Any recovery of the real estate market is likely to be marked by a seismic shift in the way real estate transactions and projects are funded.
During the real estate boom that ended in 2007, financing typically included a first mortgage funded with an 80 to 90 percent loan-to-value ratio, a secondary debt financing component and a very small amount of equity contribution to make the transaction or project work. This approach to financing real estate transactions and projects is likely gone forever.
Commercial real estate financing is almost nonexistent today. With another round of commercial real estate foreclosures expected in 2010, lenders will soon be able to clean up their balance sheets – an important precondition to making commercial loans available again.
In the future, first mortgage financing will instead be based on a loan-to-value ratio of 60 to 70 percent, with second-level bank lender financing all but nonexistent. This means there will be as much as a 40 percent "equity gap" for commercial real estate transactions and project funding.
Although there are deep-pocket investors that will fund equity at this new level, a primary solution to this yawning equity gap will be the use of joint ventures – entities typically created as limited liability companies or partnerships formed to pool funds from two or more individuals to provide equity capital for transaction and project financing and refinancing.
There are several advantages to joint ventures:
- LLCs and partnerships provide a great deal of flexibility in structuring arrangements with investors to meet their needs.
- In the new financing environment, joint venture capital is likely to be the lowest-cost option to obtain equity financing when compared to borrowing money from private third parties for second position and mezzanine financing.
- First mortgage lenders are more likely to accommodate equity financing inside a joint venture than through third-party secondary financing.
The primary disadvantage of using a joint venture for equity capital is the complication associated with structuring and documenting these agreements. It can be complex to structure and document a joint venture agreement that will provide participants with a preferred return as one of the required protections and remedies. And depending on the investors involved, there can be securities issues that must be addressed.
Much discussion, good tax advice and careful drafting are keys to developing the successful joint venture document.
In this brave new world of commercial real estate financing, there will be a greater use of real estate joint ventures to create the equity required for real estate transactions. The complexities involved are worth the time and effort to allow financing and refinancing projects to proceed in a much different lending environment.
Stephen Horenstein is a partner at the Vancouver law office of Miller Nash. He can be reached at 360-699-4771 or Stephen.horestein@millernash.com.
