JV Issues that Can Arise in Office-to-Residential Conversions
Imagine that you are an institutional investor that owns, via a joint venture with an operating partner, an office building. Vacancy is well below pre-pandemic levels and you have just received notice that a major tenant is not renewing its lease. Your operating partner presents you with a business plan to convert the building to residential use. The plan addresses the myriad of issues in which both joint venture partners are aligned, including architectural plans, zoning and regulatory requirements and the construction budget. You believe that the plan is feasible and you now turn your attention to joint venture specific items for which the partners may not be aligned.
This article discusses four categories of issues that may arise between joint venture partners in office-to-residential conversions: (i) expertise in the development and ownership of the asset, (ii) economic considerations, (iii) control and major decisions and (iv) financing related issues.
Operating partner’s expertise
Once the joint venture owner of an underutilized office building decides that the asset would perform better as a residential building and conversion of the building itself is feasible, the first major issue the joint venture partners may encounter is their lack of expertise in developing and operating residential assets. The operating partner’s value in a typical joint venture is to provide useful relationships, expertise, experience and knowledge in executing the project. Operating expertise for office assets may not carry over to skills necessary to execute a conversion to residential use, which include construction related expertise and residential sales, leasing and management experience. For example, an office building operating partner may not have the relationships and experience to handle affordable housing issues – and several municipalities are considering proposals that would make affordable/low- or moderate-income households a condition for approval of converting use from office to residential.
The joint venture partners might consider the following options to address lack of construction and residential experience within the current ownership structure: (i) buy out the current operating partner and replace it with a new residential expert, (ii) the current operating partner retains its membership interest, but a replacement operating partner is admitted to the joint venture as a third member and the sole operating partner, (iii) admit an additional operating partner, and have two operating partners, each with specific responsibilities or (iv) no change to the ownership structure and hire third party manager(s) for construction, property management and/or sales and leasing matters.
A typical joint venture compensates an operating partner with two sources of potential income. First, the operating partner receives increasingly larger shares of net cash flow (greater than its pro rata ownership interest) as the joint venture achieves larger internal rates of return. This promoted interest (also known as carried interest or promote) incentivizes operating partners to maximize returns to the capital partner. Second, an operating partner may receive fees, including for leasing and property management services. Capital partners are often careful to ensure that fees are not a major profit source for the operating partner, but instead function primarily to cover overhead.
How do the operating partner expertise options described in the section above affect a joint venture’s existing promote and fee structure? A buy-out of the original operating partner would simply provide for the new, residential operating partner as the recipient of promote and fees—but keep in mind that, in any specific market, the promote and fees for office properties may vary significantly from the promote and fees for residential assets. The same concept will generally apply where the original operating partner retains its membership interest but cedes the operating partner role to a new, third partner who specializes in residential assets.
The third and fourth options described above require a more complex adjustment of the joint venture’s promote and fee structure. If a third partner is admitted as an additional operating partner, with responsibilities to be allocated between the original office expert (who might continue to have primary responsibility for sourcing debt, for example) and the new residential expert, then the parties will need to negotiate allocation of promote—both amount and priority and revise and allocate the fee structure.
Keeping the ownership structure unchanged and hiring a third-party manager may, at first, seem to be the cleanest option. However, the new third-party manager’s compensation should (from the capital partner’s perspective at least!) come from what would otherwise have been promote paid to the original operating partner. The original operating partner may rightfully claim that it should not lose the benefit of value that its services added prior to the conversion to residential and that it would not be fair for it to forfeit all of its promote. The parties may agree to “crystallize” the original partner’s promote – for example, if a hypothetical sale of the office building (at the time of conversion) would have resulted in promote being paid to the original operating partner, and if that promote would cause the operating partner who had a 5% ownership interest to receive 20% of the net sales proceeds, then the members might agree to readjust the ownership percentages so that the original operating partner would now have a 20% membership interest.
Another key economic consideration is whether a change to the joint venture’s ownership structure will trigger a transfer tax. Many transfer tax regimes include transfers of a “controlling interest” in an entity that owns real property, so a transfer of joint venture interest to a new operator may trigger a transfer tax. Controlling interest thresholds are commonly set as “at least 50%” or “more than 50%” and the tax can be significant. In New York City, the rate can be as high as 0.65% and in Los Angeles, the recently adopted “mansion tax”, when aggregated with the California transfer tax and the City of Los Angeles transfer tax results in an aggregate transfer tax of up to 6.06% !
Control and major decisions
The capital partner’s role in a real estate joint venture is typically limited to approving or rejecting the operating partner’s requests with respect to a long list of so-called “major decisions”, such as entering into material contracts, adopting annual budgets, revisions to the business plan and financing terms. The capital partner also has approval rights over capital contributions, except for mandatory contributions to address emergencies or to allow the joint venture to pay for certain impositions such as real estate taxes and insurance.
The joint venture partners must revisit the major decisions list and the scope of mandatory capital contributions when they decide to convert their building from office to residential use. For example, approval rights over material office leases may become approval rights over the residential lease form and the minimum rent schedule – or, if the office is being converted to residential condominiums, approval rights with respect to the form of sale agreement, any bulk sales of several units to the same buyer and minimum sale prices.
Should construction costs—which were not a concern for a completed office building – become subject to mandatory capital contributions? It is reasonable for the joint venture partners to expect mandatory funding in accordance with a pre-approved budget. But what about cost overruns? The allocation of risk for cost overruns, including different allocations depending on the nature of the cost overrun (due to negligence, or force majeure, or a change in the scope of work, etc.) is often the subject of much negotiation among the joint venture partners.
Financing the conversion to residential use
Financing a completed, stabilized office building is fairly straightforward. The usual construct is that a lender provides a mortgage loan that is secured by the office building and which is non-recourse to the building’s owners. The only exceptions to the non-recourse nature of the loan are that one or more guarantors (often affiliates or principals of the operating partner) will be personally responsible for environmental indemnification and for a specified list of “bad acts” or “non-recourse carveouts”, which will include bankruptcy filings and misappropriation of funds.
A conversion to residential use will almost certainly require construction financing. In addition to the environmental indemnification and non-recourse carveout guaranty described above, a construction lender will likely require a construction completion guaranty (in case the owner’s equity and the construction financing is not sufficient to complete construction) and a carry guaranty (to cover interest payments and carry costs such as taxes and insurance, until the conversion is completed and specified rental or condominium sales thresholds are met).
Each of the topics described above are relevant to the negotiation over the allocation of risk among the partners with respect to the construction financing guaranties. Will there be a replacement or additional operating partner? Does the proposed promote and fee structure adequately compensate the guarantor(s)? Does the scope of mandatory capital contributions cover construction costs that would otherwise be payable by the completion guarantor?
Joint venture parties should carefully consider the impact that a conversion can have on the structure of and terms governing their partnership. Unlike issues related to the feasibility of conversion to residential use, the partners’ interests may not be aligned with respect to the joint venture issues that a residential conversion will raise.
Marc Lazar is a partner Robert Brownlie and Jeremy Lu are associates in Goodwin’s Real Estate Industry group. Marc is a member of the firm’s PropTech Initiative, which is focused on supporting the intersection of Real Estate and Technology through thoughtful collaboration across the two practice areas. Marc’s practice focuses on real estate finance and investments throughout the capital stack and in all asset classes, including joint ventures, private equity investments, mortgage, mezzanine and preferred equity financings, sale leasebacks, ground leases 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.