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Real Estate Horror Story – Capital Calls

One of the first things about investing you should know is you can lose all your money. If you do not know and understand that as of yet, then you may want to hold off on investing until you can stomach that. Of course, the point of investing is not that you would lose money but the opposite; you invest so you can gain money. With this goal in mind investors select the investment option that has the highest chance of returning a positive gain.

There are many types of equity investments. Real estate investing in multifamily apartments has shown to be one of the most recession resilient investment vehicles around. Not everyone has the time to manage a multifamily apartment themselves however, so multifamily real estate syndication allows passive investors the opportunity to provide a source of private equity (i.e., investment funds) which can be used by active investors to purchase and manage these investment properties for the benefit of passive investors.

Real estate goes through cycles of expansion and contraction which can impact the level of returns gained by investors. When the real estate market is transitioning downward from expansion to contraction (often sensationalized by using the word “real estate crash”) not all investments do well. Similarly in a real estate boom there are some investments that may not do well due to poor management by the investment sponsor or unforeseen circumstances.

Whether it is due to market factors or poor asset management, there is the risk that investments do not go as well as planned. When this happens there is potential for one of the scariest words in investing to come into play – a “capital call.”

What is meant by the term capital call in real estate investing?

A capital call is the a legal right of a deal sponsor (i.e. general partner and/or the asset manager of the syndication) to request additional capital from investors (i.e. limited partners/ passive investors). To put this simply, the investment manager has run out of money and needs to get additional money from investors to keep the investment successful. A capital call is a lifeline that can mean the difference between an investment that fails and one that can be turned around to provide returns for all investors involved.

There are many important legal documents that you will sign when investing in a real estate syndication, however one to pay attention to is the operating agreement. This document will include a capital call clause which details what capital commitments investors are making and expectations around future capital calls during the life cycle of the investment.

What triggers a capital call?

Capital calls may be planned or unexpected. The offering documents signed prior to investing in a real estate syndication may indicate that there are planned capital calls, what are the situations that may trigger an unexpected capital call and what next steps would be in such a case.

Expected capital calls may be capital allocated to specific expenditures (such as renovations) which would be completed at a scheduled time. Some investments may use this approach as it provides a better return for investors (due to the shorter time frame capital is held) and is cheaper for the investment manager (as they will not have a significant amount of unused capital for which they have to payout returns).

An unexpected capital call may result if there are budget shortfalls, unexpected expenses, increased capital needs to pay for damages from natural disasters, lack of profitability in the property due to high expenses or high vacancies, market changes (such as recession), or financing issues that were not planned for which require more money than expected.

How do deal sponsors and investment managers prevent capital calls?

Unexpected capital calls are not frequent and are not desirable by deal sponsors or passive investors. A capital call can create reputational damage for the deal sponsor (depending on the reason of the capital call) and cause them to lose trust with their investors in the future.

For passive investors a capital call is also undesirable as it means they have to put in more money into an investment that may not perform well. Additionally, if the investment does perform, the return may be diluted/decreased based on the increased amount of capital used. Given how highly undesirable this is, deal sponsors will take many steps before officially issuing a capital call notice.

Deal sponsors will use methods such as adjusting the business plan to prevent a capital call. A good deal sponsor will have a “capital reserve” as part of the funds raised when entering into the investment. You can think of this as a “rainy day fund” that will help pay for any issues that come up during the hold period of the investment. If the adjustments to the investment business plan do not work and the capital reserves run low, then the deal sponsor may invest additional capital out of their own pockets. If this still does not suffice, then the sponsor may choose to pause distributions to passive investors until the investment is performing better. If all of these options prove to not help, then the investment manager would choose to complete a capital call. This is why capital calls are usually infrequent.

What happens in a capital call?

When a capital call is deemed necessary the investment manager issues what is called a “capital call notice” to each investor. The notice will include details on the net amount due, intended use, detailed description of facts and circumstances and any additional financial impacts as applicable and banking information for how funds should be submitted.

Additionally, there may be a literal call where the investment manager provides further details to investors on the situation that has led to the need for a capital call and what would be required of the investors to complete the capital call. Typically, limited partners will have 10-30 days’ notice of a capital call. This would allow time for partners to respond as opposed to being caught off guard and unprepared to meet the capital call.

What happens if you miss a capital call?

The partnership agreement would cover what happens if an investor chooses not to participate in a capital call. In some agreements the capital call may be voluntary. In this case there would not be any repercussion to not completing the capital call. However, if the capital call is mandatory, not completing the capital call will have repercussions. This may have punitive impacts such as lawsuits, loss of equity, forced sales or the impact could be as simple as the dilution of their ownership portion in relation to the additional capital invested by other partners.

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