Joint Ventures or JVs are agreements formed by two or more parties with the intent of achieving a specific objective; the objective in our discussions would be that of investment in real estate development. Unlike JVs in many other businesses, in real estate the JVs are usually terminated when the objective is achieved. Even there is a wide range of possible applications with respect to the real estate investment goals JVs are formed, typically, around one or more of the following attributes:

A single investor may be unwilling to undertake a real estate venture because of its size, location, capital requirements, and/or duration. However, by sharing the risk, two or more parties may be willing to undertake the venture.

Joint ventures are frequently formed as a way to pool equity capital from one or more sources, as well as a means of bringing parties with different expertise to the venture. For example, one joint venture partner with development expertise and/or the ability to manage the operations of the real estate investment may join the venture with other partners who may be willing to invest capital in the venture. A joint venture could also involve purchasing existing properties and operating them. In this case, one of the parties may be responsible for acquisition, leasing, and management, and the others may provide capital. In much of the discussion in this chapter we will refer to the developer/operator as the partner responsible for the development and/or the operations of the property. We refer to the investor-partner, or money-partner, as the party who contributes much of the capital.

This may involve acquisition of a large tract of undeveloped land with the expectation that it will not be ready for development for many years. Indeed, the exact nature of the use, improvements, and so forth, may be uncertain. Such a venture may not appeal to a single investor, whereas multiple investors may be interested.

Participants in joint ventures may include any combination of individual investors, partnerships, corporations, or trusts. However, a joint venture in and of itself is not a legal form of organization. In order to specify capital contributions, rights, duties, profit sharing, and the like, a joint venture agreement or a business entity must be created. The choice of organizational form used to accommodate these various groups of investors could be a partnership, corporation, or trust. In this chapter, we will focus on partnerships, which are frequently the vehicle of choice in real estate joint ventures.

Because the parties to a joint venture may contribute different things, and possibly in different proportions, a partnership must be structured such that it provides economic incentives for all parties. Differences in the tax status of investors also may affect the way partnerships are structured. A joint venture can take on a number of different partnership forms. The most common is the limited partnership. As is the case with all partnerships, there must be at least one general partner and any number of limited partners. Generally, in real estate, limited partners are the investors that provide most of the equity capital, while general partners are usually responsible for managing the partnership assets and may contribute a relatively small portion of the required equity capital. Limited partners are generally very restricted in the management of a joint venture and their personal liability is limited, hence, the term limited partnership. This will be discussed in more detail later in this chapter. When determining how a joint venture is to be structured, potential investors usually consider the following factors:

1. How much initial capital will the parties contribute and how will the parties contribute additional capital if needed in the future?
2. How will the parties share in the annual cash flows to be produced from operating the property?
3. How will the parties share in the cash flow received from sale of the property?
4. Will some of the parties receive a preferred return? Will the preferred return be paid from annual cash flows and/or from sale?
5. Will taxable income (or losses) and capital gain (or loss) be shared in the same proportion that operating cash flow is distributed?
6. Who will have control over the operation of the property and decisions involving capital improvements, approving leases to tenants, financing and possibly refinancing the property, and when to sell the property?

As noted above, a joint venture is often motivated because one of the parties is in a position to invest capital and others may contribute expertise. An investor-partner may be a wealthy individual investor or perhaps a professional investment manager who raises funds from investors such as pension funds that want to invest in real estate but do not have the expertise to do so. The money-partner is usually more interested in diversification of investments and usually does not have the desire and/or expertise to develop or manage the properties. For example, the  initial capital contribution may be distributed as follows: the money-partner may contribute 90 to 95 percent of the equity capital needed for a venture and a developer/manager may contribute the remaining 5 to 10 percent. Even though one partner may be providing the operating expertise, he is generally expected to contribute some capital in order to provide for some alignment of financial interests with the investorpartners. Returns to the developer/operator and the money-partner are usually “aligned” to some extent because both have some invested capital at risk in the venture. Because the developer/operator is supplying the day-to-day operational expertise, he will often receive a share of the cash flow in greater proportion to the initial investment. This usually provides further incentive for the developer/operator to make the investment successful. It should be pointed out that the developer/manager who is promoting the project may be approaching many money-partners in an attempt to find one who is interested. As such, the relationship between equity contributions, fees, and profit sharing will be competitively driven in the market for equity capital.

