My Investment Has a Capital Call, What Should I Do? | Aspen Funds
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My Investment Has a Capital Call, What Should I Do?

Heard of “capital calls”? Wondering if it’s worth the plunge? Get the scoop on whether it safeguards your capital or leads to financial pitfalls. Tune in for a quick dive into this essential aspect of real estate investment!

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Ben Fraser: Welcome back to another episode of the Invest Like a Billionaire podcast. I am your co host, Ben Fraser, joined by fellow co host, Bob Fraser. 

Understanding Capital Calls in Real Estate

Ben Fraser: If you’ve invested in real estate for the past couple of years, even recently, and you’ve heard this term capital calls, you’re going, what is that? Should I do this? We have some news for you. If you invest in real estate and expect to, for a period of time you will be asked for capital calls. It’s just kind of part of the deal. But the question is, is this worth doing? Am I putting good money after bad, or is this something that really will protect my capital and help me not lose capital? So stay tuned. We’re gonna dive into all the things you do to understand if this is something worth doing. 

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Breaking Down the Concept of Capital Calls

Ben Fraser: So Bob, what is a capital call? Give us a real quick, just breakdown of what that means. These people hear this term, it’s floating around. And people might not know what that means. 

Bob Fraser: Capital call is when a capital guy comes knocking on your door and says, write me a check. So you’ve made a passive investment. So maybe you put a hundred grand into an apartment deal, multifamily deal or something. And the operators come back and say, something went wrong.

We’ve got an issue and we need a little more money. And so because you put in money once, you can, you got to put money in again. And of course, there’s rarely an actual obligation to put in money, so you don’t have to. But the issue is, a lot of deals that if there’s not additional capital coming in, you could lose the entire investment.

So if I put a hundred thousand in, I could lose the entire hundred thousand. 

The Risks and Implications of Capital Calls

Bob Fraser: If you’re in the equities part of the stack, you’re the last capital to get paid. You get the most bang for your buck if it works and you’re, but it’s also the riskiest if it doesn’t. And it’s really protective of the way.

So let’s say, rates went up, they got a delay, they’re rehabbing this apartment complex. So they had a bunch of delays or something for some reason. And all of a sudden now they just don’t have enough money to finish the rehab and Because it went longer, they had more interest payments, so now they’re coming and saying, Hey, we need another $30,000 from you. So that’s a capital call. 

Ben Fraser: That’s a capital call. And so to your point, it’s not usually a requirement, right? So a sponsor will come to you and say, Hey, we need X amount of dollars spread across all of our limited partner investors. This is how much pro rata we need everyone to contribute.

And then usually it’s qualified by if you don’t contribute, you will at a minimum be diluted right in your equity because they’re bringing more equity to, make it a bigger pie from the initial pie. And so you will be diluted, meaning your ownership of that equity goes down if you don’t contribute.

Bob Fraser: And let me just make a point. 

The Impact of Capital Calls on Investment Returns

Bob Fraser: Some deals are called crammed down deals and that’s where they are very delusional. So the truth is that new money is always worth more than yesterday’s money. And maybe they raised 10 million to buy this apartment complex and they only need two more.

And maybe you got for $10 million, you got a certain percentage of the deal, but the $2 million is a lot more valuable money. And so those guys can come in and say, I want a bigger percentage of the deal. And so you do what’s called a cram down of existing investors. Now, I haven’t seen any real estate deals that are doing cram downs but it’s very common.

And that’s where it is very delusional. You could literally be, really diluted, heavily diluted. So you, it’s very protective but it opens up the operator to lawsuits, investor lawsuits. 

Ben Fraser: Sure. Yeah. So it’s, maybe that’s common in real estate, but it is a possibility. And if a sponsor gets desperate enough, they have to make it attractive enough for the new equity coming in.

But to your last point, If they don’t meet this capital call, if they don’t get the funding requirement, it’s possible that the deal doesn’t make it, right? And then at that point, since you are Comedec, you are the last person paid in the line of, capital on the capital stack. You have the highest risk of loss.

