Real estate joint ventures for investors: liquidity provisions

Nooreen Bhanji (00:05): Welcome, everyone, and thanks for joining us in our video series on real estate joint ventures. Today we're going to be talking about liquidity provisions in joint venture agreements. I'm Nooreen Bhanji in our Toronto office, and I'm here with Alex Tanenbaum from our New York office.

So, Alex, let's get started. Liquidity provisions are key considerations in joint venture agreements. These are really important because parties can have different ideas about what's important to them. An operating partner may have a different idea of what they need based on what a capital partner may need. And we also want to make sure going into a JV, we have a way to get out.

Of course, we are optimistic that things are going to go great. But to be realistic, things often do not go great. And so, we want to make sure we have a clean way to exit.

Alex Tanenbaum (00:49): And even if they do go great, we want to get our money out so we can roll it into the next investment. So, JVs I always think are interesting because not only are you negotiating the marriage, but you're also negotiating divorce at the same time, right? And that's what we're talking about here is how to get out of the investment clean, efficient, and then in a timely way so that you can meet the market.

Because as we know, the real estate market is changing, you know, very quickly. And so if you take a long time to be able to effectuate an exit, you might miss your opportunity to get the best return on your investment. So, typically what we see here, Nooreen, is that at the regardless of what the liquidity provisions look like in the agreement, there is what we call a lockout period, right?

Where for a certain amount of time, no one can exit because you don't want to spend all the time and energy negotiating the JV, negotiating the relationship, and then have one party be able to turn around and get out tomorrow, right? So, whether that's two years, three years, four years, that depends on the individual transaction. Typically, we'll see in a development transaction a longer lockout period because it takes a long time to stand that building up and get it stabilized. If the asset is stabilized, maybe it's a shorter period, but it's time to put together the business plan in the way that the parties intended.

Nooreen Bhanji (02:10): Yep.

Alex Tanenbaum (02:11): You'll see a distinction here as well between programmatic joint ventures, which are those that are based on an asset class or a portfolio of properties, versus single-asset ventures, where you're really only looking at one property and it's much cleaner in that way.

Nooreen Bhanji (02:28): Right.

Alex Tanenbaum (02:28): And then the last point, just as a high-level point is, you know, there's tax considerations that we're dealing with here. And a lot of our clients inbound to the US from Canada or other countries are thinking about specific structures to make the investments tax-efficient on the way in. So, we need to make sure that whatever that structure is on the way in is respected on the way out, because that's when the tax implications will actually come home to roost, right? So, let's talk a little bit about specific ways people effectuate liquidity.

Nooreen Bhanji (03:07): Sure. So, one of the most common ones we see, Alex as you know, is a right a first offer or right of first refusal. And so, we want to make sure when we're exiting, a joint venture partner has a preferential right to buy if the other partner’s are going to sell. Yeah. This can range from a very soft right of first negotiation, right of first offer, to a more restrictive right of first refusal or right of last refusal. The problem with these clauses, although they are good for the partners in theory, is it makes it quite hard to actually market the property because a third-party buyer isn't going to want to be tied up in a dispute between the partners or wait the periods that they'll need to wait for the right of first offer, or right of first refusal to play out.

Alex Tanenbaum (03:47): And a right of first refusal is even more complicated than a right of first offer because you’d have to go out and fully negotiate your deal with a third party with them knowing full well that the other partner might come in and swoop it up at the last minute.

Nooreen Bhanji (04:01): Right.

Alex Tanenbaum (04:01): So, typically when we see right of first refusals, what the parties want to go do is actually get a preemptive waiver. If they're actually going to go out and sell, they get a preemptive waiver, no matter what happens, I'm not going to exercise if you, you know, if the pricing is X, Y or Z. Because otherwise we almost never see a right of first refusal that gets to a term sheet or a deal and then actually goes the full way that it's supposed to.

Nooreen Bhanji (04:27): Yep. And another thing we've seen recently is in the context of a right of first refusal or a right of first offer, if one party comes to the other party and says, we want to, we were going to want to sell our interest. The other party may try to negotiate a right to say, look, if you're going to sell your interest, we don't want to be paired with somebody else. We actually now want you to sell the entire property. And so now we'll begin a process of selling the entire property rather than just an interest. And so that's something you might see negotiated in those provisions as well.

So, the last point I'll make on this is on a ROFO, it's very important to protect you as the non-exercising party that if the exercising party comes out with a price you pass that there needs to be some parameters in there around, well if they go to market, they can't just sell it for any price. It has to be some relation to the original offered price.

So, let's say 95% of what I offer you at, otherwise you have to come back to me because otherwise I can offer you the property at $2 trillion just to get you out of the picture. And now I can go sell it to wherever I want.

Nooreen Bhanji (05:30): Right.

