This piece by Rob Beardsley was originally published on Lone Star Capital.
The more deals a sponsor does, the higher likelihood that they are going to have to make an unanticipated capital call for one of their properties. A capital call is a request by an investment manager for additional funding from investors in an existing investment. In fund structures and other types of investments, capital calls can be a routine function. Conversely, in value-add real estate acquisitions, capital calls are not an anticipated action in 99% of deal structures. This means that when a capital call is made for a real estate asset, there is something wrong with the property’s business plan or the market.
Capital calls are viewed as a very negative thing in the industry, and they are – we are very thankful we have never had to make one. However, the only thing worse than a capital call is an unfunded capital call. In a scenario like this, the investors are either unwilling or unable to come up with the extra capital deemed necessary to remedy the situation or ride out the storm. This could result in a temporary issue turning into a permanent loss of capital if a forced sale must take place or if the lender is forced to foreclose on the asset.
This is where your smart and rich investors come in. If a sponsor’s investors are well-capitalized and have dealt with difficult situations before, they are more likely to work towards a solution with the sponsor that may include a necessary capital call. Sponsors are usually very focused on raising capital and rarely slow down to ask LPs what the source and structure of their capital is and if they can meet capital calls in the future. This line of questioning may scare investors away as well.
A capital call scenario has pros and cons for joint ventures and syndications. Joint ventures are usually done with only one major investor contributing 80 to 90% of the equity for the investment. This major LP is usually a family office or fund. These types of investors represent larger pools of capital and only have one or a few decision makers. This means that if a capital call is needed, it can be done so relatively quickly, but it is potentially riskier since the capital call is relying mostly on one major source of capital. Family offices and funds are extremely sophisticated, so they are typically more open to a capital call to correct course.
Capital calls do not have to be made on a pro rata basis but are usually done so to avoid dilutions. Capital call provisions in joint venture and syndication operating agreements should be carefully reviewed by both sponsors and investors to ensure they are comfortable with the ramifications, such as whether capital calls are mandatory and if there is a penalty or the level of dilution if an investor does not meet the obligation.
In syndications, there are many investors so the risk of whether an investor will meet the capital call is diversified across many investors. However, the wealth level of syndication investors varies drastically. Some investors are high net worth individuals with millions in cash while others may be making their first private real estate investment with their last $50k. Many sponsors in syndications opt to make a manager advance to the investment if additional capital is needed rather than making a capital call to tens or hundreds of investors, especially if the capital need is minor. Manager advances are usually made as a loan at 0% up to 8% (or equal to the preferred return).
After all this doom and gloom, I think it would be helpful to discuss the top three ways to avoid capital calls in the first place. First, conservative underwriting will usually lead to under promising and overdelivering. By assuming a conservative stabilization period to implement the business plan, issues of timing are less likely to come up. Conservative assumptions regarding pro forma rents, vacancy, and operating expenses also help avoid cash crunch related problems, such as the inability to service the debt.
Next are reserves and contingencies. We factor in an operating reserve of roughly 1.5 to 3 months of operating expenses and debt service which is placed into the property’s reserve account at closing. Additionally, we reserve an ongoing capital expenditures allowance of about $250/unit/year which is paid out of cash flow (this is in addition to the lender’s replacement reserve). By doing this, we are reducing our projected cash flow but are increasing the likelihood of under promising and overdelivering on distributions. Lastly, we reserve a 10% capital expenditures contingency at closing based on the capex budget. We want to avoid the need for a capital call in the case of construction cost overruns.
Finally, the last way to avoid capital calls is to invest in robust growth markets where the fundamentals improve property performance and value over time, reducing the risk of a cash crunch or maturity risk. In desirable markets, there is a diverse growth story which results in more stable performance as well as more liquid capital markets. For example, if there is a liquidity crunch due to a loan maturity, in a strong market, there will be more lenders offering more favorable terms to refinance the asset and solve the pending maturity, which may otherwise require a capital call to successfully navigate.
While we have never made a capital call, we remain cognizant of potential downside scenarios and focus on how we can best mitigate risk, even if that were to require making a capital call. In the end, our reputation and our investor’s long-term best interest are the most important factors driving our business.