Real Estate Investing: Understanding the Basics of Joint Venture Equity


Real Estate Investing: Understanding the Basics of Joint Venture Equity

In recent years, technology stocks have gotten most of the market’s attention. But one investment class that remains tried and true is real estate, and many investors lack an understanding of some of the basic financing processes involved.

In real estate, a equity joint venture is an agreement that exists between two or more corporate entities to begin a separate but conjoined business project. Typically, the business structure that exists for these arrangements is a separate limited liability company (or LLC).

Most large real estate projects require financing they allow real estate operators to work with real estate capital providers. These entities are a critical part of the process, as they essentially supply the capital that will be needed to make commercial real estate projects get off the ground.

Real Estate Joint Venture Example

To understand the basic principles behind joint ventures in real estate, consider the following example. Company A owns a plot of land in the Chicago metropolitan area, but its headquarters is based in Miami, Florida. Company B is based in Chicago and is familiar with the most important industrial and demographic aspects of the city.

Company A is interested in developing the property with a new office building. Both companies see a mutual opportunity through a partnership, and they establish a joint venture together. Company A is then responsible for taking care of the capital while Company B provides the knowledge and expertise that will be necessary to make the project successful in the Chicago area.

Real Estate Joint Venture: Key Players

In our illustrated example, we can see that joint venture real estate endeavors are comprised of at least two parties often referred to as the “capital member” and the “operating member.” The capital member finances the project (or usually at least a substantial portion of the project). In contrast, the operating partner is often a real estate expert and will be responsible for the daily operations. Preferably, the operating member will be an experienced real estate professional that is established within the industry and possess the ability to acquire, develop, and manage a well-positioned commercial real estate project.

In these cases, there is really no substitute for experience and there is often a great deal of investment money on the line that will need to be protected. In any joint real estate venture, all partners are liable for both losses and profits that are connected to the joint venture agreement. However, it should be noted that these liabilities extend only as far as the particular real estate project defined in the joint venture itself. Apart from these responsibilities, the liabilities of the joint venture are separate from the business interests of each party in the agreement.

Additional Joint Venture Equity Factors

In contrast with preferred equity, the elements of a joint venture equity partnership differ in the fact that a real estate capital provider (a limited partner) can join their capital with the general partner (sponsor) in the formation of a limited liability company which will eventually acquire a the project property real estate.

The responsibility of the sponsor is to source, execute, and close the project’s business plan in a specific geographic location in which they have previously established substantial expertise. However, the sponsor may not have the ability to contribute significant capital to the venture and will have to seek a capital partner whose main responsibility is making investments in these real estate opportunities with quality sponsors.

Other differences are present in joint venture equity (when compared to preferred equity) exist because, in most cases, there is not an established priority of payment on proceeds from a capital event or from cash flow distributions. Proceeds and distributions are paid pari passu (which is a phrase in Latin that means “equal footing”) and this is based on the initial investment percentages of the sponsor and the requirements of the capital provider. This is the case until a specific internal rate of return (IRR) is reached.

IRR Requirements

After the specified IRR requirements are reached, the project’s capital provider gives promote or carried interest to the sponsor that is equal to a disproportionate profit share. After receiving this promote for the property acquisition, the sponsor completes due diligence, coordinates the closing, secures a mortgage guarantee, and begins operations for the business plan that is outlined at the time of the property acquisition.

An illustrated example, a sponsor and real estate capital provider will typically invest 10% and 90% (respectively) of all equity that will be required for the joint venture real estate project. In most cases, 90% of all proceeds and cash flow distributions and proceeds are paid to the capital provider while the remaining 10% is paid to the sponsor (pari passu) to an amount equal to 10% IRR.

The total IRR figure is inclusive of cash flow which accumulates during the holding period, return on equity invested, and a return of equity invested. After the 10% IRR threshold is reached, the proceeds that remain are split 70% to 30% (to the capital provider and to the sponsor, respectively). The additional 20% that is paid to the sponsor (which is above the initial equity contribution) is the promote. In many cases, real estate investors will experience more than one IRR requirement during the lifetime of the transaction, as well as additional promote opportunities tied to the deal. This is commonly referred to as a “cash flow waterfall,” and it helps add to the investment incentives present in the initial negotiations.

This article was contributed by Dividend Investments

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The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:

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