Real estate syndicators (general partners, operators, managers, etc.)—and, much more rarely, a fund manager—may occasionally make a capital call. I'm not talking about the capital calls you make when your initial capital is called for to make the investment. I'm talking about an unexpected capital call. These are usually submitted because something has changed or has gone wrong with the investment. Typically, the investment has become a cash flow-negative investment, and any cash reserves are either already gone or soon will be.
A pause on expected distributions is really on the same continuum, but it's far less extreme and concerning (and, thus, more common). However, a pause on expected distributions is very different from a capital call when it comes to your role. You see, with a typical syndication or closed-end private real estate fund, your role is generally very minimal once you've invested (your job is to cash the distribution checks you're sent) until your capital is returned at the end. So, when distributions are decreased or stop completely, you don't have anything to do, much less any challenging decisions to make. You're just along for the ride until the investment is over.
That's not the case with a capital call. When a capital call comes, you have to decide whether to invest additional money.
Why Do Capital Calls Occur?
Capital calls occur because the syndicator took on too much risk and the risk showed up. Why do they take on so much risk? To make more money. By taking on a lot of risk, they can display and seek to fulfill a more aggressive pro forma (i.e., one that projects a higher return on invested capital). And too many investors get all excited about that. I'm sure studies would show that investments that project higher returns have an easier time raising capital and, thus, charging fees on that capital. And when times are good, it all works out fine. The investors make a great return and the syndicators make out really well. But when times are bad, they can be bad for everyone.
The syndicator could have taken on less risk in several ways:
- Spent less on renovations and other improvements, or spent it slower
- Kept more cash in reserve
- Put more money down to reduce borrowing costs
- Used less variable interest rate debt to purchase the property
But they didn't. So, now they need more money, and their choices of where to get it from are limited. The sources include:
- Themselves (either personally or as a company)
- Another lender (who will likely charge more than the primary lender, given their second lien position)
- More investors
- The original investors (a capital call)
I've seen all four of these happen. My preference is #1, but it shouldn't be a surprise to see #4 frequently used, given that #1 and #2 are often not options at all due to lack of cash or lack of willingness. Plus, it's easier to find #4 than #3.
More information here:What Happens If You Don't Meet a Capital Call?
What happens if you choose not to make a capital call? Well, assuming the other investors do, your percentage of the investment is diluted. If the original investment was $10 million (and your share was $100,000) to buy a $30 million property and the capital call is $5 million, you no longer own 1% of the investment; you own 0.67% of the investment. Sometimes, the new money is given better terms than the old money, making things even worse. Likewise, some operating agreements include severe penalties for not meeting capital calls, like automatic loss of some or all of the original capital.
What Happens If Nobody Meets a Capital Call?
The big risk, of course, is that not only do you not send in any new capital, but neither does anybody else. Now, the investment (typically a limited partnership or limited liability company) goes bankrupt, and all capital is lost. This is really the big fear for investors who get a capital call. They're worried that if they don't meet it, they're going to lose all their money. I would argue they already have, and they're just falling for the sunk cost fallacy. Let me explain.
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Capital Calls Demonstrate Incompetence
When you collect money from investors for a typical 3-10 year syndication, you're supposed to see the end from the beginning. That expertise is why the investors are paying you. Not only do you collect enough capital from the investors to obtain the outcome you expect with the investment, but you collect enough capital to put enough down and build enough reserves that the investment will survive with a reasonable return, even if terrible things happen during the 3-10 years that you will have the investors' money.
Most syndicators making capital calls claim they just need a little more time until rents go up or interest rates go down or whatever. That's nonsense. They don't need more time. They need more money. If they needed more time, they'd go to the lender, not the investors, and beg for mercy. Hoping inflation or interest rate policy rescues your bad decisions and projections is simply desperation.