One way to share cash flow from operating a property (NOI less debt service) is  in proportion to the capital investment. For instance, if the developer contributes 10 percent of required equity, he will receive 10 percent of the cash flow. This is referred to as noncumulative pari passu distribution of the cash flows. However, it is more common for the money-partners and operating partners to share in cash flows and property appreciation disproportionately (a common example would have the investor-partners receiving a preferred distribution of cash flow and the developer-partners receiving a greater share in any property appreciation). For example, investor-partners may receive a preferred return calculated on an 8 percent yield on their initial investment. Consequently, if they invest $1 million in equity, as the property produces cash flow they receive the first $80,000 (or 8 percent of $1 million). After the capital distributions have been made to the investor-partners, the developer/operators then also receive cash equal to an 8 percent return on their initial investment  only if there are sufficient funds for distribution. To the extent that funds are sufficient, any remaining cash flow may then be split in proportion to the initial contribution or based on some other agreed-upon percentage. For example, the remaining cash flow could be split evenly (50 percent to each party). In such cases, where the developer/operators may have invested only 5 percent of the capital but will receive an incentive of 50 percent of cash flow remaining after the initial distributions, they are said to be receiving a promote. The 8 percent preferred return (used in the example) may be either cumulative or noncumulative. Cumulative distribution means that if total funds in any given year are insufficient to give the investor-partner his preferred yield, the liability to do so carries over to the next year. In these cases, in subsequent years, an investor would receive any funds that should have been paid in prior years before the developer/operator begins to receive any cash from current operations. It is also possible that all cumulative, preferred returns in arrears may be carried over into the next operating period with interest. In addition to receiving a share of the net cash flow in one of the ways discussed above, the operating or development partner also may receive fees for providing these services. For example, a fee may be paid to the party overseeing the development of the project (e.g., the development fee might be 4 percent of the hard and soft costs). A management fee also may be paid for overseeing the day-to-day management of the project once it is operating (e.g., the management fee might be 3.5 percent of effective gross income). These fees reflect expenses for services performed and are unrelated to the amount of capital invested. Indeed, such fees would generally have to be paid to third parties if such work were outsourced by the joint venture partners.

The success of an investment may not be known until the property is actually sold. At that time an assessment can be made of whether the cash flow from operations and sale was sufficient to provide an adequate return to each party. Of course, factors including market rents and income earned by the property each year as well as interim appraisals of properties may provide some guidance as to whether the investment is likely to be successful. But until the property is actually sold, cash available for final distribution will not be known with certainty. Final distributions of cash flow from sales are usually made after repayment of any debt. In general, after repayment of debt, distributions are usually made such that all parties first each receive an amount equal to their initial capital investment. Any remaining cash flow from sale is usually distributed in predetermined proportions. There may also be what is referred to as an IRR preference. This means that one or more investors must receive cash flow that is sufficiently high to achieve a specified IRR on equity invested for the entire investment period before others share in cash flows from sale. In these cases, an investor will usually receive this preference in cash flow from sale after each party has received capital equal to their initial investment. To the extent that additional cash flow remains after the partner receives the IRR preference, it may be split in some predetermined proportion (e.g., 50 percent to each party). A slight variation of the IRR preference distribution is referred to as an IRR lookback. In this case, any cash flow remaining after each party has received capital equal to their initial investment will be split in a predetermined proportion, such as 50 percent to each party. However, this split may be subject to the condition that one or more partners must earn a specified IRR (such as 12 percent). If this is not achieved in the 50 percent split, then some of the cash that would have gone to all partners must be distributed so that partners who must earn an IRR lookback do so. The difference between the IRR lookback and the IRR preference is illustrated below.

Source: Real estate finance and investments / William B. Brueggeman, Jeffrey D. Fisher.—14th ed. p. cm.—(The McGraw-Hill/Irwin series in finance, insurance, and real estate) ISBN-13: 978-0-07-37733-9