Joint Ventures for Public REITs: Opportunities and Challenges

Joint venture structures continue to be an important tool for public real estate investment trusts (REITs), particularly in market environments where traditional capital-raising strategies may be challenging from a funds from operations (FFO) dilution or leverage point of view. Joint ventures (JVs) can serve as a fourth major capital source for REITs, supplementing traditional tools such as equity issuance, debt financing, and outright asset sales. When capital markets are dislocated — as they are now — properly structured JV arrangements allow REITs to raise significant amounts of cash from institutional partners while continuing to manage the asset, preserving significant upside for shareholders and maintaining market presence. This is particularly useful in an environment in which issuing equity may be dilutive and debt is costly or would result in elevated leverage ratios.

Properly structured joint ventures allow public REITs to not only raise and deploy capital quickly but also diversify portfolios; create a positive spread between return on assets and return on equity through fee income and carried interests; recycle capital; build institutional partnerships; and validate asset values/cap rates for the rest of the portfolio. JVs introduce complexities around governance, REIT compliance, defaults, transfer rights, and tax treatment that must be addressed carefully during structuring and negotiation. This alert outlines these key strategic considerations for REITs contemplating JV transactions and examines important tax implications at each stage of a JV’s life cycle.

Strategic Use of Joint Ventures by Public REITs

Public REITs can use the joint venture structure in a variety of ways, both for new investments when other capitalization strategies are suboptimal and to generate liquidity and recycle capital. JV structures are one of the few ways REITs can create value for shareholders with the right-hand side of the balance sheet. Potential benefits of JV transactions for public REITs include:

• Source of Alternative Capital. Generally, the menu for REITs seeking to raise capital is limited to issuing equity (either at the REIT level or in the form of operating partnership units), incurring debt (secured or unsecured), and/or selling assets. The joint venture presents a fourth option that can be used effectively at times when other fundraising activity is challenging. In a volatile interest rate environment and/or an equity capital market cycle where equity prices may lag net asset value (NAV), properly structured joint ventures can serve as a competitive source of alternative capital.
• Diversify Portfolio While Keeping Upside. Joint ventures can also help diversify a REIT’s portfolio while preserving upside. Structuring JVs around certain assets allows the REIT to move those assets off balance sheet and reduce concentration risk in sectors, geographies, or operators that are seen as over-represented. As assets mature from development or core plus properties to stabilized/core ones, joint ventures can free up equity for higher-yielding opportunities, potentially allowing for higher leverage at the property level without a detrimental effect on the REIT’s overall leverage ratios. At the same time, the JV structure permits REITs to maintain market presence and relationships and continue earning pro rata revenue from the properties.
• Fee Income and Carried Interest. In joint venture structures where the REIT manages or continues to manage the assets, the arrangement creates a revenue stream for the REIT beyond its traditional rent and interest revenues. Locking in future fee income provides the REIT with flexibility in pricing its initial investment or capitalization rate. Carried interest can also provide another important revenue source for the REIT, as it results in an outsized return to shareholders from the asset. In the end, a positive spread may open up between the asset’s unlevered return and the return on the REIT’s equity in the JV entity.
• Capital Recycling. Joint ventures also facilitate capital recycling. Capital raised from JV structures can help fund acquisitions and development projects or pay down debt. Selling whole or partial interests in assets through a joint venture can be a more cost-effective method than issuing equity at the REIT level in volatile market environments. This kind of capital recycling may enable a REIT to lock in an attractively low cap rate upon transfer to the joint venture and then generate higher yields from development or redevelopment activity.
• Institutional partnerships. High-quality commercial real estate remains in high demand among large institutional investors such as insurance companies, pension funds, and sovereign wealth funds. These institutions typically have significant hard asset allocations and often prefer to be closer to the asset — directly invested — rather than investing through funds. A stable set of JV partners that are used to the REIT’s management style and comfortable with its joint venture terms and governance can be a powerful extra tool to act opportunistically under all market conditions.
• Repurchase Opportunities. Over time, joint ventures may also present repurchase opportunities. Eventually, the institutional funds or other JV partners will want to cash out. This provides the REIT with the opportunity to invest again at a lower transaction cost, without the involvement of brokers, assumption fees, transfer taxes, or extensive diligence processes and with quicker closing timelines. Contractual exit mechanisms can be complex but, if structured properly, they can also provide ample opportunity for REITs and institutional partners to transition the asset to a different capitalization and ownership structure with minimal stress and limited transaction costs.