The Future of Capital Calls and Real Estate Investments

Ben Fraser: And so it’s really important right now because we’re entering into this, the beginning parts of a lot of deals that are struggling. A lot of loan maturities are hitting over the next 18 to 24 months. Interest rates are 500 basis points higher than when most of these deals were initially underwritten.

And has completely changed the landscape. And we want to just come on and break down what are the things you should be looking at? 

Bob Fraser: Should you write a check or not? Write a check. We’re going to answer that question. 

Ben Fraser: Yes. And it’s interesting, too, because part of the reason I had this idea to talk about this is I think investors are feeling this, right?

They’ve been hearing it and we’ve talked with a lot of investors even in the past few weeks that are just saying, Hey, I just need to hold onto my cash or trying to get as much liquidity as I can because I was expecting a lot of capital calls in 2024. And if you haven’t been called yet and you’ve been invested in real estate, lucky you, but you might be getting some calls here pretty soon.

How to Navigate Capital Calls as an Investor

Ben Fraser: So we’re going to break down some of the key things you want to look for. So set the framework. I think first you have to understand and ask the question of what happened, right? 

Understanding the Causes of Capital Calls

Ben Fraser: That’s the first question you got to answer. And I think it’d come down to a few broad categories and it’s usually not, one or the other.

It’s probably a combination of both, but I put the two big categories are mismanagement and missteps of the sponsor. And then things that they couldn’t control in the economic and external environment that they’re in, that have impacted the deal and changed the deal from the initial underwriting, right?

Because when a deal is initially underwritten, they’re always building reserves in, they’re always building some sensitivities and stress tests in.  

The Impact of Economic Shifts on Capital Calls

Ben Fraser: We’ve had one of the biggest and fastest shifts in the commercial real estate market that we’ve seen in the past several decades with the interest rates rising as fast as they have, it has completely changed the game on what credit looks like, what the getting new capital, new equity looks like.

And just risk tolerance from banks, lenders, et cetera. And so you really have to understand, was this predominantly due to mismanagement of the budget, the operations things that could have been foreseen or at least could have been handled better, right? What’s been the communication of the sponsor since the deal was started?

Have they actually shown you everything has been going rosy? Hey, we’re two years in this deal, we’re going great, and then all of a sudden, out of nowhere. Hey, we only have three months left. If we don’t get these capital deals going to foreclosure, that’s not a good sign, right? If it’s been swept under the rug, I think you want to see some transparent communication.

But then also realizing like real estate is. A business, on the active side, is the sponsor. This is an active operating business that they are doing. And there’s things that you can’t foresee. There’s plans that don’t happen and things that do happen, you don’t expect.

And, we always do really good underwriting. I believe in all of our deals, we try and think through every option, stress, every conceivable thing we can think of. But at the end of the day, I know that I’m never going to hit 100% of my proforma. It’s just impossible because I can’t predict the future.

Bob Fraser: It’s all projections and all assumptions. 

Evaluating Underwriting Assumptions in Capital Calls

Bob Fraser: We all have to make assumptions now, but we’ve seen a lot of underwriting out there and we’ve seen very aggressive assumptions in some of the underwriting. You’re going to get 20% returns and here’s all of our assumptions, you’re going to see super low cap rates, you’re going to see this and that and the other, and it’s all these assumptions and, it’s a real mistake.

So it is hard for a novice to look at underwriting and figure out if it’s aggressive or not. And we had to do another show on really, how to look at the assumptions underlying these underwriting. But a lot of times, a lot of times, as you point out, it’s not the fault of the operator.

But even if it is the fault of the operator, the question is, are they doing stuff that’s right? 

The Role of Management in Capital Calls

Bob Fraser: I was just in a capital call and these guys they partnered with a pref equity company and the pref equity company says, we have a manager, a new management company that we’re starting. We will, I will give you the money on the condition that we can manage the property.

