Exercise Caution with Joint Venture Financing
Anna M. Coldwell, CPA
With the real estate market on the rise in many parts of the country, developers may have more opportunities to obtain financing through joint ventures. Such arrangements can certainly pay off, but developers must take care before jumping in. Here’s a look at several issues to address early on.
Let’s be honest — both parties in a joint venture generally want to make money. So, the following economic issues are critical to address before entering into an agreement:
- What’s the equity investor’s preferred return on investment?
- Will the developer earn the same preferred return?
- Will both parties’ equity be treated with the same priority?
- Will the developer’s preformation costs and contributions count as capital contributions?
- After the preferred returns are paid out, will the developer receive a “promote” or “carried interest” incentive?
A joint venture also raises several tax issues that parties should address in the agreement. This includes income allocation, depreciation allocation and lockout periods on the property’s sale and debt repayment.
Minimize disputes by delineating the decision-making authority clearly. Experienced developers know that a project can grind to a halt if an equity investor insists on control over relatively minor decisions like leases and repairs. The parties must find a happy medium that doesn’t risk slowing operations but still allows investors to protect their interests.
Typically, the developer will oversee construction and day-to-day operations of a completed project via an affiliated management company. But the investor will have a vote or veto rights on major decisions, such as the admission of new members to the venture, reinvestment of proceeds, financing, budgets, and property purchases and sales.
Construction Cost Overruns
During construction, the construction loan guarantee will require the developer to fund overruns. The joint venture should establish how to treat such payments.
Options include requiring the developer to simply absorb the costs, treating the costs as capital or as loans. If the agreement treats the payments as capital, the return on such capital is generally subordinate to the equity investor’s preferred return.
All good things must come to an end, as the saying goes — and that applies to financing joint ventures, too. It may be counterintuitive to think about how the partners will exit the arrangement before construction has even begun, but doing so can help avoid some uncomfortable and potentially costly conflicts later. For example, the parties might disagree about how long the venture should hold onto the property after construction ends.
The joint venture agreement should provide for a clear exit mechanism that either party can use to leave the venture on a triggering event, such as the death, incapacitation or misconduct of one of the partners. These agreements usually specify a minimum hold period after project completion in order to secure capital gains treatment for sale proceeds.
After that period, the agreement should specify what happens next: The business can dissolve, or a buy-sell clause can be activated, requiring one party to purchase the other’s interest based on a valuation by a neutral appraiser. Alternatively, the agreement could allow the parties to market the property for sale to third parties. A partner who declines an offer that’s acceptable to the other partner must either buy the other partner’s interest or sell its interest to the partner for the value set by the third party’s offer.
Worth the Work
Joint venture financing often works well for both parties involved. With proper planning, you can avoid potential problems, and the project can leverage the developer’s real estate expertise and the equity investor’s capital.
If you have questions or would like to review your situation, contact Anna Coldwell at firstname.lastname@example.org, or call her at 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.
Is a Prospective Commercial Tenant Creditworthy?
Adam M. Levine, CPA, CFP
Smart residential property landlords run a credit check before entering a lease agreement with a new tenant to help evaluate whether he or she will pay the monthly rent. This article discusses why financially stable, creditworthy tenants are essential for successful commercial real estate investments; which factors to consider when assessing creditworthiness; and how credit enhancements can make up for weak credit assessments. A sidebar discusses the use of third-party loan guarantees to bridge credit gaps.
Commercial tenants, even those backed by well-known, longstanding corporations, typically merit even more scrutiny. After all, financially stable, creditworthy tenants are essential if you are going to make the most of your real estate investments.
Why is a tenant’s credit so vital to the financial success of your real estate? It is not just about the steady income stream from rental payments. A tenant’s creditworthiness can affect your ability to borrow against your property, which in part depends on your tenants’ financial fitness. It is also relevant in buildout situations. A significant buildout can sometimes make it difficult to re-let the property if the tenant defaults. Performing a credit check before leasing space to a tenant with specific buildout requirements provides added assurance that you will not be put in that position.
Factors to Weigh
Effective creditworthiness assessments take a comprehensive view. You should routinely consider a variety of factors both before you enter a lease and throughout the lease term. These factors include the tenant’s:
- Business history;
- Place of incorporation;
- Financial statements audited or reviewed statements are preferred to compiled or internally prepared ones;
- Revenue sources and their sustainability;
- Financial institution references;
- Rent history and landlord references;
- Legal history, including previous bankruptcy filings, liens and pending litigation;
- Management team strength; and
- Required terms, including those related to buildouts or other improvements.
You also should look at the tenant’s business plan to evaluate growth prospects and market share. Depending on location, a growing number of tenants are start-up or relatively young ventures that do not have a lengthy financial or credit history. In these cases, landlords need to look beyond the more traditional factors identified above to consider how these tenants earn their money and whether their investors are creditworthy.
If the tenant is part of a national corporation, do not assume that they are as creditworthy as their parent company. Consider business unit–level profitability. Corporations can run into trouble and suddenly close locations, long before their lease terms expire. The units that survive such corporate shutdowns are usually the profitable locations. On the other hand, commercial real estate leases for cost centers, such as offices, call centers, bank branches and distribution hubs, could be the first on a troubled company’s chopping block.
Creditworthiness plays a prominent role when it comes to requiring credit enhancements from tenants who fall short of your criteria. The most common enhancement is a cash security deposit, the less creditworthy the tenant, the greater the amount of cash deposit you will require. The deposit requirement also should reflect costs to complete the transaction, for example, those related to construction, broker commissions and administrative tasks.
Some landlords go further, requiring letter of credit security deposits backed up by a third-party financial institution. The terms could allow you to draw on a letter of credit after tenant default without involving the tenant. Moreover, the financial institution may be obligated to pay you even if the tenant files for bankruptcy. However, some courts have ruled that letter of credit security deposits are part of the bankruptcy estate and, therefore, subject to the cap on landlord damages.
Be Safe, Not Sorry
Every commercial tenant does not necessarily need a sterling credit history to lease space from you. But it is good to know what you are getting into ahead of time. Assessing credit helps you know when to add appropriate protections into a tenant’s lease agreement.
Sidebar: When a Guarantee Can Fill the Credit Gap
Sometimes a prospective tenant does not meet your creditworthiness criteria and cannot provide a substantial cash deposit or a letter of credit. That does not necessarily mean you should walk away from the arrangement. A creditworthy third party may be willing to provide a guarantee to bridge the gap. The guarantor could be the tenant’s corporate parent or affiliate or an individual like the majority owner of the tenant business.
Ideally, you would like a full guarantee, but most guarantors will provide only a limited guarantee. For example, a guarantor might agree to a guarantee with a maximum dollar cap on its liability, based on the value of the lease and your potential loss in case of tenant default, or a cap based on a formula. That formula could reflect your out-of-pocket expenses, for example, lease brokerage fees, an unamortized tenant improvement allowance, an allowance for recovering and preparing the space, and past due and pending rent. Regardless of the guarantee type, review both the tenant’s and the guarantor’s financial information on a regular basis to ensure you continue to be protected.