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Since launching its LEED™ rating system in 2000, the U.S. Green Building Council’s Leadership has registered nearly 8,000 projects and certified nearly 1,000 buildings. According to the same report, at the same time, more than 38,000 professionals in the commercial building industry have become LEED™- certified. LEED™ is the first broadly accepted program to objectively measure all new and existing construction. A large number of California cities, among others through-out the country, have embraced the LEED™ paradigm and mandate that new construction be designed and built based on LEED™ certification standards. In fact, building owners, architects, developers, and contractors are required in many respects to incorporate meaningful sustainable building goals early in the building design process. The City of Calabasas has adopted the Green Develop-ment Standards, which require that all construction or re- placement of privately-owned and city-owned, non-residential structures over 500 square feet comply with the Calabasas- LEED™ rating prior to the issuance of a certificate of occupancy (Calabasas Munipal Code, Chapter 17.34). Structures up to 5,000 square feet must at least meet the standards established by the Certified rating while structures over 5,000 square feet must meet the Silver rating. In the City of Pleasanton, the Pleasanton Commercial and Civic Green Building Ordinance requires that commercial projects of 20,000 square feet or more meet a minimum LEED™ Certified rating as a condition of approval (Pleasanton Municipal Code, Chapter 17.50). Some California cities, such as the City of Santa Monica, provide expedited plan check processing for projects registered under LEED™ (Santa Monica Municipal Code, Section 8.108.050). Many other California cities have manda- tory building requirements outside the scope of LEED™, and some have instituted voluntary programs, which will likely become mandatory in the near future.

The Color of the Future Green building principles already dominate commercial and residential development. The adoption and implemen-tation of the LEED™ rating system leaves little doubt that green building will soon incorporate sustainable design as a standard, and in some cases, mandatory part of development. These are remarkable changes to conventional real estate, and promise to define modern development practices.

REsource Spring2008

by Rachael Simonoff Wexler and Shahrzad Mostofi

Rachael Simonoff Wexler is a partner in the Los Angeles office of Goodwin Procter and can be reached at (310) 788-5131 or rwexler @goodwinprocter.com. Shahrzad Mostofi is an associate in the Los Angeles office of Goodwin Procter and can be reached at (310) 788-5134 or smostofi@goodwinprocter.com.

Green building is no longer the passion of a few; it is the new standard for commercial and residential develop- ments alike. Green design is an undisputed selling point, remarkably enhancing commercial and residential project value. Green building practices reduce the tremendous impact that building design, construction, and maintenance have on both people and nature. The concept of environmentally friendly real estate is so ubiquitous today that green can be used to describe building without concern that readers will think it refers to the color of a structure.

The Green Advantage According to the U.S. Department of Energy’s Center for Sustainable Development, buildings consume 40% of the world’s total energy, 25% of its wood harvest, and 16% of its water. In the United States, the building industry is the nation’s largest manufacturing sector, representing more than 50% of the nation’s wealth and 13% of its Gross Domestic Product. Because of its impact, the building industry is ripe for an environmental overhaul. Green policies help reduce unnecessary energy and material consumption, which have long-term benefits to the nation and the world. In addition, these policies come with financial rewards. Short-term capital raising and long-term economic viability demand green building. Domestic and foreign capital is allocated to fund green building in multiples over other real estate development. The green building market has given rise to its own cottage industry, known as green lending. Green lending is supported by large and small commercial lenders and focuses solely on green design and related emerging regulations. In the wake of the collapse of the subprime lending market, many large institutional lenders have increased their funds allocated to green projects, even while less cash is generally available to lend. Green demands extend to the private equity community, as well as to public investors. Private equity real estate invest- ments and public investors (through REITs) gravitate to green building projects almost to the exclusion of those that are not. Developers and funds have learned that green initiatives are increasingly an investment prerequisite of pen- sion and endowment funds. Accordingly, such investments and allocations by private equity fund-to-funds have increased dramatically and are expected to continue to rise. Developers working with designs that are not green are find-ing it increasingly difficult, if not impossible, to raise capital.

“ Developers working with designs that are not green are finding it increasingly difficult ... to raise capital.”

A Goodwin Procter PublicationFor The Real Estate Industry

Editor-in-ChiefRobert M. Haight, Jr.

EditorsLewis G. FeldmanJohn M. FergusonDouglas A. PrawAndrew C. Sucoff

ProductionBridget C. HuffstutlerSarah E. Moore

DesignMacy + Associates www.goodwinprocter.comCopyright© 2008 by Goodwin Procter LLP. All rights reserved. Reproduction, in whole or part, without permission is prohibited.This publication may be considered advertisingunder the ethical rules of certain jurisdictionsand should not be considered legal advice.

Existing developments and funded projects under develop-ment face longer-term challenges to their economic viability, strategic position, and operating costs. Green buildings are considered “Tier 1” properties in the commercial and residen-tial market. All else has been relegated to “Tier 2.” If today’s trend continues, renewing tenants will choose green buildings over others, driving up the rate of vacancy at Tier 2 properties. Tenants who stay will likely insist that energy costs be capped to match the lower energy costs of green competitors. Conse-quently, as leases renew, look for sharp depreciation and esca-lating management costs associated with Tier 2 real estate.

LEED ing the Way to Sustainable Design Most observers agree that sustainable design is the next phase of green building. Although often used interchange-ably, not all green building incorporates sustainable design. Green building, as it has come to be understood, means resource efficient and environmentally conscious construc- tion. By contrast, sustainable design goes a step further and looks to harmonize energy conservation, resource conserva-tion, and quality of life, such as functional spatial design and improved indoor air quality. The federal government has taken the lead in instituting this next phase in green building. The Leadership in Energy and Environmental Design (“LEED™”) Green Building Rating System™ is the broadest and most well-known federal initiative to promote sustainable building for construction in new and existing offices, retail establishments, libraries, schools, museums, religious institutions, hotels, and resi-dential buildings with at least four or more habitable stories. LEED™ certification levels are Certified, Silver, Gold, and Platinum. LEED™-certified buildings have lower operating costs, reduced waste, and increased energy conservation. The majority of states have adopted LEED™ as the base-line for sustainable design. LEED™ evaluates environmental performance from a “whole building” perspective over a building’s life cycle based on accepted energy and environmental principles. More than what is required for green building, LEED™ focuses on six major design categories:

> SUSTAINABLE SITES

> WATER EFFICIENCY

> ENERGY AND ATMOSPHERE

> MATERIALS AND RESOURCES

> INDOOR ENVIRONMENTAL QUALITY

> INNOVATION AND DESIGN PROCESS

2

SPRING/2008

Since launching its LEED™ rating system in 2000, the U.S. Green Building Council’s Leadership has registered nearly 8,000 projects and certified nearly 1,000 buildings. According to the same report, at the same time, more than 38,000 professionals in the commercial building industry have become LEED™- certified. LEED™ is the first broadly accepted program to objectively measure all new and existing construction. A large number of California cities, among others through-out the country, have embraced the LEED™ paradigm and mandate that new construction be designed and built based on LEED™ certification standards. In fact, building owners, architects, developers, and contractors are required in many respects to incorporate meaningful sustainable building goals early in the building design process. The City of Calabasas has adopted the Green Develop-ment Standards, which require that all construction or re- placement of privately-owned and city-owned, non-residential structures over 500 square feet comply with the Calabasas- LEED™ rating prior to the issuance of a certificate of occupancy (Calabasas Munipal Code, Chapter 17.34). Structures up to 5,000 square feet must at least meet the standards established by the Certified rating while structures over 5,000 square feet must meet the Silver rating. In the City of Pleasanton, the Pleasanton Commercial and Civic Green Building Ordinance requires that commercial projects of 20,000 square feet or more meet a minimum LEED™ Certified rating as a condition of approval (Pleasanton Municipal Code, Chapter 17.50). Some California cities, such as the City of Santa Monica, provide expedited plan check processing for projects registered under LEED™ (Santa Monica Municipal Code, Section 8.108.050). Many other California cities have manda- tory building requirements outside the scope of LEED™, and some have instituted voluntary programs, which will likely become mandatory in the near future.