So they agreed to this property manager today. Terrible job during COVID, not doing proper credit checks and letting all the wrong people in. It just nuked the project, but they’re doing everything right to fix the project. So there’s just lots of missteps that can happen, especially when you’ve got big complex deals like, like that and lots of things where they’re really real, somebody really dropped the ball.

The question is, are they really doing, do they have a plan going forward? 

Ben Fraser: And so I would say first, get the understanding of what happened, right? You want to have a good story that makes sense, right? What you just said makes sense, right? And I think in that scenario they put a lot of tenants that shouldn’t have been renting, they did terrible screening, and then COVID hit, and they couldn’t evict.

So now they have just cash flow burned like crazy that they couldn’t predict, and they are operationally Getting the project back on track. So they’ve gone through the eviction process. They’ve replenished new tenants that are paying, that are higher quality tenants. Occupancy is trending upward.

So the first thing that I say you got to look at is, look at the operational trend lines of the project, right? Because real estate, at the end of the day, is its location, right? So if it’s in a good area, if it’s in a if it’s a good property in a good area, And you’re starting to see positive trend lines.

So the positive trend lines I would look at are you seeing, the gross potential rent, which is. What’s the market rent, in that sub market for similar type properties? Is that holding stronger or growing, right? And then you are the deal trending closer to that, right? From both a market rate standpoint for what you’re actually charging.

On the units and then also occupancy because a lot of times the breakeven occupancy, depending on the leverage and the capital stack, it’s probably going to be somewhere in that 70 to 80% range. And so it’s, they’re all right in the bubble, right? So maybe it’s 65%, but they’re pre leased to 70, which means they have new leases that have been signed, but not yet moved in.

And so you’re seeing these positive trends toward the right direction. So that’s it. Something you really want to see and then you want to understand too, the other kind of piece of this is to throw in just their interest rates, but you may not be aware, but the whole insurance market is completely in upheaval.

We’re seeing insurance renewals on a lot of properties, especially in the south southeast. 100% increases year over year, double. We haven’t seen these types of increases really ever on insurance. And so you’re seeing all these surprises aside from just the interest rate, challenges.

So understand what’s going on the expense side as well. And then what’s the path to cash flow, right? 

Understanding the Path to Cash Flow

Ben Fraser: That’s the key thing. If you can cash flow. 

Bob Fraser: Two main things we want to look at, and these are two big questions you need to answer to get your yes and your no. And that is, do they have a path to cash flow?

We’ll talk about that. 

The Importance of Clearing the Capital Stack

Bob Fraser: And then the second is. Do they have a path to clear the capital stack, to basically pay back all the lenders and investors? Path to cash flow. What does that look like, Ben? 

Ben Fraser: That’s what I’ve just been saying. You want to look at what’s the trend line for your revenue, right?

Because that’s going to create the margin if you can continue to grow revenue, whether that’s through higher market rates and higher occupancy. Those are your two real levers, right? And then you want to understand the expenses. Have they absorbed a lot of these new higher expenses? And that creates your net operating income.

And what’s that currently right now? And where has that kind of trend been going over the past three months? And where’s the next three months look like from a pre lease standpoint or just getting new leases in. And so you want to see the trend lines go in the right direction.

And then you want to see that path to cash flow because if you start getting the higher occupancy, you get your expenses under control, you get your market rates. Then, that cash flow number is hopefully not too far away. Meaning you’re the NOI, the Net Operating Income on your property.

We’ll be able to service all your debt and continue to keep the property afloat. Because if you can get to cash flow, you can ride through the storm. 

Bob Fraser: And one of the biggest issues of cash flow, yeah, is occupancy, as you just said, are they, are the trend lines good?

But then is the debt, can the debt be serviced? And a lot of times they may be talking about bringing in new debt. And so while that debt can be paid right out of cash flow and still you want to know, can it get to cash flow positive? And you want to understand too, a lot of the lenders have a debt service covering a covenant where the, you have to have a certain coverage ratio.

