Real Estate Joint Ventures: An Alternative Capital Raising Strategy

N ti ti d St t i th JV A tpresents Negotiating and Structuring the JV Agreementpresents

A Live 90-Minute Teleconference/Webinar with Interactive Q&A

Today's panel features:John W. Hanley, Jr., Partner, Davis Wright Tremaine, Seattle

Brent M. Cohen, Partner, Jones Day, San FranciscoJeffrey B. Fugal, Partner, Quarles & Brady, Phoenix

Thursday, December 17, 2009

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Basic StructureBasic Structureof

R l E J i VReal Estate Joint Ventures

t d bpresented byJohn W. Hanley, Jr.

1. What is a Real Estate Joint Venture

( ) C t th bi ti f i tit ti l(a) Concept: the combination of an institutionalcapital source and a local real estate developeror operator willing to invest that capital andor operator willing to invest that capital anddevelop or operate the venture’s real estateasset for a period of time in exchange for ap gshare of the profits.

(b) Choice of Entity and Jurisdiction.( ) F d l T S hi bl(c) Federal Tax Status: a partnership taxable

under Subchapter K of Internal Revenue Code.

2 Why a Delaware LLC?2. Why a Delaware LLC?

(a) maximum contract flexibility – Del. Act § 18-1101

(b) ease of formation, merger, dissolution(c) Delaware Court of Chancery(c) Delaware Court of Chancery(d) large body of precedent in Delaware

corporate lawcorporate law

3. What Are The Fiduciary Duties of theyManager of a Delaware LLC?

Bay Center Apartments Owner, LLC v. y p ,Energy Bay PKI, LLC, Delaware Chancery Court No. 3658-VCS (April 20, y ( p ,2009): footnote 33

4. The Operating Agreement:h d hWhat and Why?

(a) Why have a written operating agreement?(a) Why have a written operating agreement?(1) Memorialize complex terms of joint venture(2) comply with complex federal tax law requirements; make tax choices from permitted alternatives in partnership tax regulations(3) “d f lt l ” f ti(3) vary “default rules” of governance or operation found in statute or common law(4) eliminate fiduciary duties(4) eliminate fiduciary duties

(b) Appendix A – Checklist of Possible Provisions

5. Economic Terms of Operating Agreement(a) Planned Capital Contributions(b) Planned Returns (Cash Distributions). Typical joint venture

agreement may have a formula calling for several tiers of distribution of net cash flow the so called waterfall; fordistribution of net cash flow – the so-called waterfall; for example:(1) first, to Investor until Investor has received a preferred return of 8% per annum on its capital contribution(s);(2) second, to Manager until Manager has received a preferred return of 8% on its capital contribution(s);(3) third, to Investor until Investor has received a return of its capital contribution(s);(4) fourth to Manager until Manager has received a return of its capital(4) fourth, to Manager until Manager has received a return of its capital contribution(s);(5) fifth, 75% to Investor and 25% to Manager until Investor has received an Internal Rate of Return [defined term] of 15%; and thereafter; and(6) 50% to Investor and 50% to Manager.(6) 50% to Investor and 50% to Manager.

(c) Planning for Failure(d) Tax and Accounting “Technicalities”

6. Governance/Management Terms(a) Manager Model

(1) Broad grant of authority to designated manager or managing memberg g(2) reservation by capital source(s) of approval rights over “major decisions”(3) use of Annual Plan and Annual Budget as(3) use of Annual Plan and Annual Budget as benchmark or further delegation of authority(4) multiple members: voting standard (supermajority?) and mechanics of votingand mechanics of voting(5) the problem of deadlock; various mechanisms:

(i) carry-over budgets(ii) mandatory consultations mediation or(ii) mandatory consultations, mediation or

arbitration(iii) resort to expert opinion(iv) buy sell or put call(iv) buy-sell or put-call

(b) Interested Transaction Provisions( )(1) Manager or affiliate delivery to joint venture of necessary operating services; pricing standard or formula(2) manager/affiliate may not compete against joint(2) manager/affiliate may not compete against joint venture (i.e., competitive leasing activities)(3) manager/affiliate may not usurp LLC business opportunities(4) manager/affiliate may not use LLC property for personal usep(5) manager/affiliate must act in good faith and continually disclose all material information

“When a man with money meets a man with experience, the man with the p ,

experience gets the money and the man with the money gets an experience.”

