Baker & McKenzie: Are you looking to co-invest in Australian property?

The Legal Basis of Co-ownership

Where two or more entities hold land they are referred to as "tenants in common", each owning a proportionate interest in the land.  For example, on a 50/50 basis, each entity has a 50% interest, which is separate and distinct from the other party.  However, each 50% interest is not identifiable in a physical sense, and each tenant in common is entitled to their interest in the entirety of the land (unless otherwise agreed).

Subject to any agreement to the contrary (as set out below, co-ownership agreements should and usually do regulate these matters), a tenant in common may deal with their proportionate interest in the land as it chooses, without its co-owner's consent.  This includes selling, leasing and mortgaging its interest – again not with reference to any particular physical part of the property, but only to its 50% interest in the property as a whole.

Part 1 – Commercial aspects of co-ownership

Why Co-own property?

In our experience, there are various reasons for this including:

●    Insufficient available equity – a party's lack of capital required to acquire the commercial property alone. It can also be viewed from the perspective of maximising the utility of limited equity resources.

●    Experience sharing – often a party inexperienced in property ownership in a particular jurisdiction (such as a foreign party) or sector will wish to partner with a party with a track record for successful property ownership in that jurisdiction or sector.

●    Strategic alliances – this is a variation on the experience sharing model, where the intention is that the particular property ownership opportunity under consideration will allow the parties to "get to know each other" with the prospect of more extensive and mutually beneficial opportunities in other jurisdictions in the future.

There are many other valid reasons why it might make sense in any given situation to co-own property. The overarching factor, of course, is the need to give serious consideration to the added commercial and management stress that co-ownership can bring to property ownership. This is to ensure that the union will be both harmonious and beneficial for all concerned.

Good and bad co-owner qualities

Obviously, the best prospective co-owner is a party with whom property has been successfully co-owned in the past.  However, for new participants, this tends to be less of a black and white question to be viewed in absolute terms and more of a question of relative compatibility of the particular co-owners.

In our view, there should be an alignment of approach both as to matters which need to be dealt with whilst the property is co-owned and also on an appropriate exit strategy.  While comprehensive legal documents are beneficial to help manage this alignment, we do not consider that this should substitute for ensuring that the "chemistry" is right between the parties, and determining this fit at first will take a significant commitment of time and resources on both sides.

Ideally, each party will undertake appropriate due diligence enquiries of the other to ensure that the evidence suggests that there will be a positive alignment of interests, and to properly assess the strengths and weaknesses of each other.

Factors which should be taken into consideration in determining the suitability of a potential co-owner include:

●    A history of conflict with business partners and associates, particularly an overzealous desire to litigate in conflict situations. This will usually be a fairly rare occurrence. More often, this will manifest through a difficulty to find any past business associate prepared to comment favourably on their business dealings.

●    The business and operational cultures of the prospective co-owner. Every organisation has a specific way of conducting business. In a co-ownership situation, it is important that the business processes of the co-owners are sufficiently harmonious to minimise the risk that differences will cause irritation or outright dispute. We have witnessed this disparity most acutely in situations where an entrepreneurial organisation seeks to team up with an institutional investor in circumstances where they each have completely different decision making processes and/or investment horizons.

●    A desire by a potential co-owner to primarily focus on matters, which are specific to that co-owner (such as the maximising of fees for services provided on the property) at the cost of maximising the value of the property as a whole.

●    The systems a party has in place for dealing with, and responding to, enquiries and general communications. In our experience, there is nothing worse or potentially destructive to a successful co-ownership experience than a co-owner who lacks the ability to communicate positively and effectively.

Attributes of a workable and effective arrangement

Anecdotal evidence suggests that this is a combination of two key factors. First, there needs to be an open and frank approach by representatives of each of the co-owners to discuss issues, and particularly divisive issues, at the earliest possible opportunity in a positive and thoughtful manner. Secondly, while a comprehensive and carefully drafted co-ownership agreement is generally considered to be necessary, it should not contain any "hair trigger" default provisions, which would incline either of the parties to resort to a legal solution in preference to a negotiated outcome when disputes arise.

There is a balance to be achieved here. On the one hand, if a problem arises then the parties should be motivated to pick up the phone and seek to resolve it informally, rather than resort to more formal and potentially less predictable avenues. On the other hand, if after a reasonable amount of discussion, it appears clear that the co-owners have reached a position of irreconcilable differences, the co-ownership agreement should provide a swift and definitive strategy for resolution or exit.

In our experience, one of the most effective strategies is to entrench a regular informal forum of key executives from each co-owner, which is convened for the purpose of discussing all relevant potential issues. This tends to identify potential disputes at a fairly early stage and maximise the prospect that they will be resolved before escalating. If this forum is unable to resolve any matters then, before recourse to external dispute resolution, there should be a mechanism to elevate the dispute to more senior executives representing each co-owner, ideally people who are not involved in the day to day dealings between the co-owners.

