A Surge in Unplanned Capital Calls in Commercial Real Estate

Unplanned capital calls (also called “additional capital”) are generally uncommon based on our experience, but their probability can increase during periods of market volatility. A single capital call can occur due to a combination of more than one factors, yet we have observed most requests for capital lately can be distilled down to two primary drivers: 1) the high cost of debt and 2) the effects of inflation.

General Reasons “Why” There is a Surge in Capital Calls Today

1. High Cost of Debt

Sponsors today may rely on capital calls to make up for unforeseen costs to service debt obligations on past deals. Not only are these costs unexpected, but they are far higher than what sponsors had initially budgeted for in many cases.

Here’s why. The floating rate index, called the Secured Overnight Financing Rate (SOFR), is a critical benchmark that variable or floating rate loans are priced off of. Most ground-up development or value-added CRE projects are financed with variable or floating rate debt. Our investment team at CrowdStreet also regularly utilizes this rate as a benchmark to analyze deals.

Typically, the higher the rate, the higher the cost of debt that is underwritten into deals.

The pain point today is that the floating rate index jumped from 0.05% in March 2022, when the Fed first raised interest rates, to 5.31% in October 2023 - this has dramatically increased the total cost of acquiring and servicing debt.¹

Sponsors must also account for lender spreads to get to a deal's all-in or total interest rate. The all-in interest rate is the additional margin over the variable rate paid to the lender. Today, generally, lender spreads have also increased with the interest rate hikes because banks are accounting for higher risk on their loans.⁵

Not only that, but standard lending constraints also typically affect how much debt can be obtained in case of a refinance. For example, it's possible that instead of the original Loan-To-Value (“LTV”) of 65-80% that was financed on a deal just a few years ago (according to our observation), sponsors today can generally finance about 45-60% LTV; and this is assuming sponsors can obtain debt financing in today’s exceedingly challenging capital market.

Collectively, the extra burden on debt costs and the lack of debt availability, in many cases, is compelling sponsors to issue capital calls to support operating deficits and fill voids in their project’s capitalization structures.

2. Effects of Inflation

If you think real estate projects aren’t reeling from spikes in construction and operating costs since 2022, remember that inflation hit a 40-year high last year. Supply chain disruptions in the early phases of the pandemic created a supply/demand imbalance, one of the factors that led to what’s now commonly called the 2021–2023 inflation surge.⁹

While a reasonable inflation rate (generally 2.0% or less) is usually considered good because it typically encourages demand and helps keep healthy competition in the economy, problems can arise when inflation increases at above-average levels, which is the case today. We have observed that many sponsors have been dealing with budget overruns and grappling with the reality that their original budgeting needs to account for contingencies adequately. These budget overruns can often be attributed to the higher cost of construction, labor, and operations (maintenance, utilities, insurance, and taxes).

CBRE’s U.S. Construction Cost Trends report shows that construction costs went up by 12.8% in 2022 and are expected to rise further by 3.8% in 2023.² Because these costs have surged, many subcontractors have increased their bid prices to account for higher materials, labor, and financing costs.

Similarly, many operators are facing spikes in operating expenses for existing assets, notably a surge in real estate taxes and insurance. Municipalities are grappling with operating deficits, and insurance carriers are experiencing higher losses from increased extreme weather events.^6,7

The good news is that inflation has receded and is much closer to the Fed’s 2.0% annual target.⁸ And with that, we anticipate some relief over the next year for unexpected spikes in project costs.

The “How” Behind Today’s Surge in Capital Calls: A Case Study

The effects of higher interest rates, higher operational expenses, and higher development costs drive the majority of capital calls we’re seeing today. Consider three hypothetical scenarios that illustrate this as we break down the numbers behind the math. Please note, all examples are hypothetical and for illustrative purposes only.

Scenario 1: Capital call on a loan extension with variable interest rates

Table 1: Deal at Acquisition vs. Deal Today

Chart Source: CrowdStreet, Oct 2023.

Note: All numbers used in this example are hypothetical and for illustrative purposes only.

 Suppose a sponsor acquired a Class A apartment project for $100 million. Suppose the deal in question was financed with 70% senior debt and 30% common equity upon acquisition in 2020, which was a typical debt-to-equity ratio we observed during that period. Let’s assume the sponsor financed this deal with floating or variable-rate debt with a 4.0% all-in interest rate, a three-year initial term, and a two-year loan extension option. The annual debt service on this project would have started at $2.8 million.