• Validate Asset Values. Finally, favorable pricing achieved in the private institutional market can help validate asset values. That has proven extremely useful, for example, when volatility in cap rates or the public market’s lack of appetite for a particular type or class of properties creates a challenge in establishing “trusted” valuation parameters. Achieving strong pricing for a REIT’s interests in a joint venture can serve as a market signal that its public trading price may be undervalued.

Considerations and Risks of Joint Ventures

Alongside the numerous advantages described above, there are risk and downside considerations to evaluate when contemplating new joint venture transactions. One of the most significant is the loss of control. Upon transferring assets to a joint venture, the REIT typically gives up sole control over those assets. Depending on the terms of the JV agreement, joint venture partners may hold a variety of consent or approval rights with respect to “major decisions.” These typically include approvals for annual budgets, refinancings, expansions, redevelopments, and admission of new JV members. See the discussion of governance and major decisions below.

Contributing an asset to a joint venture also does not mean that the REIT will no longer incur any expenditures with respect to the property(ies). Real estate JVs usually require capital contributions from each of the partners to fund significant capital investments or unscheduled capital needs. Each party is typically required to contribute its pro rata share of the necessary capital. Members who do not contribute in a timely manner may be subject to dilution.

REITs that use parent-level debt in the form of credit facilities or bonds will also need to consider the financial covenant implications of contributing assets to joint ventures. Most modern financing will permit a REIT to take credit for the value of a joint venture in its total leverage calculations, as the pro rata share of the underlying assets or as the book value of the joint venture equity. Many REITs, however, will not be able to receive credit for the assets toward their unsecured leverage ratio, which is often tied to unencumbered real estate assets that are wholly owned by the REIT or under the REITs’ exclusive control, a criterion that a joint venture asset will rarely satisfy. More permissive credits and bonds will sometimes permit a REIT to include all unencumbered assets in its unsecured leverage ratio based on generally accepted accounting principles, in which case JV assets will be included on that basis.

In addition, dispute resolution can be a material issue. Disagreements among the parties may result in lengthy and costly disputes. A member may obstruct the investment process due to a lack of cash or a reluctance to dilute or sell its interest. If they are not anticipated, discussed candidly with the joint venture partner, and then dealt with expressly through governance covenants and impasse-breaking devices in the JV agreement, disputes over operational or capital matters can lead to a deadlock, impairing the value of the property.

Joint Venture Nuts and Bolts

When contemplating a new joint venture transaction, public REITs must consider numerous threshold issues. These include the type of venture, such as land or predevelopment, development or construction, stabilized income-producing asset, or platform. Partner selection is critical and should focus on the potential partner’s expertise, financial strength, background, goals, objectives, desired hold periods, and tax structuring requirements (as discussed in more detail under “Select Tax Considerations”, below). As discussed in further detail in the sections that follow, legal restrictions must also be considered, including those relating to tax (including REIT compliance) and ERISA.

Key economic terms must also be negotiated, including distribution waterfalls, preferred equity returns, promote structures, profit interests, internal rate of return (IRR) hurdles, tax distributions, IRR lookbacks, and clawbacks. We address some of the material governing provisions of typical REIT–joint venture provisions in the following section.

Governance and Major Decisions
In most joint ventures involving public REITs, the REIT will serve as the manager and control day-to-day operations, subject to limitations around so-called “major decisions.” The scope of these major decisions depends on the type of JV transaction at issue, but any type of joint venture will typically include acquisitions, sales and dispositions, financing, leasing and leasing parameters, budgets, business plans, material contracts, material tax decisions, affiliate contracts, and the winding up and termination of the JV. Decision deadlocks must also be addressed to avoid impairment of asset value or operational paralysis.

In the context of public REITs, properly articulating the standard of care and fiduciary duties is particularly important. Joint ventures typically require managers to act with a general standard of care, which often includes acting in the best interests of the JV, either for all actions or any action not requiring major-decision approvals. However, standard of care provisions may conflict with the fiduciary duties the REIT owes its public shareholders. Accordingly, it is important for the JV agreement to clarify that the REIT-affiliated members do not owe fiduciary duties in their capacity as manager or general partner to other JV partners when voting on major decisions.

