Often, commercial real estate investments are described as an opportunity where an individual invests a single sum of money upfront and then earns a stream of income from it over time. Ideally, it happens this way, but not always. In some cases, there is an unexpected event or circumstance that requires additional capital. In such a case, the general partner / investment sponsor may issue a “capital call.”
In this article, we will describe what a capital call is, how they can happen, and why they should be considered as part of the pre-purchase due diligence process. By the end, readers should be able to use this information to assess their risk of a capital call in a deal.
At First National Realty Partners, we are very conservative in our underwriting principles to minimize the chance of having to issue a capital call. In doing so, we feel that it presents a more accurate picture of a deal’s risk/return profile. To learn more about our current investment opportunities, click here.
Typical Commercial Real Estate Investment Structure
In order to understand what a capital call is, it is first necessary to understand how a typical commercial real estate investment is structured.
When an individual invests with a real estate “sponsor” like a private equity firm, the structure is such that the private equity firm acts as the deal leader, usually referred to as the general partner or GP. They are responsible for finding properties, performing due diligence, arranging financing, and may even manage the asset once the transaction is closed. As part of their financing effort, the private equity firm raises capital from individual investors who are referred to as limited partners or LPs.
The documents that govern the partnership between the general partner and the limited partner(s) outline the terms and conditions under which the capital is raised. This is where the capital call clause can be found.
Capital Calls Explained
If the real estate investment documentation contains a capital call clause, it gives the general partner the right to request additional capital from investors, beyond the initial raise, under certain circumstances. Usually capital calls fall into two buckets, planned and unplanned.
In some cases, a real estate investor may commit a certain amount of capital to a deal even if they don’t provide it in full at the time of the commitment. In this case, the capital call provision may outline the circumstances under which capital will be “called” from investors to support investing activities. These sorts of capital calls are planned and are frequently used in a committed capital private equity fund structure.
Or, the capital call provision could give the sponsor the right to request additional capital contributions from investors if they are needed to support the property. For example, a property could suffer major damage in a storm and there is not enough money in the reserve account for repairs. In such a circumstance, the GP could call additional capital from investors to pay for the needed repairs. This type of capital call is unplanned and the details of the investor’s obligation to participate are outlined in the deal’s offering documents.
Why Capital Call Provisions Exist
Based on the two types of capital calls described above, there are two reasons that capital calls exist.
In the planned scenario, capital call provisions exist to manage the allocation of capital for a fund. For example, a firm may decide to raise $100MM in capital for a fund that has only a general investment thesis. So, they obtain $100MM in capital commitments from investors, but may not necessarily collect that money at the time of the commitment. But, when the raise is complete and the fund goes out to find assets to purchase, they will call in the money to fund the purchases. This scenario helps both the fund and their investors manage the flow of capital in an orderly way.
In the unplanned scenario, the capital call clause exists to mitigate risk. Although it is not a desirable outcome, there are certain real estate investing situations where a property needs additional capital to continue operations. In these cases, the additional investment funds provided can be the difference between a positive investment return over the long term versus a potential loss in the short term.
When Capital Calls Become Needed
Drilling down into the unplanned scenario, there are four common events that could trigger an unplanned capital call.
Project Over Budget
In a commercial real estate (CRE) development project, a budget is created at the beginning of the construction process and it is usually based on cost estimates. Construction cost overruns are common and, if they are large enough, the sponsor may have to issue a capital call to fund them.
Commercial properties are almost solely reliant upon the rental income generated by tenants. If a major tenant were to vacate their space or if the property has fallen out of favor in a market and there is a period of extended vacancy, the sponsor may issue a capital call to fund operating deficits until new tenants can be found.
It is common for a real estate sponsor to refinance a property at some point during the investment holding period. However, if this refinance occurs in a down market, there may not be enough equity in the property to qualify for a new loan. In such a case, the sponsor may issue a capital call for enough money to pay down the principal balance of the loan far enough to qualify for the new loan.
In a “called capital” real estate fund like the one described above, potential investors commit to providing a certain amount of capital, but don’t actually contribute it at that time. When it comes time to purchase an asset, the sponsor may issue a call for capital to finance it.
These are not the only situations in which a capital call may be issued, but they are some of the most common.
What Happens If An Investor Can’t Meet The Capital Call?
When a capital call goes out, it is possible that there could be some real estate investors who do not have the funds needed to meet it. The consequences of this situation are outlined in the offering documents, but they could include one or more of the following:
- Dilution: The investors who do not fund their capital call may find that their share of the limited partnership is “diluted.” This means that, because the other partners have contributed more capital, they now own a smaller percentage of the limited liability company that owns the asset.
- Loan: The required capital contribution may become a loan that must be repaid to the partnership. In many cases, these loans have high interest rates and any distributions that the partner is eligible for are instead used to pay down the balance of the “loan.”
- Loss of Equity: In some cases, investors who don’t fund their required capital contributions could see their equity stake reduced, sometimes by as much as 50%. It should be noted that this is different from being diluted, where the investor’s stake remains the same, but it is a smaller proportionate share.
- Loss of Distributions: Investors who do not fund their capital call may find that they are ineligible for future distributions until the property is sold.
- Forced Sale: The terms of the deal could force the investor to sell their stake back to the partnership. If this is the case, the pricing may not be favorable.
- Lawsuit: In a worst case scenario, the partnership could file a lawsuit against the investor seeking to recover the amount of the capital call.
When performing due diligence on a potential real estate investment, it is critical that investors thoroughly read all offering documents, including the operating agreement, to ensure that they are aware of any capital call provisions and what the consequences of not meeting them are.
Summary & Conclusions
A capital call is a provision in a commercial real estate investment that allows the transaction sponsor to “call” for additional capital from investors.
The details of the capital call provision are outlined in the equity investment’s offering documents and it is critical that they be read and understood thoroughly.
If, for whatever reason, an investor is unable to meet their capital call requirement, there may be consequences which could include one or more of the following: share dilution, lawsuit, loss of equity, or forced sale.
For these reasons, it is critical that investors read and understand an investment’s offering documents to ensure they are aware of not only the initial capital commitment, but any potential future obligations with capital calls.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.