In any joint venture formed to acquire real estate, one point that should be addressed early in the process is whether, the extent to which, and how the parties intend to share costs incurred by each party individually in furtherance of the venture prior to the closing of the acquisition. Without a clear understanding of this allocation of responsibility, the parties may be reluctant to incur such costs or, perhaps worse, there may be subsequent disputes or animosity, or both, that could easily have been avoided.
For purposes of this article, unless otherwise indicated, we assume the following facts:
• There is a proposed joint venture (Venture) between two parties (Parties) – an institutional investor (Investor) and a local operator/developer (Sponsor);
• The Venture is being formed to acquire, either directly or through a wholly-owned subsidiary, real estate (Property);
• The Parties have agreed to contribution percentages to the Venture (JV Percentages) of 90 percent for Investor and 10 percent for Sponsor; and
• Sponsor has previously entered into a purchase and sale agreement (Purchase Agreement) with a third-party seller to acquire the Property.
WHAT ARE PURSUIT COSTS?
This article will focus on the costs incurred by the Parties in furtherance of the Venture prior to the closing of the acquisition of the Property by the Venture (Closing). These costs (Pursuit Costs) can cover a broad range of expenses associated with the acquisition of the Property and the formation of the Venture, including:
• The costs of inspection and other due diligence (e.g., the cost of environmental or other consultants to prepare environmental, property condition, and other reports; the cost of a survey; the legal costs associated with reviewing title to the Property, possible land use, environmental issues, development rights, and other legal matters related to the Property);
• The legal costs of negotiating the Purchase Agreement and other documentation (e.g., confidentiality and access agreements) associated with the acquisition of the Property;
• If there will be acquisition or construction financing (the Loan) obtained by the Venture or a subsidiary, whether by obtaining a new loan or assuming an existing loan, the legal costs of negotiating a loan (or assumption) application, term sheet, commitment, and other documentation (e.g., confidentiality agreements);
• Earnest money and other deposits (PSA Deposits) required to be delivered under the Purchase Agreement, and loan application, upfront commitment fees, and similar costs (Loan Deposits) for the Loan;
• The cost to form the Venture entity and any subsidiary formed to acquire the Property; and
• The legal costs (JV Negotiation Cost) of negotiating the Venture agreement and related documents (e.g., a management or other service agreement between the Venture and an affiliate of Sponsor) as well as other documents between the Parties (e.g., a letter of intent or a cost sharing agreement).
WHAT PURSUIT COSTS ARE ELIGIBLE FOR SHARING?
The Parties rarely agree to share all potential Pursuit Costs that may be incurred by either Party. To appreciate the limitations often imposed, it is helpful to sort Pursuit Costs into two general categories: (i) historical Pursuit Costs; and (ii) future Pursuit Costs.
Historical Pursuit Costs are known amounts that have already been incurred and can therefore be documented, explained, and evaluated. For example, the costs associated with an environmental report or a survey that has already been produced constitute historical Pursuit Costs. One Party may feel that certain historical costs incurred by the other Party are too expensive or should not have been incurred at all. In such event, because the amounts are already known, the Parties can simply agree on what is eligible for sharing, which may include full sharing, partial sharing, or no sharing for certain costs.
Future Pursuit Costs, unlike historical Pursuit Costs, are less certain. Neither Party—particularly Investor, given its role and JV Percentage—may be willing to share in the payment of all future Pursuit Costs and may therefore insist on some controls over which future Pursuit Costs are eligible for sharing. One solution is for Investor and Sponsor to approve jointly any future Pursuit Cost, and there might even be different standards of approval (e.g., reasonableness or unfettered discretion) depending on the specific cost. It may prove cumbersome in practice, however, to obtain the approval of each Party for each individual cost before it is incurred. To allow for flexibility, the Parties instead may require that each cost be incurred in accordance with a budget that both Parties approve. Adopting and complying with an approved budget also has its challenges. For example, what happens if both Parties are incurring costs within the same line item (e.g., each Party may have counsel incurring costs for legal diligence and ensuring compliance with the Purchase Agreement)? This overlap issue sometimes can be addressed with separate columns in the budget for Investor and Sponsor or by specifying the vendor or service provider who will be paid each budgeted amount.
CLICK HERE to read the full article, which was originally published in ALI CLE’s The Practical Real Estate Lawyer.
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