Today the media is dominated by news of capital calls and foreclosures (e.g. Tides Equity, Jay Gajavelli, etc). With more commercial real estate loan maturities coming due in the next twelve months and an environment of slowing rent growth, higher expense, and higher interest rates, news like that are likely to continue dominating the press. What could you do if you are a passive investor, whose principal is at risk, or even worse – lost your principal?

If you happen to be in this unfortunate situation, we hope at least that you are not in a position where you invested all of your savings in a single deal and that you are well diversified across operators, markets, and asset classes, so losses at this one investment can be offset by gains from other investments.

While you are less likely to recoup the losses, you can look back and analyze what went wrong and apply the learnings when vetting sponsors, markets, and deals in future investments.

Was it an operator error, i.e. something that could have been avoided?

Did the operator follow underwriting fundamentals and conservatism principles? Or did they rely on financing to make the numbers work relying on high leverage, floating rate, short term debt (this is one of the items gone wrong in the Gajavelli foreclosure)? Did they follow through with the business plan or did they drop the ball on execution either directly or not overseeing the property manager or not replacing an ineffective property manager?

For example, the operator could not have foreseen that the Fed would raise rates 10 times in 12 months but they could have put measures in place to hedge interest rate risk via fixed rate debt or interest rate caps for the full tenor of the loan for example.

Was it the market, i.e. something that the operator could not have foreseen?

An example of this includes natural disasters like major hurricanes or accidents like fires. Noone could have predicted the impact on insurance premiums hurricane Ian had for example. While hurricanes are not a new phenomenon, this last one was a major one and was on the foot of already rising premiums and insurance fraud, which ultimately led to premiums tripling in some cases and certain insurers exiting certain markets (e.g. California, Florida). A fire is never in the plans and while proper insurance could cover the losses, it takes time to rebuild or remediate the property, which in turn may delay the original business plan execution.

In either scenario, having enough reserves can help offset some of the loss or at least buy some time.

How did they handle the situation prior to the capital call or foreclosure?

What actions did the operator take to pivot, if at all possible? Did they communicate openly and frequently or was the loss or capital call a surprise? What exit plans do they have, if any? Did they put additional capital into the deal?

The responses to the questions above would at least help extract the lessons learned from the situation, so you can apply those lessons to future investments. In some cases, the operator may step in to make the investors whole (like Joe Fairless did when one of his first investments lost money). If the situation was caused by fraud, you may have additional remedies and protections via legal counsel or the SEC (though if the operators are illiquid or do not have other properties that can be liquidated, they may not have sufficient net worth to make investors whole). You may also be able to apply the investment losses against other passive investment income, though we recognize this is not a typical benefit of passive investing one should settle or even aim for.

Like any investment, real estate carries its own risks to. For anyone who has been in the business long enough, failures or losses could happen. In those case, one might not be able to recoup such losses (or part thereof) but can at least extract the lessons learned and apply those to future situations and to hopefully avoid repetition of such.

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.