In recent years, US real estate investment trusts (REITs) and USC corporations (corporations) have turned to joint ventures (JVs) to raise capital for a variety of purposes.
Furthermore, law changes, enacted by then-President Obama, affected tax-free treatment of certain spin-off distributions, meaning corporations with a large concentration of owned real estate previously considering a spin-off might turn to JVs as an alternative.
With no such thing as a typical JV structure, transactions can be tailored to the needs of each party. As Mike Straneva, US National Director of Transaction Real Estate, highlights, “The beauty of the partnership/LLC vehicle is its flexibility. But JVs require careful due diligence, tax structuring and corporate governance features so they have the best chance of success.”
Recent market conditions have made raising capital more difficult for REITs – commercial real estate prices have risen, yet many REITs have traded at a discount to net asset value (NAV) since May 2015. Depressed share prices make raising equity dilutive to existing shareholders, while issuing debt may negatively impact leverage ratios.
Partial interest dispositions of specific assets to JVs may be a viable option for REITs that need to recycle or raise capital. They also have the added benefit of helping validate NAV estimates.
One downside of divesting assets is the loss of net operating income (NOI) or funds from operations, but well-structured transactions where the seller retains management rights and incentive fees can help mitigate the impact to some degree.
JVs remain highly flexible and allow institutional investors to provide capital in exchange for attractive returns, while the REIT, as the typical managing partner, provides operating know-how. While JVs have comprised a smaller portion of overall transactions since 2012, REITs have made up more of the overall JV volume during the same period.
JVs can be accretive to REIT and corporate earnings before interest, taxes, depreciation and amortization by offering management fees and potentially promotes over and above certain hurdles. They can, however, create complexity for the parties involved. Potential partners in a JV need to undertake a full strategic review of the pros and cons of the specific JV arrangement, including tax structure, governance and valuation considerations.
There are three primary uses of JV proceeds:
- Supporting ongoing operations, including paying down or retiring debt
- Funding future acquisitions
- Funding the development pipeline
Gaining flexibility for REIT management teams’ capital allocation — on both sides of the balance sheet — is a priority. A strong balance sheet provides management with the flexibility to take advantage of opportunities as they present themselves.
To do this, management needs to be flexible in deciding which levers to pull at different points in the cycle. Selling noncore assets is an obvious priority, but off-loading core assets is a much less attractive proposition and may be to the detriment of management and shareholders’ long-term interests.
JVs potentially provide a solution to this. As Boston Properties highlighted in its 2014 JV portfolio deal with Norges, the JV transaction allowed Boston Properties to retain cash flows from highly desirable properties while at the same time monetizing part of the company’s portfolio and returning capital to investors via a special dividend. The proceeds were also used to help fund new development projects. The deal allowed the REIT to maintain a presence in important markets and grow its relationship with an important and deep-pocketed institutional investor.
In some cases, REITs also have the option to buy out the JV partner at a later date, to arbitrage the public-private differential by repurchasing shares or issuing special dividends. With many REIT shares trading at a discount to NAV, selling assets or partial stakes in order to repurchase shares may be accretive to existing investors. In 2015, Macerich announced that it would use a portion of the proceeds from a JV sale to buy back shares while using the remainder to issue a special dividend to shareholders.
What kinds of institutional investors might be interested in utilizing JVs?
Longer-term capital providers, such as insurance companies, pension funds and sovereign wealth funds, have been particularly interested in JVs. These investors enjoy a low-cost or highly stable source of capital, and the opportunity to purchase high-quality or tightly held assets, such as regional malls or coastal gateway office properties, remains appealing. REITs might be prepared to sell down stakes in prime assets to these institutional investors to fund their business plans, while still retaining interests in their core assets.
Other owners of real estate will likely find value in JV deals. A 2016 deal involved MetLife Investment Management (MIM) forming a JV with pension fund New York State Retirement Fund. MIM sold a 49.9% stake in a seven-building office portfolio to the pension fund for US$1.4 billion. Besides retaining a controlling interest in the portfolio, MIM agreed to manage the properties.
Domestic investors remain the most important capital source in the US real estate market, but overseas investors should continue to be considered as potential partners. Overseas investors tend to be particularly open to JV structures as a way to gain attractive returns while minimizing management requirements. Foreign pension funds also benefit from the Foreign Investment in Real Property Tax Act (FIRPTA) that enables them to invest in US real estate and JVs without a US tax cost upon exit.
Evaluating the implications associated with utilizing a JV structure is likely worthwhile for real- estate-heavy corporations that can no longer avail themselves of tax laws that allow tax-free spin- offs.
JVs offer many of the same benefits of tax-free spin-offs, such as releasing equity to be deployed elsewhere. They allow corporations to streamline real estate portfolios and reduce exposure to specific markets or disproportionately large assets. JVs may also provide an opportunity to unlock shareholder value by creating a residual public company with more distinct investment characteristics. A transaction can also help validate the worth of real estate that is not necessarily recognized.
But there are significant challenges of utilizing JV structures for both vendors and investors. Counter-party risk is an issue, especially if the seller occupies all the space. Alignment of interests is also important, particularly if the transaction is structured as a partial sale and leaseback transaction.
In such cases, it is important that the lease structure provides flexibility in NOI growth to warrant investment in the portfolio from both parties. JV arrangements can deteriorate rapidly if one partner experiences financial distress, if the partners’ interests diverge, or if the going-in valuation or operating terms turn out to be good for one party and unfavorable for the other.
Finding the right JV partner, and not just the highest bid, still remains critical. Tenants — for example, corporations participating in leaseback transactions — that continue to occupy the space ideally want long-term alignment from a partner. This likely favors insurance and pension funds, potentially sovereign wealth funds, and possibly REITs and private-equity investors targeting core-type returns.
An additional benefit may come in aligning to those with operational expertise and the ability to deliver property expansion and/or development plans across the portfolio. For large portfolios or blue-chip corporations, extracting full value from a transaction while also aligning to an appropriate partner requires a full and extensive marketing process.
Utilizing relationships and conversations remains an essential component of finding the right JV partner. The flexibility provided by a well-structured JV remains an important capital allocation tool and a welcome means to create shareholder value for both REITs and corporations.
At present, there is no shortage of interest in quality portfolios from both domestic and international institutional real estate buyers. The number of potential JV partners has likely never been higher. Careful due diligence, tax structuring and corporate governance are required, and aligning with a like-minded and trustworthy partner around a suitable structure and a clear strategy remains an essential requirement for long-term success.