Joint ventures offer win-win potential

By Allen Kenney

When it comes to investing, what you don't know can, in fact, hurt you. Countless fortunes have been lost by investors who have jumped into markets and opportunities that they don't truly understand.

That's why it's not uncommon these days for some of world's largest investor groups to partner with experienced advisors and managers. It only makes sense that some of them turn to REITs for help with their real estate investments.

Takeaways Joint ventures between REITs and institutional investors are becoming more prevalent. Joint ventures accounted for 27 percent of 2007’s $523 billion in domestic commercial real estate sales activity. REITs can partner with one or multiple investors in a joint venture. REITs normally engage multiple investors in a “commingled fund” structure, which tend to have a broader focus than one-on-one partnerships. Joint ventures present a variety of benefits to REITs and investors alike. Institutional investors can avail themselves of REITs’ experienceand expertise in real estate acquisition, development and management. In addition to income from fees and preferred returns, REITs gain access to alternative capital sources, which takes on even greater importance in tougher lending environments.

"The numbers have shown that there are more REITs now partnering with some institutional-type capital," says Dan Fasulo, managing director of commercial real estate research firm Real Capital Analytics. "More and more, REITs have looked to this format as a profitable way to add value for their shareholders."

While joint ventures between institutional investors and publicly traded real estate companies aren't exactly new, they're gaining momentum. Data from RCA illustrate this trend: joint ventures accounted for 27 percent of 2007's $523 billion in domestic commercial real estate sales activity, up from a rate of 20 percent in 2006. The $140 billion in 2007 sales activity attributable to joint ventures reflects a five-fold increase from what it was just three years earlier. Overall, joint ventures' share of total commercial real estate sales activity nearly doubled between 2004 and 2007.

Many Meanings

To make a joint venture work, it's important for all parties to be on the same page, says Michael J. Havala, chief financial officer of First Industrial Realty Trust (NYSE: FR). First Industrial has been one of the most active REITs when it comes to joint ventures, managing a total of more than $6 billion in committed capital.

"The important thing when doing a joint venture is making sure that you and your partners share the same investment strategy and overall philosophy," he says. "Our partners want to make sure that we share the same vision."

Consequently, it becomes important for joint venture partners to establish well-defined termination agreements beforehand, in case the parties decide to go their separate ways, according to David Harris, senior REIT analyst for Lehman Brothers. Doing so can avoid a "messy" split, he says. "The only way to address that is to have adequate exit mechanisms in place," Harris says.

Likewise, it's important that all parties understand the type of arrangement that they're entering. The term "joint venture" may take on multiple meanings in the real estate lexicon. For instance, it might refer to a project that is being developed cooperatively by two different real estate companies. When it comes to arrangements between institutional investors and REITs, joint ventures typically assume two different forms, Harris says. In one version, a large investor, such as a pension fund, might contract with a REIT to develop and co-invest in a certain property or group of properties. Other cases involve REITs acting as the general partner in a fund that has multiple investors.

"You either have a one-on-one relationship or several partners," Harris says. "There has been an increase in REIT involvement in both."

Typically, Harris says, when a REIT enters a joint venture with just one other partner, the REIT takes a smaller equity stake in the enterprise. First Industrial, for instance, normally takes an ownership stake of between 10 percent and 15 percent, according to Havala. The REIT also receives management fees for managing the venture's assets. Some agreements involve preferred returns for REITs, in which they earn bonuses if the assets beat certain levels of performance.

In February 2008, office REIT Parkway Properties (NYSE: PKY) invested the last of the remaining money in a $500 million "discretionary" fund with the Ohio Public Employees Retirement System (Ohio PERS). Formed in 2005, the fund is one among a suite of joint ventures for Parkway. Under the terms of their agreement, Parkway serves as the general partner in the fund, which consists of $200 million in capital contributed by Parkway and Ohio PERS, in addition to $300 million in debt.

