As an investor in multifamily syndications, understanding capital calls is essential. These calls for additional funds can be a normal part of the investment process, but knowing why they occur, the right questions to ask, and how to distinguish between productive and unproductive capital calls is crucial. In this month’s column I’m providing readers with a guide to help navigate this important aspect of your investment journey.
Why Are Capital Calls Made?
Capital calls are requests from sponsors managing the investment for additional funds from investors. They can occur for several reasons:
- Unforeseen Expenses: Sometimes, unexpected costs arise—whether it’s a sudden repair, an increase in material costs, or regulatory changes that impact expenses.
- Value-Add Opportunities: Sponsors may identify new opportunities to enhance the property’s value, such as upgrades or additional amenities, which were not part of the original plan but can significantly increase returns by enhancing Net Operating Income (NOI).
- Market Conditions: Economic changes, such as shifts in interest rates or rental market dynamics, can necessitate additional funding to maintain the property’s competitive edge or financial stability.
- Operational Needs: There may be operational shortfalls due to lower-than-expected occupancy rates or rent collections that require bridging capital to ensure smooth operations.
Questions to Ask Before Funding a Capital Call
Before you decide to contribute additional funds, it’s important to conduct due diligence and ask your sponsor some key questions:
- Reason for the Capital Call: What specific circumstances have led to this request? Is it for unexpected costs, new opportunities, or operational shortfalls?
- Use of Funds: How exactly will the additional capital be used? Ask for a detailed breakdown of the proposed expenditures and their expected impact.
- Historical Performance: How has the property performed to date? Is this the first capital call, or have there been multiple requests for additional funds?
- Impact on Investment: How will this capital call affect your overall investment? Will it increase your equity share, or is it simply to cover losses?
- Sponsor’s Track Record: What is the sponsor’s track record with managing similar situations? Have they successfully navigated capital calls in the past?
Distinguishing Between Productive and Unproductive Capital Calls
Not all capital calls are created equal. Here’s how to differentiate between a capital call that adds value to your investment and one that may not:
- Accretive Capital Calls: These are aimed at enhancing the property’s value and, consequently, your investment returns. For example:
- Upgrades and Renovations: Funding for strategic improvements that can increase rental income and property value.
- Expansion Projects: Adding new units or amenities that attract higher-paying tenants.
- Market Opportunities: Leveraging favorable market conditions to refinance or acquire additional assets.
Accretive capital calls are usually accompanied by a clear plan and projections showing how the additional funds will increase the property’s value and improve returns.
- Non-Accretive Capital Calls: These often aim to cover ongoing losses or unforeseen expenses without a clear path to increased value. Examples include:
- Operational Shortfalls: Covering gaps due to poor management or lower-than-expected occupancy without a plan to rectify underlying issues.
- Unexpected Repairs: Addressing maintenance issues that should have been anticipated during due diligence.
- Debt Servicing: Needing funds to meet debt obligations due to cash flow problems.
Non-accretive capital calls might indicate underlying problems with the property or the sponsor’s management, and they often do not contribute to increasing the overall investment value.
From a high level, capital calls are an integral part of real estate investments, but they require careful consideration and due diligence. By asking the right questions and understanding the purpose and impact of the capital being called, you can make informed decisions that protect and potentially enhance your investment. Always ask a lot of questions when capital is being called, strive to differentiate between accretive and non-accretive calls, and work hard to ensure your funds are working effectively towards achieving your investment goals.