The Color of the Future Green building principles already dominate commercial and residential development. The adoption and implemen-tation of the LEED™ rating system leaves little doubt that green building will soon incorporate sustainable design as a standard, and in some cases, mandatory part of development. These are remarkable changes to conventional real estate, and promise to define modern development practices.

REsource Spring2008

by Rachael Simonoff Wexler and Shahrzad Mostofi

Rachael Simonoff Wexler is a partner in the Los Angeles office of Goodwin Procter and can be reached at (310) 788-5131 or rwexler @goodwinprocter.com. Shahrzad Mostofi is an associate in the Los Angeles office of Goodwin Procter and can be reached at (310) 788-5134 or smostofi@goodwinprocter.com.

Green building is no longer the passion of a few; it is the new standard for commercial and residential develop- ments alike. Green design is an undisputed selling point, remarkably enhancing commercial and residential project value. Green building practices reduce the tremendous impact that building design, construction, and maintenance have on both people and nature. The concept of environmentally friendly real estate is so ubiquitous today that green can be used to describe building without concern that readers will think it refers to the color of a structure.

The Green Advantage According to the U.S. Department of Energy’s Center for Sustainable Development, buildings consume 40% of the world’s total energy, 25% of its wood harvest, and 16% of its water. In the United States, the building industry is the nation’s largest manufacturing sector, representing more than 50% of the nation’s wealth and 13% of its Gross Domestic Product. Because of its impact, the building industry is ripe for an environmental overhaul. Green policies help reduce unnecessary energy and material consumption, which have long-term benefits to the nation and the world. In addition, these policies come with financial rewards. Short-term capital raising and long-term economic viability demand green building. Domestic and foreign capital is allocated to fund green building in multiples over other real estate development. The green building market has given rise to its own cottage industry, known as green lending. Green lending is supported by large and small commercial lenders and focuses solely on green design and related emerging regulations. In the wake of the collapse of the subprime lending market, many large institutional lenders have increased their funds allocated to green projects, even while less cash is generally available to lend. Green demands extend to the private equity community, as well as to public investors. Private equity real estate invest- ments and public investors (through REITs) gravitate to green building projects almost to the exclusion of those that are not. Developers and funds have learned that green initiatives are increasingly an investment prerequisite of pen- sion and endowment funds. Accordingly, such investments and allocations by private equity fund-to-funds have increased dramatically and are expected to continue to rise. Developers working with designs that are not green are find-ing it increasingly difficult, if not impossible, to raise capital.

“ Developers working with designs that are not green are finding it increasingly difficult ... to raise capital.”

A Goodwin Procter PublicationFor The Real Estate Industry

Editor-in-ChiefRobert M. Haight, Jr.

EditorsLewis G. FeldmanJohn M. FergusonDouglas A. PrawAndrew C. Sucoff

ProductionBridget C. HuffstutlerSarah E. Moore

DesignMacy + Associates www.goodwinprocter.comCopyright© 2008 by Goodwin Procter LLP. All rights reserved. Reproduction, in whole or part, without permission is prohibited.This publication may be considered advertisingunder the ethical rules of certain jurisdictionsand should not be considered legal advice.

Existing developments and funded projects under develop-ment face longer-term challenges to their economic viability, strategic position, and operating costs. Green buildings are considered “Tier 1” properties in the commercial and residen-tial market. All else has been relegated to “Tier 2.” If today’s trend continues, renewing tenants will choose green buildings over others, driving up the rate of vacancy at Tier 2 properties. Tenants who stay will likely insist that energy costs be capped to match the lower energy costs of green competitors. Conse-quently, as leases renew, look for sharp depreciation and esca-lating management costs associated with Tier 2 real estate.

LEED ing the Way to Sustainable Design Most observers agree that sustainable design is the next phase of green building. Although often used interchange-ably, not all green building incorporates sustainable design. Green building, as it has come to be understood, means resource efficient and environmentally conscious construc- tion. By contrast, sustainable design goes a step further and looks to harmonize energy conservation, resource conserva-tion, and quality of life, such as functional spatial design and improved indoor air quality. The federal government has taken the lead in instituting this next phase in green building. The Leadership in Energy and Environmental Design (“LEED™”) Green Building Rating System™ is the broadest and most well-known federal initiative to promote sustainable building for construction in new and existing offices, retail establishments, libraries, schools, museums, religious institutions, hotels, and resi-dential buildings with at least four or more habitable stories. LEED™ certification levels are Certified, Silver, Gold, and Platinum. LEED™-certified buildings have lower operating costs, reduced waste, and increased energy conservation. The majority of states have adopted LEED™ as the base-line for sustainable design. LEED™ evaluates environmental performance from a “whole building” perspective over a building’s life cycle based on accepted energy and environmental principles. More than what is required for green building, LEED™ focuses on six major design categories:

> SUSTAINABLE SITES

> WATER EFFICIENCY

> ENERGY AND ATMOSPHERE

> MATERIALS AND RESOURCES

> INDOOR ENVIRONMENTAL QUALITY

> INNOVATION AND DESIGN PROCESS

2

SPRING/2008

REsource Spring2008

4

Andrew Kirsh is an associate in the Los Angeles office of Goodwin Procter and can be reached at (310) 788-5133 or akirsh@goodwinprocter.com.

by Andrew Kirsh

sense would dictate that such a contract would be rejected. But, for over a decade, during the sizzling real estate market, contracts such as this were not uncom-mon when sellers dictated most, if not all, material terms of a real estate acquisition. In today’s market, however, the number of real estate transactions that make economic sense is dwindling. Fewer buyers are able to obtain adequate financing due to the recent credit crunch. Thus, an imbalance between seller supply and buyer demand now exists in the real estate market. The negotiating pendulum long thought to be stuck at the top of the seller’s side is finally returning to an even position. The return of balance due to the changing market should allow buyers to negotiate more favorably certain hot button issues concerning due diligence, deposit, as-is and release pro- visions, representations and warranties, and seller remedies.

DILIGENCE AND DEPOSITIn the past, sellers were able to nego-

tiate the terms of a purchase contract such that buyers would close transactions without any meaningful diligence. Conse-quently, too often at the closing table buy-ers were left wondering: Can this building survive an earthquake? Will the roof hold up after the next significant winter storm? If not, is the property properly zoned so that it can be rebuilt? Rather than feeling insecure, buyers in today’s marketplace may see a return to normality with sellers providing a reasonable period to perform diligence on the underlying real estate.

Bargaining for a longer diligence period, however, raises other issues concerning the posting of deposits and the distribution of the purchase price to sellers. It had become commonplace for sellers to require that a portion of the

deposit go hard before the expiration of the due diligence period. Today’s market suggests that there are a few transactions in which buyers are able to post depos-its that are refundable through the due diligence period.

“AS IS” AND RELEASEIn every purchase agreement, buyers

are confronted with seemingly dozens of pages of BOLD TEXT IN ALL CAPITAL LETTERS warning them of everything that is, or could be, wrong with the property. During the last decade, these sections tended to get longer and more compre-hensive, with sellers reciting all potential defects in the purchase agreements in order to insulate themselves from the possible recourse of the buyers. The as-is and release provisions were often used to insulate sellers from liability for exist-ing environmental and archaeological discoveries. If it is later discovered that the purchased property rests on top of a waste site filled with hazardous substances or above a Native American burial ground – things that might have been discovered with a reasonable due diligence period - buyers are out of luck.

In today’s changing market, these pro-visions may be called into question. Even if buyers are able to squeeze a longer window of diligence out of sellers, buyers cannot be expected to have complete knowledge of a property’s deepest and darkest secrets, especially in situations where sellers have owned the property for a substantial period of time. Given the pro-seller environment over the last 10 years, sellers are going to be reluctant to accept such a paradigm shift in the terms of their purchase contracts and will con- tinue to desire to place the diligence risk on buyers. However, it remains to be seen how these provisions will withstand an even greater swing in the market.