Debt Amount x Interest Rate 

$70 million x 4.0% = $2.8 million

Next, let’s assume the project was acquired at a 5% going-in cap rate, which means the net operating income (“NOI”) at the time of purchase was $5 million.

Cap Rate x Purchase Price = NOI

5.0% x $100 million = $5.0 million

 With $2.8 million of annual debt service, the sponsor would be left with $2.2 million of net cash flow.*

NOI - Debt Service = Net Cash Flow

$5.0 million - $2.8 million = $2.2 million

There is $30 million in equity on this project. Therefore, the cash yield on equity would hypothetically be 7.3%.

Net Cash Flow / Total Equity = Cash Yield

$2.2 million / $30 million = 7.3%

Let’s fast forward to today, and several things have changed. Assume the sponsor successfully increased rents and managed expenses, increasing the NOI from $5.0 million to $5.75 million. The assumption is that the sponsor executes the business plan, and the project performs relatively well.

The pain point for the sponsor is that the all-in interest rate of 4.0% at acquisition is far higher today. From our estimation, let’s assume today’s all-in interest rate would be 9.0% for this scenario, which is similar to what we see today for many deals. The higher cost of debt would increase the debt service from $2.8 million at acquisition to $6.3 million today.

Debt Amount x Interest Rate 

$70 million x 9.0% = $6.3 million

Even though we have seen NOI at the property increase by $750,000, the net cash flow* on the deal would drop from $2.2 million down to -$0.55 million to service the higher cost of its floating rate debt.

NOI - Debt Service = Net Cash Flow

$5.75 million - $6.3 million = - $0.55 million

 Here, you can observe how the significantly higher cost of debt has slashed the cash yield from 7.3% to -1.8% in this hypothetical scenario.

Net Cash Flow / Total Equity = Cash Yield

- $0.55 million / $30 million = -1.8%

With an already depleted cash flow*, the sponsor is also at the end of the project’s initial loan term. Assuming the lender will likely not extend the loan in its current state, what will the sponsor do next?

What would be the amount of capital called in this scenario?

In this scenario, the sponsor faces two options:

1. Pursue the two-year loan extension option
2. Refinance the loan

Let’s assume the sponsor goes with Option 1 and decides to extend the loan for two years.

Lenders typically require sponsors to place rate caps on variable rate deals, meaning a cap on how high-interest rates can go. Rate caps are generally purchased for a specific purpose. Let’s assume that in this scenario, the sponsor must buy a new rate cap to cover the two-year loan extension option.

Not only are we observing rate caps expiring on many of the deals signed in the past few years, but obtaining new rate caps today costs astronomically more than before the interest rate hikes. An analysis shared by The Wall Street Journal with data from Chatham Financial estimated that a three-year rate cap at a 3% interest rate for a $100 million loan cost $98,000 in April 2019. This exact rate cap cost jumped to about $3.48 million in May 2023. That’s 35 times higher in a matter of three years.

For Scenario 1, we can use the Chatham Financial calculator to determine the estimated cost of purchasing a two-year rate cap with a strike price of 3%, which costs roughly $2,780,000.

The lender will likely require the borrower or the sponsor to purchase a new rate cap to obtain the loan extension. It is also reasonable to expect the sponsor to request an additional $1 million in working capital to replenish its working capital and continue operating the project. The amount of working capital is generally determined by the sponsor at their discretion based on what the sponsor decides is needed to operate the project adequately.

In this case, the rate cap costs $2.78 million. Adding $1 million to the capital call as working capital results in a total of $3.8 million, or 12.6% of the original equity, which would be roughly the amount of capital the sponsor calls in Scenario 1. This would bring the total equity in the deal from $30 million to $33.8 million.

Scenario 2: Capital call upon refinancing a matured loan

We highlighted a loan extension in Scenario 1 where the project still has a remaining term on its loan and needs a cash infusion to support the deal. But what if our original loan has matured, or the sponsor decides to choose Option 2 and refinance the loan instead of the loan extension option?

Table 2: Loan at Acquisition vs. Loan at Refinance

Chart Source: CrowdStreet, Oct 2023.

Note: All numbers used in this example are hypothetical and for illustrative purposes only.

A new loan obtainable today pales compared to what was typically placed on a project in 2020. This is a second common scenario that we are seeing afflict many deals. When the sponsor applies for a refinance, the lender determines the property’s eligibility for a new loan by assessing its current performance and then sizing a loan based on its analysis.