--Anonymous

John W Hanley JrJohn W. Hanley, Jr.Davis Wright Tremaine LLP

1201 Thi d A S it 22001201 Third Avenue, Suite 2200Seattle, WA 98101-3045

(206) 757-8262JohnHanley@dwt.comy@

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Appendix A

Checklist of Possible Provisions in Limited Liability Company Agreement

For Delaware Limited Liability Company

1. Definitions 2. Organizational Matters

2.1 Name; Trade Name 2.2 Jurisdiction; Certificate of Formation 2.3 Registered Office; Registered Agent 2.4 Principal Place of Business 2.5 Foreign Registrations 2.6 Purposes and Limitations 2.7 Term 2.8 Names and Addresses of Members

3. Capital Contributions

3.1 Initial Capital Contributions

(a) Cash Contributions (1) amount (2) due date (3) conditions of funding (4) payment mechanics

(b) Property Contributions (1) separate Contribution Agreement for real estate owned or under

contract (2) project development plans, specifications, studies, permits,

entitlements, contracts (3) lease commitments, financing commitments, other business plan

assets (4) conditions of contribution (5) agreed upon values

(c) Project Completion Guaranty (1) identity of guarantor (2) terms; scope and deadline (3) treatment of payments upon completion guaranty

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(d) Third Party Financing Guaranty (1) identity of guarantor (2) scope: non-recourse carve-outs, or full; caps; release (3) fee or other compensation (4) reimbursement and contribution issues

3.2 Additional Capital Contributions

(a) scheduled vs. unscheduled (b) capital call mechanics

(1) by whom; (2) what preconditions; (3) in what form and amounts?

(c) mandatory vs. permissive (d) failure to make mandatory capital contribution

(1) substitute loan (2) substitute capital contribution (3) deemed loan plus contribution (4) loss of management rights (5) default remedies

3.3 Capital Withdrawals 3.4 Project Mortgage Financing 3.5 Operating Deficit Loans

4. Management of Joint Venture

4.1 Managing Member or Other Structure 4.2 Scope of Manager’s Authority 4.3 Limitations on Manager’s Authority

(a) ERISA and REIT limitations (b) major decisions (c) conflict of interest transactions

4.4 Approval Procedures (Multiple Members)

(a) notice and meetings; consents (b) failure to respond

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(c) discretion standard

4.5 Delegation of Manager’s Authority

(a) officers (b) agents

4.6 Standard of Conduct by Manager

(a) general standard (b) time commitment (c) fiduciary duties; limitation of liability

4.7 Competitive Activities By Members

(a) manager and affiliates (b) other member(s)

4.8 Conflict of Interest Transactions

(a) pre-approved contracts (b) future events: alternative mechanisms

4.9 Removal of Manager

(a) standards (b) consequences (c) contracts with affiliates (d) mortgage financing limitations

4.10 Indemnification of Manager, Officers, Agents 4.11 Compensation of Manager

(a) membership interest (b) management fee (c) expenses; budget (d) affiliate contracts

5. Cash Distributions

5.1 Heart of the Business Deal 5.2 Net Cash Flow vs. Capital Proceeds 5.3 Waterfalls: Preferred Returns and Promotes

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5.4 Mandatory vs. Discretionary Distributions

(a) tax distributions (b) liquidating distributions

5.5 Withholding on Distributions 6. Allocations of Profit and Loss

6.1 Key Distinction: Net Income vs. Cash 6.2 Capital Accounts 6.3 Tax Requirements

7. Transfers of Membership Interests

7.1 Additional Members 7.2 Transfer of Manager’s Membership Interest

(a) prohibitions; limited exceptions (b) change of control of Manager

7.3 Transfer of Non-Manager’s Membership Interest

(a) permitted transfers (b) change of control of non-managing member (c) general prohibitions (d) substitution procedures

7.4 Right of First Refusal/Right of First Offer 8. Dispute Resolution

8.1 Default Provisions 8.2 Arbitration 8.3 Buy-Sell and Marketing Provisions

(a) lock-up period (b) buy-sell (c) mandatory project sale and liquidation

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9. Administrative Matters

9.1 Books of Account 9.2 Accounting

(a) fiscal year (b) consolidation (c) joint venture’s accountants

9.3 Financial Statements and Other Reports 9.4 Tax Returns 9.5 Tax Matters Partner 9.6 Member Inspection Rights

10. Dissolution and Liquidation

St tf d R l E t t J i t V t Strafford Real Estate Joint Venture WebinarBrent M. Cohen

