Joint venture consolidations in commercial real estate
INSIGHT ARTICLE |
For many years, the party with a majority ownership interest in a commercial real estate project owned through a joint venture was primarily responsible for consolidating the financial results of that joint venture or letting it stand as an off-balance sheet entity.
While consolidation rules have become more and more complex over time, that calculus changed significantly when the Financial Accounting Standards Board issued Accounting Standards Update (ASU) 2015-02, Consolidation (Topic 810)—Amendments to the Consolidation Analysis. This amendment to Accounting Standards Topic 810 (Topic 810), requires builders, developers and other parties to closely evaluate not just majority ownership, but what entities are driving economic and financial performance at every project stage. Given the resurgence of development projects, particularly joint ventures structured as limited liability companies (LLCs) or limited partnerships (LPs) where multiple parties are involved, this latest guidance is vital for real estate professionals to understand. In this article, we’ll take a quick look at both current and updated accounting rules, and illustrate what stakeholders need to review at major phases of a typical commercial real estate project.
Topic 810 provides guidance and rules to help real estate professionals determine if consolidation of a joint venture is required. While the guidance is divided into two consolidation paths – the variable interest entity model and the voting interest model – the first step is to determine if the joint venture is a variable interest entity (VIE). A joint venture is generally considered a VIE if it meets one or more of the following conditions:
- The investors do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support.
- As a group, the holders of the equity at risk (generally members or partners) lack the power, through voting or other rights, to direct activities that most significantly impact a joint venture’s economic performance.
- As a group, the holders of the equity at risk (generally members or partners) lack the obligation to absorb a joint venture’s expected losses, or have the right to receive a joint venture’s expected residual returns.
While these VIE criteria can be met in a variety of ways, a very common way is when one party provides some form of guarantee on behalf the joint venture. This may include debt guarantees, performance guarantees or financial return guarantees. These guarantees often don’t lapse upon project completion, since lenders and other interested parties aren’t inclined to lose additional security provided by a guarantee until the real estate project is stabilized and generating sufficient cash flow to fund its commitments.
If a joint venture is determined to be a VIE, the consolidating entity may change over the life of the project. That means a construction or real estate entity must determine the role it plays in the design, operation, investment or financial support of the project. For example, an investor may have a large financial stake in a development venture, but no active role in making decisions about design, construction or leasing. Conversely, a design-build firm may have little or no financial investment in the engagement, but significant control over key project decisions.
If the joint venture is not a VIE, accounting guidance turns to the voting interest model under Topic 810 (810-20-25), particularly as it relates to LLCs and LPs. Under the voting interest model, the managing member or general partner for LLCs or LPs is presumed to have authority to consolidate a joint venture, and no further analysis is generally needed. Note that the new guidance has key rule changes that push LLCs and LPs away from the voting interest model. Those changes are summarized below.
Specifics of new guidance
ASU 2015-02 becomes effective for public businesses for fiscal years beginning after December 15, 2015, and all other companies for fiscal years beginning after December 15, 2016. Entities may adopt the guidance early, but must adopt it as of the beginning of the annual period that includes the adoption date. Under the new guidance, LLCs and LPs are presumed to be VIEs unless a simple majority (or a lower threshold) of the non-managing members or limited partners that are unrelated to the general partner have either substantive kick-out rights or substantive participating rights over the managing member or general partner. Substantive kick-out rights allow the non-managing members or limited partners to:
- Dissolve the partnership, or
- Remove the managing member or general partner without cause.
Similarly, substantive participating rights allow these same members or partners to block or participate in significant financial and operating decisions.
Once a joint venture is determined to be a VIE, a company must apply the same tests to determine if it is responsible for consolidating the joint venture discussed above
If the answer is “yes” to these tests, all joint venture financial reporting should be consolidated. Additionally, all financial activity between the joint venture and company should be eliminated, including any revenue recognized for work done for the joint venture.
Bear in mind that the specifics of every joint venture are different. That’s why it is important for commercial real estate professionals to make careful evaluations, based on the facts and circumstances of each specific development project.
Under both current and new guidance, joint venture stakeholders are required to regularly evaluate their responsibilities for consolidating financial reporting under a VIE. Commercial real estate development projects are typically divided into four stages (origination and design, construction, lease-up and stabilization, and operations and sale). That means the power to direct joint venture activities that most significantly impact economic performance can change over the life of the project. To properly make evaluate which party has that power during each phase, each party must understand key drivers of economic performance during each stage, and identify stakeholders that have the power to control those activities. With that in mind, let’s take a closer look at each stage:
Origination and Design. Most often, this is the stage with the lowest level of joint venture activity. For example, assume a developer finds an old building in a promising location with strong multi-housing renovation potential. Since it may not be feasible to fund the entire project, the developer may seek majority funding from investment partners who would get the majority of long-term revenue from the multi-housing site. In exchange, the developer would get to build the project and keep a percentage of its long-term revenue. The investment partners are generally not involved in any of the significant decisions outside of setting their investment requirements. In this case, the developer is most likely driving early design outlines, operating agreements, loan negotiations, revenue and expense projections, and commitments for any cost overruns. It is usually at this stage where operational and debt agreements will determine if the joint venture is a VIE. Because of the high level of control over these activities at this stage, a developer will often be responsible for consolidating the joint venture.
Construction. This stage of a real estate project substantially influences final design standards and build quality, both of which affect a joint venture’s current status and future operation. Continuing the multi-housing development example, the key considerations at this stage include control of final property and development design decisions, approval or veto rights on the construction budget (including change orders, budget sources and uses), and supervisory authority over construction and development (including decisions on hiring or removal of the construction manager). The party exercising control in these areas is accountable for consolidating the VIE on its books.
Lease-Up and Stabilization. Now that the project has moved from developmental concept to constructed reality, the joint venture emphasis moves toward non-construction stakeholders. In this stage, significant activities include ownership of marketing and sales roles, such as pricing units, approving tenants, and handling lease agreements. In addition, the party that approves (or can veto) the initial lease-up budget and manages the multi-housing complex with a wide level of discretion has the responsibility to consolidate the joint venture.
Operations and Sale. In this final stage, the main focal point is typically maximizing cash flow to support an exit price. Significant activities include determining who has approval and veto power on the annual budget, who may initiate and approve a sale of the property, and who controls day-to-day management of the joint venture. Two other key evaluations at this stage include understanding what party is accountable for any future property re-marketing or redevelopment, and what party has authority to place indebtedness on the property and distribute the debt proceeds. During this stage, a joint venture typically obtains permanent financing and the removal of prior guarantees. For those reasons, a construction joint venture might no longer considered a VIE, meaning that stakeholders should use the voting interest model to determine the proper consolidation conclusions.
The ramifications of any joint venture consolidations can affect a company’s financial statements for years. For example, the developer of the aforementioned multi-family project may consolidate the joint venture and be required to defer recognition of any revenue and profit until it no longer consolidates the entity several years later. This lack of revenue recognition may have a negative effect on financial and nonfinancial covenants governing the developer’s bank debt or its ability to obtain surety bonds. That’s why it’s wise for real estate professionals and associated partners to assess the short- and long-term financial considerations of joint venture consolidations early in a project’s life.
Many developers, contractors and real estate companies will be affected by the new guidance. The degree to which the recognition (e.g., timing) and measurement (e.g., amount) of a particular joint venture depends on its own facts and circumstances. One thing is certain, the key to arriving at the proper conclusion when evaluating a joint ventures’ impact on the financial statements is a robust understanding of the governing documents, the roles each party plays in the joint venture, and the phase of the joint venture. Early evaluation and discussion will help to prevent surprises.