Joint venture agreements must include provisions to ensure that financial and operating reporting is done on a public-company cadence, particularly when the JV is consolidated in the REIT’s financial statements. Likewise, the JV agreement(s) must provide that income and activities of the joint venture will operate in a REIT-compliant manner and should permit the manager to take any action needed to ensure such compliance. As discussed further below, the REIT must also evaluate whether any fees or reimbursements it receives pursuant to the underlying economic deal could trip up REIT compliance testing.

Key questions include which party bears the risk and cost for REIT compliance and which party is responsible for diligence. For example, should the REIT have the unilateral discretion to add a taxable REIT subsidiary (TRS) to the structure to alleviate concerns of impermissible income streams, or is this a “major decision” that requires approval from JV partners? The JV agreement should further clarify which party bears the cost of any TRS tax leakage. Cooperation from JV partners is essential.

When there are related party concerns, language regarding disclosure and reporting requirements must be included to ensure that the REIT can confirm compliance with ongoing requirements.

In connection with this role as manager, the REIT should also consider added risks in the form of debt guaranties (e.g., non-recourse carve-outs, environmental indemnities, and, in particular for development-related platforms, completion and equity funding guaranties). The typical expectation is that the manager (in this case, the REIT) will offer the lender-facing guaranty protection from a creditworthy entity, subject to indemnification from the joint venture except in instances of manager fault or, specifically in development deals, construction cost overruns.

Defaults and Remedies
Common examples of defaults under joint venture agreements include bad acts such as fraud, theft, gross negligence, and willful misconduct; breach of transfer provisions; breach of fiduciary duties; bankruptcy; taking major decisions without the requisite approval; and failure to fund required capital contributions.

When a default occurs, a range of remedies may be available to the non-defaulting party or parties. These may include removal of the defaulting party(ies) from management roles; acceleration of exit rights or expiration of lockout periods; exercise of put or call rights; indemnification for damages; loss of voting rights; loss of promote; the issuance of shortfall loans; dilution of ownership interests; and cross defaults tied to related obligations or agreements. Some of these remedies may become more complex or difficult to implement if the JV is not performing well.

In considering these remedies, a public REIT must pay particular attention to the implications of loss of control. Such a loss can have far-reaching consequences for valuation, disclosure, and regulatory compliance. Therefore, there is often a strong desire to limit the scope of available remedies or to bifurcate them based on a materiality standard. Public REITs typically seek to avoid “key man” or “change in control” triggers that could lead to automatic loss of rights or governance influence. Refer to the next subsection, Transfer and Exit Rights, for further discussion of change-in-control provisions.

If a REIT is removed as manager due to a default or change in control, the joint venture agreement should include specific REIT compliance protections. These may include express requirements that the joint venture will continue to be operated in a REIT-compliant manner, possibly including “springing” provisions that take effect automatically upon removal. The REIT may also seek to retain control over certain fundamental decisions, even if it is no longer serving as manager. Additional protective provisions may include requirements to hire REIT consultants or advisers if the replacement manager is not experienced in REIT compliance as well as clear delineation of liability for failure to operate in a REIT-compliant manner — including which party bears the economic risk in such scenarios.

When negotiating default remedies, another key consideration is the possible acceleration of exit rights. The agreement may provide for a forced sale, which may not be desirable if the value of the REIT largely comprises the underlying real estate assets and/or the REIT is required to sell during a down market. The REIT should consider mitigants, such as rights of first offer (ROFOs) and rights of first refusal (ROFRs) provisions or delay of buyout rights to protect its valuation and interest during negotiations.

Transfer and Exit Rights
Transfer rights and exit mechanisms are critical in any joint venture structure involving a public REIT. The agreement must clearly define permitted transfers and address how the REIT can engage in major corporate transactions, such as mergers or consolidations, without violating the JV’s requirements.

One key area of concern is change-in-control provisions. Defining what constitutes “control” can be complex, especially when the REIT is a public company with a rotating board of directors. Some joint venture agreements tie control requirements to ownership or the requirement that the REIT and/or its operating partnership (OP) remain in control of the JV investor member. Others link control to board composition, which raises the need to address natural board turnover and preserve flexibility. Needless to say, ordinary course trading in the securities of the REIT (or OP), and the issuance of new securities by the REIT (or OP), should be specifically carved out of any transfer restrictions in the JV agreement.

