Copyright 2010, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Real Estate Joint Ventures, October 2010
There are several important financial considerations that should be addressed in any real estate joint venture agreement.
Costs and Expenditures
In a simple joint venture, each joint venture participant is typically required to pay its respective proportion of all capital costs and expenses attributable to acquiring and maintaining the joint venture property and developing the project.
In certain joint ventures, one joint venture participant contributes assets, while the other joint venture participant invests cash. There may be a significant tax advantage for a joint venture participant to contribute assets rather than cash to the joint venture, the principal such advantage being the non-recognition of taxable gains at the time of contribution.
The contribution of assets by one joint venture participant could lead to a potential future conflict between such joint venture participant and the joint venture participant which invested cash. Such potential conflict could arise in a situation in which market conditions favour the sale of the project. In such circumstances, the joint venture participant which invested cash could reasonably be expected to favour a sale of the project as a means of realizing a lucrative return on its investment, while, on the other hand, the joint venture participant which contributed assets would be disposed to resist such sale, in the hope of deferring the realization of a taxable gain.
If one joint venture participant contributes assets and the other invests cash, it is vital that a proper value of the assets being contributed to the joint venture be established. The determination of such value may be complicated, depending on the circumstances. For example, the property or asset in which the joint venture participant is contributing cash may be undergoing an expansion. The purchase price attributable to the interest being acquired by such joint venture participant may be based on the projected cash flow relating to the property following the expansion. In such a situation, the parties may agree that the joint venture participant which is contributing the property and selling the interest therein to the joint venture partner investing cash would pay all of the costs of finishing the expansion.
As well, it may be that there is existing financing on the property, and that the joint venture participant contributing the property and selling the interest therein to the joint venture partner investing cash has agreed to remain 100% responsible for and agrees to indemnify the latter in respect of all such costs and obligations related to such financing.
In a situation in which one joint venture participant grants to and in favour of a third party a mortgage of its interest in the project, such joint venture participant should be solely responsible for all payments due and owing under such mortgage.
Most joint venture agreements specify that the joint venture participants are entitled to receive their proportionate share of all net cash flow. Provisions should be inserted in the joint venture agreement to establish the manner in which net cash flow is to be determined and the times and the manner in which such cash flow is to be distributed. As well, provisions should be included in the joint venture agreement relating to the proceeds of financing, expropriation, insurance, partial sales of the property and other revenue items for the purpose of calculating net cash flow.
The sharing of net cash flow as between the joint venture participants is often stated to be on a proportionate basis, commensurate with their respective capital contributions. However, this is not always the case. In certain joint venture arrangements, the joint venture participant which invested cash (as opposed to contributing assets) is entitled to receive a preferred return on the net cash flow arising from the project, up to a stipulated maximum amount, above which net cash flow is distributed, pari passu, proportionately to all joint venture participants up to a further stipulated maximum amount and thereafter the joint venture participant which contributed assets is entitled to an additional return as a "promote".
Generally, joint venture agreements provide that each of the joint venture participants is responsible for paying its own taxes. This is especially important in those instances in which one of the joint venture participants is a pension fund or a Crown corporation which manages pension fund money and whose income is exempt from tax. In such a situation, it is critical that the pension fund or Crown corporation has the right to file separate returns. In a co-ownership, each co-owner is also entitled to select the tax write-offs it wishes to take, regardless of the capital cost allowance in respect of the buildings. This may not be as relevant for a taxexempt entity but is very relevant if one of the joint venture participants is taxable and the other has loss carry-forwards about to expire.
Of course, one must also deal with an unexpected financial reversal in the event revenues from the project are insufficient to defray the expenses. Usually, the joint venture participants agree that they will contribute additional funding in order to pay any such deficiency, in proportion to their joint venture interest. Whatever the approach, it is important to include in the joint venture agreement provisions setting out the circumstances and protocol for the payment of additional capital contributions. Usually, a joint venture agreement will provide that any joint venture participant may, by written notice, demand each of the others to pay its proportionate share of the deficiency. The joint venture agreement should also contain provisions to the effect that, if a joint venture participant fails to pay its proportionate share of the deficiency, each of the other joint venture participants – provided that it has paid its respective proportionate share of the deficiency – is entitled to various remedies, including the right to buy out the defaulting joint venture participant, the right to terminate existing management contracts, the exclusive right to sell the project, and the right to dilute the interest of the defaulting joint venture participant. Another remedy found in many joint venture agreements is the right of the non-defaulting joint venture participant to advance the monies on behalf of the defaulting joint venture participant as a demand loan with interest at an above market, unattractive, rate. Such demand loan is typically secured by a collateral charge on the interest of the defaulting joint venture participant in the project.
Third -Party Liabilities
Generally, joint venture agreements provide that, to the extent that any third-party liabilities are not able to be expressed as being on a several and proportional limited recourse basis, as between the joint venture participants, each joint venture participant will indemnify the other from any liability greater than its proportionate share, with such obligation being secured by the collateral charge on its respective interest in the project.
The joint venture agreement should also contemplate limitations on the acceptable leveraging of the project – expressed either in terms of a specific dollar amount or as a percentage of fair market value of the project.
If one joint venture participant guarantees financing for the project, a provision should be included in the joint venture agreement establishing a protocol for compensating such participant for the cost of providing its guarantee. Usually, such protocol is addressed by means of a guarantee fee and an indemnity secured by a collateral charge.
Joint venture agreements commonly provide that each of the joint venture participants will grant to each of the other joint venture participants a collateral charge on its respective interest in the project, as security for the observance and performance of its liabilities and obligations thereunder. If the joint venture is structured as a co-ownership, each such collateral charge is often registered in the appropriate land registry office and financing statements are filed under the appropriate personal property security legislation. Usually, the joint venture agreement provides that each such collateral charge shall be subject and subordinate to any encumbrances approved by the joint venture participants (such as any mortgage securing any project financing), but shall have priority over any separate mortgage granted by a joint venture participant to a third-party lender with respect to its interest in the project.
Each joint venture participant should ensure that the joint venture agreement contains provisions stipulating the operative period of time for the joint venture and an "exit mechanism" providing for the sale of the project or other disposition of its respective interest therein at the full value thereof.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.