For Joint Ventures
There can be several benefits to going into a joint real estate venture, as it combines the expertise of a developer with the capital and resources of an investor. This person can be either an “equity member” or a “capital member,” depending on his or her stake in the partnership.
These types of arrangements can be very beneficial, but they can be a legal nightmare if you don’t plan ahead. Before you decide to get into one of these ventures, you need to keep some things in mind.
Choosing the Right Title
Before you decide to get into a joint real estate venture, you want to make sure you file it under the right title, as each of them has their benefits, as well as their drawbacks. Limited liability companies (LLC’s) are commonly used for these types of ventures because their structures are both simple and flexible. But they can come with negative tax consequences.
Most real estate ventures involve some type of third-party financing, which usually comes in the form of a mortgage or a loan. Joint venture agreements are meant to outline the terms and obligations of a loan, and investors will want to do everything they can to minimize their risk. The problem, however, is that a construction company may not have enough money to meet the stipulations of the loan, which may require the project to be completed in its entirety. Therefore, the agreement should be very specific about any current and future financing.
Timing of Initial Investment
When a joint real estate venture is initiated, three things will happen:
- The land is purchased
- The construction loan is secured
- The capital member will make an initial investment
The developer may negotiate with the capital member so he or she can get the money sooner. This can be done to cover certain costs, which may include:
- Due diligence investigations
- Paying lender fees
- Paying other important costs before construction
This type of arrangement should be made before the capital member makes the first investment.
This is the most critical part of a joint venture agreement, as it sets certain thresholds (or “waterfalls”) on the expected return for each member. This can be set in one of the following ways:
- An equal share of the return
- An unequal share of the return (either a 95/5 or 90/10 agreement)
- A 60/40 arrangement (where 60% goes to the capital member, and 40% goes to the developer)
It’s important to understand both the benefits and drawbacks of each arrangement, and it should be agreed upon before you decide to enter.
Identifying Management Responsibilities
As you might have expected, every member of a joint real estate venture has their own set of responsibilities, and it depends on what they bring to the table. The developer will be responsible for overseeing the construction of the property, and he or she will also be in charge of the day-to-day operations that will take place throughout the entire project. The developer may also hire a management company to oversee certain aspects of everyday operations.
The responsibilities and obligations of each member should be clearly defined in the agreement – some of which could pertain to the following:
- Admitting new members
- Reinvesting capital
- Approving budgets
The capital member may be responsible for approving construction and operating budgets because he or she is putting money into the project. He or she may also set certain thresholds, where the developer may not incur costs more than a certain amount.
Sometimes developers will need more money than they expected to keep the project going, and that can lead to certain disputes. The agreement should have a provision that addresses this issue, and it should set the terms by which additional capital can be awarded. All of this should be done before either member decides to enter the agreement.
These extra costs can be addressed in the following ways:
- The developer absorbs the extra cost
- The extra costs are treated as capital
- The extra costs are treated as loans
Additional capital is commonly treated as investor contributions where the equity member expects to see a return. The reason is that it makes the developer more accountable in terms of sticking to the approved budget. The additional costs will mean that he or she will not expect to get as much of a return.
Disclosure of Fees
Any fees for one member should be approved by all the other members, but ideally they should be agreed to prior to entering. Developers may charge certain fees, which may include:
- Acquisition fees
- Construction management fees
- Disposition fees
- Refinance fees
Some of them may be related to the management company that the developer has hired. Capital members may also charge asset management fees, and they may charge other fees related to refinancing and redistribution.
Removing a Managing Member
When the construction phase of the project has been completed, the developer has no reason to be a part of the agreement. So, once he or she has fulfilled his or her part of the deal, the developer will leave, and that will leave the equity member with a much greater risk.
The joint venture agreement should specify how a developer should leave, as well as how the capital member will take over management responsibilities. He or she may have the ability to sell the property should the need arise, and he or she may also approve any budgets or refinancing with regard to future operations. Both members should also understand what is expected of them during each phase of the project.
Having an Exit Strategy
Not only should the responsibilities of each member be outlined during the different phases of the project, but there should also be a clear strategy for how a member can leave the agreement. And there should be a “minimum hold period” after a project has been completed. This is meant to protect any capital within the arrangement.
A common strategy is to use a “buy/sell agreement,” where a member can sell their share of a company if he or she decides to leave. A member can also buy a share from another member – thus relieving that person’s responsibility and stake in the agreement.
Because of the complexities of joint real estate ventures, disputes can occur because of something that has not been clearly defined in the arrangement. So, any stipulations should use “clear language” to eliminate any confusion about the responsibilities and obligations of each member.
Still, there are times when a dispute is inevitable. That’s why the agreement should have some means of arbitration, and it should set a specific location for any litigation that may occur.
Hiring a Real Estate Attorney
While there are many benefits of entering a joint real estate venture, there are certain legal risks that come with these types of agreements. And knowing how to protect yourself from these liabilities is critical. That’s why it pays to hire a qualified real estate attorney, as he or she can advise you in the planning stage of a joint venture agreement.
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