A seller puts its multi-million dollar, multiple-occupant retail shopping center with certain structural and environmental challenges up for sale. The property is offered on the following terms: the seller provides no representations about the asset or its condition; the buyer is given seven days of due diligence to discover the condition of the property; the buyer must make a hefty, non-refundable

deposit; and the asset is sold in an as-is condition with disclaimers by the seller for all actual or potential defects. In other words, the seller doesn’t tell the buyer the condition of the property, doesn’t provide the buyer a reasonable opportu-nity to discover the condition of the prop-erty, and then prevents the buyer from any recourse should a defect be found after the purchase is closed. Common

2

NEGOTIATING IN A SEE-SAW MARKET

CONCLUSIONIn this ever-changing real estate market-

place, sellers will no longer have the lux- ury of dictating one-sided, seller-friendly purchase agreements. Instead, as the pen- dulum swings to its nadir, savvy buyers will now have more ability to maximize value and obtain certainty through negotiating more balanced real estate purchase agreements.

higher purchase prices.

that sellers identify all litigation proceed-

“ The return of balance due to the changing market should allow buyers to negotiate more favorably cer tain hot button issues.”

transaction, want to own the property,

specific performance is the only remedy capable of putting the buyer back in the position the buyer would have been in but for the seller default. Furthermore, anything other than specific performance would make it too enticing for sellers to walk away from a binding contract in order to sell the property at a higher price even after the payment of liquidated damages to the first buyer. In today’s real estate market, this may not be an issue, so buyers should be able to negotiate specific performance. In the absence of such a provision, buyers may want to pay attention to the liquidated damages figure to create a deterrent for sellers from backing out of contracts for

SELLER REPRESENTATIONS AND WARRANTIES

Other than informing buyers of their organizational makeup and their author-ity to enter into a particular transaction, sellers have typically not made any mean-ingful representations concerning the property or its history. Sellers have been successful in refusing to make worthwhile representations while, at the same time, limiting diligence for buyers. In this chang-ing marketplace, there will be greater push back on sellers to make certain representations and warranties.

Representations from sellers concern-ing matters that buyers cannot adequate- ly examine through diligence may over time come to the forefront of negotiations between buyers and sellers. Although buyers may not be able to obtain unquali-fied representations from sellers, buyers may now be able to negotiate for repre- sentations concerning information known to the seller. In addition, because buyers do not want to inherit litigation when purchasing real estate, buyers could ask

ings involving the property or actions that may lead to future litigation. Lastly, buyers should consider that no matter how successful buyers are in receiving representations from sellers, without a survival period such representations may be meaningless. But, getting such a sur- vival period will continue to be a tough negotiation between buyers and sellers.

REMEDIESA real estate contract is essentially non-

binding when a buyer’s remedies, due to a seller’s default, do not provide for specific performance. Because liquidated damages do not adequately remedy buyers who, at the conclusion of the

REsource Spring2008

4

Andrew Kirsh is an associate in the Los Angeles office of Goodwin Procter and can be reached at (310) 788-5133 or akirsh@goodwinprocter.com.

by Andrew Kirsh

sense would dictate that such a contract would be rejected. But, for over a decade, during the sizzling real estate market, contracts such as this were not uncom-mon when sellers dictated most, if not all, material terms of a real estate acquisition. In today’s market, however, the number of real estate transactions that make economic sense is dwindling. Fewer buyers are able to obtain adequate financing due to the recent credit crunch. Thus, an imbalance between seller supply and buyer demand now exists in the real estate market. The negotiating pendulum long thought to be stuck at the top of the seller’s side is finally returning to an even position. The return of balance due to the changing market should allow buyers to negotiate more favorably certain hot button issues concerning due diligence, deposit, as-is and release pro- visions, representations and warranties, and seller remedies.

DILIGENCE AND DEPOSITIn the past, sellers were able to nego-

tiate the terms of a purchase contract such that buyers would close transactions without any meaningful diligence. Conse-quently, too often at the closing table buy-ers were left wondering: Can this building survive an earthquake? Will the roof hold up after the next significant winter storm? If not, is the property properly zoned so that it can be rebuilt? Rather than feeling insecure, buyers in today’s marketplace may see a return to normality with sellers providing a reasonable period to perform diligence on the underlying real estate.

Bargaining for a longer diligence period, however, raises other issues concerning the posting of deposits and the distribution of the purchase price to sellers. It had become commonplace for sellers to require that a portion of the

deposit go hard before the expiration of the due diligence period. Today’s market suggests that there are a few transactions in which buyers are able to post depos-its that are refundable through the due diligence period.

“AS IS” AND RELEASEIn every purchase agreement, buyers

are confronted with seemingly dozens of pages of BOLD TEXT IN ALL CAPITAL LETTERS warning them of everything that is, or could be, wrong with the property. During the last decade, these sections tended to get longer and more compre-hensive, with sellers reciting all potential defects in the purchase agreements in order to insulate themselves from the possible recourse of the buyers. The as-is and release provisions were often used to insulate sellers from liability for exist-ing environmental and archaeological discoveries. If it is later discovered that the purchased property rests on top of a waste site filled with hazardous substances or above a Native American burial ground – things that might have been discovered with a reasonable due diligence period - buyers are out of luck.

In today’s changing market, these pro-visions may be called into question. Even if buyers are able to squeeze a longer window of diligence out of sellers, buyers cannot be expected to have complete knowledge of a property’s deepest and darkest secrets, especially in situations where sellers have owned the property for a substantial period of time. Given the pro-seller environment over the last 10 years, sellers are going to be reluctant to accept such a paradigm shift in the terms of their purchase contracts and will con- tinue to desire to place the diligence risk on buyers. However, it remains to be seen how these provisions will withstand an even greater swing in the market.

A seller puts its multi-million dollar, multiple-occupant retail shopping center with certain structural and environmental challenges up for sale. The property is offered on the following terms: the seller provides no representations about the asset or its condition; the buyer is given seven days of due diligence to discover the condition of the property; the buyer must make a hefty, non-refundable

deposit; and the asset is sold in an as-is condition with disclaimers by the seller for all actual or potential defects. In other words, the seller doesn’t tell the buyer the condition of the property, doesn’t provide the buyer a reasonable opportu-nity to discover the condition of the prop-erty, and then prevents the buyer from any recourse should a defect be found after the purchase is closed. Common

2

NEGOTIATING IN A SEE-SAW MARKET

CONCLUSIONIn this ever-changing real estate market-

place, sellers will no longer have the lux- ury of dictating one-sided, seller-friendly purchase agreements. Instead, as the pen- dulum swings to its nadir, savvy buyers will now have more ability to maximize value and obtain certainty through negotiating more balanced real estate purchase agreements.

higher purchase prices.

that sellers identify all litigation proceed-

“ The return of balance due to the changing market should allow buyers to negotiate more favorably cer tain hot button issues.”

transaction, want to own the property,

specific performance is the only remedy capable of putting the buyer back in the position the buyer would have been in but for the seller default. Furthermore, anything other than specific performance would make it too enticing for sellers to walk away from a binding contract in order to sell the property at a higher price even after the payment of liquidated damages to the first buyer. In today’s real estate market, this may not be an issue, so buyers should be able to negotiate specific performance. In the absence of such a provision, buyers may want to pay attention to the liquidated damages figure to create a deterrent for sellers from backing out of contracts for

SELLER REPRESENTATIONS AND WARRANTIES

Other than informing buyers of their organizational makeup and their author-ity to enter into a particular transaction, sellers have typically not made any mean-ingful representations concerning the property or its history. Sellers have been successful in refusing to make worthwhile representations while, at the same time, limiting diligence for buyers. In this chang-ing marketplace, there will be greater push back on sellers to make certain representations and warranties.

