The last several years have seen a clear trend toward direct investment in real estate by family offices, and away from indirect holdings through private fund investments and the public markets. An oft-cited reason for this shift is the desire of family offices to assert direct control over their investments. However, such control can often prove illusory. This article explores the common pitfalls that family offices encounter when structuring direct real estate investments and provides practical suggestions for obtaining and maintaining a meaningful level of control over such investments.
THE TREND TOWARD DIRECT REAL ESTATE INVESTMENT
Family offices represent a diverse array of interests, wealth and skill sets. As a result, the motivations behind the trend toward direct investment in real estate among family offices are not uniform. For instance, family office investors may be seeking to diversify their portfolio or they may simply be aiming to direct their investments to assets that they have actually vetted on a case-by-case basis, rather than leaving such decisions to the discretion of a fund manager. An additional motivation may be a desire to minimize their exposure to the fees that funds charge (e.g., the common fund management fees of 2% of AUM and 20% of profits) or to maintain their investment in an asset for longer than the typical fund timeline of 5 years. While some or all of these reasons may hold true for a particular family office, an underlying theme is a desire by family offices to obtain and maintain a heightened level of control over their investments.
STRUCTURE OF DIRECT REAL ESTATE INVESTMENT
Few family offices employ full-time real estate professionals and managers. In order therefore to invest directly in a real estate asset, those family offices often designate an experienced real estate operator capable of handling the day-to-day activities associated with such an investment. This could take the form of a management arrangement with a real estate operator, paying the manager a fee based on a percentage of revenues. Alternatively, the family office might own the property and ground lease the entirety to a developer and/or operator on a long-term basis. Perhaps the most common structure, however, is to co-own the property through a joint venture with a real estate operator who acts as managing member of the venture. In this scenario, the operator typically takes a relatively small equity stake in the venture with the family office holding an outsized majority interest (while the equity split varies, a five to ten percent interest on the part of the operator is typical).
THE JOINT VENTURE AND PROTECTIVE RIGHTS
Be Careful What You Bargain For ? The (Un)Intended Result of Protecting Your Rights
As noted above, the shift toward direct investment by family offices is often based on a desire to assert greater control over decisions relating to the asset and its management. In a joint venture with a real estate operator, the operator is generally the managing member and the party in control of the day-to-day decision-making for the venture. As a bulwark to the significant level of control exerted by the managing member, the family office will typically bargain for the right to approve certain major decisions. To protect these major decision approval rights, two important enforcement mechanisms are often employed in the joint venture agreement: (i) the right to buy-out the operating partner (whether as a call right or through a buy-sell mechanism) in the event of a deadlock over a major decision, and (ii) the right to remove the operating partner in the case of a breach (such as taking an action without obtaining the required approval of the family office). In either case, a change in control of the asset may be the result of enforcing such safeguards, a potentially problematic outcome.
PRACTICAL PROBLEMS ASSOCIATED WITH ENFORCING YOUR RIGHTS
A forced change in control of the asset may pose specific problems from a financing perspective. If the acquisition was financed with a third party lender, as is usually the case, the financing documents will most often prohibit a change in control without the lender?s consent, as the lender would have underwritten its financing based on the reputation and experience of the operating partner, and possibly the creditworthiness of the affiliate of the operating partner providing any necessary guaranties. It is not surprising then that lenders will often insist Legal on the right to approve any such change.