Photo of Rab Nalavala Rab N. Nalavala

NEW YORK CITY—Acquiring and developing properties is expensive work for fledgling real estate developers. As a developer you are more than willing to bring your “sweat equity” to a property transaction; however, procuring “actual equity” to effectuate such transaction can be challenging. After you have maxed out the equity available from your rich dentist cousin and your nana’s bingo winnings, you will need to consider how to attract institutional capital—a “money partner.”

Once you have identified your money partner you will need to structure, negotiate and document your joint venture (with the assistance of knowledgeable legal counsel). In our practice, we constantly encounter new developers who historically may have relied on “friends and family” as their money partners or may have even self-funded acquisition and development work, but now need additional capital sources as they expand to larger or more complicated projects.

There are many different ways to structure equity investments and we will explore a few traditional methods for structuring that will benefit developers as they initially seek out more institutional investors. As you know, each real estate transaction and related joint venture relationship is unique to that specific deal as the corporate and tax consequences vary for each party. Accordingly use the below guidelines as items to initially consider, and then subsequently vet them with your legal, tax and financial advisors.

Once you have selected a property to purchase and develop, you will need to form a single purpose entity (“SPE”) whose only asset is said property (a SPE is required by most lenders, as SPE’s provide bankruptcy protections for lenders). If you are projecting that you may require additional debt in the form of mezzanine financing (with the pledge of the shares of the property owner SPE serving as collateral, rather than the property itself), you will also need to form another SPE that is the sole owner of the property owner SPE.

Upon formation of the above entities, create another entity to own the property owner (or mezzanine owner), which will constitute the so-called “joint-venture” entity and will be the entity that encompasses all the outside investors.  The JV entity consists of two or more owners: you (the developer or property manager) and your money partners.

TIP #1:  Ascertain where you will register your joint venture entity and the type of corporate entity – while most joint ventures are limited liability companies, there are jurisdictions where it might be more beneficial to create a limited partnership.

Typically you will be funding your investment with large amounts of institutional equity (money partners can often put in 80%-90% of the required capital), your investor (or investors) are going to expect certain rights, in particular, “Major Decision” rights over the development and operation of the property. These Major Decisions vary with each transaction, but typically include the ability to sell the property (e.g., passive money partners may want to sell and move on quickly), finance the property (e.g., the provision of guarantiescompletion and otherwise to the lender on the project) and budget approval.

As a developer, your critical concerns are completing your project while retaining management and development rights to receive the highest possible return on your actual and sweat equity. Accordingly, you should be prepared to negotiate issues related to your removal as the manager of the project (e.g., significant cost overruns vs. actual negligence), dispute resolution between you and your money partner (e.g., buy-sell mechanisms), and how you receive your “promote” (i.e., structuring of the waterfall with respect to proceeds).

Photo of Matthew Scheid Matthew Schneid

TIP #2: In the event your money partner’s approval is required for “Major Decisions” regarding development decisions, fight hard for unanimous approval so that you do not get overruled.  Then retain some degree of control by providing for “deadlock” items, such as the ability to buy-out your money partner.

In a scenario with multiple investors, you need to access whether some of the investors will have disproportional rights as related to the amount of their investment.  This becomes complicated as multiple parties will be negotiating major decisions in the joint venture agreement. One item to note is that lenders do not favor multiple investors in a joint venture who have significant control rights with respect to the project. Consider placing these multiple investors in a separate entity that enters into the joint venture and which entity has the collective control rights of all of the investors in that entity.

TIP #3:  Try to limit the time and expense of negotiations by agreeing in advance to a letter of intent which should clearly cover critical items, such as “Major Decisions” and waterfall structure with respect to the disbursement of project proceeds.

The offering of an equity investment in real estate to multiple investors may trigger certain federal and/or state securities laws.  With respect to federal securities regulations, many joint venture transactions are afforded legal protections whereby registration of these “real estate securities” may not be required.  Further, these federal law protections may pre-empt state securities laws and regulations requiring registration.  Of course, depending on the complexity of the joint venture and the nature of your investors, be sure to vet these issues with your legal advisor.

TIP #4: Do not be pennywise and pound foolish. Be sure to hire knowledgeable legal counsel—particularly as it is likely that your institutional money partner will be represented by counsel. Remember that legal fees will typically be treated as entity expenses and accordingly proportionately paid (e.g., if the developer only owns 10% of the equity in the joint venture, then they are only responsible for 10% of such entity’s legal fees).

Keeping the above guideposts and tips in mind can help you structure your joint venture relationship in a manner that is both legally and fiscally beneficial to both you and your money partner.

Rab N. Nalavala is a member of Cole Schotz P.C. and Matthew Schneid is an associate at Cole Schotz P.C. The views expressed here are the authors’ own.