The Dynamics of Developer/Contractor Co-ownership Relationships

By: Mark S. Biskamp (Co-author) and Robert (Bob) H. Voelker (Co-author)
Real Estate in the Changing World: Confronting the Crisis
May 2010

In one sense, general contractors have been acquiring interests in real estate ever since they’ve been filing and foreclosing liens. And, on occasion, contractors have provided "sweat equity," contributing a portion of their construction services for an ownership stake in a project.

With higher borrower equity requirements now needed to obtain financing, contractors are considering providing credit support to development transactions by becoming equity participants in or credit enhancers for the underlying real estate project, in addition to serving as the general contractor on the project. For example, a general contractor that owns property to be developed could team with a developer to benefit from the developer's expertise. As a second example, a developer finds itself out of money — often on an existing project — and looks to the general contractor on the project for some capital in exchange for a piece of ownership. And finally, in a twist on the second scenario, some developers may offer equity positions to the general contractor's principals as opposed to the general contractor entity.

Though one executive at an international contractor opined that the "contractor-as-part-owner" trend is neither strong nor sustainable, some contractors and developers may find themselves entertaining such options while the economy recovers. Moreover, the contractor-as-part-owner arrangement can be beneficial to the contractor in several ways. First, the contractor can increase its opportunity to be engaged for the construction work in an economy that is seeing fewer real estate project starts (and those that are starting are being heavily bid by contractors with excess capacity). Second, the contractor’s investment helps insure that the project will move forward by providing equity to obtain loan approval. Finally, the contractor is able to receive both a fee under its construction contract and a return on its equity investment.

Dual Roles
The contractor must evaluate the proposed equity transaction as both a service provider and an investor. As a service provider, the contractor must understand how it is going to be paid the contract price and its fee. As an investor, the contractor must be assured of the viability of the project and understand the financial contributions required, the expected return on investment and the source of repayment. In some respects, the roles of service provider and investor may conflict. For example, seeking the highest contract price and fee may impact the return on the contractor’s equity investment. The contractor should evaluate the construction contract pricing and equity investment together to determine the best overall economic result.

The contractor will need to understand the leverage that the developer holds over the contractor's equity position in the event of disagreements over construction matters. The developer may attempt to offset the dollar amount of disputed construction costs (such as cost overruns) against distributions to be made to the contractor under the ownership agreement. The contractor should consider holding the equity interests through a separate legal entity as opposed to holding the equity interests itself in order to create better legal separation of roles. Such concerns may also exist for the developer if the contractor attempts to offset costs against any development fee due the developer for its services to the ownership entity.

Profits and Losses
The contractor should require that the co-ownership agreement clearly document how profits and losses are shared. The "waterfall" provisions should be examined carefully, particularly for any preferred returns and promotes that may be ahead of the contractor’s distributions. The contractor should understand any provisions that may require capital calls in the event of project losses. Ironically, if capital calls are required of the contractor for cost overruns or change orders under the construction contract, the contractor will be contributing its own money to pay for its fees as a service provider. Tension with the developer co-owner may also arise as only the contractor will benefit from payments for cost overruns or change orders.

Contract Administration
The developer will want to limit the ability of the contractor to make decisions concerning the construction contract in order to avoid conflicts of interest between the contractor’s roles as project co-owner and service provider. Instead, the developer will want the construction contract treated as any third party construction contract would be treated, even if the contractor is the majority co-owner in the project. The developer may argue that the contractor will have the ability to negotiate as a party to the construction contract; however, the contractor will not want limitations on its right to participate as a partner in the ownership entity in major project decisions that impact its equity investment.

Exit Strategy
As the equity investment will last beyond final payment under the construction contract, the contractor should understand the exit strategy for the investment as well as any possibility of being forced out by the developer. The co-ownership agreement may contain a buy-sell provision where the co-owner initiating the buy-sell can require the other co-owner to elect to either sell its equity interest for a specified price or buy the initiating co-owner’s interest for the same price. Buy-sell provisions may be problematic for a contractor with a minority equity interest if there is no ready access to capital to respond as a buyer. The co-ownership agreement may also have a marketing right where either co-owner can require a sale of the project. Both the buy-sell and marketing right can specify holding periods before they are triggered in order to allow a period of time for the project to appreciate.

Disputes
Disputes between the contractor and developer can be particularly problematic in an equity participation relationship. If litigation arises, the contractor will incur expense not only as the contractor but also as a co-owner of the project, and a conflict of interest clearly arises from such dual roles. Therefore, any mechanism to resolve disputes amicably and with as little cost as possible will benefit all parties, and alternative dispute mechanisms such as mediation and arbitration may be less expensive than litigation and more appropriate in such co-ownership relationships.

Challenging financial times in real estate require creativity from all parties, and equity participations can be beneficial in meeting such challenges. In entering into any such arrangement, however, the parties need to be aware of the dynamic conflicting tensions between the parties and carefully consider how inevitable conflicts are to be resolved.