Back to basics - real estate joint ventures

This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.

Summary and implications

Joint ventures (JVs) are an increasingly popular method of investing in commercial real estate. They allow parties to pool capital in a way that shares both the risk and the potential equity upside of property investments. The model is increasingly common where one party has local knowledge or expertise (perhaps a local developer), whilst the other has equity to invest (maybe an Asian pension fund). Below we revisit the basic terms and structuring options that prospective JV partners should consider.

JV terms

JV terms will flow from what each party brings to the table, must envisage the long-term nature of the relationship, and should include provisions on financing, control and exit.

Financing is flexible, and JV structures can accommodate different financial contributions from each partner. Further thought should nevertheless be given to issues such as allowing and possibly capping third-party financing, any ongoing capital requirements, whether these should be met pro-rata to the initial split of the finance, and how to deal with defaulting partners. Things are further complicated when the number of JV participants increases.

Careful consideration and agreement on control of the JV is critical both to the success of the project and to the maintenance of good relations between the parties. The documentation might provide for decisions to be made by a board split 50:50 between two JV partners. However, this raises the spectre of deadlock, and referrals to experts or more complicated resolution procedures might need to be considered. Where the plan is to develop the property, certain key actions might need to be allowed to happen without agreement if deadlock might scupper the project. Frameworks for dealing with potential situations like these should be set out in the JV agreement.

A simple exit scenario might see the property being sold and the proceeds shared in agreed proportions at the end of the JV's life. However, things are rarely so straightforward. One party might plan from the beginning to exit earlier than the other(s) by selling to a third party, so pre-emption rights, put options and call options might need to be discussed. What if a party simply loses faith and wants out earlier, or if other partners join the venture, or there is a change in control of one of the parties? These issues need to be foreseen and dealt with in the documentation.

In the heady days at the beginning of a JV it is easy to forget that the road to a healthy return is long. JV parties therefore need to remember that they will be tied together for an extended period of time (not just for Christmas…), and the terms of their agreement should reflect a degree of realism.

Choice of JV structure

Vehicles commonly used for JVs include:

• limited partnerships;
• offshore unit trusts; and
• onshore or offshore limited liability companies.

Thought should be given to the cost of running the structure as well as management and decision-making if the vehicle is offshore, but the key drivers are usually tax and regulatory considerations.

Tax considerations

The tax efficiency of a JV structure is critical. If tax is incurred on gains at both the JV and investor level, the appeal of a proposed vehicle will decrease.

One benefit of an offshore unit trust is that it can be structured in such a way that (rental) income from the property is attributed directly to investors and there is no UK tax on gains or income profits payable at the JV level.

Although limited partnerships are tax transparent, capital gains tax risks can arise for existing investors where further capital is likely to be injected into the project during its life. This is because the dilution of the existing investors' interests may be deemed a "part disposal", which may give rise to a tax charge even though the investors do not receive any profit at that time.

If the priority is to maximise returns on exit, then mitigation of transfer taxes is likely to be important. Sales of UK non-residential real estate are currently subject to stamp duty land tax (SDLT) at a rate of five per cent on gross asset value above £250k (with lower rates applied to the portion below £250k). Transfers of limited partnership interests by investors will attract SDLT at the same rate because the vehicle's transparency means that investors are deemed to have disposed of a real estate asset itself, rather than an interest in a partnership. By contrast, interests in offshore unit trusts and companies can be sold with the JV entity still holding the property, and so no SDLT is payable.

Regulatory considerations

A limited partnership JV could be treated as a collective investment scheme (CIS) for UK regulatory purposes unless it takes advantage of one of the available exemptions, most likely the "group" exemption or the "existing business" exemption. If the JV is classified as a CIS, it will need to appoint an operator authorised by the UK Financial Conduct Authority, which typically increases the time, cost and administrative burden.

The EU's Alternative Investment Fund Managers Directive (AIFMD) generally does not apply to JVs. However, because they are not expressly exempt (despite a declaration in the Directive's recitals that joint ventures "should" not be covered), it is important for JVs to fall outside the definition of an AIF. This will probably be the case if each JV party has control over the day-to-day management of the JV and the property. This is usually achieved by giving all the JV parties approval rights over the business plan and a share in key decisions.

Conclusion

It is important from the outset that the JV parties take time to identify their respective roles, the nature and objectives of the JV, the sources of financing, management structure and the apportionment of risk – all this with a view to maximising returns in the most tax-efficient manner.

To make the process as safe, painless and ultimately profitable as possible, potential JV participants should engage with their own tax, legal and other professional advisers at an early stage, and remember that a JV is for its life, not just for Christmas.