By Scott McCorvie | CEO, Enhance Senior Living
Senior Living Joint Venture Investment
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I get a lot of questions regarding different structures for seniors housing real estate investment. Most of you are probably aware of the traditional sale-leaseback, or sale-manageback (RIDEA) in seniors housing. But, with private equity groups dominating the transaction markets lately, there's a new focus on JV transactions. In this article, I’ll analyze the basic structure of the JV, waterfall cash flow distributions, and the pros and cons of the structure for seniors housing.
Just as the name states, a joint venture is a shared partnership between two or more entities within a single investment. The JV includes at least one Limited Partner (“LP”) and at least one General Partner (“GP”). The LP owns the majority position of the equity, and is typically an institutional investment group (REIT, Private Equity, Family Office, etc.). The GP will own a minority position in the equity, and is typically the seniors housing developer/operator. Together, the GP and LP will own 100% of the equity, with typical splits being 80/20, 90/10, or 95/5. This structure is frequently used for new development, but can also be used for acquisitions – especially when there’s material upside from improved operations, unit conversions, renovation, market reposition, etc.
So, why mess with the complexity of a JV structure for seniors housing? I’ll look at this from both the LP and GP perspective. For the LP, it creates less financial risk as they typically take a preferred position to the cash flow distribution (discussed later) from both operations and future sale. It’s also beneficial to the LP as it creates favorable alignment for the operator to be fully invested in the overall operations and bottom line (compared to a management fee arrangement). For the GP, it creates higher compensation for improved operations and value creation. It also gives the GP more control over major decisions like renovations, conversions, capital expenditures, management decisions, financing, and dispositions.
However, there are some things to consider before jumping into a JV arrangement. First, on both sides, the legal fees are much larger and can be much more time-consuming negotiating the documents. Also, the GP will need to provide 5-20% of the equity, which will be illiquid for the life of the investment. The GP, as partial owner, is also typically bound by the covenants and guarantees of the financing. There are also things to consider on the LP side. The LP, although majority owner, does not have absolute control over the investment and any future capital decisions (refinancing, disposition, etc.). Also, the LP typically cannot quickly change the operator if the performance goes south (assuming the GP is the operator).
And, the biggest question is how does the LP and GP split the cash flows from operations and value creation? This is the biggest risk mitigate for the LP and incentive for the GP. The JV documents will list out how the cash flow is distributed for both groups, and is typically structured as a “waterfall” with multiple tiers based on pre-determined financial metrics (“hurdles”). Each JV is unique, but the LP typically has a preferred position “pref”, and will receive all cash flow, or pari-passu (pro rata share) of cash flow until a predetermined investment hurdle is achieved (i.e., 8% equity return, 12% leveraged IRR, etc.). After the first hurdle is achieved, the GP will start receiving an unequal (larger) portion of the cash flow compared to their equity investment. This unequal distribution is referred to as their “promote” and will continue to increase as the financial performance increases. The waterfall usually contains multiple hurdles, with the GP receiving larger portions of the cash flow upon meeting each hurdle.
Overall, JV structuring is present in all commercial real estate investing, but is predominant in seniors housing. This is largely due to the strong operational nature of the industry, and how critical it is to have the right operator (and fully aligned operator) to achieve maximum financial success.
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