag rights, and events of default; and
• Governance – decision-making and reserved matters, manager’s authority, manager removal rights and related party considerations.

Achieving the right balance in respect of the above issues, is key to ensuring the success of a real estate joint venture. Clearly, investors and managers are unlikely to be entirely aligned on all of these topics and, whilst the manager is likely to have some overlapping interests in its capacity as an equity holder, the main value of their role in the project is in the fee and promote structure. As such, a manager will seek the most favourable fee structure with limited removal rights and a broad scope of authority, whilst the investors will want to ensure that their returns are maximised at the same time as ensuring that the manager can be replaced if they fail to perform to the standard expected.  In such circumstances, they  will want some or all of the promote to be available to any replacement manager that they need to bring in.

Investors will also want to ensure that they can achieve an exit at an appropriate juncture, either collectively or individually, and interests as between investors themselves may not necessarily be aligned in this regard. For instance, some investors may have a shorter investment horizon than others and, therefore, want to exit sooner, whilst longer term investors will want to ensure that any incoming investor satisfies certain criteria (whether that be financial, reputational or other characteristics, such as that they are not competitors). The degree to which investors wish to participate in the operation of the joint venture and decision-making process is also an area of much debate as some investors will be happy for the manager to manage the asset as it sees fit (being incentivised by the fee and promote structure to make good decisions) with investors only being consulted on a narrow category of fundamental issues, whereas others will want to be more active in the decision-making process of the joint venture; particularly, where the joint venture is intended to operate as a platform so as to invest in a range of real estate assets.

However, of greatest importance to investors will be to ensure that their commitment with respect to the venture is capped, meaning that sufficient headroom will need to be built-in to any agreed commitment cap so as to cover cost overruns and contingencies (eg in the original or updated business plan).

Another key area for discussion is how the venture should deal with related party arrangements given that, in most cases, the manager and/or developer and possibly other service providers are likely to be affiliated entities. Ideally, investors would want to ensure that any conflicted entity does not participate in any decisions of the venture relating to it, or one of its affiliates and that, if one affiliated entity commits an event of default, such event will trigger a cross-default across all other affiliated arrangements (where the breach is serious enough).

6. Some parts of the commercial real estate sector have been badly impacted by the economic challenges of the pandemic. What areas of joint venture documentation come under most challenge in those circumstances in your experience?

Perhaps somewhat unexpectedly, we have continued to see significant investment being made in commercial real estate across a variety of asset classes and jurisdictions. Of course, there is currently some uncertainty, but many of the initial fears regarding the future of home-working, lack of financing options etc. are beginning to assume a better perspective.  More predictably, we have seen that logistics and residential asset classes have been more favoured and active than more traditional commercial offices.

Many of the difficulties encountered by real estate joint ventures during the pandemic (again, dependant on the stage of the relevant asset’s life cycle) relate to procurement issues (e.g. force majeure) and delays to construction, and deferred or unpaid rent, which inevitably have led to increased costs. So, some investors have been asked to inject more capital and exit options have been relatively few whilst market uncertainty has been high.

In terms of the joint venture documentation, such pressures have led to many venture partners scrutinising and – in some cases – renegotiating their levels of financial commitment and engagement with the decision-making processes of the venture, and the scope of events of default.  For earlier stage developments, there has also been re-examination of the business plans and whether target markets and timings need to be re-assessed.  Moreover, managers have been keen to review their fee structures given that the unforeseen delays and higher costs generated by the pandemic may have negatively impacted on their forecast remuneration.

At this stage (and it is probably still too early to say definitively), I do not anticipate the pandemic to result in any long-lasting changes to the way in which real estate joint ventures are structured or operate.

7. Do you have a view on whether joint ventures in the real estate sector may become more or less common over the next few years?

Joint ventures in the real estate sector are already an integral part of real estate investment mix and I suspect that this is likely to continue for the foreseeable future; indeed, I imagine that joint ventures will become even more common in future. Whilst commercial real estate – in my view – will continue to be a story of investment success over the longer term, the increased levels of uncertainty we have seen over recent times will likely lead many investors to continue to spread risk by investing in a number of different ventures, rather than being over-exposed to a particular asset or sector, and may require greater occupational flexibility from the properties in which they invest.