Key man requirements may also be included in the agreement, particularly where a specific individual’s continued involvement is critical to the venture. However, public REITs need to be mindful to ensure that the rights of its board to take employment action with respect to such key individuals are not restricted, such as including a path for replacement of such individuals. Additionally, public REITs often require protections against the transfer of interests to competitors.

Exit rights in a joint venture typically include equity transfers through ROFOs or ROFRs, forced sale provisions, buy/sell mechanisms, and put or call rights. The timing of exit rights is often subject to lockout periods designed to preserve long-term alignment and investment stability. It is also important to assess whether the transactions contemplated by the exit mechanisms fall within safe harbor exceptions under relevant securities and tax rules.

Acceleration of exit rights may be triggered by certain events or conditions, such as favorable market conditions that enable the REIT or its partner to capture promote. Structuring these provisions in advance helps avoid disputes and misalignment when market conditions change or strategic priorities evolve.

Select Joint Venture Tax Considerations

Please note: The following discussion of select tax considerations does not purport to be an exhaustive presentation of all relevant tax issues for a public REIT and its potential joint venture partners and should not be considered tax advice. All parties are strongly advised to consult their Goodwin tax contact or other tax advisers based on their individual circumstances.

Formation Stage
If the joint venture formation includes contributions of REIT assets, the REIT must consider the extent to which the proposed transactions may require the REIT to recognize gain (or loss) in the contributed assets, the feasibility of structuring options to mitigate such gain or loss, and/or the potential impact of any gain recognition that cannot be avoided (such as increased REIT distribution requirements). Structures to accommodate the tax needs of joint venture partners (such as the use of subsidiary REITs) and/or to mitigate transfer taxes and property tax reassessments can exacerbate the risks of recognizing gain or loss. When the joint venture is considered a related party to the REIT, special rules may treat gains recognized in the formation as ordinary or limit the REIT’s ability to use losses in the contributed assets. Prohibited transaction (or dealer) tax implications also should be considered.

To this end, various “leveraged partnership” and other structures potentially can be used to extract cash or allow the joint venture to assume REIT liabilities on a tax-deferred basis as part of the contribution of assets to a joint venture, depending on the facts. In some cases, a REIT that is active on the buy side may be able to use Internal Revenue Code Section 1031 exchanges to shelter gain on the cash component of the contribution transaction. These structures are inherently complex and often entail some level of tax and regulatory risk. Even where gain deferral is achieved temporarily, the lack of step-up in basis (and resulting allocations of depreciation deductions disproportionately away from the REIT) may create a distribution requirement issue for the future. The REIT must also consider REIT qualification concerns if the structure is challenged by the Internal Revenue Service, including the potential impact on REIT opinions and public disclosures.

Even where the transaction is tax-deferred at the federal level, the contribution of assets to a joint venture can trigger state and local transfer taxes and property tax reassessments. These issues can be particularly significant for properties located in high-cost jurisdictions such as California. The tax complexities are generally more challenging for joint ventures involving subsidiary REITs.

Operational Stage
A public REIT must evaluate the tax consequences of its ongoing ownership of an interest in the joint venture and the tax  consequences of the venture’s operations. If the joint venture is taxed as a partnership, the public REIT must “look through” the partnership for purposes of applying the REIT asset and income tests. This means that the public REIT must assess whether its share of the assets and income held by the joint venture will qualify as good assets and good income under the REIT rules.

In cases where the joint venture is structured to operate through a subsidiary REIT, the public REIT’s interest in the stock of the subsidiary REIT qualifies as a good REIT asset and generates good REIT income, provided that the subsidiary REIT remains qualified as a REIT. However, maintaining the REIT qualification of a venture’s subsidiary REIT creates additional REIT compliance responsibilities and risk allocation issues, which must be addressed during the negotiation of the joint venture agreement. For example, the subsidiary REIT will generally have smaller bad income and bad asset baskets than the public REIT so income or assets that the public REIT could absorb may cause a subsidiary REIT to fail to qualify as a REIT.

Fees received by the public REIT for managing the joint venture’s assets are generally treated as bad income. That said, in partnership joint ventures, the “self-charged” portion of such fees — fees paid by the partnership to the public REIT that are borne by the REIT in its capacity as a partner — often can be disregarded for REIT compliance purposes. If the amount of bad income potentially would create a REIT qualification issue, even after accounting for self-charged fees, a TRS typically can be employed to provide these services to the joint venture.

