Commercial real estate can be a valuable addition to your investment portfolio. If you have significant capital, you may want to consider investing in real estate through a joint venture. Joint ventures provide a way to access direct real estate without the need to manage assets on your own.
Think of joint ventures as miniature private funds. Unlike funds that raise capital from many investors for multiple real estate deals, joint ventures involve a minimum of two partners investing in a legal entity to acquire a single real estate asset. In this article, we will focus on joint ventures with two members: the sponsor and investor member.
Evaluating the Sponsor and Track Record
In a joint venture, evaluating the sponsor's capability to execute the business plan is just as crucial as assessing the underlying real estate investment. A good sponsor will have a historical track record that reflects successful investments in similar assets and strategies. Consider metrics like deal size, property type, geography, internal rate of return, cap rate, cash-on-cash return, and equity multiple.
Remember, success in one property type or geography doesn't guarantee success in another. Look for a track record that aligns with the investment you're considering. Additionally, review the background information and professional experience of the sponsor's key principals.
Partnership Contributions
As an investor member, it's important for the sponsor to have a meaningful stake in the joint venture. Typically, you would want the sponsor to contribute at least 5% to 10% of the total investment equity. This ensures the sponsor has an incentive to actively participate without exerting too much control. However, the exact proportion may vary depending on the deal size.
Rights and Responsibilities
In a joint venture, the sponsor is responsible for the day-to-day management of the real estate, while the investor member retains major decision-making rights. These rights may include approving changes to the business plan, major expenses, annual budgets, property manager appointments, and significant leases. The investor member may even have the power to remove or replace the sponsor if necessary.
Fee Sharing
Fees related to the purchase, operation, financing, and sale of a real estate asset can significantly impact the overall investment budget. Make sure all fees are clearly detailed upfront in the offering materials and the joint venture's organizational documents. Fees should be fair and consistent with the local market for the asset size and type. Avoid duplicative fees and ensure any conflicts of interest are disclosed.
Real Estate Due Diligence Costs
Due diligence costs associated with identifying, underwriting, and acquiring a real estate asset can quickly add up. The allocation of these costs should be discussed and specified upfront. Typically, the sponsor bears these costs until an agreement is reached with the investor member to invest in the deal.
Economic Incentive for the Sponsor
Most sponsor/investor joint ventures include an economic incentive for the sponsor to achieve strong results. This incentive, known as "carried interest" or "sponsor promote," rewards the sponsor for outperformance. The financial arrangement between the sponsor and investor should strike a balance to ensure proper alignment of interests.
Use of Debt
Understanding how leverage will be utilized in the joint venture's real estate acquisitions is crucial. The type and amount of debt should align with the business plan. Typically, the sponsor drives decisions on debt financing, but the investor member may have approval rights. Consider the sponsor's ability to provide any required guarantees and evaluate the need for the investor member to provide a guarantee.
Documenting the Strategy and Exit
The joint venture documents should clearly outline the investment strategy, timeline, and exit scenarios. Mechanisms for triggering the sale of the asset or buying out the other member's interest should be established. Fair market value determination methods should involve independent third parties. A well-defined business plan minimizes disputes and ensures a smooth conclusion to the investment.
Investing in real estate through a joint venture has unique considerations. Carefully evaluate the sponsor, understand the partnership contributions, rights, and responsibilities, and ensure fair fee sharing and economic incentives. With the right expertise and negotiation, joint ventures can be a rewarding investment strategy.
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If you need assistance with investing in commercial real estate or evaluating joint ventures, Plante Moran Realpoint Investment Advisors (PMRIA) is here to help. Contact us today to discuss your strategy options.