Guide to Understanding and Evaluating Capital Calls in Commercial Real Estate.

Capital calls are a crucial aspect of a commercial real estate (CRE) investment, representing the need for additional funds to meet project requirements. Investors should be well-informed about capital calls, distinguishing between “good news” capital calls and “bad news” capital calls. This guide provides an overview of capital calls, explains the difference between positive and negative situations, and offers insights into analyzing capital call requests.

UNDERSTANDING CAPITAL CALLS

DEFINITION: A capital call is a request made by the managing entity of a real estate investment to investors, asking them to contribute additional capital beyond their initial investment. These calls typically arise when a project needs more funding to cover unforeseen expenses, capitalize on opportunities, or fulfill ongoing obligations.

STRUCTURE: Capital calls are outlined in the investment agreement and operating documents, most typically the operating agreement. They specify the frequency, amount, and purpose of the calls. In most cases, capital calls are not required to be funded, but if they are not funded, the investor may experience dilution or their equity investment may become junior to new capital coming into the investment.

DELINEATING BETWEEN GOOD NEWS AND BAD NEWS CAPITAL CALLS

GOOD NEWS CAPITAL CALL

1. Opportunity Seizure: A capital call to seize a profitable investment opportunity can be considered good news. An example of this might be acquiring more units than originally underwritten in a broken condo project at a favorable basis or paying to entitle land with a forward purchase contact for a buyer to acquire that land.
2. Project Enhancement: Calls for additional capital to enhance the project, such as improving property amenities, funding new Tenant Improvement and Leasing Commission costs, or renovating more units than were originally intended in the business plan can be seen positively if they lead to a high return on investment and will increase the net operating income of the project.

BAD NEWS CAPITAL CALL

1. Unforeseen Expenses: If the capital call is prompted by unforeseen expenses like construction delays, cost overruns, or legal issues, it may be considered bad news as it can suggest a lack of project management foresight, or extraneous circumstances such as a negative change in market conditions, or unforeseen disasters such as hurricanes or pandemics.
2. Cash Flow Issues: A capital call to address cash flow problems can be a red flag. It may indicate that the project is not generating expected returns or has encountered financial challenges.
3. Debt Related Capital Call: When a capital call is required to cover a shortfall in meeting obligations related to the debt, it signals financial strain and potential liquidity issues. Examples could include insufficient cash flow to pay debt service, capital required to fund the purchase of a replacement interest rate cap, to pay extension fees, to pay down the debt to pass required DSCR/DY tests, or a cash in refi.

ANALYZING CAPITAL REQUESTS

REVIEW PROJECT PERFORMANCE

1. Financial Statements: Examine the project’s financial statements to assess its current performance. Look for signs of positive cash flow, healthy returns, and adherence to budgetary projections. Compare the original business plan to actual performance and determine why performance may be off track.
   
2. Market Conditions: Evaluate the local real estate market conditions and how they may impact the project. Positive market trends can justify strategic capital calls.
   

SCRUTINIZE THE PURPOSE OF THE CALL

1. Detailed Explanation: The managing entity should provide a detailed explanation of the purpose behind the capital call. Assess whether it aligns with the initial investment strategy and if the new strategy makes sense.
2. Risk Mitigation: If the capital call addresses a risk mitigation strategy, evaluate its necessity and effectiveness in safeguarding investor interests.
3. Exit Strategy: Assess the viability of the project’s exit strategy before and after the capital call. If the capital call is not funded, what are the prospects for the exit? If the capital call is funded, how does that change the business plan and the prospects for the exit?

UNDERSTAND THE CAPITAL STRUCTURE

1. Before the Capital Call: Review the capital stack before the capital call – is there senior debt and equity? Is there preferred equity? Where does your investment sit in the pre-capital call structure?
2. After the Capital Call: Review the proposed capital stack post the capital call. Where does your investment sit in the post-capital call structure? In most instances, the existing limited partner equity in the deal will become subordinate to a member loan or fresh capital being provided by preferred equity or mezzanine debt. Investors may also experience dilution. Understand if that dilution is 1:1 or has greater penalties if you do not participate in the capital call.

COMMUNICATION AND TRANSPARENCY

1. Open Communication: Assess the managing entity’s communication strategy. Transparent communication about the reasons for the capital call, the expected impact, and the long-term strategy is crucial.
2. Investor Relations: Consider the track record of the managing entity in maintaining strong investor relations. Previous instances of transparent communication through quarterly reporting and successful problem resolution are positive indicators.
   

CONCLUSION

Understanding and evaluating capital calls in commercial real estate necessitates a thorough analysis of project performance, the purpose behind the call, and the managing entity’s communication strategy. Distinguishing between good news and bad news scenarios allows investors to make informed decisions and navigate the complexities of real estate investments more effectively. Regular monitoring of project developments and proactive communication with the managing entity are essential for successful investment management in the dynamic world of commercial real estate.

This article is for informational purposes only, and is not a recommendation or offer to buy or sell securities. This content is intended for accredited investors only. Information herein may include forward looking statements and is for informational purposes only. Forward-looking statements, hypothetical information, or calculations, financial estimates and targeted returns are inherently uncertain. Past performance is never indicative of future performance. Advice from a securities professional is strongly advised, and we recommend that you consult with a financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks and tax consequences associated with any real estate investment. All real estate investments are speculative and involve substantial risk and there can be no assurance that any investor will not suffer significant losses. A loss of part or all of the principal value of a real estate investment may occur. All prospective investors should not invest unless such prospective investor can readily bear the consequences of such loss.

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