Dealings with financiers and other third parties

Dealings between a lender and a borrower always need to be undertaken with a degree of finesse and skill. This is increased if the borrower happens to be two or more co-owners, or even where only one co-owner is involved, but the parties are looking to tie the lender (or syndicate of lenders) into the legal co-ownership arrangements in the event of them stepping into the shoes of the co-owner in a default situation.

Once again, in our experience, thoughtful and positive communication augmented by well thought through documentation appears to be the most successful means to deal with the dynamics of such a potentially volatile situation.

Part 2 – Legal Drafting and Key Touch-Points

Background

Below is a short summary of some of the core legal provisions which can be expected in agreements governing co-ownership arrangements in Australia. We have referred particularly to those provisions aimed at preventing a fundamental breakdown in co-ownership arrangements, as well as provisions the negotiation of which, can often provide some insight into the compatibility of co-owners on the sort of issues discussed in Part 1.

Co-ownership Laws in New South Wales

Land laws governing co-ownership of land in Australia comprise state and territory based legislation. Generally speaking, these laws are consistent across the jurisdictions and substantially reflect the principles discussed below, which are focussed on New South Wales legislation. There will be minor differences from jurisdiction to jurisdiction.

Two of the key principles that have been established on the rights and obligations between co-owners are:

(a)  each co-owner is entitled to use and occupy the entire property, but must also permit each other co-owner to do the same without demanding rent or occupation fees from them; and

(b)  if one co-owner spends money in carrying out necessary repairs and maintaining the property without the consent of the other co-owner, that co-owner cannot force the other to contribute for the expenses paid for by that co-owner. In some cases, however, it may be that the co-owner incurring the expenditure can recover from the others the amount by which the improvements have increased the value of the property.

Apart from the above, the law is relatively uncertain when it comes to regulating rights between co-owners. For this reason, it is advisable for co-owners to enter into a co-ownership agreement or other legally binding arrangement to regulate both critical and day-to-day matters.

Legal variations of co-ownership

Co-ownership arrangements can take various forms but most commonly occur as an incorporated or unincorporated investment venture. We have not attempted to summarise the reasons for the choice of one of these structures over the other, as they depend on a large variety of transaction specific considerations. This includes, for example, the parties' existing corporate structure, the structure in which the asset is held before acquisition and the investment horizons of the co-owners.

●    Incorporated co-ownership arrangements

For example, where the parties agree to set up a company or unit trust and channel their investment activity through that entity. The co-ownership agreement in these circumstances takes the form of a "shareholders' agreement" or "unit holders' agreement". The relevant investment will be held by a single entity (i.e. the company or the trustee of the unit trust) and the co-ownership agreement will include provisions regulating how a party deals with their shares or interests in that entity, as well as the more normal operational issues associated with co-ownership of a property.

●    Unincorporated

This is simply an agreement or informal arrangement between parties to co-invest without the use of any jointly owned or controlled corporate vehicle or trust. Co-ownership agreements in this case are more likely to be produced on a property by property basis.

The reasons why the parties will opt for one structure over another generally do not have much to do with the commercial imperatives. Usually, the choice is driven by issues such as tax, partnership law or ease of transacting. In Australia, most co-ownership arrangements are based on the unincorporated model.

Co-ownership Agreements

A co-ownership agreement in its simplest form, is an agreement through which co-owners aim to deal with all of the matters regulating management and control of a co-invested asset that may arise between them during the course of their ownership. These matters should primarily include:

(a)  Co-ownership committee: establishing a co-owners committee made up of representatives from the owners, which meets regularly to make decisions on matters affecting the building, much like a board of directors for a company.

(b)  Joint decisions and disputes: this process has already been discussed in Part 1. At first instance, where the co-owners cannot reach a unanimous decision, disputes should go to a co-ownership committee. Following any failure of the committee to resolve the dispute, each co-owner should have already appointed its managing director or a board member, to further consider and attempt to resolve the dispute with their counterpart/s.

If there is a failure at that secondary level, an expert (who will either be pre-nominated in the agreement or selected based upon clear principles in the agreement relating to the particular type of dispute) can then be given the power to make a decision. This decision is usually binding unless the subject matter exceeds an agreed amount and one of the parties indicates that they intend to start legal proceedings rather than accept the decision. Agreed amounts vary significantly from deal to deal but we have seen figures ranging from $100,000 up to $5 million. The principle is to try and discourage parties from litigating, and create a financial incentive to try and resolve any disputes in good faith.

(c)  Pre-emptive rights: these involve restrictions on dealing with an owners' interest in the land (or in shares/units in the land-holding entity), usually by way of a "first right of refusal" (i.e. any owner intending to sell their interest has to offer it to their co-owner first) together with a right to approve any proposed transferee, lessee or purchaser of the relevant interest if the right of first refusal is not taken up.

