Real estate joint ventures for investors: governance considerations

Alex Tanenbaum (00:05): Welcome back to our series on real estate joint venture. Today we're going to be talking about joint venture governance basics. And we're going to also talk about how the current market conditions that we're seeing in both the US and Canada are affecting the way that people are changing and revisiting some of those common governance provisions.

So, the real estate joint venture is a very tried and true approach to ownership and development of real estate. Typically, you'll see a capital partner who contributes the majority of the money but has not as much operational control, and then a development partner or an operating partner who contributes a smaller amount of money but has operational day-to-day control and expertise.

So, they'll provide, you know, “sweat equity”, right? Typically that operating partner has day-to-day control, subject to major decision rights, veto rights in favour of the capital partner for certain major matters where you wouldn't want them to go out and do that on their own. And JVs with multiple partners, you might see a list of unanimous versus supermajority matters.

But for purposes of this discussion, let's just assume we're talking about a garden variety, you know, 95-5, 90-10 joint venture with a capital partner and an operating partner.

Nooreen Bhanji (01:30):

So, one of the considerations to keep in mind here is the capital partner and operating partner will have different considerations, different things that are important to them in this decision making process. The operating partner wants to make sure they've got enough operational freedom. This is what they're good at. They know how to operate projects, developments. They want to make sure they've got the freedom to do what they need to do and what they do best.

But the capital partner wants to make sure they're protecting their investment. They, you know, signed on to the deal based on certain investment approvals, and they want to make sure the transaction is continuing to keep in line with such investment and approvals. The other thing to keep in mind here, Alex, that's sort of an overarching thing, is because the operating partner or development partner might be the one that they've entered into a development management agreement with, a property management agreement with.

We want to make sure we're managing conflicts of interest. So the way you'll see that play out is that the JV agreement may provide that in cases where the JV needs to issue a notice of default under those management agreements or some other type of enforcement scenario, it's going to be the capital partner alone, the one that doesn't have the conflict, that’s going to have the ability to make those decisions on their own.

Alex Tanenbaum (02:38): And that operating partner. You know, they need that property management agreement or that development agreement. Because until we get to a liquidity exit event on the JV, those fees that they get under those agreements, that's how they keep the lights on.

Nooreen Bhanji (02:52): Right.

Alex Tanenbaum (02:52): And so, they're going to protect that as much as possible. So, you really want to make sure as the capital partner that you have control over your ability to send that notice of default, enforce your rights, etc.

So, let's talk about major decisions. What do we typically see. Typically, you know, the first one you typically see is affiliate agreements. What we just talked about. You would also see a sale of the property an exit of any kind: sale, transfer etc. You would see acquisition of additional property. Sometimes you would see bankruptcy. You would see financing, which sometimes financing is any financing.

Sometimes it's only outside of certain defined limit. Definitely you'll see changing the tax structure, especially for Canadian or other, you know, foreign investors inbound to the US. That tax structure and keeping it—respecting that tax structure is essential to the economics of the investment. You would also see environmental compliance. Once we know there's a problem, any action relating to that problem would have to have the majority support or the support of the capital partner.

You might, in certain circumstances, see what we view as the expanded list, which is entering into major leases, maybe certain types of CapEx at the property if it's stabilized, settling or instituting litigation, maybe you'd see property tax challenges, things like that, and then you would also get into property-specific major decisions. So, in a development deal, you would see amending the plans and specifications, maybe selecting the general contractor.

And then you would also want to think about what sector are we in. So, if it's student housing for example, you might want you might see a major decision on agreements with the university, something like that. Or if it's a data centre, you might see agreements with the municipality relating to utility service to the property because, as you know, data centres use outsize amount of utilities. And keeping the lights on literally is, you know, that's the whole business there.

Nooreen Bhanji (04:58): Yep. So, Alex, why do we care about these major decisions and what happens if the parties can't agree? Because there's a very long list. It's quite often the case that they can't agree. And so, in a JV agreement what you typically see as a default provision is that after a certain amount of time where senior executives try to meet to hash out the issues and come up with a resolution, after this, you might see the default going to arbitration, in which case the decision may be decided by an arbitrator, an expert.

But what you have to think about here before just agreeing to this clause is, does that make sense? Is an arbitrator really the right person to make a decision about whether to proceed with development, whether to amend your plans and specs? And probably in many cases, they're not. And you don't want to—

Alex Tanenbaum (05:42): Well, you would think that the experts are the people who are in the JV, right? That that's why they're doing it.

Nooreen Bhanji (05:47): Right, right. So, we want to be careful about those arbitration clauses and making sure that for certain decisions, it does not default to arbitration and a binding agreement by somebody else. And so what do you do if it's not arbitration? You could do nothing. Does it always make sense to do nothing? Probably not. Because in a development situation, if the decision is being made of whether we should continue with the next phase of development and the parties can't agree, do you just sit with the development as it is?

Probably the party that wanted to do the development does not want to do that because rates are increasing, the market is changing.

Alex Tanenbaum (06:19): And doing nothing absolutely favours the capital partner, right? They can sit and do nothing and wait for that developer to get more and more and more desperate, because that's how the developer keeps the lights on. They do deals, they exit deals, and they get more money and they roll it into the next one.

Nooreen Bhanji (06:35): Right. And so, if you don't do nothing, what else can you do? Well, you might see in this sort of situation that there's a buy-sell. So, one party can, you know, initiate a buy-sell. And then there's a for sale or shotgun purchase. And is that really what you want? Maybe not. Because if it's a development deal, there's still time periods that have to pass by which a party has a right to accept that offer, then to close. Many things may be changing in that time—

Alex Tanenbaum (07:00): Yeah, and what if it's a down market?