And it’s usually somewhere around 1. 25, meaning that the property has to have enough cash flow to cover the debt service at 125% of the debt service. And so you want to do all that math and. And ask and really push on that and a lot of times when people do capital calls They will have a webinar that will have a call and it’ll be available to ask questions So these are the questions you need to ask is show me the path to cash flow show me what this looks like and and it may not be clear may not be a clear answer one of the other deals I’m looking at they’re getting ready to do a capital call and basically they need Because interest rates spiked and they’re seeing a maturity in their bridge debt, they need a million dollars just to just to put a rate cap in place for one more year.

So it buys you one year. So then the question is, you have to ask what does that one year buy you? What after one year? What if the rates don’t go down? Is it the same story again? And the answer is probably yes to another capital call. And Not good, right? Not good. So it’s not always a clear cut decision on the cash flow, when you have these big one time expenses, you have to make assumptions on interest rates and you have to make assumptions on insurance and on taxes, right?

We see huge, big tax raises recently, some for some reason. So you have to make assumptions and all that. 

Ben Fraser: Yeah. And I think that’s a great point, right? We, yeah. A capital call should hopefully be a one time thing, right? So the next kind of part of the questions you should be asking is, How much time does this buy you, right?

And in this case, you just gave an interest rate cap that they’re buying for one more year, which basically Limits the the interest rate that they’re paying on their debt service. And they’re basically buying a swap so that they can keep a fixed rate at a lower rate. You can pay the debt service at that lower rate versus the readjusted higher rates.

They’re very expensive right now for obvious reasons, because interest rates have gone up so much. And if that capital call only buys you enough time for one year, you better see really strong performance within a few months. Like service, not only the current debt service, but adjustment in the interest rates after a year.

And if you don’t, then you should ask the question, what happens if we’re a year from now? We’ve got a little bit of improvement. Are you going to do another capital call? 

Bob Fraser: Because another capital call generally is not an option. Generally you, I’ve never seen a second capital call work.

Generally you got one shot, right? You got one shot to convince investors. And I’ve seen a lot of mistakes where they say, okay, we need X bucks. We divided a buck up a gum, a box to all their LPs. And then only about 50% of the people respond. They only raised half of their required number.

You have to get that, so you get it, it’s all or nothing with these capital calls. If you need 3 million bucks, we need 3 million bucks, and a billion and a half isn’t going to do it. So a second capital call is not a, not an, not going to work. You want to really look hard at this capital goal, will it get them over the hump cashflow wise?

Ben Fraser: Yeah. A hundred percent. And I think the other main thing we’ll look at you said earlier is how do they clear the capital stack? And what do you mean by that? Explain that. Yeah. We’ve talked about capital stack before and it’s very important right now if you’re doing a capital call to understand.

What does the current capital stack look like? Is it, a bridge debt lender with a short maturity with some preferred equity on top that’s hard pay, which means they actually have takeover rights if they’re not being paid current. And then you’re the last, sliver here.

Understanding the Capital Stack in Depth

Bob Fraser: And let’s dive in a little bit deeper on that and just talk about hard pay, soft pay and the capital stack. So just because we want to be, really explain this to people that this may be a new concept. So the capital stack starts with the senior lender and typically that’s a bank or bridge lender and that’s the senior mortgage and they have a lien on the property and guess what?

They get money. They get it. Paid off 100% before anybody gets anything else, right? So that’s called priority and they have the top priority. So every bit of cash coming out they have priority then the second part of the stack is a mess debt if there is any now that’s uncommon But it would be a second lane A second line in essence.

And they get paid the next money after the first, the senior lender gets paid off. Then they get the next money before, and they get paid off a hundred percent before anybody else gets a dime. And then the next, and those are fairly simple. People understand those are mortgages, right? Then is preferred equity, pref equity.

And this is where this is actually, this is equity, but they get paid off. A lot of times, 100% before common equity gets in. And then common equity is what you and I typically invest in as a limited partner. So we get paid last. Okay, so talk about pref equity and we’ll talk about bridge first. Talk about bridge, the nuances of bridge and talk about, then talk about pref equity.

