Joint Ventures: How the Deal is Done
[July/August 2006]
The Growing Trend of REITs Teaming with Institutional Partners
Is Gaining Momentum
By Steve Bergsman
Earlier this year, ProLogis (NYSE: PLD) announced the formation of the North American Industrial Fund LP, a joint venture with a number of institutional partners from North America and international locations. ProLogis will have a 20 percent equity interest in the fund, which is expected to have a total capitalization of $4 billion. This ProLogis fund is a recent example of a growing capital sourcing and allocation strategy used by REITs.
Joint ventures between REITs and capital sources were originally created as an alternative financing source for the REITs, but now are also used for strategic acquisitions. The benefits to both parties are numerous. REITs can acquire more by investing less, plus earn fees on the management of joint venture owned properties. Investors, on the other hand, like investing with an entity that has its own capital in the deal. Plus, it gets in-house expertise in regards to property and asset management.
"REITs are increasing their use of joint ventures and funds to finance real estate purchases and development pipelines, and diversify their revenues with additional advisory and management fees," states a survey conducted in April 2006 by Moody's Investors Service.
The joint venture movement began to evolve in the mid-1990s, but there were just a few participants. At the time, there was a lot of skepticism about these deals within the analyst community, which had trouble fitting joint ventures, especially when they appeared on off-balance sheet portfolios, into the context of the overall company.
Joint venture activity with institutional partners is not just happening among REITs. In March, United Trust Fund LP teamed with GE Commercial Finance Real Estate to form a joint venture that would acquire single-tenant, net lease facilities. The joint venture immediately made its first deal in March, a $50 million transaction involving the corporate offices of Belk Department Stores in Charlotte, N.C.
Conceptual Changes
Developers Diversified Realty Corporation (NYSE: DDR) has been one of the pioneers in joint ventures since the mid-1980s when the deals were not a popular concept.
"When we were creating deals in the 1990s, we were highly criticized because joint ventures made things like analytic reporting more complicated," says Joe Padanilam, DDR's senior vice president of acquisitions and dispositions. "It really took a long time for analysts to acknowledge that joint ventures had a financial benefit. Some analysts even said they wouldn't pick up coverage on DDR because it took too much time, while others claimed DDR was trading at a lower multiple because of this perceived complexity."
"The real estate market was in a downward swing in the early 1990s due to the recession, and companies could purchase properties cheaply. There was no need for a partnership at that time," says Dave Henry, vice chairman and chief investment officer for Kimco Realty Corporation (NYSE: KIM), which specializes in neighborhood and community shopping centers. "However, in the late 1990s, the real estate market recovered and business prices escalated. Most REITs had low leverage balance sheets and properties were too expensive to buy." A joint venture gave REITs the opportunity to purchase property together with a partner.
REITs tapped the institutional investment marketplace by forming joint ventures to finance their development projects. The structure proved so flexible and efficient that the rush to form joint ventures picked up speed in the new millennium. Obviously, from the recent announcements of ProLogis, GE Commercial Finance Real Estate and others, the trend has not ebbed.
Gaining Momentum
Earlier this year, a Fitch Ratings report on REITs noted: "Fitch will consider more positively management teams that have demonstrated discipline with respect to development and joint ventures. Companies with varied access to capital and a large unencumbered asset pool will be credited with the best financial flexibility."
"At Fitch, we think it is very important for REITs to have access to a broad variety of capital sources," explains Tara Innes, a Fitch Ratings managing director. "That would include private equity investments such as pension fund dollars. It's a positive that REITs are accessing private capital in joint venture situations."
Joint ventures allow REITs to reduce business concentration risk, Innes explains. "Most of the companies doing joint ventures have been very careful to identify acquisitions or development opportunities for their funds that are distinct and apart from what they are doing on their balance sheet," she says.
Stock analysts seem to like these deals as well. A recent Bear, Stearns & Co. Inc. review of shopping center REIT Regency Centers Corporation (NYSE: REG), noted: "Regency uses joint ventures as a means of self-funding without tapping the equity markets, a strategy that we think has served it well. We believe that Regency's pursuit of the joint venture structure makes sense–return on equity is high due to fee income, and less capital is required."
"Joint ventures are now in vogue," Padanilam says. "Everyone wants a joint venture partner because it means access to capital, and using a joint venture can increase your returns. You get the management fees as well as control over a larger amount of assets for a small investment in a pool of properties."
Today, it is difficult to create value through acquisition deals because there is too much capital chasing properties. However, if a REIT can partner with an institution, putting 20 percent to 25 percent of its own capital into a fund, then reap management, acquisition and incentive fees, "that is a pretty good business strategy," says Ralph Block, REIT investment strategist for Phocas Financial and creator of "The Essential REIT" newsletter.