First, they would likely begin by examining the current NOI the property generates. Second, the lender must determine how much debt service the property can sustain. Lenders typically use the Debt Service Coverage Ratio (“DSCR”) constraint to calculate this. For multifamily assets, a typical ratio that lenders generally require is 1.25x.³ 

Let’s carry the hypothetical example from above where the NOI at the time of refinance is $5.75 million.

NOI / DSCR = Debt Amount

$5.75 million / 1.25 = $4.6 million

Once the lender has calculated the amount of debt service that they believe the project can feasibly cover on an annual basis, they can then determine the remaining loan amount that the sponsor is eligible to borrow. They do so by using the interest rate to back into the loan amount:

Debt Amount / Interest Rate = Debt Amount

$4.6 million / 9% = $51.1 million

Similar to the example above in Scenario 1, the net cash flow* on the deal would also drop, from $2.2 million in 2020 down to $1.15 million today to service the higher cost of debt.

NOI - Debt Service = Net Cash Flow

$5.75 million - $4.6 million = $1.15 million

Also, even with a $750,000 increase in NOI, the significantly higher cost of debt would hypothetically decrease the cash yield from 7.3% to 3.8% in this hypothetical scenario.

Net Cash Flow / Total Equity = Cash Yield

$1.15 million / $30 million = 3.8%

What would be the amount of capital called in this scenario?

In this scenario, the sponsor is only able to qualify for roughly $51.1 million of loan proceeds, which is $18.9 million short of the $70 million loan that was placed on the property at acquisition.

This means the sponsor has two choices:

1. Replace $18.9 million of senior debt with a different form of capital
2. Sell the property

Despite its improved performance, the project would likely sell for less today than its original $100 million purchase price. This is because multifamily properties nationally have seen cap rates expand over 100 basis points since 2020, according to data by CBRE, which would imply that the original 5% cap rate would be 6% or higher today.⁴

This is why we have observed that many sponsors facing a refinance scenario today typically opt to recapitalize the project instead of selling it. In the meantime, they generally continue to focus on improving the property’s performance and wait for a potentially more viable point in the real estate cycle to sell.

Let’s assume the sponsor chooses Option 1 and proceeds to recapitalize the project with a new, more expensive loan to avoid realizing a loss, but with far lower proceeds. Typically, sponsors would consider using common equity, preferred equity, mezzanine debt, or a combination of any of these three types of capital to fund the gap.

Investors in Scenario 2 can expect a capital call of up to $18.9 million, or 63% of the original equity, depending on how the sponsor decides to fund this gap to pay off the matured loan, refinance the project, and reduce its debt to a level that they believe is sustainable today.

Funding Gap / Original Equity = Percentage of Original Equity Called

$18.9 million / $30 million = 63%

This would bring the total equity in the deal from $30 million to $48.9 million. Lastly, expect an allotment for additional working capital to be factored into this scenario.

Scenario 3: Capital calls due to higher development costs

Table 3: Original Budget vs. Budget Today

Chart Source: CrowdStreet, Oct 2023.

Note: All numbers used in this example are hypothetical and for illustrative purposes only.

Our third and final scenario is a development project that was originally expected to cost $60 million. Let’s assume the sponsor obtained a senior construction loan for $40 million or 66.7% Loan-to-Cost (“LTC”), with the remaining $20 million or 33.3% contributed as equity to start developing this project in early 2022.

Senior Loan / Total Cost = Loan-to-Cost

$40 million / $60 million = 66.7%

We have observed that project development costs have increased considerably over the past two years. Therefore, it is plausible to assume that this project experienced a $10 million or 16.6% increase in total costs, over and above the original $60 million budget on this project.

When project cost increases are mainly outside the sponsor’s control, lenders typically increase their loan size. However, they generally do so under the conditions that the sponsor contributes some additional equity, and the project reappraises at a value higher than its original budget.

In this scenario, let’s assume that the sponsor can obtain an additional $5 million in construction loan proceeds from the lender. Provided the new $70 million budget is justified, the lender’s LTC has decreased slightly from 66.7% to 64%.

Senior Loan / Total Cost = LTC

$45 million / $70 million = 64%

With the lender covering $5 million of the $10 million construction cost increase, the sponsor is left to fill the rest.

What would be the amount of capital called in this scenario?

While you might immediately think that the capital call is the remaining $5 million of the project cost increase, the answer is that part of the cost increase has already been capitalized.  Due to the risky nature of development projects, sponsors usually have construction budget contingencies. A construction contingency in industry parlance means some buffer to fund any surprises or additional costs during construction.