Ben Fraser: Yeah. So bridge is, you’re referring to as bridge debt, which is, generally senior debt and generally non bank debt. So this was very common kind of in the 2020, 21 kind of era where a lot of deals were done at pretty high valuations and there’s a lot of attraction for doing this as a sponsor.

We’ve talked about this in the past. But They generally get very high leverage, 80% on purchase price plus 100% on renovations. 

Bob Fraser: If you’re doing a deal and you’re getting 80% bridge, that means you don’t have to raise 20%. So it’s a good deal. 

Ben Fraser: Good deal. It’s non recourse to the sponsors, meaning there’s no personal guarantees except for fraud.

And pretty attractive, really high leverage, don’t have to raise much equity. I don’t have any, I don’t have any personal guarantees on the line. So it was very attractive. Good. The issue was. They’re always floating rate. They’re floating right now. It’s unless you bought an interest cap, interest rate cap.

And so and that’s a lot. 

Bob Fraser: Usually three years. Usually a max of three years. And so what’s happening, a lot of the deals are now maturing. These bridge debts and the floating rates are spiking up. 

Ben Fraser: 100%. So that’s where a lot of these deals were initial three year terms, they’re starting to hit their maturities.

Yeah. We’ve talked about this in past episodes, but at least 25% or more from what we’re seeing so far. Will not qualify for refinance. So they don’t have, they haven’t hit the operational targets in NOI necessary to achieve the valuations to get new debt that would pay off their current debt.

And so that’s where a lot of deals are at. And preferred equity, yeah, preferred equity generally sits on top of that and increases your effective leverage even more. So they come in and take anywhere between 70 to 80% or kind of.

Bob Fraser: I’ve seen them from 80 to 90. So they, so you only raise 10% common equity and you’re 90% leveraged.

Now this is an example of very risky underwriting and there, but the 25% IRRs. Yeah. That’s if everything goes great, but anyhow, so right. Back to PREF. 

Ben Fraser: Back to PREF. There’s generally two common types of PREF, hard pay, soft pay. Preferred equity generally is structured where they have a current pay portion that they are expected to get on an ongoing basis.

So they say it’s a preferred return or it’s almost like an interest rate where they have to pay that every month. Okay. So it’s cash. 

Bob Fraser: So the property has to pay cash, a portion of it. 

Ben Fraser: And so that’s usually somewhere in the 6% to 8% range paid out every month, just like you pay your senior lender.

And then they have a back end fee, which is somewhere between, say, 6% and 8% that gets paid out, not in cash, but once the property sells or refinances and they get paid off, that accrues every year. So it’s expensive, but it can effectively increase your leverage, it can help.

Increase returns for the equity investors, but the kind of big distinctions are hard paper, soft pay. So a hard pay for an equity group. If they are not being paid on their current portion that has to be paid out in cash every month, that 68%, they have the rights generally to fire the manager, which is the sponsor and take over the deal and make decisions on the strategic And or force a sale.

And or force a sale. 

Bob Fraser: Now, if they force a sale, they don’t really care about the common equity on top of them. They just want to get paid off. So anybody down the capital stack, forces a sale generally will mean. A wipe, a hundred percent wipe out for the equity guys. So you get the senior lender starts or forecloses, the junior lender forecloses, or the pref equity guy takes over a deal to force a sale.

All those cases, you will see the equity guys, the common equity guys get wiped out. 

Ben Fraser: So that’s the capital stack. 

The Path to Clearing the Capital Stack

Ben Fraser: And I think going back to the initial question is how do they clear the capital stack? And what that means is what’s the path? They got the path to cash flow. But then, what’s the path to get fully stabilized, meaning they kinda hit higher occupancy, they’re hitting their projections on their net operating income, and then whenever, if they have a bridge debt lender that is, their note is maturing in a year, they’re gonna have to either refinance or sell.

And, based on valuations, based on the current net operating income, what are the assumptions that they’re making to refinance that? What’s the interest rates that they’re using in their analysis? What’s the valuations they’re using in their analysis? And. What you want to do, so path to cash flows first, because that saves a property from getting behind in payments and having a foreclosure.