Financial vs. Strategic
There are two camps when it comes to joint ventures, observes Lisa Sarajian, a managing director in Standard & Poor's Real Estate Finance Group. The first is the "financial" joint venture to fund new development, such as ProLogis utilizes, and the second is the "strategic" joint venture, which is done to enhance a portfolio of properties through acquisitions. For example, that would include the $2.74 billion acquisition of 100 shopping centers from CalPERS/First Washington by a Regency/Macquarie venture.
"A company strategically wants to buy an asset but it is too big a purchase for the balance sheet, i.e., it would be difficult to issue a billion in stock for the purchase," Sarajian says. "They find an institutional investor that will share in the ownership."
Formula for Success
For ProLogis, as well as most other REITs, the basic formula for financing a joint venture is this: the company develops a property on its books and, when fully leased, it is then sold to a joint venture. (Institutional partners prefer a steady income stream, which comes with a fully leased property.) The difference between the cost of development and sale is the profit, but more often than not, the REIT will leave a portion of that development profit in the fund in exchange for ownership units. The remainder of the profit is used to finance new development.
ProLogis constructed its first of many joint ventures in 1999. At one time, the company listed 14 joint ventures, but after some consolidation in 2005, the number stands at 12, with a total capitalization of almost $10 billion. Paul Congleton, ProLogis managing director–North American Fund Management, stresses that joint ventures are very much an integral part of ProLogis' success formula.
"As a REIT we are required to distribute most of our income to our shareholders, and as a result we don't generate and retain enough cash to fund the capital needs of the business going forward," he explains. "We could go to the public marketplace to have access but that has a dilutive effect on our existing shareholder base. As a result, we have sought to find other ways to finance growth and acquisition of our development activities, and we have done so through the private equity side, setting up funds to do so."
Congleton adds, "For us to continue to build buildings, we need to have access to capital. The most efficient and profitable way for us to do that is through private fund management."
Development Dealings
Regency's first deal was with the Oregon Public Employees Retirement Fund, and it has since formed two other major partnerships: with Macquarie CountryWide Trust, a subsidiary of Australia's Macquarie Bank; and the California State Teachers Retirement System. It also has several smaller joint ventures with individual investors or retail chains, such as Publix.
For the most part, the company grows through development, says Mary Lou Fiala, Regency's president and chief operating officer. However, Fiala says all the company's acquisitions are done through its previously mentioned joint ventures. "For our shareholders, we feel it's a better investment of our capital to be in development," Fiala says. "Our joint venture partners would love to be part of that, but it is a choice we have not given them."
Of Regency's 393 properties at the end of 2005, only 212 were 100 percent owned, the remainder were held as part of a joint venture. While Regency has only 20 percent interest in the joint ventures, Bear Sterns reports that the company collects advisory fees equivalent to 30 to 45 basis points of fair market value, based on an annual appraisal.
"Our fee income has grown from $1.7 million in 2000 to $28 million in 2005," Fiala says.
Federal Realty Investment Trust (NYSE: FRT) had eschewed joint ventures until two years ago, when it formed the Clarion Lion Property Fund with ING Clarion Partners to acquire up to $350 million of stabilized, supermarket-anchored, shopping centers in Federal's wheelhouse, namely the East Coast and California markets. This was truly a strategic joint venture.
"We didn't do this to expand our access to capital. We didn't do it to effectively dispose of a portfolio of properties like other REITs. We didn't do it to leverage up our company in any way, shape or form," says Jeff Berkes, Federal's senior vice president and chief investment officer. "We simply did it to increase our concentration within markets where we like to do business."
To be exact, Federal historically focuses on properties that have redevelopment, remerchandising or expansion capabilities, or, to put it another way, properties with a lot of potential for net operating income growth. "Federal didn't purchase properties outside its parameters," Berkes says. "So, we set up the joint venture to be able to go after those properties."
Right Partner, Right Structure
Another REIT from the joint venture class of 1999 is SL Green Realty Corporation (NYSE: SLG). Since that formative year, the company has taken to the joint venture structure in a big way by constructing more than a dozen with institutional investors such as Prudential Real Estate Investors and The Carlyle Group, a private, global investment firm.
"We set out a business plan when we enter the joint venture, and we are very good at executing what we lay out," notes Andrew Mathias, SL Green's chief investment officer. "We have joint governance on major decisions with certain dispute resolution mechanisms built in. In addition, we insist on rights of first offer to make sure that, if the partner has a change of heart and wants to sell, we have the first opportunity to buy that interest.
"We have done a number of joint ventures, so we have a fairly standard template for governance and rights."
Kimco has learned that it is critical to choose a partner that is easy to work with and creates good chemistry with your company, Henry says. "Kimco chooses institutions that think the same way we do when evaluating the shopping center market so that everyone is on the same page."