Let’s assume the sponsor had originally budgeted $3 million of contingency. The contingency is designed to fund overages such as increased construction costs, so the sponsor is ultimately left with a $2 million gap. 

In this scenario, investors can expect a capital call for $2 million or 10% of original equity.

Industry-Wide Occurrences or Isolated Incidents?

The three hypothetical scenarios depicted above point to systemic reasons for why we have seen a surge in capital calls lately. All three scenarios begin with the assumption that each project is viable: the real estate is in demand, it is situated in a desirable location, and a competent sponsor backs it. In other words, everything else in the deal that could have gone wrong has gone well. 

When interest rates and inflation change rapidly and exponentially, projects that would have otherwise likely been viable can require additional capital. Generally speaking, when a project has been well executed yet requires additional capital, our experience in previous real estate cycles suggests that it warrants supporting them; this is especially true when the shock to the project is exogenous. 

With that in mind, there are still instances today where sponsors may be overextended and present undue operating risk to projects. There are also instances where, despite strong sponsorship, a project simply cannot justify the contribution of new capital, or at least not in the structure the sponsor is proposing.

Situations such as these require exploring the concepts of simple dilution, punitive dilution, and sunk costs. To learn more about these concepts and our thoughts on the prospect of “Throwing Good Money after Bad,” please read our article here.

*Cash-flow’ or ‘Cash-flowing’ when used by Crowdstreet in this context refers to investments in which current revenues cover all expenses and typically provide leftover money at the end of the month. This does not mean, however, that this will provide a distribution directly to investors or that the investment will continue to perform in this manner. Distributions are never guaranteed and investing in commercial real estate entails substantive risk. You should not invest unless you can sustain the risk of loss of capital, including the risk of total loss of capital.

Disclosure:  CrowdStreet, Inc. (“CrowdStreet”) offers investment opportunities and financial services on its website, the CrowdStreet Marketplace ("the Marketplace"). CrowdStreet offers broker dealer services through CrowdStreet Capital LLC (“CrowdStreet Capital”), a registered broker dealer, Member FINRA/SIPC.

This article was written by an employee(s) of CrowdStreet and the contents of this publication are for informational purposes only. Neither this publication nor the financial professionals who authored it are rendering financial, legal, tax or other professional advice or opinions on specific facts or matters, nor does the distribution of this publication to any person constitute an offer, recommendation, or solicitation to buy or sell any security or investment product issued by CrowdStreet or otherwise. The views and statements expressed are based upon the opinions of CrowdStreet. All information is from sources believed to be reliable. This article is not intended to be relied upon as advice to investors or potential investors and does not take into account the investment objectives, financial situation or needs of any investor. All investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance or success. All investors should consider such factors in consultation with a professional advisor of their choosing when deciding if an investment is appropriate. CrowdStreet assumes no liability in connection with the use of this publication. An investment in a private placement is highly speculative and involves a high degree of risk, including the risk of loss of the entire investment. Private placements are illiquid investments and are intended for investors who do not need a liquid investment. No guarantee or representation is made that a project will achieve its investment objectives or that investors will receive any return on their investment. Investors should consult with a financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks associated with any investment opportunity.  All investors should review the offering's documents carefully before investing. 

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*’Cash-flow’ or ‘Cash-flowing’ when used by Crowdstreet in this context refers to investments in which current revenues cover all expenses and typically provide leftover money at the end of the month. This does not mean, however, that this will provide a distribution directly to investors or that the investment will continue to perform in this manner. Distributions are never guaranteed and investing in commercial real estate entails substantive risk. You should not invest unless you can sustain the risk of loss of capital, including the risk of total loss of capital.

Sources:

1. https://www.newyorkfed.org/markets/reference-rates/sofr 
2. https://www.cbre.com/insights/books/2022-us-construction-cost-trends 
3. https://www.multifamily.loans/apartment-finance-blog/what-is-dscr/ 
4. https://www.cbre.com/insights/briefs/higher-rates-push-up-prime-multifamily-cap-rates-in-q3
5. https://www.linkedin.com/feed/update/urn:li:activity:7115046397577453570/ 
6. https://www.trepp.com/access-trepp-multifamily-property-expense-report-august-2023-summary 
7. https://www.propertycasualty360.com/2023/08/08/multifamily-insurance-rates-are-up-as-much-as-28-414-241723/ 
8. https://www.federalreserve.gov/newsevents/pressreleases/monetary20230920a.htm 
9. https://en.wikipedia.org/wiki/2021%E2%80%932023_inflation_surge