A capital call is a provision in the real estate investment structure that allows the sponsor to request (call for) additional capital.
When the business plan progresses as planned and/or when the market cooperates, it is very rare that the sponsor team would need to make a capital call. However, as with any investment, there are risks involved. Thus, on occasion, the sponsors may have to call for additional capital. This is never a pleasant experience for anyone (GPs or LPs). Nevertheless, it might be the second best option vs. letting the project get worse or having to rush and sell the property at a loss.
Usually the sponsorship team would/should contribute first. However, in certain situations their contribution might not be sufficient OR collectively they might not have sufficient capital due to low personal liquidity. This is when the call may extend to the LPs. How the GPs contribute the capital (equity vs. shareholder loan) may also require additional steps, such as obtaining lender approval.
Capital calls will dilute the returns on your investment since more money is required for the same size investment, i.e. if you want to achieve the same target return or avoid losses, you need to contribute more.
Why would the sponsors issue a capital call?
There are many situations that might trigger a capital call. Below we will name a few.
The operator underestimated capex needed or had an unexpected event that resulted in more capex being required to complete the rehab (the likelihood of this happening with heavier lift projects is higher).
The operator did not raise enough capital upfront for operating reserves or depleted operating reserves for other purposes (e.g. large unexpected expenses like interest rate cap escrows, or funding cash shortfalls, etc.).
The market materially changed. Today’s environment is a case in point. If the operator did not include sufficient cushion when underwriting the deal, such market events can adversely affect the property performance. For example – continuous and high increase in interest rates on a deal with floating debt; or high increase in commodity prices, resulting in material rise in materials and capex costs.
The property is underperforming due to a poor operator or poor property manager, resulting in higher vacancies or not achieving target rent increases.
What you need to know if a capital call occurs?
When a capital call occurs, you will receive written communication from the sponsor noting the $ amount of the capital call, your share, and when the money is due.
The private placement memorandum (PPM) will outline the terms and conditions of a call and implication of lack of compliance (penalties or alternatives). As an LP you should ask questions and have the right to know how the capital call funds will be used and what triggered the call. You should be aware of the alternatives, including what happens should you not contribute (in which case dilution of your ownership share may be one consequence).
Lastly, ensure you understand the reasons behind the call as you never want to put more good money after bad. Thus, it is helpful to understand whether there is still equity in the deal, why the sponsor has chosen to infuse additional capital vs. perform a cash-in refinance or sell the property, timing of the turnaround, etc..
How do you mitigate a capital call as an LP?
Mitigating the risk of a capital call starts before you invest in a deal by vetting the sponsor, the deal, and the market upfront.
Familiarize yourself with the PPM, so you are aware of the capital call process and implications/alternatives in the beginning. Do not be afraid to ask questions to your sponsor at the beginning of the process.
Continuous communication throughout the tenor of the deal is also key. You will be able to observe the progression of the business plan via the monthly or quarterly updates or your direct interactions with your sponsor. Thus, a capital call should not be a surprise if or when it occurs (unless the sponsor was withholding information, was not truthful, or committed fraud).
As with any investment, there are risks involved. The key is to identify the risk upfront and then determine how it can be mitigated and whether you want to proceed. This will help you avoid negative surprises if or when they occur. As we like to say, the only way to avoid risk is not to take one… though that might not be the best option either, if you want to grow and leave a legacy.
Should you have any questions or want to learn more about real estate investing or for an overview of our target markets, please reach out to info@dbacapitalgroup.com.
Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.