What about the equity? : a qualitative analysis of governance provisions and return structures for equity investments in joint venture real estate projects

Abstract

This paper looks at the equity component of real estate finance -- the equity portion of the capital stack, if you will. It begins by characterizing the process through which real estate equity is secured by developers, and conversely, how it is placed by investors. It moves on to a discussion of the typical components of joint venture real estate LLC operating agreements -- the primary document used to formalize joint equity investments in real estate projects. Through the author's observation of a collection of operating agreements (primarily at the institutional level) governing both operating real estate projects and ground-up development projects, the paper discusses the six primary governance issues that are common across most joint venture real estate projects -- financing and capital structure, cash management, leasing, investment horizon, dispute resolution and defaults, and certain administrative issues. It further outlines how contractor control, control of the construction process and cash management issues emerge as the three additional critical governance issues in ground-up development projects.

(cont.) The paper continues with a discussion of the two primary return structure models prevalent in the market today -- preferred equity and participating equity. While the models are often tailored to meet the specific needs of parties to different transactions, the primary negotiated variables -- hurdle return rates, profit percentages (promotes), and carried interest amounts -- generally remain consistent. The author observes that the level of contractual control demanded by investors does not necessarily increase with projects of greater risk. Instead, the quantity of controllable issues increases. Further, there appears to be a positive correlation between the level of control demanded by an investor and the investor's level of investment in the project as a percentage of total equity. Additionally, as the priority of an investor's ownership claim rises (i.e. straight preferred equity over participating equity), the level of direct contractual control demanded by the investor tends to decrease.