Real estate is rarely something you can just invest in and forget about. Redevelopment, capital expenditures, vacancy rates, and market downturns can all result in the need for additional capital to be invested. In an investment that involves multiple investors, a capital call might be required to keep the investment afloat or the development moving forward.
What is a capital call?
A capital call is the right a manager of a real estate partnership or private equity fund has to request capital from the investors. This is money the investors have promised to contribute either to purchase an asset or for additional cash needed during the life of the investment.
Some capital calls are planned and scheduled, so investors are already planning to invest the additional capital. The capital call is unexpected in some instances. This is called an unforeseen capital call.
Capital calls are addressed in the capital commitment agreement, or a capital call provision in the partnership or subscription agreement. When an investor commits to an investment through a partnership or fund, they are committing a certain amount of money. This may be limited to the amount of the initial investment, in which case they wouldn't be obligated to provide additional capital later on.
If the commitment is higher than the initial investment, the manager or sponsor can request any portion of the remaining funds if it's needed while the investor still has equity in the deal.
When is a capital call needed?
Planned capital contributions are common with development projects or investments that will involve major renovations. Instead of the sponsor collecting all of the money up front, they will draw from it as it's needed during the project.
Unforeseen capital calls are less common, but may be necessary in some situations. Here are a few examples of situations that will trigger a capital call.
A project going over budget
Anyone that's been involved in a construction project knows that unexpected things come up, and additional expenses get added. Most developers expect some degree of overages, so this is usually budgeted for. However, if the overages are more than the sponsor planned for, they may have to request more capital from the investors.
Increase in vacancy
A reasonable amount of vacancy is accounted for when projecting a property's future income. However, several factors can cause vacancy rates to increase more than anticipated. Whether temporary or long-term, a decrease in rental income may make it difficult for the manager to cover the property expenses and make the loan payments.The investors may have to inject more cash into the project to cover the expenses
Loans often have terms shorter than the investment's holding period. This means that the sponsor either has to refinance the real estate or pay it off. If the market is in a downturn, there might not be enough equity in the property to refinance for enough to pay the original note. The options are to sell the property at a loss or pay the principal balance down enough to be able to refinance.
A real estate investment fund may take on investors to purchase multiple assets. An investor may commit to provide an additional capital contribution above their initial investment when it's time to purchase more assets. The fund manager will request the remaining unfunded capital commitments to invest in more assets.
These are just a few examples of situations where a capital call would be necessary. There may be other possible scenarios depending on the investment. The need for additional capital contributions may be more or less likely from one investment to the next.
A limited partner may be more likely to be required to contribute additional capital in a limited partnership because the agreement often limits the amount of cash reserves a general partner can maintain.
Private equity funds are usually more likely to have the cash available on hand to cover expenses that a limited partnership may not be able to. Since the investor's money is usually spread out across multiple properties, high vacancy on just one of them won't have as great of an effect on the fund as a whole.
Capital call notice
When additional capital is needed, the manager will issue a notice to each of the partners that haven't yet invested all of their committed capital. This notice should explain why the capital call is being made, how it will be distributed, and any management fees that are included.
The capital call notice may include:
- Amount of capital needed
- Amount the investor has committed to
- Amount the investor has already contributed
- Total amount the investor will have contributed after the call
- Remaining uncalled capital
- Why the additional capital is needed
- Itemized list of how the funds will be used
- Due date
Unable to meet capital call
Some investors may not have access to the money needed to make their required contribution. Maybe they simply don't have it, or it's tied up somewhere else. A capital call might not be made for several years, so the partner hasn't been careful to keep enough cash on hand in case it's needed.
In any instance, a request for capital usually isn't optional. The investor committed to a certain amount of money when the agreement was signed, so they're expected to pay their share. The agreement will specify what the repercussions are for a partner not making their contribution.
There are a few ways this situation may be handled.
Their partnership interest is diluted
The percentage of their share in the partnership may be reduced. Since other partners have contributed more, their share may be diluted proportionally.
The requested amount becomes a loan
The additional capital the partner failed to contribute may become a loan. The partner is now in debt to the partnership for the amount of requested capital not contributed.
This loan may be at a high interest rate. It's often required that any distributions the investor is entitled to will be paid toward the loan while there is still an outstanding balance.
Loss of equity
Some partnerships have strict rules when it comes to partners that don't make their contribution. The partner might have their equity in the partnership reduced by as much as 50%. It could be reduced even more in some cases.
Give up distributions
The partner may even lose their right to collect distributions, or any other payouts, until the real estate is liquidated or the partnership is dissolved. This can result in a significant amount of money depending on the length of time left on the investment.
Forced to sell
The investor may even be forced to sell their interest back to the partnership. This is likely at a reduced value due to their interest being diluted.
Limited partners and investors in a real estate fund have limited liability protection, but only when it comes to anything over the investment they've committed. Failing to fulfill their obligation to contribute to a capital call may be a breach of their original agreement. This breach could result in a civil suit to enforce their capital commitment.
Any combination of the above
Failing to make a required contribution can also result in a combination of any of the above penalties. Their equity may be cut in half, they may be forced to sell, or they could lose their distributions as a punishment but still be required to pay it back as a loan.
The exact way a partnership will handle situations where an investor doesn't contribute the additional capital required of them depends on the original agreement. The penalty may even be different depending on the amount of the capital call. It may also depend on whether the partner didn't contribute at all or just wasn't able to contribute the full amount.
An investor can suffer a significant loss by not providing the money the partnership needed. The partnership, as a whole, can also suffer quite a bit from not receiving all of the money it needed. If the other partners aren't able to cover the difference, it puts everybody in a bad situation.
Capital call facility
Some situations require immediate capital. The manager may not be able to get everyone's capital contribution quickly enough to fund the partnership's capital needs. Capital call facilities are lenders that provide bridge financing to venture capital firms or partnerships to provide the money they need while they wait on the investors to make their contribution.
These loans are typically very short term. The funds normally have to be paid back in 30-90 days.
These lenders are known to offer financing quickly, even within a day in some instances. A lender may also offer a capital call line, which will provide a line of credit that the partnership leaves open to access funds as needed.
The bottom line
The ability for a sponsor to make a capital call is necessary in most investment situations. When it comes to real estate, unexpected expenses aren't uncommon. Without the ability to request additional money from the partners, all of the investors are at risk of suffering a loss if the financial needs can't be met.
As an investor, it's important to understand how much more money you might be required to contribute during the life of the investment. Pay close attention in your due diligence to understand what kind of additional contributions might be required of you. Simply having enough money available to make the initial investment may not be enough. Keeping enough funds available to cover any capital calls will keep your position in the investment safe.