Drafting Real Estate Development Joint Venture Agreements: The Most Important Issues To Cover
BATTLECALL GUEST EXPERT: Robert J. Abalos, Esq.,
InvestingInLand.com
Joint venture agreements between partners on a real estate development
project can be quite easy to draft or a major negotiating chore, depending on
the needs and disposition of the parties. I've drafted agreements between
amateur investors short of capital but long on enthusiasm and experienced
professionals needing cash that were a snap to put together and also endured
endless, tiresome, bickering wars of attrition around the negotiating table
between parties with the same levels of experience.
It really comes down to the personalities and dispositions of the parties
when drafting partnership or joint venture agreements. Some people just were
meant to work alone while others enjoy the comradeship or at least temporarily
put up with others in a pleasant way as they achieve some long-term goal.
Real estate development joint venture agreements contains much of the same
boilerplate as any other type of such agreement but there are specific
provisions related to real estate that often cause problems for the partners. In
addition, some general provisions often cause problems for the parties when they
are poorly drafted. Here is a list of some of the most important issues
confronting drafters of these agreements and some of my suggestions on how to
avoid problems during the venture.
Know your partner's source of cash. Before even agreeing to
sit down and draft a potential agreement, you need to know who you are doing
business with in some depth. Explore their finances, credit rating, and
especially the real source of their income. Banks and financial institutions
have a "Know Your Customer" rule and so should you. Request financial
statements, tax returns, a copy of their credit report, and a complete resume
with references. Sometimes investors needing cash to complete a development
project are wary about asking an investor with resources for much in the way of
information since they don't want to "spook" their rescuer with paperwork or
personal inquiries.
No matter how desperate you may be for a cash infusion, you had better know
where your partner's cash is coming from. Horror stories in this area are very
common and I've heard and seen plenty of them. I once knew an established real
estate condominium developer who was so happy to have found the short-term
financing he needed to complete a project that he failed to review his partner's
financial statements. He soon found four FBI agents at his office threatening
him with criminal prosecution for doing business with a known organized crime
figure who was laundering illegal money through real estate projects. Only the
fact that the FBI had a wire tap on his phone and knew he was essentially just
plain dumb that kept him out of jail but unfortunately not out of the bankruptcy
court. Ask for documentation and verify what you are told. No deal is better
than a bad one.
Know your partner's needs. So many negotiations become
stalled when both partners agree on the long-term goals of their joint venture
(making a profit when selling the project in two year's time) but have little
clue as to what each partner needs along the way until completion. Take, for
example, the common situation where an experienced developer takes on an
inexperienced partner with capital. Both share a common vision and desire, a
successful project and the profits from its sale. But each may disagree on how
to get there. The inexperienced partner may have a burning desire to learn the
real estate development process and may be investing capital not just to earn a
profit but to learn from a seasoned professional. However, the experienced
developer may just be looking for a capital partner and does not want to play
the role of mentor or teacher.
The reverse is also common. The novice capital partner may not want to know
anything about the project except when his profit check is in the mail while the
professional wants an active partner on the job site. Sharing financial goals is
essential in joint ventures but so is sharing other aspects of the project like
time, energy, commitment, education, and more. One successful partnership team I
know that worked together for years on many developments abruptly ended when one
of the parties got married for the first time at the age of 51 and the other
partner did not realize that work was not going to be as important to this
person as it had been before becoming a newlywed. They continued to share a
common financial goal, making money building strip malls, but could no longer
agree on how to emotionally get there.
Clearly define the purpose of the venture. This is a common
error with many joint venture agreements. The purpose of the agreement is not to
create a joint venture between the parties but to create a joint venture towards
the development of a specific, named, and easily identifiable project built and
owned by the parties. Joe Jones and Bob Smith may be partners in many ways,
business and personal, but the purpose of the real estate joint venture
agreement is not to elaborate on how they treat each other but specifically how
they develop a new 65-unit apartment building to be located on the corner of
Main and Cherry Streets in Boomtown, USA. The joint venture agreement is a
roadmap for building the development project, not how each of the venture
parties treats each other during the project.
The percentages of ownership and capital
contributions. Who gets what after paying how much? My best advice is
avoid 50/50 partnerships, even if one partner clearly has all the voting power
on a project. People who feel they own half eventually want half the say, even
if the contract tells them they have no say. Also, leave room for the
possibility of future capital contributions if necessary to preserve percentages
of ownership. Jim Jones may agree to buy 45% of the project for $100,000 but if
the development needs additional cash, he may not want to contribute any more
cash but still retain 45% ownership.
I also prefer using a schedule of payments to be paid over the course of a
project rather than a lump sum amount due at the start, although each investor
can insist otherwise. There is just too much temptation when one partner pays
another a huge wad of cash at the beginning of a project for fraud, cost
overruns, and other wasteful spending. Better to have the non-capital partner
earn successive payments at various target points during construction.
This technique also keeps non-capital partners involved in the project's
progress, a helpful anti-litigation protection device. It's very hard to claim
"I didn't know what was going on at the job site" when it is clear you did know
when you wrote your third, fourth, fifth, sixth, and seventh investment check.
Scheduled payments are useful but the non-capital partner needs to verify that
the funds will be available when needed and sometimes a bank issued
line-of-credit or some other irrevocable guarantee works well.
Loan guarantees and defaults. Lots of emphasis should be
placed on providing lists of assets to be used in case of default when personal
guarantees are given on construction loans and other forms of financing. What if
Jim and Bob both guarantee a loan but it goes into default and Jim says he's not
paying? Bob better have quick recourse not only to protect his own personal
assets but also the project. I place all default remedies on a hair trigger in
my agreements with difficult but possible ways to cure defaults. In other words,
if you default I'll work with you to cure but it will cost you and I'll claim a
default within seconds of one occurring. Forfeiture of partial joint venture
interest is one common remedy. These provisions include default on loans,
capital calls, or any aspect of the joint venture.
