Joint venture problems encountered in office to apartment conversions -Dlight News


Imagine you are an institutional investor owning an office building through a joint venture with an operating partner. The vacancy rate is well below pre-pandemic levels and you just got the news that a major tenant is not renewing their lease. Your operator will provide you with a business plan to convert the building into residential use. The plan addresses a variety of issues on which both joint venture partners agree, including architectural plans, zoning and regulatory requirements, and construction budget. You believe the plan is feasible and now turn your attention to joint venture specific issues that the partners may not be aligned on.

This article addresses four categories of issues that may arise between joint venture partners in office to apartment conversions: (i) expertise related to the development and ownership of the asset, (ii) economic considerations, (iii) control and major decisions and (iv) funding issues.

Expertise of the operating partner

Once the joint venture owner of an underutilized office building decides that the asset would perform better as a residence and that remodeling the building itself is feasible, the first major problem the joint venture partners may encounter is their lack of Expertise in the development and operation of residential assets. The value of the operating partner in a typical joint venture is to provide useful relationships, expertise, experience and knowledge in carrying out the project. Office property operating know-how must not be transferred to skills required to carry out a conversion to residential use, which includes construction-related expertise and experience in residential property sales, leasing and management. For example, an office building operations partner may not have the connections and experience to solve affordable housing issues—and several municipalities are considering proposals that would make affordable low- and middle-income households a condition of office-to-residential conversion approval .

The joint venture partners could consider the following options to address the lack of construction and housing experience within the current ownership structure: (i) buy out the current operating partner and replace it with a new housing expert, (ii) keep the current operating partner its membership portion, but a replacement Operating Partner will be included as the third member and sole Operating Partner in the Joint Venture, (iii) allow one additional Operating Partner and have two Operating Partners, each with specific responsibilities, or (iv) no change to the ownership structure and mandate ( a) third party administrators for construction, property management and/or sales and leasing matters.

economic considerations

A typical joint venture rewards an operating partner with two potential sources of income. First, the operating partner receives increasingly larger shares of the net cash flow (greater than its partial ownership interest) as the joint venture generates higher internal returns. This promoted interest (also known as carried interest or promote) gives operating partners an incentive to maximize returns for the capital partner. Second, an operating partner may receive fees, including for leasing and property management services. Capital partners often ensure that fees are not a major source of profit for the operating partner, but are primarily used to cover overhead costs.

How do the operating partner expert options described in the section above affect a joint venture’s existing funding and fee structure? A buyout of the original operating partner would simply make the new residential operating partner the recipient of promotions and fees – but remember that office property promotions and fees in each specific market can differ significantly from residential property promotions and fees. The same concept generally applies when the original operating partner retains its membership interest but cedes the role of operating partner to a new, third party partner specializing in residential real estate.

The third and fourth options described above require a more complex adjustment to the joint venture’s funding and fee structure. If a third partner is admitted as an additional operating partner, with responsibilities to be shared between the original office professional (who, for example, could still have primary responsibility for raising debt) and the new housing professional, the parties must negotiate the allocation of the grant – both amount and Priority – and review and allocation of fee structure.

Leaving the ownership structure unchanged and hiring an external manager may seem the cleanest option at first glance. However, the compensation of the new third party manager should (at least from the point of view of the capital partner!) come from what would otherwise have been paid to the original operating partner. The original operating partner may rightly argue that they should not lose the value added by their services prior to conversion to dwellings and that it would not be fair if they forfeit all of their support. The parties may agree to “crystallize” the original partner’s subsidy – for example, if a hypothetical sale of the office building (at the time of conversion) would have resulted in subsidy being paid to the original operating partner, and if that subsidy to it If the Operating Partner, which had a 5% interest, would receive 20% of the net sales proceeds, members could agree to readjust the ownership percentages so that the original Operating Partner would now have a 20% interest.

Another important economic consideration is whether a change in ownership structure of the joint venture will trigger a transfer tax. Many transfer tax regimes involve the transfer of a “controlling interest” in a company that owns real estate, so a transfer of joint venture interests to a new operator may trigger a transfer tax. Controlling interest thresholds are usually set at “at least 50%” or “more than 50%” and the tax can be significant. In New York City, the tax rate can be as high as 0.65%, and in Los Angeles, the recently introduced “mansion tax” combined with the California property transfer tax and the City of Los Angeles property transfer tax results in a total property transfer tax of up to 6.06%!

Control and important decisions

The role of the capital partner in a real estate joint venture is typically limited to approving or denying the operating partner’s proposals regarding a long list of so-called “key decisions,” such as the business plan and financing terms. The capital partner also has approval rights for capital contributions, except for mandatory contributions to deal with emergencies or to allow the joint venture to pay certain duties such as property taxes and insurance.

The joint venture partners must review the list of key decisions and the level of mandatory capital contributions when deciding to convert their building from office to residential use. For example, approval rights for essential office leases may become approval rights for the condominium lease form and minimum lease schedule—or, if the office is converted to condominiums, approval rights for the form of the purchase agreement and any bulk sales of multiple units to the same buyer and reserve prices.

Should construction costs, which do not play a role in a completed office building, become subject to capital contributions? It is reasonable that the joint venture partners expect mandatory funding according to a pre-approved budget. But what about cost overruns? Allocation of risk for cost overruns, including different attributions depending on the nature of the cost overrun (due to negligence or force majeure, or a change in scope of work, etc.), is often the subject of much negotiation between the joint venture partners.

Financing the conversion to residential purposes

Financing a completed, stabilized office building is relatively easy. The usual construct is that a lender provides a mortgage loan that is secured by the office building and has no recourse to the building’s owners. The only exceptions to the non-recourse loan type are that one or more guarantors (often affiliates or principals of the operating partner) are personally responsible for the environmental compensation and for a specific list of “bad acts” or “non-recourse carveouts” , which will include bankruptcy filings and embezzlement of funds.

A conversion to residential purposes will almost certainly require construction financing. In addition to the environmental damages and non-recourse carveout guarantees described above, a construction lender will likely require a completion guarantee (if the owner’s equity and mortgage lending are insufficient to complete construction) and a carry guarantee (to cover interest payments and incidental expenses). such as taxes and insurance, until conversion is complete and set thresholds for rental or condominium sales are met).

Each of the issues described above is relevant to the negotiation of the risk sharing between the partners in relation to the mortgage guarantees. Will there be a replacement or additional operating partner? Does the proposed funding and fee structure adequately compensate the guarantor(s)? Does the amount of mandatory contributions cover construction costs that would otherwise be borne by the completion guarantor?

Joint venture parties should carefully consider how a conversion may affect the structure and terms of their partnership. In contrast to issues related to the feasibility of residential conversion, the interests of the partners may not be aligned with respect to the joint venture issues that residential conversion raises.

Marc Lazar is a partner. Robert Brownlie and Jeremy Lu are partners in Goodwin’s Real Estate Industry Group. Marc is a member of the company’s PropTech initiative, which focuses on supporting the intersection between real estate and technology through thoughtful collaboration between the two practice areas. Marc’s practice focuses on real estate finance and investments across the capital stock and asset class, including joint ventures, private equity investments, mortgage, mezzanine and preferred equity finance, sale-leasebacks, leaseholds and loan restructurings. He has extensive experience representing institutional investors, hedge funds, real estate and other private equity funds, as well as lenders and developers.

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