By definition, a capital call is a legal right granted to the manager of a partnership or fund to compel payment of money promised to it by investors or, more technically speaking, limited partners. In some cases, particularly in the case of a fund, capital calls are planned and issued according to a predetermined schedule. The forecasted capital call, however, is not the focus of this article.
This article will address, head-on, unforeseen capital calls, which are often referred to in limited partnership operating agreements as “additional capital contributions”. In practical application, additional capital contributions or, unforeseen capital calls, grant the sponsor or general partner the power to go back to investors and ask them to put more money into an investment on top of their existing equity commitment. It is important to note that unforeseen capital calls are a relatively rare occurrence, but since they can occur (and often did occur during the Great Recession), they are worth discussing openly rather than simply hoping they never happen.
The right to issue a capital call is standard in almost every private equity real estate partnership or joint venture agreement. Therefore, it is important for investors to understand why they exist, how they are used and what an individual’s options are in the event they occur.
In this article, we will outline the most common capital call scenarios and explain why capital calls may be justified in real estate partnerships as well as why investors should actually want them to exist. Finally, we will conclude by providing tools for assessing the merits of a particular capital call to help investors avoid the situation of “throwing good money after bad”.
Capital call scenarios
There are numerous scenarios that can force an operator into a situation where it feels compelled to issue a capital call. The following are a few of the more common ones:
- A capital call is often warranted when an unexpected and sustained drop in occupancy leads to impaired levels of NOI, which in turn, causes the property to become capital constrained. Now the operator is in a quandary – it no longer possesses enough capital to fund tenant improvements and leasing commissions to attract new tenants, yet it can only attract new tenants, raise NOI and return to normal operations by deploying the necessary capital upfront to fund tenant improvements and leasing commissions. Within the commercial real estate community, a property in this state is commonly referred as a “zombie building”. Becoming known as a zombie building is particularly troublesome for an operator since leasing brokers will now avoid it knowing that the probability of being paid a full leasing commission on time is low. Often, the only way out of this predicament is for the operator to issue a capital call.
- Capital calls might also be issued in a redevelopment project if the cost of capital renovation goes over budget. For example, a $100,000 elevator refurbishment plan may turn into a $500,000 elevator replacement reality. To the extent that unexpected costs arise in a redevelopment project that are critical to the lease up of a property post-renovation, that cost overrun might only be adequately solved through a capital call.
- Capital calls also may be issued to satisfy changing financing requirements. Such cases were all too common during the Great Recession as falling property values eroded current equity in a property. In order to refinance maturing loans, owners oftentimes needed to infuse extra capital to hang onto assets and weather the downturn or risk losing properties altogether. Consider the following example – an operator acquires an office building for $30,000,000 in 2007 and places a 70% loan-to-value senior loan on it. Therefore the capital stack for that property at acquisition is as follows:
The operator (or borrower) places a loan on the property with a three-year term with the possibility of two one-year extensions, subject to certain hurdles.
Fast-forward to 2010 – the real estate market is down and the property has suffered a 10% drop in occupancy. The lender reappraises the property and it determines that the current value is $24,000,000. The lender communicates to the borrower that it is ineligible to extend $21,000,000 loan given the new value. However, the lender is open to resizing and extending the loan at the same original terms, 70% loan-to-value, but at the new appraised value. This means that the lender is now only willing to lend $16,800,000 on the property and is requiring the borrower to either pay down the difference or else simply pay off the full $21,000,000 outstanding principal balance. The new proposed capital stack of the property with a resized loan would look like this:
The borrower is now faced with a tough decision: a) issue a capital call of $4.2 million to pay down the existing loan and recapitalize the property or b) sell the property in a down market.
If the operator does proceed to sell the property and it manages to fetch the $24,000,000 recently appraised value, investors suffer a 66% loss on their investment since the sale only delivers $3,000,000 of net proceeds once the $21,000,000 loan is paid off. However, if the market gains knowledge of the fact that the seller is forced to liquidate and is perhaps now beyond the loan maturity date (known as a maturity default), it can rapidly drive the price down even further as buyers fade their bids. A capital call could save such a property from the opportunistic vultures or even outright foreclosure.
Capital call provisions and why they exist
Capital call rights will vary from offering to offering. For example, some operating agreements will only allow a capital call in certain situations and may have a cap on it as a percentage of an investor’s original investment amount. For non-participants, dilution may be limited to the amount of new capital contributed as a percentage of the new total capital amount or may be more punitive, perhaps 1.5X to 2.0X of the capital call amount. If non-participation provisions are relatively punitive, it often means that the sponsor only intends to trigger a capital call if it is absolutely critical to the continued viability of the property and, therefore, needs as many assurances as possible that it will be fulfilled. While punitive dilution provisions are not in the interest of individual non-participants, they are in the interest of all participants and of the property as a whole.
Capital call language in real estate operating agreements is predicated on the assumption that all partners, both general and limited, want a mechanism in place to remedy the types of scenarios outlined above, which can provide the property with lifeline capital at a time when it may be most needed. In other words, why let your property fall prey to the vultures if you can vulture it yourself?
Another way to think of capital calls is to consider that they are similar to margin calls in the stock market. If the value of an investor’s margined securities account dips precipitously, a broker will issue a margin call where the investor must either deposit additional funds in the securities account or accept that the fact that the broker will liquidate securities until a stabilized margin level is re-established. Investors participate in commercial real estate private equity capital calls for much the same reasons as they make margin calls – they don’t want to sell at the bottom of a market.