Alex Tanenbaum (05:30): Maybe it's one of my affiliates. And so, you want to make sure that you're protected, and you're really getting what the market is bearing for the for the asset.

Nooreen Bhanji (05:37): And there's also, on a similar point, got to be some type of time constraint here to market changes quite quickly. So, if we said no to a certain set of terms one day, six months later, we might say yes to it or the terms might have changed. So, we want to make sure if we're giving the other party a right to sell at 95% or whatever it is, that has to be within 180 days, say, if it's not, then you need to come back to us because the market could have changed.

Alex Tanenbaum (06:02): And the last, last, last point here is you want to be thinking about the specific asset classes that you're dealing with. Some asset classes move quicker than others. If you're trying to sell a multifamily building, it's going to move more quickly than a specialized use, like medical office or data centre. That tends to move less quickly just because it's a specialized use. So, consider that when you're thinking about those time periods.

Alright. Let's talk buy-sell. Because this is another one, we typically see especially when there's a deadline. So that's if the parties can agree on some kind of a major decision or a basic governance matter. You would typically see what's called a buy-sell sometimes referred to as a “shotgun” buy-sell. Again, we're talking weddings here, right?

It's like a shotgun wedding, this is a shotgun divorce. Typically, the way you see that is that the party who initiates it establishes a price that they view is the price of the asset or assets. And the other party then chooses whether they want to be the buyer at that price or the seller at that price. This has some pros and cons. Why don't you tell me what those are?

Nooreen Bhanji (07:15): Sure. So, the pro here is the process is quick. We don't have the valuation issues that we'll talk about later. We don't need a broker. We don't need to go to market. We don't need to, you know, because the buyer knows the asset, we won't need to spend time for the buyer to do due diligence. And so, the process can play out quite quickly, which is a good thing in these scenarios, especially if it's a development we want to get moving.

The disadvantage here: it's risky. When you start the process, you have no idea if you're going to be the buyer or be the seller. And so, if you know you want to be one of those two, there's no certainty here. And it’s also—

Alex Tanenbaum (07:48): And you can't game it, right?

Nooreen Bhanji (07:49): Yep, you cannot.

Alex Tanenbaum (07:49): You can't game it with the way you price it. Because the other guy is going to pounce, if you price incorrectly.

Nooreen Bhanji (07:54): Exactly. You know, and in these cases, it really does benefit whoever has the deepest pockets, because if you need to go out and buy this property quickly, you can only do that if you have access to capital. So one of the things we see negotiated often here is the party, probably the operating party who maybe doesn't have as much access to capital, will try to negotiate a longer timeline for when they have to respond to the buy-sell offer, or for when they have to close to make sure they have got time to get enough capital and they're not forced to sell just because they don't have the capital.

Alex Tanenbaum (08:25): Because when they get that notice, the first thing they're going to do. “Hello other capital partner, I need money. Let's talk, we have a deal”. And that process takes a long time to do. So, they need every single day of that to get their deal done, exercise and then actually get it closed on time.

Nooreen Bhanji (08:40) Right.

Alex Tanenbaum (08:41): So, the other thing that with buy-sells though, is that it really does benefit the party who feels the most confident in their ability to value the asset, right?

Nooreen Bhanji (08:50): Right.

Alex Tanenbaum (08:51): You're not going to market. You don't know what the market value is. And in real estate, like in a lot of assets, you can't get an accurate valuation unless you're going to market and, you know, people can play with, appraisals all they want.

So, if you, the operating partner typically will be in a bit better position here to really understand the value. So, what we see often in the circumstances, capital partners, the first call they make if they get a buy-sell or give a buy-sell, is to other potential operating partners to say, what's your opinion of value here so that they can accurately value it.

Because the last thing you want, the last thing you want, is to send that notice and have the other guy respond immediately! Then you know that you've valued it wrong.

Nooreen Bhanji (09:34): Right. Exactly. So, another liquidity provision we can talk about is tag along and drag along rights. We don't see these as commonly in Canada, but the easy way to think about it is a tag protects the minority shareholder, or the minority joint venture partner. And what this could mean is if the majority owner wants to sell the asset or sell their interest in the asset, the minority can choose to tag along to this.

The drag along protects the majority owner. And so, in the event that the majority owner wants to sell the asset, they can drag the minority interest along with them. In the real estate context, this is primarily relevant for programmatic JVs, not as much for single asset ventures. And because there's other liquidity provisions that may make way more sense when it's a single asset.

Alex Tanenbaum (10:22): And this is not unique to real estate. Tag and drag is also quite common in tech, small investments, corporate transactions as well. So, you know, you see this all over the place. And as the minority partner, you know, typically what you want to consider is where, you know, you have a different opinion of value, right? If the majority partner is desperate for cash and they make a deal that you think is wrong or, you know, not at the right value, do you really want to be dragged at that price?