December 17, 2009

Restructuring the Distressed Joint VentureVenture

• I. Examples of Distress: Fracturing of themortgage loan relationship

• II. Restructuring a loan often will necessitate restructuring or recapitalizing the project joint venturerecapitalizing the project joint venture

• III. Sources of New Capital• IV. Replacing the Operating Member

V I ti f O ti M b t• V. Incentives of Operating Member to Cooperate

• VI. Forms of Investment• VII. Conclusion

I. Examples of Distress: Fracturing of themortgage loan relationshipmortgage loan relationshipA. Construction loan out of balance – need for more capital or construction

ceases

B. Failure of borrower to achieve lease-up hurdle or pre-sales

C. High vacancy rates – breach of DSCR or other financial covenants

D. Looming maturity date

II. Restructuring a loan often will necessitate restructuring ornecessitate restructuring or recapitalizing the project joint ventureventure

A. Borrower typically seeks a) extension of term and b) reduction of principal, or conversion of a portion of the principal into a contingent future payment obligation Borrower may also seek acontingent future payment obligation. Borrower may also seek a lower interest rate, relaxed covenants (DSCR or operating covenants for lease-up or pre-sales)

B. Lender conditions typically require additional capital to be invested in the project to pay down loan or provide needed operating capital

C. The need for new capital may force a restructuring of the LLC.

III. Sources of New CapitalA. Existing members

1 Does operating agreement provide for calling of additional1. Does operating agreement provide for calling of additional capital? If not, alternatives are dissolution by agreement, or if there is deadlock, by state court dissolution proceeding

2 If dditi l it l i ll d h t i f f il t2. If additional capital is called, what is consequence of failure to contribute?

3 Dilution of economic interest or loss of management rights?3. Dilution of economic interest or loss of management rights?

B. Admission of new members

1. Is unanimous consent required?

2. What management and control rights are required by new i t ?investor?

3. What economic return does new member require?

IV. Replacing the Operating Member:Sources and Uses of Member StressSources and Uses of Member Stress• A. Did operating partner obtain the loan? Lender

consent may be required to replace operating partner.

• B. Common removal provisions:1. Buy-Sell – triggered after passage of time,y gg p g ,

or default – difficult to compel performance within tight lender time-constraints

2 Buy out triggered after default difficult to2. Buy-out – triggered after default – difficult to compel performance

• C. Removal from management position – retains equity interestO• D. Obstacles 1. Importance of timely completion of loan restructure2. Litigation cost3. Ability (or not) to terminate related service contracts held

by manager or affiliate (e.g. property management contract or construction contract))

V. Incentives of Operating Member to CooperateCooperate

• A. Exposure on Guaranties – completion, bad-boy, springing p p , y, p g grecourse for bankruptcy

1. Lender will require new guaranty fro new manager, need to divide exposure. Old guarantor may have p g yreimbursement right versus joint venture and contribution claims against other members.

• B. Exposure for breach of duties under operating agreement and related service contracts.

• C. Exposure on performance bonds

• D. Carried interest or hope certificate going forward

• E C h t l t l d “ ”• E. Cash ransom to release control and “go away”

VI. Forms of Investment

• A. Purchase of mortgage loan

• B. Subordinated Loan

C P ti t d b k t• C. Pre-negotiated bankruptcy

• D. Issues for Operating Member: Guaranty exposure

• E. Issues for existing capital partner: fiduciaryg p p yduties

VII. Conclusion

Contact Information

Brent M. CohenJ DJones Day

555 California Street, 26th FloorSan Francisco, CA 94104,

Direct Dial: (415) 875-5879E il b h @j dEmail: bmcohen@jonesday.com

REAL ESTATE JOINTREAL ESTATE JOINT VENTURES: SURVIVING IN A

DISTRESSED MARKETDISTRESSED MARKET

Presented byJeffrey B. Fugal

QUARLES & BRADY LLPT N th C t l ATwo North Central Avenue

Phoenix, Arizona 85004

jeffrey.fugal@quarles.com

ADDITIONAL EQUITY ANDADDITIONAL EQUITY AND CHANGE IN MANAGEMENT

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NEW CAPITAL

• Revaluation of Capital Accounts ("book-up" or "book-down") and/or modification of distribution waterfall in the case of new equity investment.