Representations from sellers concern-ing matters that buyers cannot adequate- ly examine through diligence may over time come to the forefront of negotiations between buyers and sellers. Although buyers may not be able to obtain unquali-fied representations from sellers, buyers may now be able to negotiate for repre- sentations concerning information known to the seller. In addition, because buyers do not want to inherit litigation when purchasing real estate, buyers could ask

ings involving the property or actions that may lead to future litigation. Lastly, buyers should consider that no matter how successful buyers are in receiving representations from sellers, without a survival period such representations may be meaningless. But, getting such a sur- vival period will continue to be a tough negotiation between buyers and sellers.

REMEDIESA real estate contract is essentially non-

binding when a buyer’s remedies, due to a seller’s default, do not provide for specific performance. Because liquidated damages do not adequately remedy buyers who, at the conclusion of the

buyers. While the hotel employees will be terminated simultaneously with the termination of the manager, for a host of practical and economic reasons, buyers (or their managers) typically rehire most of the existing employees. Subtlety is re-quired, as there often is an exodus of em-ployees and a general reduction in service quality once word gets out that the hotel is being sold. The termination of the em-ployees often will subject the transaction to the Work Adjustment and Retraining Notification Act (the “WARN Act”) and any equivalent state laws. The WARN Act sets forth certain notification require-ments in connection with any mass layoff and imposes penalties for failure to com-ply with these requirements. However, there are limited exceptions to the no-tification requirements, and, in many instances, the notification requirement may be waived if the buyers make offers of employment to a certain minimum number of existing employees on com-parable terms and conditions as the em-ployees’ prior arrangements. Transitioning vacation and sick time can also present thorny issues.

As a preliminary matter, buyers should inquire as to whether the hotel employees are union employees subject to a collec- tive bargaining agreement or if there are union-organizing activities ongoing. If there are, the union may have certain approval rights with regard to the sale of the hotel or the rehire of the employees.

REsource Spring2008

nvestors know the importance of con- ducting thorough due diligence in the acquisition of real estate assets. Gener ally speaking, the due diligence tasks for completed and stabilized projects are the same regardless of the type of assets to be acquired. For those evaluat-ing hotel assets, however, the due dili- gence tasks are greater, and these ex-panded investigations are crucial to under- standing not only the real estate being acquired, but the business that comes with it. For hotel assets, apart from the due diligence associated with tax structur- ing issues that arise if tax-exempt entities or REITs are involved, there are four main categories of additional due diligence required to evaluate both the real estate and the business: (i) branding; (ii) hotel management; (iii) employment matters; and (iv) operating licenses and permits. Each area must be evaluated for financial as well as legal consequences.

What’s Your Brand?While many consumers may be under

the impression that every Hilton, Marriott, and Hyatt is owned by the chains bear-ing the same name, in reality most hotels are not owned by the “flag”

associated with the hotels. Rather, institu- tional investors, REITs, and other third par-ties usually own the hotels and enter into licenses to associate the hotels with a particular hotel brand or chain. Like any brand driven business, the brand associ-ated with a hotel can enhance the value of the real estate asset. Brands known for luxury accommodations or a hip lifestyle can command higher room rates, but such luxury and lifestyle bring higher operating expenses and more frequent capital im- provement projects to remain associated with the brand.

In addition to brand value, real estate investors should evaluate the following:

• Termination rights and associated fees (characterized as liquidated damages) • The right of the licensor to grant additional licenses to other hotel owners and the right of the owners to own other hotels in geographic proximity to the hotel • The services that the licensor will pro- vide (e.g., national advertising, centralized reservation systems, award programs) • If the brand will change in connection with the sale (in some cases, a hotel guest will go to sleep in a Hyatt and wake up in a Hilton), who is responsible for removing signage, branded inventory, etc., and what is the time period for doing so?

is reluctant or unwilling to cooperate with the transition, which is often the case, especially where the prior management is affiliated with a brand that is exiting the hotel. Hotel management contracts almost never adequately address transi-tion issues, and so they are subject to negotiation, often right up to the closing. Transition issues include employment matters (discussed below), electronic transfer of guest room and function book- ings, marketing proposals and other infor-mation, and final accounting matters.

With respect to the existing manage-ment, the management agreement should be reviewed to assess whether it can be terminated (if the new owners desire to install their own managers) or assigned (if the new owners want to re- tain the managers). In either case, there may be certain fees and costs that are due to the managers. Whether the buyers or the sellers pay these fees is highly negotiable. In some instances, the hotel buyers will not have any choice as the hotel is subject to a long-term management agreement, especially where manage-ment is affiliated with the brand. Such a management agreement may be viewed as an asset or a hindrance to prospective buyers, depending on whether the buyers believe that they can better drive revenues with a different brand or management.

In any case, careful due diligence will help minimize the costs of the transition, avoid delays in closing, and maximize the return to the investor from the revenue-producing asset.

Fired and Rehired The third issue to assess in connection

with a hotel asset is employment matters. If the hotel manager is to be terminated at closing, the hotel employees will also be terminated as the employer cannot assign its rights to the employees to the

A union hotel may also be more expensive to operate than a non-union hotel and the financial underwriting for the future performance of the hotel will need to take into account these factors.

Permits, Licenses, & Revenues The final additional category of due

diligence in connection with a hotel acquisition involves operating permits and licenses. Room revenue is only one profit center for hotel assets; hotels often have other revenue sources that have unique licensing and permitting requirements. A typical example is a liquor license for hotel bars and restaurants, catering functions, room service, and in-room mini-bars. There are also spa or health club licenses, banquet and conference licenses, and pool or recreational facility permits. Obtaining copies of these permits and licenses is a key due diligence exer- cise to ensure the hotel is properly author- ized to generate revenue from these services. It is essential to retain competent liquor licensing counsel or other expertise to run the gauntlet of state and local requirements to ensure uninterrupted liquor service at the hotel.

Diligence is the Difference Acquiring operating hotel assets re-

quires additional due diligence that goes beyond an evaluation of the real property and the improvements. Failure to spend the required time, energy, and money on such additional tasks could result in unexpected and disappointing surprises following the closing. The purchase of existing hotel assets requires an evalua- tion of both the real estate and the operation of the hotel. The additional dili- gence could be the difference between a hotel that puts a mint on the pillow and a hotel that is itself a mint.

by: Benjamin Tschann and Christopher Barker

6

KEY ASPECTS of HOTEL REAL ESTATE DUE DILIGENCE

Christopher Barker is a partner in the Boston office of Goodwin Procter and can be reached at 617) 570-1462 or cbarker@goodwinprocter.com.

Benjamin Tschann is an associate in the San Francisco office of Goodwin Procter and can be reached at (415) 733-6051 or btschann@goodwinprocter.com.

Can I See the Manager?Sometimes the management company

affiliated with the brand will manage the hotel, but often the manager will be an affiliate of the owner or a third-party management company. Changes in man-agement of a hotel in connection with an acquisition can present unique challenges. The transition is not always seamless and can be quite rocky if the existing manager

“ The additional diligence could be the difference between a hotel that puts a mint on the

pillow and a hotel that is itself a mint.”

• Brand reputation and consumer demand • Licensing, marketing, reservations system, technical services, and other fees due to the licensor

• Assignment rights

• Required periodic property improvement plans (so-called “PIPs”), costs associated with PIPs, and the frequency with which the licensor may “re-PIP” the hotel and require the owner to make capital improvements to rooms, furnishings, and common areas

buyers. While the hotel employees will be terminated simultaneously with the termination of the manager, for a host of practical and economic reasons, buyers (or their managers) typically rehire most of the existing employees. Subtlety is re-quired, as there often is an exodus of em-ployees and a general reduction in service quality once word gets out that the hotel is being sold. The termination of the em-ployees often will subject the transaction to the Work Adjustment and Retraining Notification Act (the “WARN Act”) and any equivalent state laws. The WARN Act sets forth certain notification require-ments in connection with any mass layoff and imposes penalties for failure to com-ply with these requirements. However, there are limited exceptions to the no-tification requirements, and, in many instances, the notification requirement may be waived if the buyers make offers of employment to a certain minimum number of existing employees on com-parable terms and conditions as the em-ployees’ prior arrangements. Transitioning vacation and sick time can also present thorny issues.