Carried interest earned by the public REIT from a joint venture can often be treated as good REIT income, assuming that the underlying assets generate good REIT income and do not run afoul of dealer property rules.

Exit Stage
The structure and timing of an exit from a joint venture also raise significant REIT-specific tax considerations. Certain exit strategies may be constrained by REIT requirements or the need to avoid dealer property treatment.

In-kind separations of joint ventures — in which the REIT and its partner divide the underlying assets — can also create tax risks. If the REIT contributed the assets to the joint venture, these in-kind separations may be taxable under the “mixing bowl” rules, which disallow nonrecognition treatment in certain asset distributions for a period of time following a contribution.

Exit planning is especially important when considering a joint venture that invests through one or more subsidiary REITs and is required to exit by selling stock of its subsidiary REITs.  Issues to consider include (i) whether the likely buyers are well-suited to acquire a subsidiary REIT and (ii) whether a multi-asset venture should establish a separate subsidiary REIT for each investment (or conversely, how to manage sales of separate assets out of a multi-asset subsidiary REIT).  Finally, there may be adverse consequences for a public REIT when a joint venture investing through a subsidiary REIT dissolves through the public REIT acquiring the other partner’s interest. Such a transaction would not generate a step-up in the tax basis of the REIT’s assets; rather the step up would be effectively limited to the selling partner’s share of the subsidiary REIT stock held by the venture, and therefore the subsidiary REIT would not benefit from increased depreciation deductions. Moreover, that step-up in the selling partner’s share of the subsidiary REIT stock may be lost, or the built-in gain attributable to the public REIT’s historic share of the venture (that is, not the share acquired through the buy out of the public REIT’s partner) may be triggered, if the public REIT desires to clean up its structure by liquidating the subsidiary REIT at a future date. Thus the public REIT may be required to continue to hold the property in the subsidiary REIT for an extended period of time.

Tax Deferral Protections
When a REIT is successful in contributing assets to a joint venture on a tax-deferred basis, the REIT typically seeks contractual protections to ensure continued deferral for some period. The need for such protections from the joint venture is especially acute if the contributed assets in question were previously acquired by the public REIT through its operating partnership (i.e., an UPREIT structure) in exchange for OP units on a tax-deferred basis and the operating partnership may owe tax indemnities to the original contributors pursuant to a so-called “tax protection agreement” if the joint venture triggers the original contributors’ deferred gain. Such protections would typically include provisions that prohibit the sale of protected assets by the joint venture for a defined period (or required damage payments for an early sale).

In the case of contributed properties with so-called “negative capital account,” debt maintenance may be required at the joint venture level in order to preserve the public REIT’s deferral and/or to avoid tax protection payments to the original contributors to the public REIT’s operating partnership. Such a debt maintenance requirement can preclude or limit the use of a subsidiary REIT within the joint venture because contributions of negative capital account property to a subsidiary REIT will trigger recapture (gain) of the negative capital account.

Use of Subsidiary REITs and Non-US Investors and US Tax Exempt Investors
Another critical consideration in structuring joint ventures involving public REITs is determining whether any of its joint venture partners wants or needs one or more subsidiary REITs in the joint venture structure. Using a subsidiary REIT structure in the joint venture can be significantly more tax-efficient for certain non-US investors. Depending on the nature of the non-US joint venture partner, the desired tax structure may require that the REIT is domestically controlled and/or that sales of properties are structured as sales of stock of subsidiary REITs. Although most non-US investors in such a subsidiary REIT are generally subject to US FIRPTA taxes on distributions of US real property gains from the subsidiary REIT, sales of stock of a “domestically controlled” REIT avoid US FIRPTA taxes for all non-US investors. Sovereign investors on the other hand generally can avoid such FIRPTA taxes on sales of minority positions in a subsidiary REIT regardless of whether the REIT is domestically controlled. Qualified foreign pension funds, in contrast, avoid FIRPTA taxes on US real property gains from a subsidiary REIT, regardless of whether the gain arises from a sale of the asset by the subsidiary REIT or a sale of the subsidiary REIT’s stock and regardless of whether the subsidiary REIT is domestically controlled.