So, if having to issue a capital call demonstrates incompetence and desperation, why in the world would you want to invest more money with a syndicator who makes one? I wouldn't. Not for this investment and certainly not for a new one. My general bias is against capital calls. Given the choice, I haven't ever made one. I assume no one else will either and that my entire investment is now lost. Many of those who do make capital calls are just “throwing good money after bad” and end up losing more than their original investment.
If you do decide to meet a capital call, it's important that you view it as an entirely new investment and do at least the same amount of due diligence on it, including the fact that the syndicator now has a black mark/red flag (the capital call) against them. You should still assume the original capital is gone. The lender has; otherwise, it would be offering an extension of some kind on the loan. In fact, I'd demand better terms on the new money than on the old money. Any other type of “rescue money” would certainly do the same.
My Experience with Capital Calls
I've had individual properties and even funds go bad due to fraud, incompetence, and even just bad luck. Here are some examples.
One of my funds owned a dozen or so properties. One of them just didn't work out. With wrong assumptions, the risk showed up, and the investors' equity was essentially wiped out. This is a risk when you invest with leverage. If you only put down 25% and the property falls in value by 25%, your equity is gone. If it also has negative cash flow, as it often does when worth 25% less, you have to make a judgment call about whether that cash flow and the value of the property will improve before it runs out of cash. The fund manager had to decide whether to inject more capital into the property or just mail in the keys to the lender. In this case, the manager, wisely in my opinion, chose to mail in the keys. Yes, it sucks to lose money, but honestly, the money was already lost by that point. The fund should still have an overall annualized return of about 10% per year, not too bad considering one of the properties was a complete loss. This example is a good demonstration of why it's generally better to invest in a fund than a single syndication.
Another capital call was the result of fraud. The syndicator had fraudulently obtained additional leverage to purchase other properties, using the property owned by the syndication as collateral, despite the LLC agreement saying he wasn't allowed to do that. Well, the other investments went bad, and so did this one because the fraudster was also incompetent. The fraudster went bankrupt and went to jail. But what about the investors (including me)? The lender called in the collateral, and the investors had to decide whether to throw in additional capital to keep the property. This capital injection was set up as a new investment, and it had dramatically better terms than the original investment. I chose not to participate, but enough others did that the property was rescued, at least for a few years. The property has muddled along for years now, trying to complete its value-add projects and reduce the vacancy rate. The second investment may do OK, but the original investment is still probably a total loss. Stay tuned for more details, but no promises on when. I think we're already in Year 8 of what was supposed to be a three-year investment.
I also invested in a single-family house fund once which didn't even really bother making a capital call. Due to incompetence at managing leverage (i.e., overleveraging and giving lenders way too much power to call their own capital from the fund), the fund became cash flow negative and ran out of cash reserves. I don't recall if it even really attempted a capital call, but if so, not nearly enough investors elected to participate. The lenders didn't offer much mercy either. The fund started selling homes, often at fire-sale prices to pay off lenders and meet cash flow needs. The difference between the price the fund paid and the price the fund received for these houses was about the same as the investor equity. The lenders (debt investors) for the fund seem to have made out fine, but the equity investors will likely be nearly completely cleaned out.
I invest in another fund that owns properties (managed by various separate syndicators), including one that made capital calls after its variable interest rates went up 4% in 2022. The fund has decided to make the capital calls using the return of capital from other properties in the fund and cash flow from the other properties. While the final results are not yet in, I'm skeptical this was the right decision, as properties owned by the separate syndicator have been foreclosed on and other investors in the properties are suing the syndicator. But we'll see in a few more years how it all works out.
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Have You Had a Capital Call Success Story?
I'd love to hear some stories where an unexpected capital call really worked out well. Where the additional capital gave the syndicator an additional year or two and everything turned around and the original investors received their capital and some sort of return on it. I don't think it happens very often, but I was unable to find any sort of study suggesting how common the various outcomes actually occur. If you've had one of these experiences, please share the details in the comments below.
What do you think? How do you deal with an unexpected capital call? Do you view unexpected capital calls as “never events” or as a routine part of investing in private, passive real estate?
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