Development: Joint Ventures With Investors

By Brian Bader, CPA
As more and more capital flows into real estate, financing structures are becoming more sophisticated, slicing the two Rs--risk and return--in a wide variety of ways. This often is the case in development financing, where potential profits are high but risks are too. The goal of these arrangements is to assure the investment group some type of priority return, plus a participation in the ultimate profits, while at the same time giving the developer the necessary incentive to proceed with the project. The investment can be pure equity or part loan and part equity. The following are some key elements to be negotiated in setting up this type of transaction.

Return of Capital and Preferred Return
The initial negotiating issue is the amount of capital the investor will put in the project and the preferred return to be received. Assume the investment group puts up 30 percent of the equity. In a "pari passu" structure, assuming the project is successful, both investor and developer will share the proceeds until they receive back their capital investment and a specified return (say, 10 percent). By comparison, in a subordinated arrangement, either or both the investor's return of capital and preferred return will have priority over that of the developer.

Look-back Return

In a further variation of the investor's priority position, he may be given a "look-back return." This assures him that he will receive the promised return before the developer shares in the remaining cash flow.

Example: Assume the partners agree that cash flow will be distributed in the following order: (1) return of capital to the investor followed by return of capital to the developer; (2) preferred 10 percent return to the investor followed by a similar return to the developer. Assume further that the initial projection was that a 15 percent return would be realized. If the investor has a look-back return, he then receives an additional 5 percent of cash flow so that his total return equals 15 percent. After that, the developer either may receive a similar return or the remaining cash flow will be divided on an agreed-upon basis, for example, 50-50. The look-back return has the purpose of giving the developer the maximum incentive to meet the construction schedule and manage the property efficiently because most of his return will not be paid unless the project is very successful or can be sold at a significant profit.

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The Promote and Tiered Rates of Return
The previous example involved priority and subordinated distributions. A further variation involves increasing in the share of the developer as higher rates of return are realized. The joint venture agreement may provide that the investor receives 80 percent and the developer 20 percent of the cash flow up to the point where the investor realizes, say, a 15 percent return. After that, the developer's share may be "promoted" to 30 percent and the investor's share reduced to 70 percent. If the investor's return subsequently reaches 20 percent, the developer's promote may be further increased so that the split becomes 60-40 or even 50-50. Similarly to the above, this gives the developer the incentive to use his best efforts.

Pooling Deals and the Clawbacks

An institution such as a pension fund, once having chosen an operating partner, hopes to do more than one transaction. If each deal is completely separate from the others, the operating partner (whose profit generally is back-ended as described above) may be tempted to take excessive risks because losses will be borne primarily by the institution while the operating partner will benefit more on a very successful deal. To prevent this from happening, many institutions insist that all deals with a single operating partner be pooled and be subject to a "clawback", i.e., the right of the institution to use some of the operating partner's profits in one deal to reduce the capital partner's losses on a subsequent deal.

Brian Bader is a Partner in the Real Estate and Hospitality Services practice in BDO Seidman's New York office. He can be reached at (212) 885-8203.

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