|August 13, 2008|
Previously published on August 4, 2008
Like any successful marriage, the joining together of landowner and developer for the ownership and development of a resort property depends on a firm foundation of trust, communication and each party’s commitment to making the partnership work. No partnership works well unless both parties’ needs are being met and their mutual and individual goals are attained.
Hospitality joint venture projects where one partner contributes the land and the other partner provides the construction funding and/or development skills require the same trust, communication, commitment and goal-oriented approach. The stage when both partners are excited about their future together and are committed to the success of the resort is the time for the partners to focus on their respective roles in the joint venture (JV). The success of the resort JV will depend on the parties working together at the beginning to lay the proper foundation for the project by structuring the entity and creating their joint venture agreement (the “JV agreement”) and creating a vision for their future.
Creating the Entity and Initial Funding of the Venture
When two or more parties join together to form a hospitality joint venture, they must select the type of entity to use since a “joint venture” is not a formal legal entity. For federal and state income tax reasons, and because of the relative ease of operation and absence of most statutory formalities, the choice of entity for most resort joint ventures is a limited liability company (LLC). The LLC is a creature of state law which has the tax benefits of a partnership passing through taxation down to the members and avoidance of double taxation at the entity level, while at the same time providing limited liability for the “partners.” For the purposes of this article, we will assume a two-party JV where the parties have elected to form a LLC whose sole purpose will be the development of the resort property.
The state of formation is determined by the parties on a case-by-case basis, however, generally either the parties will file in the state where the resort property is located or where one of the members is located. The parties may also consider filing in Delaware, particularly if one of the parties to the venture is domiciled in Delaware and is comfortable with having Delaware law govern the venture. Delaware has traditionally been viewed as having a long history of corporate and limited liability company judicial precedent for the parties to rely on in the event of disputes between members. However, many other states have laws that provide adequate protection for the members. While it may be distasteful to consider the possibility of disputes during the “honeymoon” phase of the relationship, it is a reality the parties must address. Upfront structuring clearly laying out the intent of the parties with their common purpose as well as potential exit strategies can provide some comfort for those who believe, as Ben Franklin did, that “an ounce of prevention is worth a pound of cure.”
One of the threshold questions for the parties is how the resort venture will be funded. Will all working capital come from one or both members? Will loans from the members or third parties be necessary? If loans are required in addition to the equity contributions from the members, are both parties responsible for loan repayment individually or solely from the JV? Each member of the LLC will make some form of capital contribution to the entity and the value of that contribution will generally represent that member’s percentage interest in the LLC for the purpose of profit distributions during the life of the JV. If additional capital contributions will be required by both parties to the venture, a full description of the mechanism for handling unanticipated additional revenue requirements, and the remedies for failure to advance funds when needed, including dilution, should be provided in the JV agreement.
For the member contributing cash and perhaps development skills to the JV (the “developer”), the valuation of the developer’s initial capital contribution is relatively simple. The developer’s initial capital contribution begins with a tally of the amount of initial cash being contributed by the developer, including any construction loans for which the developer will obtain and be solely responsible, or to the extent of the developer’s guaranty. Additional cash infusion by the developer, as is often needed during the construction phase or later after the resort is developed, would be viewed as additional capital contributions by the developer. In addition to the developer’s capital contributions, the developer might also receive fees through separate agreements with the JV for acting as contractor or for managing the development or construction of the project. These are supplemental avenues for the developer to generate income from the JV and it is generally advised to have these additional agreements executed simultaneously with and attached as exhibits to the JV agreement, or referenced therein.
For the member contributing the land (the “landowner”), the valuation of that land will generally determine the landowner’s capital contribution, unless the landowner is making an additional cash contribution or a cash-equivalent contribution. The land will not be valued at its cost when acquired by the landowner, but rather, regardless of the acquisition cost, the landowner’s capital contribution would be the current market value of the land at the time it is contributed to the venture, or an agreed value. Given the current fluctuations in the real estate market, a new appraisal of the land will generally be necessary for an accurate calculation of the value of the land being contributed. Some landowners negotiate a preferred return on their investment of the land, giving them a premium above the actual value of the land contributed to the JV. The preferred return would have to be provided for in the JV agreement.
The landowner’s contribution of the land to the JV will be viewed from a federal tax perspective as a tax-free exchange where the landowner contributes the land in exchange for the landowner’s membership interest in the JV. The land may be contributed outright as a transfer of the land between the landowner and the JV or it may take the form of a party contributing its ownership of another LLC entity which owns that land to the JV. The parties must consider whether the contribution of land to the JV, regardless of the method of transfer, triggers any state revenue or transfer tax requirements and whether the landowner or the JV entity will bear the burden of payment of those costs. The parties are advised to consult their tax advisors to determine the tax treatment, including the deferral of taxes, applicable to the transfer of the land to the resort JV.