• Issuance of partnership interests to new service providers– Profits Interests– Possible changes in tax law on carried

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Possible changes in tax law on carried interests

RESTRUCTURING

JOINT VENTURE DEBT

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INCOME FROM DISCHARGE OF

R d ti f I d bt d COD

INDEBTEDNESS

• Reduction of Indebtedness = COD Income. Treas. Reg. § 1.61-12(a)

• Recourse Debt versus Nonrecourse Debt– General tax rules/partnership tax rules– Partially recourse and partially

nonrecourse debt

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– Impact of single purpose entities

• Transfer of Property in Satisfaction• Transfer of Property in Satisfaction of Recourse Debt

– Bifurcated treatment

– Sale and exchange -- Treas RegSale and exchange Treas. Reg. § 1.1001-2(c)

D bt ll ti T R– Debt cancellation -- Treas. Reg. § 1.1001-2(c)

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Example: T transfers to a creditor an– Example: T transfers to a creditor an asset with a FMV of $6,000 and the creditor discharges $7,500 of g ,indebtedness for which T is personally liable. The amount realized on the disposition of therealized on the disposition of the asset is its FMV ($6,000). In addition, T has COD income of $1,500 ($7,500 - $6,000).

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• Transfer of Property in Satisfaction of Nonrecourse Debt– Sale and exchange -- Treas. Reg.

§ 1.1001-2(c)N COD i th f i i t– No COD income -- therefore, gain is not excludible under IRC § 108

– Example: T transfers to a creditor an asset with $a FMV of $6,000 and the creditor discharges

$7,500 of nonrecourse indebtedness. The amount realized on the disposition of the asset is $7 500is $7,500.

– Planning for COD income• Pre-foreclosure debt reduction

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• Sell collateral followed by payoff of debt with sales proceeds

• Release of GuaranteesRelease of Guarantees– General Rule – No COD income

P ti l G t– Partial Guarantees

• Acquisition of Debt by a Third Partyq y y– Related Party Acquisitions

COD income under IRC § 108(e)(4)– COD income under IRC § 108(e)(4)

– Related Party defined in IRC § 267(b) d IRC § 707(b)(1)

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and IRC § 707(b)(1)

• Significant Modifications of Debt Instrument"Si ifi t difi ti " l d d– "Significant modification" equals deemed exchange. Treas. Reg. § 1.1001-3(b)

– If "new debt" is respected as debt has adequate– If new debt is respected as debt, has adequate stated interest and is not publicly traded, then debtor should be okay (unless amount of debt is

d d)reduced)

– If debt is publicly traded, then the issue price of the new debt is its FMV This could result in CODthe new debt is its FMV. This could result in COD income. IRC § 1273(b)(3).

• Liability Shifts – IRC § 752

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Liability Shifts IRC § 752

EXCLUSIONS FROM COD INCOME

• Bankruptcy and Insolvency -- IRC §108(a)(1)(A) and (B)

EXCLUSIONS FROM COD INCOME

108(a)(1)(A) and (B)

• Qualified Real Property BusinessQualified Real Property Business Indebtedness -- IRC § 108(a)(1)(D)

• Purchase Money Debt Reduction --IRC § 108(e)(5)

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• New IRC Code § 108(i)• New IRC Code § 108(i)– Election to defer COD income from debt

i d i 2009 2010 til 2014reacquired in 2009 or 2010 until 2014 and then spread COD income over 5 yearsyears

– Partnership Level Election – Revenue Procedure 2009 37Procedure 2009-37

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ISSUANCE OF PARTNERSHIP

IRC C d 721

INTEREST TO A CREDITOR

• IRC Code § 721– Creditor has nontaxable exchange of debt

ffor partnership interest

– Exceptions for unpaid rent, royalties or interest. Prop Treas. Reg. § 1.721-1(d)(2)

– Impact on bad debt deduction under IRC

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§ 166

• IRC Code § 108(e)(8) – AmericanIRC Code § 108(e)(8) American Jobs Creation Act of 2004

– If FMV of partnership interest is less than adjusted issue price of the debt, the partnership recognizes CODthe partnership recognizes COD income

M i FMV f t hi i t t– Measuring FMV of partnership interest Prop. Treas. Reg. § 1.108-8(b) (liquidation value approach)

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(liquidation value approach)

IRS Circular 230 DisclaimerIRS Circular 230 DisclaimerAny U.S. federal tax advice included in this communication was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding U.S. federal tax-related penalties or (ii) promoting, marketing or recommending to another party any tax-related matter addressed herein.addressed herein.

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Cover PagePollHanley - Basic Structure of the Typical Real Estate Joint VentureHanley - Checklist of Possible ProvisionsCohen - Real Estate Joint VentureFugal - Surviving a Distressed Market