Nooreen Bhanji (07:01): Yep.

Alex Tanenbaum (07:02): You just can get stuck, right?

Nooreen Bhanji (07:04): Not an ideal situation either way.

Alex Tanenbaum (07:11): So, speaking of the down market, let's talk about the current market because I think there's a perception out there that it's a down market, but it's really a disjointed market. Some sectors are going gangbusters right now. Some sectors are limping along. And it really just depends on where you are. And it could be as simple as where geographically what sector.

You know, what kind of financing you have on your property. So things are just changing so rapidly in the real estate market right now, that it really depends on what kind of asset you're in. We're seeing high office vacancy. We're seeing high interest rates, we're seeing overbuilding in certain sectors because everybody piled in. And so, now you're seeing some opportunities now and also some challenges, and layering on top of that is what we're calling the “debtpocalypse”.

And that is over the last few years, as interest rates have remained elevated in both the US and Canada. A lot of developers, instead of refinancing their loan at a much higher interest rate, have been “amending and extending”, right? That's the term. I'll add one other point to this: “amend, extend and pray” because they're praying that interest rates go down.

Now the problem here is that interest rates have stayed persistently high. And all indications from certainly from the fed are that when they start coming down, they're going to come down more gradually. And so how much more can “amend and extend” really work? So what's the “debtpocalypse”? $925 billion of US commercial real estate that is going to mature in 2024.

Now some of that will be amended and extended, right? Because the banks want it, the banks want to do it, etc. it's fine if they're good deals or whatever. A lot of it though, they're going to run out of road here and they're going to need to either refinance at much higher rates or find other ways to plug the gap.

And if they are refinancing because values are lower, they need to fill the gap of equity to maintain their LTV ratio. So where does that money come from? It comes from capital partners and joint ventures. And it also comes from other private structures like preferred equity, which is a debt-like economic structure, but with equity-style governance. So, what are you seeing in Canada? Is it the same story?

Nooreen Bhanji (09:31): It's a similar story in Canada, Alex. We're optimistic for the rest of 2024. Liquidity should improve. Cost of capital should improve. But like you say, mortgage renewals are still at rates that are much higher than they would have been when the parties entered into those loans. So that still results in majorly increased borrowing costs. And we're still seeing funding challenges for office, land and residential loans.

Alex Tanenbaum (09:56): So, let's put it together. We talked about governance. We talked about the current market. How is the current market affecting governance? So listen, a lot of deals that were entered into a few years ago are still doing okay. But we're certainly seeing a lot of challenges now. And it's making people rethink some of the terms that they're entering into for new JVs, right?

One of the things that we're seeing a lot is challenges with appraisal. So, the typical JV approach is to have annual appraisals done of the asset or assets as part of your general reporting. So that'll affect maybe a crystallized promote, so economics of the asset. It might affect asset management fees that are paid on a yearly basis based on the value of the property.

And it also might affect performance trigger which might, you know, you could get a performance trigger to turf your other partner. And, you know, so what we're seeing though is because the market is so disjointed that you're seeing dramatic differences of view of valuation right between the capital partner and the sponsor, between one appraiser and another, etc.

And we're seeing it on both sides. We're seeing inflated, deflated valuations. And it happens because of off market or subjective assumptions that are being fed to these appraisers, typically by the operating partner. So we're increasingly advising our clients to ask for either a major decision approval over the identity of the appraiser. So, someone who's maybe had no prior dealings with the operator, maybe not able to be influenced by the operator, or an objection mechanic where the appraisal comes in and the capital partner is able to object to it, maybe get another appraiser, maybe go to some type of a defined structure for how to get to an agreement on value.

Nooreen Bhanji (11:45): And another thing we're seeing in this current context in major decisions is it's often a major decision that any sale or transfer of the asset is a major decision, must be agreed to by all the partners. The problem here is, what we're seeing in this market when there's a loan default or a refinance.

It's fine that it's a major decision when you eventually have to go and sell this transfer or transfer this property, give the keys back to the lender. But the problem is before that, there's probably months and months of negotiation, and those negotiations are probably happening just with the operating partner and the lender. And there's all sorts of discussions that may be happening there that the capital partner’s left out of.

And that's because of the way we've historically drafted these major decision provisions to say that it's only the sale or transfer that's a major decision. So one thing that capital Partners may want to think about in this market is giving themselves some more opportunity to be part of those discussions, to have more visibility as to what the operating partner is doing.

And that's going to require a change in maybe what their historical agreements would have said about when consent or of the partners is required in a sale or transfer scenario.

Alex Tanenbaum (12:53): Because when you're having those discussions with the lender. Now we're outside of the bounds of my expertise. As in real estate, you need to let me operate the way I want to. Now we're talking about financial matters, where the capital partner actually may be able to add value. They may be able to, you know, introduce the sponsor to a new lending relationship, something that can actually save the asset.

Nooreen Bhanji (13:15): Right.

Alex Tanenbaum (13:15): And so as a capital partner it's mostly your money! So, you want to make sure that if you're going to lose all of it and give the keys back to the lender, that you're part of those discussions and you don't just hear about it at the very end, right?

Nooreen Bhanji (13:27): For sure.

Alex Tanenbaum (13:28): So, it's important in the current market, I think, that our clients are looking at those precedent agreements.

You know, it's not just as simple as refreshing it, because the way that the current market is working, we're seeing a lot of new types of disputes, new types of challenges come up. So, the next time you're looking at a joint venture, call Nooreen. But next, look at that precedent agreement and think about some nuanced but meaningful changes you can make to that form so that you're protected in the type of market that we're in right now.