Fred Berliner, senior vice president and director of acquisitions for United Trust Fund (UTF), says choosing the right joint venture partner can be difficult. "But once you have the right partner, it is really an easy business," he says.
Berliner says his company's partnership with GE Real Estate is unusual, because many joint ventures marry a company with real estate expertise and one with capital to invest. With UTF and GE Real Estate, both companies had real estate expertise and capital. That explains why the two companies have done six to eight transactions over the past 15 years, Berliner says.
From a non-REIT point of view, GE looks for two important features when it enters a joint venture, says Bill Gregory, equity leader for GE Real Estate Business Property based in Shelton, Conn. First and foremost is to team up with an entity that gives you access to a market you otherwise might not have (in the case of UTF, single-tenant, net lease facilities). Secondly, GE Real Estate looks for partners that reflect its values. "One of the things that is important and that we do well is the surety of execution," Gregory says. "When you create a joint venture, there are more parties involved so you run the risk of weakening your execution capabilities. Because UTF and GE have had so many deals together, we actually get better execution. We leverage each other, putting our customers through a more rigorous process."
Making the Switch
European Investors Inc. has been doing joint ventures with REITs since the early 1990s. The New York-based investment manager with offices in Munich and Amsterdam matches its investor clients with REITs.
The reason EII migrated from making direct investments and hiring a brokerage firm to manage the properties to this format was that it wanted direct ownership in a national portfolio of properties. It could either do that by creating a portfolio outright and then hiring a third-party manager, such as a CB Richard Ellis, or it could enter into a joint venture with a local operating partner. Stuart Mackintosh, a principal and managing director for EII, says the company opted for the latter strategy because it was looking for partners with a long-standing presence in local markets, plus ones that would have an ownership position in the venture so there would be an automatic alignment of interest between the REIT partner and investors.
From a capital source perspective, "The key thing is to set up ground rules and that includes budget and leasing guidelines under which the operating partner works," Mackintosh says.
Any meaningful lease is discussed with EII. "In reality, most any kind of lease negotiation is going to fall into established guidelines, but if they don't, a good operating partner is going to pick up the phone and discuss strategy," Mackintosh says.
Most joint ventures in which EII is involved have terms of 10 years. "Typically, joint ventures have what we call a lock-up period where both parties agree not to sell for a certain number of years, and that can be three to five years, standard practice," Mackintosh adds. "If your partner is a REIT, it wants investors that are in for the long term."
Unwinding Investments
Since a number of the early joint ventures got their start in the mid-1990s, the industry is first coming to terms with closure. Some joint ventures are open ended in terms of time limits, but others run a maximum of seven to 10 years.
There are numerous ways to unwind investments. For example, in November 2005, SL Green and a joint venture partner, SITC of the Caisse de depot et placement du Quebec, an investment manager founded by Quebec's legislature to manage public pension funds, recapitalized a midtown Manhattan property acquired in 2002 at 1515 Broadway.
Since the property was appraised at more than double the $484 million purchase price, SL Green had exceeded its performance threshold. As a result, it was entitled to "a higher proportion of every dollar going forward," says Mathias. "We were able to pick up 20 percentage points of ownership in the building."
In DDR's case, the company has a history of unwinding partnerships after being one of the 1990s pioneers in starting joint ventures. "We have been able to demonstrate financially to the market the benefits of joint ventures," Michelle Dawson, vice president of investor relations for DDR says. "On the sale of an asset, if you have a promote you can get a disproportionate share of proceeds. With the increased value of the property, a REIT can recognize more than the prorata share of the upside."
A more complicated redemption transaction was done by ProLogis. In February, it formed the $4 billion (total capitalization) North American Industrial Fund with institutional investors from around the globe. ProLogis contributed properties acquired a month earlier when it purchased the remaining 80 percent ownership interest from closed partnerships.
"That was the first time four of our funds terminated," Congleton says. "It was done at the behest of our capital partners, who had seen a shift in their overall investment strategies. They came to us and we were able to work out a mutually beneficial liquidation of those funds."
Equally as important to ProLogis and followers of REITs, was the fact that the company was able to demonstrate a successful exit strategy. "We had successor funds in place," says Congleton. "We were able to take those assets and move them into the next fund structure."
Despite ProLogis' success, S&P's Sarajian is not so sanguine that all funds will unwind so smoothly. If there are one or two blips in the years ahead, Sarajian believes all bets are off.
"Once you get into litigation that means pulling management time and talent away from the core business. Then you will see things get messy."
"The bottom line on joint ventures is for REITs to acquire properties they could not purchase on their own and to enhance their portfolio. On the investor side, it gives them a chance to team with operators that have the experience to run the properties," says Henry. "It's a wonderful marriage."
Steve Bergsman is a regular contributor to Portfolio.
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