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Five Lessons From A Real Estate Joint Venture Gone Bad

 

Commercial Building on top of Top of falling tower of blocks

 POST WRITTEN BY Dave Scherer-Sep 14, 2018, 09:00am 

 

Our worst real estate deal, a campus apartment complex and parking structure, looked like a sure winner on paper, but resulted in the smallest profit in our company’s

11-year history. Yet we learned significant lessons about risk management in joint ventures that changed the way we think about how to invest in real estate — lessons I believe can benefit other property investors.

My partner and I started our private equity real estate investment business in 2007 to preserve and grow wealth for our investors and ourselves. At the time, real estate as an asset class was coming under great stress. So when we bought this campus asset in 2012, we had experience in short sales. When a lender agrees to take a loss, it’s a recognition that a troubled asset isn’t going to turn around on its own. It needs a workout — a supervised improvement regimen that the bank may not have resources to execute.

We bought the apartment complex at $14.4 million, a significantly discounted short-sale price, as the 900-space parking garage alone cost more than $15 million to build. But the deal also included an equity partnership with a local operator that owned other student housing complexes in the area.

Partnerships Pose Operational Risk

Before we finalized the acquisition, we were confident that we did our homework on our soon-to-be partner. He was local and had worked with other property investors who spoke highly of his competence and honesty. Furthermore, the partner would have skin in the game — a 10% equity stake. Both of these factors led us to believe we were in good hands.

We were dead wrong.

Student housing leases are signed in April as students and parents make plans for the next academic year. During these important spring months, our partner did not report to us on leasing progress. In the summer, we learned we were 20% behind the prior year’s fall occupancy rate. At the same time, we learned that our partner had hired his own companies to work on the property. Both the conflict of interest and the lack of transparency were troubling.

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To amend the situation, we threw ourselves into the project to bring leasing numbers back in line. We lined up a management company to take over onsite maintenance and leasing. We made capital improvements, sharpened the marketing and leased out extra space in that huge garage.

Finally, we sold the property after owning it a little more than a year. The workout strained our resources, and our partner became a hindrance once we stepped in to change the equation. The joint venture was never going to be a productive partnership. The asset achieved a 9% IRR and a 1.12x equity multiple, which was significantly below our projected 17% IRR and 2.00x equity multiple.

Building A Better Joint Venture

Ideally, a partnership gets a project done more quickly and profitably. But one analysis of Commerce Department data on international deals found joint ventures on average are 2% less profitable. When a project encounters headwinds, getting on track is at best a distraction and at worst a liability. Our experience led us to develop five rules to follow in picking our partners going forward:

1. Nail down partnership duties. An LLC’s operating agreement should define each partner’s rights and responsibilities. Who contributes financing, personnel and equipment? Who will be the lead manager? We make sure this legal document protects our interests, and even includes walk-away points for dissolving the arrangement.

2. Make sure the partner has real skin in the game. To have aligned goals, partners should take on the same level of risk. When one partner has significantly more at stake, it begs the obvious question: What’s the other partner’s motivation? Our partner was earning money by hiring another firm he owned to do work on the property.

3. Date the partner before falling in love with a deal. Business and social interactions allow potential partners to size up their approaches and build trust for future operations. Understand a partner’s capabilities and ethics. Visiting their office gives a sense of how they operate, but also ask past employees how were they treated and if business was conducted the right way.

4. Eliminate all potential conflicts of interest. Service divisions such as in-house construction, property management and maintenance are always susceptible to conflicts when investors are involved. That’s because the decision to sell a property will impact the stream of revenue for these divisions. For instance, selling a property at the best time for investors may not be what’s best for the partner offering services.

5. Manage a new partner like a new employee. Have expectations and responsibilities clearly written and defined in the business plan, including deadlines and when progress is tracked and reported. Hold regular meetings to go over operational performance. We didn’t know our partner was struggling until it was too late.

These steps don’t have to appear punitive; all parties in a deal bear responsibility for its execution. Putting all responsibilities in writing displays professionalism. Interviews with joint venture partners by McKinsey & Co. suggest that alignment and trust are essential to success. In a good match, all parties will rely on each other when the relationship is tested. Perhaps the best feature of a performance management framework is understanding each other’s objectives and what each brings to the table as a partner. Ultimately, both partners perform better.

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https://www.forbes.com/sites/forbesrealestatecouncil/2018/09/14/five-lessons-from-a-real-estate-joint-venture-gone-bad/#321f88775f4c

Dave Scherer CommunityVoiceForbes Real Estate Council Principal and Co-Founder at Origin Investments,a top-ranked commercial real estate investment firm.

 

 

 

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