When a general partner or sponsor underwrites or evaluates a real estate investment, they determine a specific amount of capital that should be required to execute the business plan.
What is a capital call in private equity?
A capital call, or a “drawdown,” occurs when a project sponsor requests payment from its limited partners or investors to meet a project goal. The request can be upfront or called at different intervals after the initial contribution. Additional capital is requested for various reasons depending on the type of investment or the circumstance.
Generally, the legal right to issue a capital call is standard in almost every private equity real estate partnership or joint venture agreement. The details of these capital calls (structure, amount, timing, etc.) should be stated in the investor’s offering document or agreement.
Two categories of capital calls
Typically, capital calls fall into two categories: planned and unplanned.
When capital calls are planned (or scheduled), investors are told in advance the amount of capital that the sponsor will request. This predictability allows them to prepare and allocate the anticipated amount, for instance, in the case of some real estate funds or development projects where capital is called periodically and as needed.
However, sponsors can also issue unplanned capital calls in the case of unforeseen circumstances, which can be both operational or market-level. Each capital call scenario is unique to the investment, but generally speaking, there are four common reasons sponsors may issue unplanned capital calls:
1. To compensate for budget overruns
A budget is typically created at the onset of a development project and is based on future cost estimates. Construction costs, however, may overrun these estimates, which can introduce financial risk to a project, especially during periods of market volatility.
In this case, the sponsor can potentially issue an unplanned capital call if the cost overrun is significant and the originally planned capital calls are unable to make up the amount necessary to cover these shortfalls.
2. To make up for operational shortfalls
The financial health of CRE properties hinges largely on their income. Any unforeseen shortfalls in operations such as tenant turnover, capital expenditure, tax increases, or natural disasters can cut into the property’s net operating income.
A capital call may be necessary if, for instance, a major tenant vacates its space and the forecasted occupancy declines relative to its original assumptions. This additional funding can potentially help cover operating deficits until the vacant space is leased to new tenants.
3. To fill refinancing gaps during market stress
Market volatility can affect property valuations and often the amount of loan that can be acquired upon refinancing. Capital calls may be issued to satisfy any changing financing requirements.
Consider a property that was hypothetically acquired for $30 million five years ago, and a 70% loan-to-value (LTV) was placed on this project: today, the lender appraises the property and determines the current value of the property is $24 million.
The lender communicates to the borrower that they are ineligible to receive the entire requested loan given the reduction in the property’s value – the LTV is still the same at 70%, but the value has decreased which means that the amount of debt allowed (mortgage) will now be lower. The owner has an option to pay down the gap in financing by contributing more equity to successfully refinance the deal. In this scenario, a capital call could possibly be a good option for the investment.
4. To chase new opportunities
Sometimes a new opportunity may arise that can compel the sponsor to request additional capital. Consider, for instance, an office or a retail project: imagine a new tenant wants to sign a lease at the property and significant tenant improvements and other costs are involved for the sponsor to lease the space to the tenant. The sponsor may issue a capital call to collect additional funding to potentially help push up the occupancy and therefore potentially enhance its profitability.
Learn more about capital calls and access our top 10 capital call FAQs.
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