Bruce Bagdasarian
In the commercial real estate world, raising equity for real estate investment and deploying the private equity model of investing have been increasingly commonplace. Before the stock market crash of 1987, bank underwriting standards were far looser than today, with some projects receiving 100% financing, especially in the mid to late 1980s. Accordingly, less equity was needed. But underwriting changed dramatically after 1987. Among other things, more equity was required, often, no less than 30% of the project costs. While standards have fluctuated since that time, especially as we led up to the Great Recession of 2008, banks have continued to require financial covenants, including loan to value ratios of no more than 70%. Since 1987, another phenomenon occurred: a massive build-up of capital looking for alternative investments. All of the above developments have created the conditions for the expansion of the real estate equity market and the surge of the real estate private equity model. This article is a brief overview of real estate equity investing, key joint venture (“JV”) terms, and investor considerations in the current market.
In the capital stack, mortgage debt sits in the most senior position, then mezzanine debt, then preferred equity, and then common equity in the most junior position. Each slot in the capital stack has a range of returns in accordance with its level of risk, with common equity typically having the highest return for the highest risk. Preferred equity differs from common equity in that it often has some of the hallmarks of debt (e.g., a mandatory redemption date in some cases) and a return that is required to be paid before cash flow or sales or refinance proceeds are shared between the investors the sponsor for its promote (the share of the profit paid to the sponsor after all returns and capital have been returned).
Investors in the preferred equity market are comprised of friends and family, family offices, institutional investors, and crowdfunding companies, each with its own level of requirements, the institutional and crowdfunding sources requiring the most onerous terms. The attraction of preferred equity and common equity is that it is a means to generate significant returns as a passive investor and allows the investor to enter markets where it has little or no knowledge, relying on the sponsor to understand the market and to hit a home run. Hence, the investor needs to choose its sponsor carefully and to know what terms are market for the investment being made. The attraction of the private equity model with a promote structure and the creation of a fund from which to draw funds for investment, is that the sponsor can invest little equity and obtain significant returns due to the promote structure and fees earned over a series of investments.
JV agreements for non-fund related deals (e.g., a one-off investment with investors) are typically limited liability company agreements, but in the case of funds, limited partnerships are typically used. Some of the key issues that are negotiated in JV agreement are (i) rights to consent to major decisions (such as sales and financings), (ii) triggers that allow removal of the manager, (iii) obligations to invest additional capital, (iv) transferability of direct and indirect ownership interests, and (v) Buy/Sell rights for events like major decision deadlocks. There are many nuances to the various terms and they are negotiated accordingly based on the leverage of the investor and the type of investment being made. Where an investor has a 90% interest in a deal, it rightly expects to have consent rights over major decisions and many other rights. Where the investor has a 10% interest or where it is part of a large fund where it does not have a significant interest, it expects to be a passive investor with few protections.
In rising markets, the remedy sections of JV agreements rarely get tested. Everyone is happy when projects are performing well and the returns exceed the pro forma. But in today’s environment, where increased interest rates and rising construction and insurance costs have caused many properties to experience some distress, these key remedies are being tested more frequently. Once a bump in the road is hit, it naturally focuses the investors on the sponsor and the property manager, and, in some cases, exposes poor management, prompting discussions about whether the sponsor, serving as manager of the JV, or the property manager, should be removed. But restrictions under loan documents can be a hinderance. A lender will usually prohibit a change in control of its borrower. So, determining a remedy is a delicate decision and requires a clear understanding of rights and where an investor should exert leverage, if it has any. In a recent case, an investor client was faced with the choice of removing the sponsor from management and perhaps inviting litigation or taking a less aggressive path to require removal of the property manager. It chose to work with the sponsor to remove the property manager and required the sponsor to include the investor in discussions with the new property manager on a regular basis, so that the investor was in the loop and could add value. But the painful process of righting the ship underscored the need to (i) pick sponsors carefully, (ii) require the sponsor to have enough skin the game that it’s interests are adequately aligned with the investor, (iii) have adequate controls and rights where the investor has a significant investment in the deal, and (iv) have an exit ability either through a forced sale or some other mechanism within a period of time that works for the investor.
The commercial real estate equity market will continue to be robust and a great opportunity to for investors to invest in real estate in a passive way and in various markets. However, the current environment underscores the importance of picking good sponsors and being careful in negotiating JV agreements.
Bruce Bagdasarian is Chair of Sheehan Phinney’s Real Estate Department.