Shareholders Sweet on Joint Ventures, Too Research shows that REIT shareholders appear to be enamored with joint ventures. A 2006 study published in the Journal of Real Estate Financial Economics found that markets generally “respond positively” to joint venture announcements. The study, conducted by R.D. Campbell and N. White-Huckins of Hofstra University and University of Connecticut professor C.F. Sirmans, examined 185 joint venture announcements of at least $15 million between 1994 and 2001. Their goal was to gauge the involved companies’ “cumulative abnormal returns,” which reflect the differences between a stock’s expected return and its actual return during a specific time period. Researchers often use them to illustrate the effect of news on a stock’s performance. In total, the academics discovered that during the three-day window including the day before and day after an announcement, REIT stocks beat their expected total returns by 0.32 percent. Joint ventures have “been very well received by the investing public,” Havala says. Henry says the investing public’s opinion of joint ventures has clearly shifted. “Over the years, it has changed from investors and rating agencies being concerned that joint ventures introduced a level of complexity,” he says. “Now, they are fully supportive of the joint venture model, because they realize it’s a way for REITs to increase incremental earnings and leverage their capital. It’s definitely an accepted business model today.”

"We had the discretion to place money on behalf of our partner, Ohio PERS," says Steven Rogers, Parkway's chief executive officer. "That gave us the flexibility to be able to deal in a changing marketplace, and it allowed us to be able to close quickly with people, which is very important."

Parkway holds a 25 percent equity stake in the fund and collects management fees from operating the partnership's assets. Parkway also stands to gain from preferred returns on the fund. Having already laid the groundwork for another discretionary fund, Rogers says Parkway intends to seek out more of these arrangements with large investors.

"The return on investment to our common shareholders is much higher in a fund investment than in a fee-simple investment. The economics of discretionary funds are just simply better," Rogers says. "This can be a very lucrative arrangement for Parkway as we go forward with these funds."

The commingled real estate fund structure, which combines multiple sources of capital, doesn't differ significantly from the ventures shared by REITs and one other partner, according to Harris. However, the commingled funds often have a wider focus than what he calls the "cut-to-suit" arrangements typically found in one-on-one ventures.

"Many of us are moving toward the commingled fund model," says Kimco Realty Corporation (NYSE: KIM) Vice Chairman and Chief Investment Officer David Henry, referring to the REITs that have been entering into joint ventures. Henry describes the related fees in commingled funds as being "a little more generous" for the REIT, as opposed to those generated in a single-investor arrangement.

Harris notes that industrial REITs, in particular, seem to have embraced fund management. AMB Property Corporation (NYSE: AMB), for example, has overseen joint venture funds coupled with institutional investors for more than 20 years. ProLogis (NSYE: PLD), for example, manages 18 property funds with a total of more than $19 billion in assets worldwide. The ProLogis funds all have geographic focuses, including Mexico, Korea and Europe. One fund, ProLogis European Properties (Euronext: PEPR), is traded publicly.

Narrow, one-on-one ventures, on the other hand, are more common among retail REITs, according to Harris. For instance, mall developer Macerich (NYSE: MAC) and the Alaska Permanent Fund Corporation (APFC) in January announced the joint acquisition of The Shops at North Bridge, a prominent retail property in downtown Chicago. The APFC is charged with investing the state's oil revenues, overseeing total assets worth $39 billion. The $515 million deal marked the second such endeavor by the two parties—the two also co-own the Tysons Corner Center shopping mall outside of Washington, D.C.

One Hand...

It's no secret that large institutional investors such as the APFC have a natural affinity for direct investment vehicles when it comes to real estate. The latest research conducted by the Pension Real Estate Association (PREA), a nonprofit trade group that represents major institutional investors, indicates that, in 2005, institutions with at least $25 billion in assets allocated approximately half of their real estate allocations to direct investment vehicles in 2005. The same data also suggest that institutions dedicate 90 percent of their overall real estate allocation into private investment structures, which include direct investment among other forms.

However, the benefits for major institutional investors of REIT joint ventures are clearly evident, according to real estate industry and financial experts.

"It's what every major institutional capital source looks for in a partner," Fasulo says. "They get the knowledge of knowing that they're partnering with a very well-financed and well-run operation."

For instance, joint ventures offer an alternative to direct investment to achieve outsized returns and risk diversification in one fell swoop, Harris says. The experience and skill that REIT managers can provide certainly make partnering with them an attractive option. "Some of the best real estate managers in the world are REITs," says Michael Grupe, NAREIT's executive vice president for research and investor outreach.

That element of expertise is what drives the second-largest public pension fund in the United States, the California State Teachers' Retirement System (CalSTRS), to form these partnerships, according to CalSTRS spokesman Ricardo Duran. CalSTRS, which oversees a total of $166.5 billion in assets that includes an $18.8 billion real estate allocation as of January 31, has entered into a number of high-profile joint ventures with REITs in recent years.