Treat It Like Any Acquisition of Real Property
All Right, Title and Interest
The landowner’s contribution of the land to a hospitality JV will typically involve all the issues one would consider when acquiring real property. The JV would expect the land to be contributed, along with the following:
- all right, title and interest in all streets, ways, roads and alleys used in connection with the property
- all development rights or credits, air rights, water rights, mineral or other rights or interests attributable to the property
- all appurtenances, reversions, remainders, easements, rights and rights of way appurtenant or related to the property
- all buildings and other improvements and fixtures located on the property
- all site plans, surveys, environmental audits, soil studies, engineering plans and studies, and all other studies specifically relating to the property
- all permits, consents, approvals, licenses, authorizations, warranties and other rights granted by or obtained from any governmental entity with respect to the property
Representation and Warranties
The landowner would be expected to make certain representations and warranties with respect to the property being contributed to the JV. Typical representations would include, but not be limited to, the landowner’s representations that:
- it has fee simple title to the land
- there are no liens or encumbrances other than those specified and agreed to
- it has the authority to transfer the property and the transfer would not violate any existing contracts or options relating to the property
- there is no pending or threatened litigation relating to the property
- there is no pending special assessment or condemnation proceeding affecting the property
- it has not received any notice from any governmental authority that there is a violation of any ordinance, regulation, law or statute pertaining to the property
- there are no hazardous materials used, manufactured, placed or stored on, under or near the property, or other environmental matters concerning the property
To the extent there are exceptions to any of these representations and warranties, they need to be disclosed and investigated by the JV or the developer to determine the viability of moving forward with the resort venture.
Prior to making its cash contribution, the developer should look at the potential transfer of the land to the JV as a typical purchaser would do in a real property purchase. Due diligence inquiries and inspections of the property should be performed consistent with the best practices utilized for acquisition of land. Land being contributed to a venture may be in various stages of pre-development. It could be raw and untouched or partially developed, and the type of inspections and due diligence performed should correspond with the level of development. For instance, the developer should confirm the feasibility of the construction and development of the property and whether the property is buildable from an engineering, geotechnical and environmental perspective; whether there are available utility systems to the boundaries of the property; whether there are zoning matters or building restrictions which will need to be addressed; whether there are any title issues which will need to be remedied; or whether there are any corporate, lender or governmental consents which will be needed for the resort project to proceed.
The parties might consider meeting with applicable local governmental authorities to assess the regulatory and political landscape against which the property might be developed and to determine whether there are any governmental incentives available to the JV. Existing surveys and title insurance policies should be reviewed prior to the contribution of the land to the JV. Since the beneficial ownership of the property will generally be changing with the contribution of the land to a newly formed JV, the JV will generally need to obtain an owner’s title insurance policy in its own name covering the property upon the transfer of the land into the JV. The parties will need to determine whether the cost of the new title insurance policy will be a JV expense or solely the responsibility of one of the JV members.
Adjacent Land Issues
The nature of the land being contributed might trigger other decisions for the parties. If the land being contributed is just part of the landowner’s property in the area, what happens with adjacent or surrounding properties owned by the landowner if the resort is successful? While a successful resort is, of course, the goal of the parties, it raises issues for the parties to address. Will adjacent or surrounding land be available to the JV for expansion? Will there be some right of first refusal granted to the JV where the landowner must first offer the property to the JV before the adjacent or surrounding area can be sold to one or more third parties? Should there be an option to purchase the property granted to the JV? What if the adjacent or surrounding area increases in value as a result of the success of the resort? Does the JV or the developer partner share in that appreciation in value in some way? To minimize the potential for discord, these issues should be addressed in the JV agreement when applicable.
Timing and Logistics
The timing of the landowner’s contribution of the land to the JV often becomes a delicate logistics issue for the parties. Because of the potential transfer tax, title insurance and other costs incurred during transfer, and the landowner’s understandable reluctance to transfer its property to the JV without assurances that the hospitality venture is viable, the actual contribution of the land will generally take place only after all due diligence has been completed, the developer and landowner have finalized the terms of their JV agreement and it is clear the project is moving forward. As a result, the land is often contributed by the landowner simultaneously with the receipt of the resort’s construction financing.
After the initial real property acquisition issues are addressed and the landowner and developer determine they wish to move forward together to develop the resort property, the funding and capital contribution issues discussed above are generally the first items addressed in the JV agreement.