As a preliminary matter, buyers should inquire as to whether the hotel employees are union employees subject to a collec- tive bargaining agreement or if there are union-organizing activities ongoing. If there are, the union may have certain approval rights with regard to the sale of the hotel or the rehire of the employees.

REsource Spring2008

nvestors know the importance of con- ducting thorough due diligence in the acquisition of real estate assets. Gener ally speaking, the due diligence tasks for completed and stabilized projects are the same regardless of the type of assets to be acquired. For those evaluat-ing hotel assets, however, the due dili- gence tasks are greater, and these ex-panded investigations are crucial to under- standing not only the real estate being acquired, but the business that comes with it. For hotel assets, apart from the due diligence associated with tax structur- ing issues that arise if tax-exempt entities or REITs are involved, there are four main categories of additional due diligence required to evaluate both the real estate and the business: (i) branding; (ii) hotel management; (iii) employment matters; and (iv) operating licenses and permits. Each area must be evaluated for financial as well as legal consequences.

What’s Your Brand?While many consumers may be under

the impression that every Hilton, Marriott, and Hyatt is owned by the chains bear-ing the same name, in reality most hotels are not owned by the “flag”

associated with the hotels. Rather, institu- tional investors, REITs, and other third par-ties usually own the hotels and enter into licenses to associate the hotels with a particular hotel brand or chain. Like any brand driven business, the brand associ-ated with a hotel can enhance the value of the real estate asset. Brands known for luxury accommodations or a hip lifestyle can command higher room rates, but such luxury and lifestyle bring higher operating expenses and more frequent capital im- provement projects to remain associated with the brand.

In addition to brand value, real estate investors should evaluate the following:

• Termination rights and associated fees (characterized as liquidated damages) • The right of the licensor to grant additional licenses to other hotel owners and the right of the owners to own other hotels in geographic proximity to the hotel • The services that the licensor will pro- vide (e.g., national advertising, centralized reservation systems, award programs) • If the brand will change in connection with the sale (in some cases, a hotel guest will go to sleep in a Hyatt and wake up in a Hilton), who is responsible for removing signage, branded inventory, etc., and what is the time period for doing so?

is reluctant or unwilling to cooperate with the transition, which is often the case, especially where the prior management is affiliated with a brand that is exiting the hotel. Hotel management contracts almost never adequately address transi-tion issues, and so they are subject to negotiation, often right up to the closing. Transition issues include employment matters (discussed below), electronic transfer of guest room and function book- ings, marketing proposals and other infor-mation, and final accounting matters.

With respect to the existing manage-ment, the management agreement should be reviewed to assess whether it can be terminated (if the new owners desire to install their own managers) or assigned (if the new owners want to re- tain the managers). In either case, there may be certain fees and costs that are due to the managers. Whether the buyers or the sellers pay these fees is highly negotiable. In some instances, the hotel buyers will not have any choice as the hotel is subject to a long-term management agreement, especially where manage-ment is affiliated with the brand. Such a management agreement may be viewed as an asset or a hindrance to prospective buyers, depending on whether the buyers believe that they can better drive revenues with a different brand or management.

In any case, careful due diligence will help minimize the costs of the transition, avoid delays in closing, and maximize the return to the investor from the revenue-producing asset.

Fired and Rehired The third issue to assess in connection

with a hotel asset is employment matters. If the hotel manager is to be terminated at closing, the hotel employees will also be terminated as the employer cannot assign its rights to the employees to the

A union hotel may also be more expensive to operate than a non-union hotel and the financial underwriting for the future performance of the hotel will need to take into account these factors.

Permits, Licenses, & Revenues The final additional category of due

diligence in connection with a hotel acquisition involves operating permits and licenses. Room revenue is only one profit center for hotel assets; hotels often have other revenue sources that have unique licensing and permitting requirements. A typical example is a liquor license for hotel bars and restaurants, catering functions, room service, and in-room mini-bars. There are also spa or health club licenses, banquet and conference licenses, and pool or recreational facility permits. Obtaining copies of these permits and licenses is a key due diligence exer- cise to ensure the hotel is properly author- ized to generate revenue from these services. It is essential to retain competent liquor licensing counsel or other expertise to run the gauntlet of state and local requirements to ensure uninterrupted liquor service at the hotel.

Diligence is the Difference Acquiring operating hotel assets re-

quires additional due diligence that goes beyond an evaluation of the real property and the improvements. Failure to spend the required time, energy, and money on such additional tasks could result in unexpected and disappointing surprises following the closing. The purchase of existing hotel assets requires an evalua- tion of both the real estate and the operation of the hotel. The additional dili- gence could be the difference between a hotel that puts a mint on the pillow and a hotel that is itself a mint.

by: Benjamin Tschann and Christopher Barker

6

KEY ASPECTS of HOTEL REAL ESTATE DUE DILIGENCE

Christopher Barker is a partner in the Boston office of Goodwin Procter and can be reached at 617) 570-1462 or cbarker@goodwinprocter.com.

Benjamin Tschann is an associate in the San Francisco office of Goodwin Procter and can be reached at (415) 733-6051 or btschann@goodwinprocter.com.

Can I See the Manager?Sometimes the management company

affiliated with the brand will manage the hotel, but often the manager will be an affiliate of the owner or a third-party management company. Changes in man-agement of a hotel in connection with an acquisition can present unique challenges. The transition is not always seamless and can be quite rocky if the existing manager

“ The additional diligence could be the difference between a hotel that puts a mint on the

pillow and a hotel that is itself a mint.”

• Brand reputation and consumer demand • Licensing, marketing, reservations system, technical services, and other fees due to the licensor

• Assignment rights

• Required periodic property improvement plans (so-called “PIPs”), costs associated with PIPs, and the frequency with which the licensor may “re-PIP” the hotel and require the owner to make capital improvements to rooms, furnishings, and common areas

REsource Spring2008

8

of the aggregate required capital and the capital funded by the funding partner on behalf of the defaulting partner. Such contribution should then earn a return sufficient to compensate the funding partner for making such priority contribution. If such priority contribution equals only the capital that the defaulting partner failed to fund (which is a mistake often found in real estate joint venture agreements), then the funding partner will repay to itself a portion of the capital that the defaulting partner failed to fund, thereby yield-ing a windfall to the defaulting partner.

For example, assume that venture contributions are made by, and cash is distributed to, Partner A and Partner B on a 50/50 basis. The venture calls for $100 of additional capital, and Partner A contributes its share of required capital ($50) and Partner B’s share of required capital ($50) due to Partner B’s failure to contribute. If only the $50 contributed by Partner A on behalf of Partner B (as opposed to the entire $100 contributed by Partner A) is treated as a priority contribution, and immedi- ately after such priority contribution is made, the venture distributes $50 in cash, then $25 that would have been other- wise distributed to Partner A will be used to pay the priority contribution, and Partner B effectivly pays only $25 when it should have contributed $50 to the venture. This example simplistically demonstrates the attention required when draft- ting such provisions in joint venture agreements.

Expect the Unexpected Capital to sustain a venture is a paramount concern for

the venture’s viability; this is particularly true during troubled times. Partners must expect the unexpected and carefully scrutinize the capitalization provisions of their joint venture agreements to ensure that their agreements accurately reflect the intentions of the partners and that their interests are appropriately protected.

