Commercial Loans and Fun Blog

Joint Ventures - A Primer

Posted by George Blackburne on Sat, Oct 17, 2015

Condos_under_constructionA joint venture is a sort of a "partnership" between a developer and one or more passive investors to build a commercial property.  The developer brings to the partnership the project; his expertise, as described in detail in his CV or curriculum vitae; and some prepaid expenses, such as architectural fees, engineering fees, and his down payment on the land.  The investor brings to the "partnership" the majority of the equity required by the construction lender.  I've used the term "partnership" throughout this article, but these business entities are almost always set up as limited liability companies ("LLC's").

Almost all commercial construction loans are made by banks.  Banks today are not going to take all of the risk of a construction project by loaning to the developer 100% of the total cost of the project.  Usually the bank will only cover part of the total cost of construction, and the developer will have to cover the rest.  How much of the total cost of the project that the bank will cover is determined by their loan-to-cost ratio.

 

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Example:

Doug Developer wants to build six town homes.  The total cost of the project - including land costs, hard costs, soft costs, and the contingency reserve - is $2,500,000.  This is a relatively small project, so his construction loan request will be small.  He therefore wisely applies to a small bank located close to the subject property.  (George's note:  Doug did two smart things here.  First he matched the size of the loan to the size of the bank to which he applied.  Secondly, he applied to a bank with a branch located just down the street.  Construction lenders greatly prefer local projects.)

Nearby Neighborhood Bank NT&SA has a bank policy that it will only make commercial construction loans today up to 70% loan-to-cost.  Remember, the total cost of the project is $2.5 million.  Seventy percent of $2.5 million is $1,750,000.  This is the largest construction loan that Nearby Neighborhood Bank will make.  Doug Developer will be expected to come up with the remaining $750,000.

Doug paid $500,000 for the land, and he put down $125,000.  The seller carried back a short term first mortgage of $375,000.  Doug also paid $65,000 for all of the architectural plans and another $22,000 for the engineering work.  He therefore has $212,000 in equity into the project.  He is short $538,000.  

$750,000 required equity - $212,000 in developer contributions = $538,000 shortfall

Where is Doug going to come up with the missing $538,000 in cash?

Doug approaches Dr. Dan Deeppockets, a retired neurosurgeon, and invited Dr. Dan to enter into a joint venture with him.  Doug Developer and Dr. Dan negotiate the following deal:

Dr. Dan will contribute the needed $538,000 in additional equity.  If the project is successful and the condo's are sold off, Dr. Dan first gets his $538,000 investment back.  Then, if there is any money left over, Doug Developer gets back his $212,000 cash contribution.  If there any money left over, Dr. Dan gets a preferred return (before Doug Developer) of 15%.  If there is still any money left over, Doug Developer earns a 15% return on his $212,000 cash contribution to the project.  Any money left over?  Dr. Dan and Doug developer agree to split any remaining profit 50-50.  This repayment schedule is known as a waterfall.

End of example.

 

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Who can qualify for a joint venture?  In order to qualify for a joint venture, a developer needs one heck of a curriculum vitae (construction experience resume).  After all, the developer is saying, "With my brains and your money, we are going to make a fortune together."  I don't know about you, but if I were the guy putting up the dough, that developer's brain would have to be pretty darned impressive.

In real life, almost no one ever qualifies for an institutional joint venture - a JV with some huge fund.  If you are an average commercial mortgage broker, I strongly urge you never to work on a joint venture.  You'll never get paid.  Personally I have come to the conclusion that the only developers who can convince a life insurance company, a REIT, or some wealth fund to JV with them are developers who are rich enough to build the project for cash using their own dough.  You and I, as commercial mortgage brokers, will never get to represent one of these guys.  Helloooo?  You will never get paid.  The guys we as brokers get are the developers who spend their last dimes on the architectural and engineering fees.

But what about private joint ventures - joint ventures with wealthy private investors?  Many years ago, scores of broker-dealers raised money for development deals.  Then the rolling commercial real estate depression hit in the early 1990's, and all of these broker-dealers were sued into oblivion.  For 25 years developers found it extremely difficult to raise equity dollars from private investors.

Then something changed.  During the Great Recession, President Obama signed the JOBS Act, which now allows real estate developers and entrepreneurs to publicly advertise to accredited investors for investments, just like hedge funds have been allowed to do for decades.  This is huge.  

Thirty years ago the syndication business was enormous, far larger than the hard money business nationwide.  The syndication industry is not back yet, but I predict that it will return over the next five to seven years.  My own hard money commercial mortgage company, Blackburne & Sons, is looking at a relatively tiny ($1.8 million) joint venture in California.  In fact, we just issued a  Letter of Interest.  Risky-risky-risky, but I remain very bullish (after 20 years of being a perma-bear) on the future of the U.S. economy.

 

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