Rationally assess the situation
The common knee-jerk reaction to a capital call is to immediately conclude that a property has somehow gone off the tracks and it’s irreparably broken. While that might be true, it is certainly not necessarily the case. When faced with a capital call, it is important for investors to do a thorough analysis of the situation. It is easy for emotions to dominate but rational thought is paramount. As you begin to contemplate participating in a capital call, the following are key questions that the sponsor should be able to adequately answer:
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Why did the property reach a state that a capital call was unavoidable?
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What events that led to the current situation were beyond the control of the sponsor?
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What events that led to the current situation were within the control of the sponsor?
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In retrospect, what could have been done differently to avoid the capital call?
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What are the exact consequences for the property and investors if the capital call fails?
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What are the consequences for those investors who abstain from participating in the capital call?
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How will the additional capital contribution be used?
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How will the prescribed use cure the property’s current state of distress?
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What return does the sponsor target for investors purely on the capital call contribution?
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What is the new targeted blended return for all capital, original contribution, and additional contribution?
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How much, if any, is the sponsor willing to reduce or waive fees or profits participation if investors fulfill the capital call?
The most difficult but absolutely critical realization for investors to make in this situation is that, in most cases, your original investment is now, partially or fully, a sunk cost. A capital call might resurrect some or all of the original equity, but that is not the reason you should or should not participate.
Consider the example from above. In 2010, that office property only has $3 million of current equity – $6 million of equity is gone. The decision to infuse the $4.2 million to pay down the existing loan must make sense from the perspective of: a) earning a substantial return on the $4.2 million investment and b) preserving the $3 million of remaining equity. It must make sense from a purely go-forward perspective.
Therefore, to make an informed decision, first examine the current state of the deal. You are looking to satisfy the following conditions:
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It appears feasible that fresh capital will improve property performance.
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The root of the issues leading to the capital call was largely outside of the direct control of the sponsor.
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In retrospect, if better decisions could have been made, the decisions that were made were communicated to investors at the time and were generally agreed upon.
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Selling the property in the current market looks bad for all parties.
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The sponsor is still solvent and capable of executing a business plan.
If you can satisfy most of the above conditions (such situations are rarely black and white), then the basis for participating in a capital call is present. The next step is to analyze the capital call as a new and distinct investment because, in essence, that is exactly what it is. As mentioned above, your old investment is impaired or entirely gone – you are now an opportunistic buyer of your own asset. This means a capital call should target opportunistic returns. As a result, ideally, you now want to satisfy the following additional conditions:
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Isolating the capital call as a stand-alone investment targets opportunistic level returns to investors. One rule of thumb is that capital call investment should generate a 2X or greater return within a three to a four-year time period. Again, this is only on the capital call amount itself and not a blended return on the overall investment.
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It appears more likely than not that the real estate market will improve from its current state over the next few years – it’s always good to have the wind at your back in this situation. If you feel the market won’t improve, it warrants a more stringent examination of the assumptions made to achieve the targeted returns on the capital call.
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The sponsor is offering some form of concession to investors for participating in the capital call. This may translate into reduced or deferred fees or an investor-friendly promote on the capital call. The key takeaway is that a good sponsor should be willing to offer some sort of an olive branch to investors in acknowledgment of the situation.
SPV vs. direct platforms
To some extent, how an investor responds to a capital call depends on the investment vehicle and how the capital call terms are worded within an investment offering. For example, there are notable differences in how capital calls are structured in Special Purpose Vehicle (SPV) vs. Direct-to-Investor crowdfunding platforms.
SPV platforms, as a policy, will often NOT participate in capital calls but, instead, simply accept dilution on the original investment amount. This policy can have two primary negative ramifications. First, SPV investors, in this situation, have no individual choice to participate or not participate – hence there is no option for an investor to make a follow on opportunistic investment in the deal. Second, the inability of a sponsor to issue a capital call to its SPV limited partner potentially creates a challenging situation for sponsors. For example, the sponsor might lack the necessary resources to manage their property on their own through a crisis or unforeseen event. Therefore, that property is now more likely to be forced into liquidation at a disadvantageous time and, as noted above, the original investors cede the opportunistic investment opportunity to the buyer.
In contrast, investors in Direct-to-Investor platforms, such as CrowdStreet, have the autonomy to choose whether or not they want to participate in a capital call. In addition, if the capital call terms are particularly advantageous, the Direct-to-Investor approach also gives investors the option to fulfill OTHER investor’s unfulfilled capital calls. The bottom line is that participating or not participating in a capital call should be an individual investor choice. You are, in fact, a limited partner. It is this platform’s belief that limited partners should be granted these types of decision-making rights in private partnerships rather than having that decision dictated by an intermediary entity.
It is important to reiterate that capital calls are a rare occurrence but more common during times of market stress, such as was the case in 2009 and 2010. To date, CrowdStreet has not had any capital calls occur in the more than 67 offerings across almost $2 billion in investment opportunities it has hosted on the CrowdStreet Marketplace. However, it is fair to say that this could change at any time. The potential for capital calls justifiably exists in any private real estate offering – it is part of private equity real estate investing. If you are confronted with this unlikely but possible situation in the future, hopefully, you are now better equipped to navigate it.