Practical Remedies for Failure to ContributeMany partners focus on rights that are not normally exer-

cised and overlook other rights that ultimately become more relevant. For example, partners often heavily negotiate compli-cated “squeeze down” rights (i.e., the right of a funding part-ner to receive a disproportionate share of the venture’s profits due to the non-funding partner’s failure to make a required contribution). However, the right to squeeze down a partner’s profits is not a useful remedy if the venture yields no profits, which is often the case in situations where the venture requires additional unanticipated capital and a partner fails to make its required capital contribution.

Instead, more appropriate and useful remedies might be (i) the right to make a priority loan or capital contribution to the venture payable from distributable cash of the venture before other distributions are made to the partners, or (ii) the right to make a loan to the defaulting partner payable from cash otherwise distributable to such defaulting part-ner. If the aggregate capitalization of the venture will, at least for some time, exceed the aggregate fair market value of the venture’s assets such as in a pre-development joint ven- ture, the partners may want to provide that any loans made by a funding partner to the defaulting partner will be guaranteed by a creditworthy affiliate of the defaulting partner.

Although the right to make a loan to the venture or defaulting partner is the remedy that a funding partner will typically exercise in the event that the non-funding partner fails to make its required capital contribution, partners often overlook legal restrictions of general applicability on such loans, including state usury laws and licensing requirements, such as those stipulated under California’s Finance Lender’s Law. For example, absent the application of an exemption to usury or a usury savings clause, a loan made by one partner to the other partner pursuant to the joint venture agreement may violate state usury laws if the interest on such loan exceeds the legal limit (which is usually the case) and, depen- ding on the jurisdiction, the making of such loan may subject the funding partner to significant penalties. Note, however, that loans made to the venture rather than the defaulting partner may be characterized as priority capital contributions in order to avoid the application of such lending laws.

If the venture agreement provides, as a remedy for the failure of one partner to make a required contribution, the right of the funding partner to make a priority loan or contribution to the venture, then such contribution should equal both the capital funded by the funding partner in respect of its share

Defining Capital Requirements

Because real estate joint ventures are typically formed con- currently with an acquisition of real property or at the incep- tion of a development project, venture partners understand- ably focus on the initial capitalization necessary to acquire the property or complete the development of the project. But what if additional capital is required to satisfy unanticipated needs after acquisition or development? For example, in the current market, ventures may have difficulty refinancing existing debt that comes due at the same loan-to-value ratios that were customary when such debt was first obtained.

In analyzing matters related to the funding of additional capital, partners should carefully consider:

• Who will have the right to determine whether additional capital is needed or to “call” such capital, and should any such capital call require the prior approval of the other partners?

• If a partner is an investment fund or other entity whose authorization to enter into the venture is limited to a maximum dollar amount, how will the obligation to fund additional capital affect such authorization and should such entity’s capital obligations be capped?

• Should additional capital funding be optional or oblig- atory? If optional, how will the venture secure any cash that is needed to sustain the venture and its business? If obligatory, what will be the remedies for the failure to make a required contribution?

There are no standard or simple answers to these questions. The resolution of these issues will vary from one venture to another depending on the nature of a venture’s assets and its business and the identity and bargaining leverage of the partners. However, as the recent radical and rapid shift of the capital markets shows, partners must anticipate the unexpected and thoroughly consider and address each of the questions above, and others, when negotiating their joint venture agreements.

Dean Pappas is a partner in the Los Angeles office of Goodwin Procter and can be reached at (213) 426-2525 ordpappas@goodwinprocter.com. Hamilton Tran is an associate in the Los Angeles office of Goodwin Procter and can be reached at (213) 426-2528or htran@goodwinprocter.com.

As the allocation of global investment capital to real estate has increased in recent years, joint ventures between capital partners and devel- oper partners have become commonplace in real estate transactions, making joint venture agree- ments familiar real estate documents. Familiar as they may be, however, many joint venture agree- ments overlook or do not adequately address critical issues that often arise during the joint venture relationship. One basic but significant provision found in joint venture agreements is capitalization – the funding of the venture by its partners. Capitalization will become even more significant in the current volatile real estate and credit markets as traditional debt financing becomes scarcer and the infusion of equity may be the only means to sustain joint ventures.

“Capital to sustain a venture is a paramount concern for the venture’s viability....”

by Dean Pappas and Hamilton Tran

Issues in Joint Venture Capitalization

REsource Spring2008

8

of the aggregate required capital and the capital funded by the funding partner on behalf of the defaulting partner. Such contribution should then earn a return sufficient to compensate the funding partner for making such priority contribution. If such priority contribution equals only the capital that the defaulting partner failed to fund (which is a mistake often found in real estate joint venture agreements), then the funding partner will repay to itself a portion of the capital that the defaulting partner failed to fund, thereby yield-ing a windfall to the defaulting partner.

For example, assume that venture contributions are made by, and cash is distributed to, Partner A and Partner B on a 50/50 basis. The venture calls for $100 of additional capital, and Partner A contributes its share of required capital ($50) and Partner B’s share of required capital ($50) due to Partner B’s failure to contribute. If only the $50 contributed by Partner A on behalf of Partner B (as opposed to the entire $100 contributed by Partner A) is treated as a priority contribution, and immedi- ately after such priority contribution is made, the venture distributes $50 in cash, then $25 that would have been other- wise distributed to Partner A will be used to pay the priority contribution, and Partner B effectivly pays only $25 when it should have contributed $50 to the venture. This example simplistically demonstrates the attention required when draft- ting such provisions in joint venture agreements.

Expect the Unexpected Capital to sustain a venture is a paramount concern for

the venture’s viability; this is particularly true during troubled times. Partners must expect the unexpected and carefully scrutinize the capitalization provisions of their joint venture agreements to ensure that their agreements accurately reflect the intentions of the partners and that their interests are appropriately protected.

Practical Remedies for Failure to ContributeMany partners focus on rights that are not normally exer-

cised and overlook other rights that ultimately become more relevant. For example, partners often heavily negotiate compli-cated “squeeze down” rights (i.e., the right of a funding part-ner to receive a disproportionate share of the venture’s profits due to the non-funding partner’s failure to make a required contribution). However, the right to squeeze down a partner’s profits is not a useful remedy if the venture yields no profits, which is often the case in situations where the venture requires additional unanticipated capital and a partner fails to make its required capital contribution.

Instead, more appropriate and useful remedies might be (i) the right to make a priority loan or capital contribution to the venture payable from distributable cash of the venture before other distributions are made to the partners, or (ii) the right to make a loan to the defaulting partner payable from cash otherwise distributable to such defaulting part-ner. If the aggregate capitalization of the venture will, at least for some time, exceed the aggregate fair market value of the venture’s assets such as in a pre-development joint ven- ture, the partners may want to provide that any loans made by a funding partner to the defaulting partner will be guaranteed by a creditworthy affiliate of the defaulting partner.

Although the right to make a loan to the venture or defaulting partner is the remedy that a funding partner will typically exercise in the event that the non-funding partner fails to make its required capital contribution, partners often overlook legal restrictions of general applicability on such loans, including state usury laws and licensing requirements, such as those stipulated under California’s Finance Lender’s Law. For example, absent the application of an exemption to usury or a usury savings clause, a loan made by one partner to the other partner pursuant to the joint venture agreement may violate state usury laws if the interest on such loan exceeds the legal limit (which is usually the case) and, depen- ding on the jurisdiction, the making of such loan may subject the funding partner to significant penalties. Note, however, that loans made to the venture rather than the defaulting partner may be characterized as priority capital contributions in order to avoid the application of such lending laws.

If the venture agreement provides, as a remedy for the failure of one partner to make a required contribution, the right of the funding partner to make a priority loan or contribution to the venture, then such contribution should equal both the capital funded by the funding partner in respect of its share

Defining Capital Requirements

Because real estate joint ventures are typically formed con- currently with an acquisition of real property or at the incep- tion of a development project, venture partners understand- ably focus on the initial capitalization necessary to acquire the property or complete the development of the project. But what if additional capital is required to satisfy unanticipated needs after acquisition or development? For example, in the current market, ventures may have difficulty refinancing existing debt that comes due at the same loan-to-value ratios that were customary when such debt was first obtained.

