Capital Calls: The Good and The Bad
To all investors out there: When you hear the term “capital call” what is your initial reaction? Panic? Concern? Frustration?
Due to the fact that capital calls often require real estate investors to provide additional funds within a short time period, they can be seen as a source of financial burden and stress since investors may not have the necessary funds available or enough time to raise it. Unexpected capital calls also indicate their investment is not as sound as they first thought and is potentially at risk of falling apart. As such, capital calls can have a negative connotation among real estate investors.
But as you’ll learn below, there’s more nuance to capital calls. While sometimes they may be a sign of a distressed deal , other times they are simply a part of the investment process wherein an investor makes an initial investment into a deal - which is essentially responding to a General Partner’s “capital call.” Keep in mind, there are specific things investors can look for to help avoid deals that have higher chances of “bad” capital calls.
What are Capital Calls?
In real estate, a capital call is any time a deal sponsor requests additional capital from investors. Capital calls are generally thought to be either good or bad, let’s drill down into each:
Good capital calls: Any time an investor invests in a deal, when they secure that initial investment, they are responding to a capital call. The hope is that this initial investment will yield positive returns and that there will be no further need for additional capital to be invested.
Bad capital calls: Real estate deals can go sideways with rising expenses combined with static or falling revenue. In these instances, sponsors may ask for additional capital from investors, depending on the structure of the partnership.
There are specific things that investors can do before choosing deals that will significantly limit the chances of a future capital call.
3 Ways You Might Avoid Bad Capital Calls
Avoiding bad capital calls comes down to knowing how to perform proper due diligence. Before investing in a real estate deal, look for the following things:
1. An experienced General Partner/Management team: A passive real estate investor should thoroughly research the management team of any syndication they are considering investing in to determine their track record and experience with successful projects. By understanding the background and success rate of a syndication’s management team, an investor can better gauge how likely it is that their investment will result in a potentially negative capital call.
2. Capital Call Process Outlined in Offering Documents: Before investing in a syndication, a passive real estate investor should read and understand the terms of the agreement carefully to ensure that all aspects regarding capital calls, returns, and other financial obligations are clearly outlined in writing. It is also important to understand the details of how capital calls work on each deal so they can prepare accordingly if one is issued during the course of their investment life cycle. Investors must understand when capital calls are likely to come about, how much money is typically required for each call, what rate of return is associated with those calls, and other related information before entering into an agreement with a sponsor.
3. Robust Scenario Plannings: An experienced General Partner will have planned for a multitude of variables. Examples of these variables are: supply chain cost increases, rent growth stagnation, interest rates increase, etc. The investment strategy should incorporate risk mitigation tactics. Some of our favorite strategies that have inherent downside protection are interest rate caps, vertical integration with construction (having more control over timing and costs), extendable loans, and of course, a large capital preservation strategy to “weather the storm” as needed.
Taking your financial future into your own hands is the best way to ensure security. To foster a safe and prosperous investment portfolio, two things should remain at the forefront:
Diversify Investments: Passive real estate investors should consider diversifying their investments across multiple syndications as opposed to investing in one or two large-scale deals, as this will help mitigate risk by spreading out capital across multiple sources and potentially reduce exposure to bad capital calls.
Stay Informed: Passive real estate investors should stay informed on market trends and changes taking place within their syndications as well as those surrounding them that may impact overall performance such as changes in local zoning laws or market shifts that could affect demand for rental properties or occupancy rates. By staying up-to-date on relevant developments, passive real estate investors can be better prepared to take appropriate action if needed when looking to avoid a bad capital call.
Learn More About Successfully Investing in Real Estate
Real estate is among the most attractive investment opportunity available. But many would-be investors struggle to match their financial goals to an investment strategy.
This is why we created Blueprint, a 7 part course which walks you through the basics of real estate investing, how to set goals, choosing the right strategy, plus more. This 7-part course also includes tactics on how to distinguish between good deals vs. bad deals as well as the characteristics of a good sponsor — details that are immensely helpful if you hope to avoid bad capital calls.
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