And so, you need to think about perhaps putting in some parameters around valuation as to when they can drag you. As a majority, you know, the one thing that you really want to focus on is: what if I want to just sell a partial interest? Do I want my minority to be able to tag on a partial interest, sort of a proportionate sale, or can I get out of my partial interest, you know, securitize or get money out, but stay in the investment without having the complication of the tag. So, those are some sort of initial thoughts you want to consider when you're negotiating a tag and a drag.

Nooreen Bhanji (11:32): So, let's talk about some of the issues that come up in all of these scenarios, which is around valuation.

Alex Tanenbaum (11:37): Yes.

Nooreen Bhanji (11:37): So, when you actually get to the point where you need to value the exiting partner's interest, you're not necessarily in the best place as partners as you were when you maybe began the joint venture. And so, these are complicated provisions that are contentious, that take a long time.

Alex Tanenbaum (11:51): And by definition, if you're at this point, you haven't had a friendly—

Nooreen Bhanji (11:55): Right.

Alex Tanenbaum (11:56): —you know, we're going to sell at this price. Everybody's happy.

Nooreen Bhanji (11:59): Right.

Alex Tanenbaum (11:59): By definition, nobody's happy about this point.

Nooreen Bhanji (12:02): Right, right. And so, one of the ways you can mitigate the risk, is you really want to make sure as you're drafting the joint venture agreement, you be as specific as you can about how the appraisal will work, how you'll pick an appraiser, what qualifications the appraiser will have. You might want to put in schedules showing the calculation, showing how actually you're arriving at the number.

Because when you actually get to that position, you want to make sure you're sort of following a procedure that can limit the amount of dispute as much as possible.

Alex Tanenbaum (12:29): And you also want to make sure that no party is going to be able to exercise undue influence on the appraiser and the appraisal process. So, as you know, like a lot of appraisals, they typically operate under assumptions and certain, you know, subjective criteria as to what's going to happen with the property.

Nooreen Bhanji (12:49): Right.

Alex Tanenbaum (12:49): And so, if you're the operating partner who's running that show, you may be feeding off market assumptions to that appraiser. And so, as a capital partner, you might consider, you know, putting some parameters around who the appraiser is, whether they have prior dealings with either party, etc., because you could get you could influence the proceedings quite a bit.

Nooreen Bhanji (13:10): Right, right.

Alex Tanenbaum (13:10): But you know, it's important obviously, as you were saying, Nooreen, to have a lot of parameters around the process, but you don't want to kill the deal, right? You don't want to negotiate 50 pages of this because first of all, when people are getting into a transaction, they don't often like to think about this.

Nooreen Bhanji (13:30): Right.

Alex Tanenbaum (13:30): Everyone is pro deal. They think it's going to work. They're not necessarily trying to get into a knockdown, drag out fight over how the exit looks. It doesn't make people happy. So, you want to have something where people can feel confident that there's a path, but you also don't want to have the tail wag the dog here.

Nooreen Bhanji (13:52): Yep. And one of the other sort of overarching considerations in these agreements, when parties enter a JV, they know who their partner is. They're comfortable with that partner. They're comfortable with that partner's experience, that partner's net worth. The fact that that partner's not a competitor to them. The problem in all of these liquidity provisions, is you can end up getting paired with a partner that you didn't expect and involuntarily.

Alex Tanenbaum (14:13): A competitor maybe.

Nooreen Bhanji (14:14): A competitor! And so, one of the things that parties may want to think about as you're negotiating, do you want to put in other provisions restricting your final say or having a final say on who that purchaser actually is? Once you go through all these provisions, do you want to say, at the end of the day, it can't be a competitor.

You've got to be able to comply with whatever that company's anti-money laundering sanction regulations are. Do we want to make sure that partner has a certain amount of experience in the industry? Do we want to make sure that partner has a certain amount of net worth? Those are things we may want to include in all of these liquidity provisions to make sure at the end of the day, you're getting a partner that you can actually continue a working relationship with.

Alex Tanenbaum (14:53): Yeah. And sometimes you see a blacklist, right? Sometimes you see a list of named entities where, hey, you know, they're off limits. We're not going to be in a deal with them. So, you know, it gets complicated because the longer that list is or the longer that list of criteria is, the more hampered necessarily the other party is going to be when they try to liquidate and they're going to say, listen, you're chilling the market. If I can't go to these people, these are the ones who might buy it. Like, what are we doing here?

Nooreen Bhanji (15:22): Right.

Alex Tanenbaum (15:23): So, it does become a little contentious here. But the point is, think about it now. Think about it at the beginning. Don't think about it when everyone's in dispute. Make sure that you get it right when everybody's happy and feeling good.

Right? You know, before the wedding. Not after couples therapy. And you've gone through that whole process, right? So, that is the story here. It's important to be accommodating to the liquidity needs of each party. But you also have to protect your interests and be able to exit when you want, and what works for either party.