In analyzing matters related to the funding of additional capital, partners should carefully consider:

• Who will have the right to determine whether additional capital is needed or to “call” such capital, and should any such capital call require the prior approval of the other partners?

• If a partner is an investment fund or other entity whose authorization to enter into the venture is limited to a maximum dollar amount, how will the obligation to fund additional capital affect such authorization and should such entity’s capital obligations be capped?

• Should additional capital funding be optional or oblig- atory? If optional, how will the venture secure any cash that is needed to sustain the venture and its business? If obligatory, what will be the remedies for the failure to make a required contribution?

There are no standard or simple answers to these questions. The resolution of these issues will vary from one venture to another depending on the nature of a venture’s assets and its business and the identity and bargaining leverage of the partners. However, as the recent radical and rapid shift of the capital markets shows, partners must anticipate the unexpected and thoroughly consider and address each of the questions above, and others, when negotiating their joint venture agreements.

Dean Pappas is a partner in the Los Angeles office of Goodwin Procter and can be reached at (213) 426-2525 ordpappas@goodwinprocter.com. Hamilton Tran is an associate in the Los Angeles office of Goodwin Procter and can be reached at (213) 426-2528or htran@goodwinprocter.com.

As the allocation of global investment capital to real estate has increased in recent years, joint ventures between capital partners and devel- oper partners have become commonplace in real estate transactions, making joint venture agree- ments familiar real estate documents. Familiar as they may be, however, many joint venture agree- ments overlook or do not adequately address critical issues that often arise during the joint venture relationship. One basic but significant provision found in joint venture agreements is capitalization – the funding of the venture by its partners. Capitalization will become even more significant in the current volatile real estate and credit markets as traditional debt financing becomes scarcer and the infusion of equity may be the only means to sustain joint ventures.

“Capital to sustain a venture is a paramount concern for the venture’s viability....”

by Dean Pappas and Hamilton Tran

Issues in Joint Venture Capitalization

the income tax leakage, make investing in income-producing assets such as hotels through a REIT more complex and expen-sive. In the current market, however, it is a price that fund sponsors seem willing to pay.

Dealer IncomeAvoidance of so-called “dealer income”

is another issue that confronts REITs. As a general rule, REITs are supposed to receive income from the ownership of real estate held for investment rather than from act-ing as “dealers in property,” and the IRS imposes significant penalties on REITs that receive dealer income. Typical examples of transactions that can trigger dealer income are the sale of individual condominium units in a development deal, the sale of outpar-cels or pads in a retail investment, or the triggering of an early forced sale in a joint venture. While there are a number of rules relating to the “dealer” issue, one safe har-bor that has been established is for REITs to hold investments for a period of four years after they are “put in service” before dispo-sition. Another possible solution may be to

structure such a transaction as a debt investment rather than as an equity investment.

Wanted: Creative Problem-Solving

It does not appear at present that alloca-tions of capital to real estate funds are being curtailed, and fund sponsors do not appear to have slowed down their fund-raising ef-forts. In fact, it is possible that even more diverse sources of capital may flow into commingled real estate funds as a wider range of overseas investors seek to take ad-vantage of the currently weak U.S. currency and relatively stable U.S. commercial real estate market. Couple this with fund spon-sors having to consider a wider range of in-vestment opportunities in order to achieve their targeted return (including investing in jurisdictions outside the U.S.), and the prog-nosis appears to be for greater complexity in deal structuring and the need for creative problem solving.

The e x i s -tence of publ ic ly- traded real estate invest- ment trusts (REITs) and the proliferation of commingled real estate investment funds has made investing in institutional-quality real estate increasingly mainstream and available to a wider class of investors. Fund sponsors in particular, through the use of creative struc-turing, have been able to access a diverse array of capital sources and have given real estate a prominent seat at the capital markets table.

To attract capital from investors as diverse as governmental and corporate pension plans, U.S. and overseas insurance compa-nies, university endowments, private foun-dations, and sovereign wealth funds acting on behalf of foreign governments, fund sponsors typically use a variety of structures including “blocker entities” and private REITs to marry their capital with their invest-ment strategy by accounting for investors’ tax and regulatory requirements. While the goal is to attract the greatest amount of cap-ital into their funds, the tradeoffs sponsors face are less flexibility, greater complexity, and increased costs when actually making investments.

Blocker Entities and REITS Fund sponsors often use corporate

blocker entities to change the character of

REsource Spring2008

Christopher Price is apartner in the New York office of Goodwin Procter and can be reached at (212) 813-8951 or cbprice@goodwinprocter.com. Rishi Sehgal is an associate in the New York office of Goodwin Procter and can be reached at (212) 813-8849 or rsehgal@goodwinprocter.com.

real estate investment can mitigate these adverse tax consequences and the admin-istrative requirements associated with the imposition of certain taxes.

To address tax issues for non-U.S. and U.S. tax-exempt investors, many funds choose to include a privately-held REIT at some level in the fund structure. By con-verting the character of income and gains from U.S. real estate, REITs can effectively solve a host of tax and regulatory issues that affect a broad range of potential inves-tors, such as those sensitive to UBTI, those

not wanting to bear the burden of filing separate state tax returns, and those non- U.S. investors concerned about effectively-connected income. In addition, the use of REITs, when coupled with certain non-US investors’ status, treaties, or dispositions by selling REIT stock as opposed to real prop-erty may address FIRPTA tax concerns.

While one or more REITs in a fund may solve a number of investor issues, specific tailoring is required for a fund to acquire many types of real estate assets that offer attractive investment opportunities while still complying with the regulatory require-ments that govern REITs. These require-ments include (i) limitations on types of as-sets held and the character of REIT income, (ii) holding periods for investments, and (iii) consideration of exit strategies.

6 10

income derived from an investment. For example, income generated by a U.S. real estate investment and allocated to certain non-U.S. investors can result in adverse tax consequences to such investors. These consequences depend on the nature of the investments and the jurisdiction of residence or status of the investors and

may include the generation of income “effectively-connected” with a U.S. trade or business (i.e., a non-U.S. person being deemed engaged in a U.S. trade or busi-ness and subject to tax at regular income tax rates), including taxes imposed under certain provisions of the Foreign Invest-ment in Real Property Tax Act (FIRPTA) on the disposition of real property, and the im-position of a “branch profits” tax (an addi-tional tax imposed on corporate investors that are treated as engaged in business in the United States). U.S. investors that are otherwise tax-exempt may be subject to tax on unrelated business taxable income (UBTI) as a result of a real estate invest-ment. The interposing of a suitable corpo-rate blocker entity into the structure of a

“ Fund sponsors use a variety of structures... to marry their capital with their investment strategy....”

Taxable REIT Subsidiaries While the REIT rules present a

minefield for acquisition specialists at real estate funds and the damage caused by tripping one of the mines can be eco-nomically severe, a number of structuring solutions are available for investments that might otherwise not be eligible to be held in a REIT. Examples include investments in assets that are primarily real estate but that also constitute operating businesses, such as hotels. While the underlying asset is real estate, the income that is derived from the asset is not considered rental income but rather operating income from a trade or business. To convert this income into good rental income, a separate taxable subsid-iary, often wholly owned by the REIT (a “TRS”), can be created to lease the asset from the REIT. Because the REIT rules do not allow the TRS to operate the business itself, the TRS must enter into a third-party management or franchise agreement.

