Joint Ventures in the Real Estate Bear Market

The current recession has brought significant challenges to the commercial real estate market. Among the most acute difficulties are disappearance of capital from customary lending sources and diminishing property income and property values.

In light of these conditions, commercial real estate owners, prospective buyers and other real estate investors may increasingly turn to real estate joint ventures as a means of completing deals. Property owners needing additional equity capital, real estate investors looking to assemble capital and existing joint venture participants with under-performing assets are among the most likely candidates to (re)consider this structure.

This article will provide an overview, in context of the current U.S. commercial real estate market, of situations in which real estate ventures may be considered—as well as new challenges that may be associated with such arrangements.

Market Background Rise and Fall of CMBS

Prior to this recession, real estate owners could leverage with high levels of debt at low interest rates. Commercial real estate was perceived to be a relatively safe investment. In this climate, low capitalization rates were applied, more investors included real estate or real estate securities in their portfolios, and property values rose.

Rise and Fall of CMBS

One way the market met the demand for real estate investing was through more securitization of commercial mortgage debt. The amount of commercial mortgage backed securities (CMBS) grew dramatically, to the point where approximately $230 billion of CMBS was issued in 2007. Commercial banks also became more active in making loans secured by commercial real estate. Commercial banks, combined with CMBS, issued up to as much as 83 percent of outstanding commercial real estate debt.

With the recession, the amount of new CMBS tumbled to $12.1 billion in the first quarter of 2008 and has been virtually dormant since then. Commercial banks are now focused on shoring up capital reserves and have tightened lending standards.

The viability of many of these existing loans are now suspect. It is estimated that much of the CMBS will not qualify for refinancing at anticipated leverage requirements (perhaps two thirds of the $154.5 billion coming due by the end of 2012 will not qualify). Much of the pool of whole loans held by commercial banks will face refinancing problems with heightened underwriting standards. (Of the estimated $524.5 billion of whole loans held by commercial banks coming due by the end of 2012, it is estimated nearly 50 percent wouldn't qualify for refinancing).

There is less opportunity for potential buyers to obtain acquisition financing and for property owners to refinance. And even if such parties can obtain financing, it will cover less of the money needed to purchase or finance a commercial real estate investment.

In short, there is insufficient systemic capacity to refinance defaulting and maturing commercial real estate loans at existing levels.

Decreasing Property Income and Property Values

Another widespread consequence of the recession is reduced net operating income from commercial property. There is less demand for space and increased stress on the ability of tenants to pay rents. Basically, there is more risk and less current return. This, combined with reduced leverage opportunities, is a simple recipe for lower property values—and for stress on existing investments. Reputable market analysts predict drastic reductions in property values.

Depressed Market

The broader consequences of reduced financing supply and diminishing property incomes and property values are not surprising. Fewer property trades are taking place, real estate investors are forced into longer hold periods on their investments, and loan defaults are increasing. Investors face diminishing or negative returns on many investments.

It is unlikely that real estate market conditions will improve quickly. As a result, commercial real estate professionals will need to move outside the prior status quo to make or salvage deals.

Joint Ventures as a Partial Solution

Joint ventures are structures through which multiple parties co-invest. In real estate, the investment most often involves buying commercial property, but could be virtually any investment, including providing additional capital or making or buying loans. A joint venture is often limited to a single investment, but could also be a holding company for multiple investments. Joint Ventures are typically structured as limited liability companies or partnerships; they are often limited to two individuals or parties, but can consist of many more. They can be fairly complex or relatively straightforward.

Joint ventures merit attention in the current market for several reasons. First, parties unaccustomed to joint venture structures may look to them as a way to assemble capital. Second, potential disputes may occur within existing joint venture structures. Third, mortgage loan covenants will affect potential ownership or management changes within a joint venture.

Joint Ventures as a Means to Assemble Capital

Most commercial real estate lenders are increasing their underwriting requirements and restricting the total amount of leverage they will allow on property. In addition to reducing their own loan-to-value underwriting requirements, mortgage lenders will not allow secondary financing to cover much of the capital needed for an investment. In other words, not only will lenders lend less, they may not allow subordinate lenders to lend as much either. Lenders will require borrowers to have more skin in the deal.

Investors may need investment partners to bridge capital shortfalls in new acquisitions and in refinancing or satisfying requirements in existing loans. Joint ventures are a structure through which such private capital can be assembled.

Joint Ventures as a Source of Disputes

Typically, a joint venture will have an operating agreement that addresses the management and operations of the joint venture. Most joint venture agreements provide for one member to have management control of the joint venture and provide other members the opportunity to replace management upon the occurrence of certain events (or simply upon the passage of time).

In distressed real estate environments, where there are stresses on both a particular investment and on joint venture members, there will likely be an increasing number of disputes within existing joint ventures. Disputes are most likely to arise with regard to control rights and mechanisms as set forth in the agreements. Examples of such rights and mechanisms include:

• Rights of members to make a capital call if additional funds are needed for the investment—with adverse economic consequences to parties that do not contribute additional funds.
• Restrictions on the ability of joint venture members to transfer interests to third parties.
• Mechanisms through which some members may be able to force the joint venture to liquidate the investment or to initiate a buy-sell mechanism, in which a joint venture member can require other members to elect to either sell its own interest or buy the other member's interest.

Joint venture members may, in certain scenarios, attempt to take advantage of another's circumstances. Others will be forced to take action due to their own circumstances. One party may wish to divest an asset—even if at a loss. Parties may disagree whether to contribute additional capital. One party to the joint venture may want to force a management change or initiate a buy-sell provision. All of these types of control rights and mechanisms may be increasingly tested and disputed.

Mortgage Loan Covenants as a Factor in Decisions to Exercise Rights

For joint ventures whose investment is the ownership of real estate (or providing subordinate financing), mortgage loan documents usually contain covenants addressing changes in ownership and control of the borrower. Such provisions will be an important factor in deciding whether to exercise rights and remedies under a joint venture's governing documents or in deciding whether to invest in an existing joint venture.

In addition, most mortgage loans are accompanied by a limited guaranty. It is common for the guaranty to be made by only one of the members of a joint venture or a party related to only one of the joint venture members. A mortgage loan will generally require a substitute guarantor if the joint venture interest of the guarantor is transferred. Thus, as a practical matter, a member that is not the guarantor must be willing to become a guarantor of the mortgage loan if it acquires the interest of the guarantor member.

Conclusion

In this real estate bear market, commercial real estate owners and investors may need to consider joint ventures.

Joint ventures are a viable means of assembling capital. However, they can be fraught with potential for disputes and unexpected obligations. Before entering into such arrangements, would-be joint venture members should ensure they understand—and are prepared to successfully handle—the full array of risks and responsibilities.