EY: JV structures getting more scrutiny

 Post-downturn, fund managers have been conducting stricter due diligence on their partnerships with local market players - and uncovering more problems.   

Although joint ventures have been a longstanding part of real estate dealmaking, fund managers haven’t closely examined the structure of those partnerships until the past several years, according to a new report from tax and advisory firm EY. The impetus for the change was the downturn, which exposed a laxness in due diligence and documentation across the property sector, the firm stated.

Given how important it is for fund managers to form successful joint ventures with local partners, “it is therefore surprising that operational due diligence has only recently become a more prominent feature of the front end of partnership negotiations – especially in cases where these duties are assigned to partners who are not experts in this space,” Howard Roth, global real estate leader, and Mark Grinis, global real estate investment fund services leader, wrote in the report. Poor due diligence, after all, could expose a fund platform to risks relating to returns, reputation or fraud.

As investors continue to demand greater transparency from fund managers, more firms are reviewing their partners’ existing controls and systems to clarify and more precisely document the calculation of management fees, the maintenance of insurance, the processing of leases and the billing of pass-through costs. “Worryingly, the vast majority of review cases reveal problems, particularly for properties with a high level of transaction activity, like multifamily assets,” the authors wrote.

Typical JV terms and fees include a development management fee of 4 percent to 7.5 percent; an asset management fee of up to 2 percent; a property management fee of 2.5 percent to 5 percent on gross income; an acquisition fee of up to 0.75 percent; and a disposition fee of zero to 1 percent of the sales price, minus outside broker fees, according to EY.

Moreover, with increasing expansion into emerging and lower-transparency markets, more real estate managers are implementing anti-corruption programs, with a key part of corruption prevention being a clearer understanding of how partners and third-party intermediaries conduct business on their behalf. Indeed, a growing number of property companies are incorporating anti-corruption clauses in contracts and conducting audits of partners and service providers to assess their compliance with anti-corruption measures.

Additionally, real estate firms that have been expanding their global presence have been training internal staff and partners about anti-corruption guidelines, such as those issued by the US Department of Justice and the UK Serious Fraud Office, since business customs can vary across countries. “At a minimum, anti-corruption procedures have become a standard part of transaction due diligence for buying property or buying companies that own real estate,” Roth and Grinis noted in the report. “Going forward, the emphasis on anti-corruption measures is likely to intensify, especially as more real estate funds register with the Securities and Exchange Commission and heighten their focus on overall risk management and transparency.”

Investor demands for tighter property oversight measures and controls also have driven fund managers to take proactive measures to minimize questionable management activities and cost leakages, such as testing automated data reporting technologies and developing scoring criteria for manager performance. Cost leakages can include inaccurate or missing lease data in the rent roll; expenses posted to the wrong account or property and checks paid to fictitious vendors; contracts that are not bid out to secure the best pricing and terms; and unapproved write-offs for accounts receivable balances that are otherwise collectible, according to the report.

“Implementation of these kinds of proactive measures represents a significant mindset shift for fund managers over the last five years,” the authors wrote. “It is reflective of an ongoing push in the industry toward greater transparency and of an intensely competitive fund environment, where every detail differentiates one manager from the next.”