The TRS collects operating revenue and pays the operating expenses and capital improvement costs of the asset and then pays rent to the REIT, which is an expense against the income of the TRS. Rental pay-ments cannot be performance-based and careful consideration must be paid to valu-ation of real and personal property of the asset and the income forecasts of the as-set. Because the TRS is a taxable entity, the income it earns from the operation of the asset is subject to applicable income taxes, which results in tax “leakage” in the structure. Additional documentation, administrative costs associated with mul-tiple entities, and structuring that may be required to satisfy a mortgage lender along with negotiating difficulties that may arise with a joint venture partner, not to mention

income derived from an investment. For example, income generated by a U.S. real estate investment and allocated to certain non-U.S. investors can result in adverse tax consequences to such investors. These consequences depend on the nature of the investments and the jurisdiction of residence or status of the investors and

may include the generation of income “effectively-connected” with a U.S. trade or business (i.e., a non-U.S. person being deemed engaged in a U.S. trade or busi-ness and subject to tax at regular income tax rates), including taxes imposed under certain provisions of the Foreign Invest-ment in Real Property Tax Act (FIRPTA) on the disposition of real property, and the imposition of a “branch profits” tax (an ad-ditional tax imposed on corporate investors that are treated as engaged in business in the United States). U.S. investors that are otherwise tax-exempt may be subject to tax on unrelated business taxable income (UBTI) as a result of a real estate invest-ment. The interposing of a suitable corpo-rate blocker entity into the structure of a real estate investment can mitigate these

the income tax leakage, make investing in income-producing assets such as hotels through a REIT more complex and expen-sive. In the current market, however, it is a price that fund sponsors seem willing to pay.

Dealer IncomeAvoidance of so-called “dealer income”

is another issue that confronts REITs. As a general rule, REITs are supposed to receive income from the ownership of real estate held for investment rather than from act-ing as “dealers in property,” and the IRS imposes significant penalties on REITs that receive dealer income. Typical examples of transactions that can trigger dealer income are the sale of individual condominium units in a development deal, the sale of outpar-cels or pads in a retail investment, or the triggering of an early forced sale in a joint venture. While there are a number of rules relating to the “dealer” issue, one safe har-bor that has been established is for REITs to hold investments for a period of four years after they are “put in service” before dispo-sition. Another possible solution may be to

structure such a transaction as a debt investment rather than as an equity investment.

Wanted: Creative Problem-Solving

It does not appear at present that alloca-tions of capital to real estate funds are being curtailed, and fund sponsors do not appear to have slowed down their fund-raising ef-forts. In fact, it is possible that even more diverse sources of capital may flow into commingled real estate funds as a wider range of overseas investors seek to take ad-vantage of the currently weak U.S. currency and relatively stable U.S. commercial real estate market. Couple this with fund spon-sors having to consider a wider range of in-vestment opportunities in order to achieve their targeted return (including investing in jurisdictions outside the U.S.), and the prog-nosis appears to be for greater complexity in deal structuring and the need for creative problem solving.

The e x i s -tence of publ ic ly- traded real estate invest- ment trusts (REITs) and the proliferation of commingled real estate investment funds has made investing in institutional-quality real estate increasingly mainstream and available to a wider class of investors. Fund sponsors in particular, through the use of creative struc-turing, have been able to access a diverse array of capital sources and have given real estate a prominent seat at the capital markets table.

To attract capital from investors as diverse as governmental and corporate pension plans, U.S. and overseas insurance compa-nies, university endowments, private foun-dations, and sovereign wealth funds acting on behalf of foreign governments, fund sponsors typically use a variety of structures including “blocker entities” and private REITs to marry their capital with their invest-ment strategy by accounting for investors’ tax and regulatory requirements. While the goal is to attract the greatest amount of cap-ital into their funds, the tradeoffs sponsors face are less flexibility, greater complexity, and increased costs when actually making investments

Blocker Entities and REITS Fund sponsors often use corporate

blocker entities to change the character of

REsource Spring2008

Christopher Price is apartner in the New York office of Goodwin Procter and can be reached at (212) 813-8951 or cbprice@goodwinprocter.com. Rishi Sehgal is an associate in the New York office of Goodwin Procter and can be reached at (212) 813-8849 or rsehgal@goodwinprocter.com.

real estate investment can mitigate these adverse tax consequences and the admin-istrative requirements associated with the imposition of certain taxes.

To address tax issues for non-U.S. and U.S. tax-exempt investors, many funds choose to include a privately-held REIT at some level in the fund structure. By con-verting the character of income and gains from U.S. real estate, REITs can effectively solve a host of tax and regulatory issues that affect a broad range of potential inves-tors, such as those sensitive to UBTI, those

not wanting to bear the burden of filing separate state tax returns, and those non- U.S. investors concerned about effectively-connected income. In addition, the use of REITs, when coupled with certain non-US investors’ status, treaties, or dispositions by selling REIT stock as opposed to real prop-erty may address FIRPTA tax concerns.

While one or more REITs in a fund may solve a number of investor issues, specific tailoring is required for a fund to acquire many types of real estate assets that offer attractive investment opportunities while still complying with the regulatory require-ments that govern REITs. These require-ments include (i) limitations on types of as-sets held and the character of REIT income, (ii) holding periods for investments, and (iii) consideration of exit strategies.

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income derived from an investment. For example, income generated by a U.S. real estate investment and allocated to certain non-U.S. investors can result in adverse tax consequences to such investors. These consequences depend on the nature of the investments and the jurisdiction of residence or status of the investors and

may include the generation of income “effectively-connected” with a U.S. trade or business (i.e., a non-U.S. person being deemed engaged in a U.S. trade or busi-ness and subject to tax at regular income tax rates), including taxes imposed under certain provisions of the Foreign Invest-ment in Real Property Tax Act (FIRPTA) on the disposition of real property, and the im-position of a “branch profits” tax (an addi-tional tax imposed on corporate investors that are treated as engaged in business in the United States). U.S. investors that are otherwise tax-exempt may be subject to tax on unrelated business taxable income (UBTI) as a result of a real estate invest-ment. The interposing of a suitable corpo-rate blocker entity into the structure of a

“ Fund sponsors use a variety of structures... to marry their capital with their investment strategy....”

Taxable REIT Subsidiaries While the REIT rules present a

minefield for acquisition specialists at real estate funds and the damage caused by tripping one of the mines can be eco-nomically severe, a number of structuring solutions are available for investments that might otherwise not be eligible to be held in a REIT. Examples include investments in assets that are primarily real estate but that also constitute operating businesses, such as hotels. While the underlying asset is real estate, the income that is derived from the asset is not considered rental income but rather operating income from a trade or business. To convert this income into good rental income, a separate taxable subsid-iary, often wholly owned by the REIT (a “TRS”), can be created to lease the asset from the REIT. Because the REIT rules do not allow the TRS to operate the business itself, the TRS must enter into a third-party management or franchise agreement.

The TRS collects operating revenue and pays the operating expenses and capital improvement costs of the asset and then pays rent to the REIT, which is an expense against the income of the TRS. Rental pay-ments cannot be performance-based and careful consideration must be paid to valu-ation of real and personal property of the asset and the income forecasts of the as-set. Because the TRS is a taxable entity, the income it earns from the operation of the asset is subject to applicable income taxes, which results in tax “leakage” in the structure. Additional documentation, administrative costs associated with mul-tiple entities, and structuring that may be required to satisfy a mortgage lender along with negotiating difficulties that may arise with a joint venture partner, not to mention

income derived from an investment. For example, income generated by a U.S. real estate investment and allocated to certain non-U.S. investors can result in adverse tax consequences to such investors. These consequences depend on the nature of the investments and the jurisdiction of residence or status of the investors and

may include the generation of income “effectively-connected” with a U.S. trade or business (i.e., a non-U.S. person being deemed engaged in a U.S. trade or busi-ness and subject to tax at regular income tax rates), including taxes imposed under certain provisions of the Foreign Invest-ment in Real Property Tax Act (FIRPTA) on the disposition of real property, and the imposition of a “branch profits” tax (an ad-ditional tax imposed on corporate investors that are treated as engaged in business in the United States). U.S. investors that are otherwise tax-exempt may be subject to tax on unrelated business taxable income (UBTI) as a result of a real estate invest-ment. The interposing of a suitable corpo-rate blocker entity into the structure of a real estate investment can mitigate these

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