"We enter into real estate joint ventures to play to the strengths of both partners," Duran says. "Our strength is as a provider of capital, while our partners should be chosen for their top-notch knowledge of the markets in which we're interested and their talents at executing deals that will benefit our members."

Grupe maintains that a joint venture allows for the same kind of "targeted approach" for institutional investors that direct investment does, as well as a clear understanding of how their money will be invested. The result is a highly "tailored investment," he says.

Besides their expertise in operating properties and developing assets, REITs also offer joint venture partners a chance to leverage the companies' history in the real estate business, according to Fasulo. Whereas a pension fund probably has tenuous connections, at best, to architects, engineers and builders, REITs have well established relationships with these stakeholders. Similarly, when it comes to pitching a development project, retailers are probably more willing to hear out a REIT who they've worked with before than unknown representatives from a private equity group.

Harris does sound one important note of caution for institutions who might be enticed to join the growing number of joint venture partners in the current real estate environment. "Things have changed a little," he says. "I'd be careful extrapolating based on very recent history."

Harris notes that the buoyant returns enjoyed by joint venture investors in recent years have come in an environment strong property pricing. However, going forward, rising capitalization rates and falling real estate valuations could push investors' returns down, he says.

Joint Ventures' Commercial Sales Activity
	Buyer JV	2004	2005	2006	2007
APARTMENT	Joint Vent	$7,165,570,410	$18,765,500,156	$17,998,971,206	$34,919,418,340
	%	14%	21%	20%	35%
Apartment Total		$50,940,636,329	$88,728,918,763	$91,640,482,291	$99,462,875,641
HOTEL	Joint Vent	$2,011,322,349	$4,254,104,076	$7,149,272,823	$29,035,685,955
	%	13%	14%	19%	33%
Hotel Total		$16,083,566,656	$29,489,273,312	$38,202,041,724	$87,934,548,261
INDUSTRIAL	Joint Vent	$1,724,805,434	$4,781,157,915	$6,458,068,060	$7,167,641,073
	%	8%	13%	15%	15%
Industrial Total		$20,547,605,139	$36,693,120,596	$43,139,611,820	$47,700,917,754
OFFICE	Joint Vent	$15,390,084,396	$18,655,151,126	$29,381,752,059	$44,070,114,738
	%	21%	18%	21%	20%
Office Total		$74,354,071,684	$102,005,898,457	$137,629,793,252	$215,067,505,975
RETAIL	Joint Vent	$4,768,521,814	$10,401,159,874	$13,152,813,198	$24,661,922,818
	%	9%	20%	24%	34%
Retail Total		$54,436,472,054	$50,868,190,927	$54,781,531,663	$72,480,523,397
Total	Joint Vent	$31,060,304,404	$56,857,073,147	$74,140,877,345	$139,854,782,924
	%	14%	18%	20%	27%
Grand Total		$216,362,351,861	$307,785,402,054	$365,393,460,749	$522,646,371,028
SOURCE: Real Capital Analytics

...Washes the Other

Joint ventures' benefits to REITs are clear as well, according to the experts. In some ways for REITs, it seems like joint ventures are spurred primarily by what they don't—or can't—do.

As real estate industry professionals note, the REIT choice imposes significant rules on companies' operations, particularly with regard to asset structure and cash retained. Because 90 percent of a REIT's taxable income must be distributed to shareholders in the form of a dividend, REITs rely to a somewhat greater extent on outside capital sources to help finance growth.

Industry observers also seem to agree that when credit becomes more difficult to come by, joint ventures take on even greater significance. In today's dicey lending market, funding from joint ventures can either replace borrowing or make it easier to access debt.

Sometimes with joint ventures, it's about more than just increasing the amount of a REIT's capital base, according to Havala. They can also expand the "scope" of that base, he says. Havala contends that joint ventures have enabled First Industrial to acquire assets that are "less friendly" to the company's capitalization structure, particularly when it comes to the development side of a REIT's business, such as raw land.

"That's a perfect investment to have in a joint venture format," he says. In general, according to Havala, joint ventures have been vital to First Industrial's ability to fund its growth, helping the company seize attractive opportunities.

"We saw a lot of growth opportunities in our business," he says. "Going the joint venture route was the right answer for us."