Management of the venture. The joint venture agreement must
clearly state who manages all aspects of the venture, from start to finish, and
precisely how they are to be paid and when. A very common litigation problem
happens when the partners clearly agree that a partner should receive
compensation for doing a particular job but never agreed in advance HOW MUCH or
WHEN the money was to be paid.
For example, one partner will manage the property, select tenants, handle
complaints and cleaning until the venture project is sold. Even if the partners
agree on compensation (5% of gross rental receipts) the question becomes when
are those funds paid? Monthly when received or accrued at the time of sale? Do
accrued payments also include interest due? At what rate? These technical
management issues cause lots of litigation because the parties expect different
things. Can one party veto the tenant selection of the other party when the
agreement is silent?
This recently came up when one partner in a joint venture I know of wanted to
lease office space to an anti-abortion "pro-life" group while the other
vehemently objected. It wasn't a political decision for either party, neither
had any ideological motive, but one partner wanted a paying tenant (ANY paying
tenant) and the other was concerned about the building's "reputation." Can one
party fire or terminate an employee, vendor, subcontractor, or decide not to
renew a lease? These are all "where the rubber meets the road" kind of questions
and better than answer them in the agreement than in a courtroom later.
Duration, termination, and buy-sell agreements. If it is a
joint venture it needs a beginning and an end, both carefully specified. The end
may be many years or decades into the future but there needs to be some concept
that this venture will eventually come to an end. Questions such as how long
will the project be held before sale are obvious but what about conditional
questions that can only be answered in the future?
Say, for example, that a joint venture agreement says a completed apartment
building will be sold "two years from the date when the structure has a rental
occupancy of 80% or higher" but when those two years elapse, the real estate
market is in a recession and property sales prices are low. Can one partner
still insist on a sale even if it means taking a loss on the project that a
simple delay in selling might avoid? What if certain reasonable triggers in the
contract are never met, not necessarily intentionally but due to bad luck or
poor skill?
In this example, what if occupancy never hits 80% because one partner
intentionally manages it that way (to avoid triggering the two-year countdown to
sale) or because they just can't find tenants for the project (the rents are too
high, for example). A clear duration of the venture should be given and various
reasons to accelerate or delay termination can be written into the contract
although they are quite tricky due to their arbitrary and subjective
application.
The ultimate way out of a duration and termination issue is a buy-sell
agreement between the parties essentially saying "If you want to stay in longer
and not sell now, that's fine with me, just buy me out now." The buy-sell
agreement becomes essentially as stand-alone mini contract-within-a-contract but
it is nice to have that option when the partners disagree. Some agreements call
for arbitration by a third party and my experience with arbitration is mixed. I
usually do not bother with the concept and try to build in as many contractual
escape routes as possible rather than let a retired judge arbitrate the parties
out of their dispute.
Bookkeeping and custody of all venture records. This item is
a great source of controversy and litigation. One party has all the receipts,
bills, checks, tax documents, invoices, building plans, and all the other
paperwork and computer files associated with a joint venture and the other party
wants to review them, either individually or through their representative such
as an accountant or lawyer. Who gets access, when, and why? Do copies have to be
provided when requested? What about possession of original documents? Can one
party just show up at the other's office and say "Show me" or do they have to
make an appointment? Must it be for cause or will any reason do? Can original
documents be taken by a party for review off their normal premises?
I think fundamentally when trust breaks down between parties the first thing
they fight about are the records of the transaction since those are where the
joint venture's secrets, profits, and cash really live. It is not enough for the
joint venture agreement to broadly state "Joe Smith will have physical custody
of all venture records with Bob Palmer having the right to review them at any
time." What if Bob wants to make photocopies of them or remove originals from
the office for an IRS audit, for example? It is no solution to prepare two (or
more) identical sets of each document in a venture and distribute them to all
parties. This is impractical and still means one partner is in possession of the
originals and not just a copy of them.
Involving third parties does not work either, for example, allowing a lawyer
hired by a partner free access at any time. The key is to make the papers less
important than they really are by doing whatever possible to guarantee a
SUCCESSFUL joint venture. People only want to pick over the corpse and paperwork
trail of a FAILED venture. Draft in specific remedies but realize no matter how
particular they are in the event of a disaster they won't work very well for one
party, normally the one not in possession of the originals.
There are obviously many other important issues and this analysis just
scratches the surface of drafting real estate joint venture agreements. These
points above, however, in my twenty years of experience with them are probably
the most important where specific attention is required.
Joint ventures represent an excellent way to develop real estate, especially
if you own land but do not have the experience of building houses, malls, or
structures. The reverse is also true. If you lack capital but have significant
construction experience it is usually quite simple to find a landowner
attempting to develop their land.
I encourage the use of joint ventures between landowners and
homebuilders or contractors because if you own land it is simple to contribute
it to a venture rather than coming up with cash. I joint venture with
homebuilders quite often to build homes on land lots I acquire through land
subdivision, tax sales, or other sources. Since I get the land for "free" (the
residue of subdivison) or at extremely discounted prices, I am literally buying
a joint venture interest in a valuable completed property with little or no real
investment out of my own pocket.
Why tie up capital in land, making it unavailable for immediate reinvestment,
when a joint venture partner will sell you a valuable percentage interest in a
completed project for a fraction of its true market value? Plus using this
method gives you a person with an equity stake in the quick and successful
completion of your project rather than merely a hired contractor who thinks of
your land and your development as just another job to be finished, hopefully on
time.
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