Limited exceptions can be allowed where the proposed transfer is to a related body corporate (or to a trust or fund) where the co-owner or its related body corporate is the manager, trustee or responsible entity of the trust or fund. These exceptions can vary substantially between co-ownership agreements and are often the most contentious part of these negotiations.

(d)  Division of rights: it is possible to either allow parties to further divide their rights, or restrict them from doing so. For example, a party could be permitted to sell half their interest to a third party, or the agreement could require a party's interest to always remain at 50%.

A variation on the theme which we have seen in recent times, is to allow a party to split its 50% interest any number of times, provided that it remains the only representative on the co-ownership committee for the entire 50% interest, and all of the parties it assigns part of that 50% interest to, are members of its corporate group.

(e)  Major default: matters which the parties consider to be major defaults will usually be set out in a co-ownership agreement. These will generally extend to insolvency or bankruptcy of a co-owner, failure to act or pay money in a manner required which has a material adverse effect on the owned property, or consistent failure to comply with obligations under the co-ownership agreement even after notices are served by the other co-owner requiring compliance.

In these circumstances, the defaulting party can lose its right to vote in the co-ownership committee until the default is rectified. If the default is not rectified within a given period (or in the case of insolvency, immediately on that event occurring), the non-defaulting party is usually given the right to buy out (either itself or via a third party) the defaulting party's interest at a price determined by market valuation.

(f)   Valuations: as there are often situations where valuations are required in a co-ownership context, particularly on rights to purchase a co-owners' interest, there should be a procedure in every co-ownership agreement determining how these are to be carried out and allowing for joint valuations or separate valuations with an independent valuer to resolve disputes.

However, it is usually advisable for co-ownership agreements to avoid a requirement for joint valuations of property in the ordinary course of ownership. Each co-owner will most likely have very different valuation concerns and considerations for its relevant fund/company, and may also not want to know what the other co-owner is valuing the property at, in case that valuation becomes binding simply through its knowledge of it.

(g)  Budgets, keeping records, insurances: operational provisions should include a variety of general regulations dealing with day to day management of the co-owned asset and the manner in which the co-owners wish to carry out, collect information on and report on that information.

(h)  No partnership: it is generally important to confirm that the co-owners are not in a partnership and that they intend their liability to be several (i.e. separable in accordance with their 50% interests) and not joint. It should be noted however, that this declaration will not always be effective at law if the parties are in fact operating a partnership.

One matter to be particularly careful of for foreign investors using structured investments is that depending on the particular circumstances of a deal, co-ownership arrangements can sometimes be treated as a tax law partnership, which has impacts for income purposes. For example, a tax law partnership could arise where co-owners carry out construction of a new building which is subsequently to be leased, despite the fact that at law, the parties are not in a legal partnership relationship.

Depending on the investment structure, the nature of the asset and various other considerations, this could impact upon requirements for the co-ownership entities to lodge a partnership tax return, or otherwise impact upon the individual taxation position of the investors. Each investment needs to be assessed on its particular circumstances and co-owners should of course always obtain independent advice on their taxation positions before finalising their investment structure.

Funding Issues

In general, where a co-owner uses third party debt, the lender will register their mortgage over the title to the property in the normal manner. However, as referred to in Part 1, this would often be subject to an agreement between the lender and the other co-owner, under which the lender agrees to be bound by the terms of the co-ownership agreement, in the event that it enters into possession of the property (i.e. the lending co-owner defaults).

The usual situation, where only one co-owner is seeking finance, is for there to be a tripartite agreement involving each of the co-owners and the lender, under which the procedures on default are dealt with. These are primarily aimed at not disturbing the rights of the co-owner who has not financed their interest.

Where each co-owner is securing finance over the property, it would be relatively normal for a multi-party deed to be entered into under which the rights of all of the parties are dealt with simultaneously. Each lender would then register a mortgage on the title to the land securing a 50% interest in the property.

It is becoming increasingly common in some Australian jurisdictions for co-owners to obtain their own certificate of title representing only their proportionate interest in a co-owned property, to simplify the mechanics of this lending process.

Conclusion

Moving forward, we consider that market dynamics will continue to enhance the attractiveness of co-ownership arrangements.

Our clients, and the various industry bodies with which we work, suggest that available capital is not going to become significantly more abundant any time soon.  At the same time, a bearish outlook is going to continue to foster a desire to co-invest; whether to take advantage of potentially complimentary skill sets, to spread the risk in the event that an investment opportunity turns sour, or to open up new investment horizons.

It is clear however, that there can be many complexities in a co-ownership relationship, and getting the chemistry wrong, or failing to appropriately provide for a reasoned and comprehensive scheme to resolve disputes when the relationship runs into difficulties, can cause significant issues.  With this in mind, we think that the market will see an increase in ongoing "strategic partnership" arrangements, as organisations realise the inherent value in a co-owner where the chemistry is able to be achieved, and the benefits in tying up that relationship over the longer term.