Joint venture consolidations in commercial real estate development
INSIGHT ARTICLE |
Since the Great Recession, a greater number of development projects have been structured as joint ventures, with parties sharing risk and reward. These joint ventures are primarily structured as limited liability companies or limited partnerships. Yet real estate professionals continue to face confusion over the consolidation of real estate project entities and joint ventures.
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.
Consolidation rules under ASC 810, however, have become more complex over time, and builders, developers and other parties are required to closely evaluate not just majority ownership, but what entities are driving economic and financial performance at every project stage. It is vital for real estate professionals to understand the accounting rules in order to determine what stakeholders need to review at major phases of a typical commercial real estate project.
Joint venture requirements
ASC 810 provides guidance and rules to help real estate professionals determine if consolidation of a joint venture is required. 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. 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 affect a joint venture’s economic performance.
- As a group, the holders of the equity at risk 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 common way is for one party to provide some form of guarantee on behalf the joint venture. This may include debt, performance 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.
Under ASC 810, LLCs and LPs are presumed to be VIEs unless a simple majority (or a lower threshold) of the nonmanaging 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 nonmanaging 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. This is particularly relevant as most commercial real estate joint venture entities are structured as LLCs or LPs.
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 individual development projects.
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, so the power to direct joint venture activities that most significantly affect economic performance can change over the life of the project. To properly 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:
- Origination and design. Most often, this is the stage with the lowest level of joint venture activity. For example, a developer finds an old building in a promising location with strong multihousing 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 multihousing 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 multihousing development example, key considerations at this stage include control of final property and development design decisions, approval or veto rights on the construction budget, and supervisory authority over construction and development. 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 nonconstruction stakeholders. In this stage, significant activities include ownership of marketing and sales roles, approving tenants, and handling lease agreements. In addition, the party that approves (or can veto) the initial lease-up budget and manages the multihousing 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 remarketing 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 be 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 multifamily 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.
Other considerations for structuring a joint venture
Technology infrastructure of the joint venture
Selecting project management and enterprise resource planning systems for a joint venture are critical to a project’s success. Determining which partner will host or manage these systems, or if the joint venture itself will procure and manage its own systems, is a decision that must be considered early enough in the arrangement to incorporate necessary protections within the joint venture agreements. Additionally, the complexity of the job and its stakeholders will dictate the level of complexity of the systems. In a recent $1 billion joint venture project in Miami, for example, the JV partners did not give enough consideration to this aspect, and attempted to use QuickBooks to account for the project. Proper job costing and retainage tracking was not addressed at inception, which resulted in major rework—and headaches for the joint venture accounting team later in the job.
Joint venture accounting team structure and approval workflow
Development of an organizational chart for the joint venture’s accounting team, identification of individual responsibilities and defining approval workflow are issues that should be considered at inception to reduce confusion after a project has ramped up and transaction volume has increased. Documenting manual process flow, or establishing automated workflow for invoice processing, change orders and other key processes are important operations decisions that should be addressed at inception to avoid confusion and missed expectations later in the project.
Operational reporting requirements
There are many day-to-day and month-to-month reporting considerations that should be addressed at project inception. Daily logs, subcontractor submittals, requests for information, and monthly cost projections and forecasts are among the many critical pieces of information that are exchanged on any given project, and are often overlooked. Determining who is responsible for creating, retaining and approving—as well as the frequency and content of reporting to key stakeholders of the joint venture—should be defined early and given careful consideration to ensure project success and reduction of confusion and finger pointing.