But if there’s not enough, uh, operating income to support the value and the values have gone down a little bit right now, right? Because interest rates are higher. Then they’re not going to be able to clear the capital stack. And with a refinance or a sale, and that impacts you as an equity holder where you’re not going to be able to, they’re going to have to continue to figure out the capital stack with that gap that they have, right?

We talked about it. Those are the real big things. 

Bob Fraser: How can a novice figure that out? If the cap rates are real and the assumptions on the refinancing, like clearing the capital stack are accurate. 

Ben Fraser: Yeah those get a little more technical. The kind of simple thing I’ll say, here’s a simple heuristic to use cause most deals will refinance into agency loans.

So this is a Fannie Mae or Freddie Mac. These are agencies. Government supported lenders that have generally more attractive financing than other banks and bridge lenders. And they only generally lend on stabilized assets, right? So it’s a perfect fit for kind of refinancing into more permanent financing.

I’d say the primary thing they look at is debt service coverage ratio, and they want to see right now a 1. 25 X debt service coverage ratio. So what that means is they have enough net operating income. Divided by their now new debt service from the Fannie Rufferty loan at a 1.

25 ratio. So there has to be On a 25% coverage of the On a 25% coverage. So that’s the simple one. 

Bob Fraser: Are those amortizing? Are those full amortizing or interest only?

Ben Fraser: They’re usually interest only, but they will, the 125 is based on amortizing debt service. 

Bob Fraser: Gotcha. So that means where they’re paying interest and the principal portion as well.

So you got to ask that. And then what are their LTV limits? Cause that’s another issue that properties are having. 

Ben Fraser: Yeah. LTV is less of an issue because they’ll generally go up to higher LTVs, but with current debt service at the interest rates right now, inevitably the LTVs have to be a lot lower though.

That’s usually the constraint is debt service because of interest rates being higher. 

Bob Fraser: Really the main thing is 65% average ratio is and there you go. 

Ben Fraser: Here’s the last thing I’ll say on capital stack cause we’re getting really in the weeds here, but a highly leveraged deal on the front end.

Let me say this, the higher the leverage from senior debt to MES to PREF and that kind of whole stack ahead of you as common equity, the more that is of the capital stack, the harder to play everything to achieve. Everything is harder because in this environment, credit has tightened, leverages are coming down, interest rates are higher, everything’s more expensive.

So the chance of success goes down in my mind exponentially, the higher the leverage that you have is. So I think that’s it. Just a simple thing to understand is what was the initial underwriting and leverage? If it was 80%, 90%, combined, it’s a very, in my mind, small chance that the deal is going to survive.

Bob Fraser: And let me say one final thing here. 

Final Thoughts on Capital Calls

Bob Fraser: So getting back to our yes versus our no. Yeah. I think you, your first app, your first approach should be, this is a yes looking for a no. Your default should be a yes because you realize that if your answer is no, and if this doesn’t work, you will get wiped.

Probably. You’re probably looking at. Depending on the market and everything, but you’re looking at probably 100% losing 100% of your investment. So you should be saying, let me go and be protective about this unless there is really a reason why this is definitely good money after bad.

This is not going to get me. This is a bridge to nowhere, right? This is a capital call that gets me. It doesn’t get me across the chasm and then it shouldn’t. But if it can get you across, you really should do, you really should do the capital calls. And then smart investors always reserve a little bit for capital calls.

I understand that even the best deals and the best operators have a deal. Sometimes it just goes, it goes a little haywire. 

Ben Fraser: Right? So hopefully this was informative to you and helpful. 

Conclusion and Sign Off

Ben Fraser: And we’re planning on doing a lot more of these kinds in this vein, because we know this is a really important issue for investors over the next few months.

So feel free to write in questions, other things that we can spend more time on. And We really appreciate you listening. Hopefully you got a lot of value from this. We appreciate your feedback, any reviews, sharing this with folks, and hopefully you tune in next time for another episode of our podcast.

Thanks so much.


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