In recent years, developers have turned increasingly to the formation of real estate funds as a tool for raising capital, diversifying risk and responding more nimbly to changes in the real estate market. Real estate funds have taken off, raising $60 billion in 2006, an increase of more than 70 percent from the $35 billion funds raised the year before.
Despite the upsurge in real estate funds, or rather because of it, developers who are seeking a steady source of capital for their projects (or investors looking to put money into real estate development) should consider the alternative of creating a joint venture. For developers, the market for real estate funds is becoming increasingly crowded and joint ventures offer the prospect of potentially greater economic returns.
Many industry experts believe that the real estate fund market probably peaked in 2006 and that there will be growing competition for investment dollars. Several of the larger real estate funds are expected to enter the market to raise capital in 2007 and 2008, which will make it more difficult for smaller developers and first time funds to compete. In addition, many institutional investors have internal guidelines proscribing investment in first-time funds.
At the same time, the growth of real estate funds means there is more money chasing development projects and properties. In the race to get money out the door, many investors see competitive advantages in teaming with an experienced local developer with a proven knack for identifying good properties.
This confluence of interests is fueling a growing interest in joint ventures as an alternative to real estate funds. With equity behind them, developers can seize opportunities before market conditions change or competitors sweep in and have funds available to place deposits and conduct due diligence. Although joint ventures serve similar purposes for developers as real estate funds, they operate differently and have important advantages as well as disadvantages.
In a typical joint venture arrangement, an investor will commit a certain sum of capital to a developer (usually in the tens or hundreds of millions of dollars), which then has a pool of capital to draw on and does not need to secure separate equity financing for each project they undertake.
Joint ventures often provide better terms to the developer than a fund. Many funds offer their limited partners a preferred return of 8 percent to 10 percent in addition to return of their invested capital. After these payments are made, developers typically receive a 20 percent share of any further ROI. The terms of joint venture arrangements can vary considerably but the preferred return to the investor typically falls in the 6-8 percent range and the back-end split is often much more favorable, with developers even securing not unheard of 50/50 splits with their investors.
It can be difficult for developers to raise their first funds since investors, especially institutional investors, are looking not only at the experience of the developer but at their track record in managing funds. In a joint venture, there is no fund to manage and hence investors are interested only in proven ability of the developer to complete projects on time and within budget and to generate a favorable ROI. Further, a successful joint venture can be a stepping stone for developers seeking to raise a first fund.
Another advantage of a joint venture is that it is not an exclusive relationship; developers can have multiple joint venture partnerships. With a real estate fund, the sponsor has a fiduciary duty to its investors to finance all development projects through the fund. In the joint venture, if an investor passes on a deal, the developer can seek out other equity partners.
This brings us to the biggest drawback of a joint venture. Although the developers may realize a higher return, they often exercise less control over the developments they opt to pursue. The equity partner typically has effective veto power over each project. The developer can seek out other investors, but that raises significantly the time and transaction costs, which negates a key benefit of having capital in place.
With the market for real estate funds shifting, this may be an opportune time for developers, especially those who have not raised a first fund, to seek out single investors with whom they can build a long term relationship. Joint ventures yield similar benefits to a fund, provide a bridge to a more favorable fund market and further establish a developer’s credentials when the time is right for establishing a fund.
