Capital Calls: What to Know Before You Put In More Cash

0:00Every real estate investor eventually faces the same version of the same problem. A deal needs more cash than expected. For an individual owner, it might be a major repair, prolonged vacancy, rising expenses, or refinance shortfalls. In a partnership or syndication, that request may arrive as a formal capital fall. The structure is different, but the underlying decision is the same. Will adding more money protect a sound investment and cover the plan? That no longer works. I'm James Sanders, stepping into the host seat for Dave Meyer. And today I'm with my co-host, Kathy Fecky, and we're talking about why real estate deals run short on cash, how investors should evaluate the next move, and what situation can teach us about underwriting, reserves, debts, and risk in the current market.

0:52This is On The Market. Let's get into it.

0:59Kathy, how are you doing? I'm doing great. Kate, I'm excited about this topic. There's so much to talk about. Yeah, and capital calls, like, I mean, to keep it kind of simple for everyone, it's when you're buying a property, you're using a performa. These are your projections on the deal, whether it's a rental property, it could be a development deal, it could be a flip home. During those projections, you need a certain amount of capital that's anticipated to do that deal. Now, if you're the individual operator, like a flip, and I need more cash, I just got to bring more cash to the table or go borrowing.

1:29But when you're in a formal partnership, like a joint venture partnership or a formal syndication, this is where the operator is asking the investors more for the capital to bring it in. And it's always a question of, is it the right move to bring the capital in or not? And so the deal's out of money. It's more than you were expecting to put into the deal. And you've got to write a check to keep this thing going or look at either selling the asset or just taking the loss. But it's something that happens across the board, but we've been hearing a lot more about it, especially the last 12 months.

2:03There's been a lot of different capital calls going on, especially with the floating interest rates. People's projections are slowing the economy. And Kathy, you're probably one of the most experienced people that I know that has been in a lot of syndications. I mean – I'm really happy to say we have never issued a capital call at Real Wealth. We haven't done that. But I was in a deal where in the documents, and again, when it comes to a syndication, that syndication is ruled by the documents. You can't just willy-nilly decide to change things. When you go into a deal, there's a framework of how the money flows, basically, how you get paid out, who gets paid first, and if there is a requirement for a capital call.

2:51And a lot of new investors don't maybe read through the PPMs. They don't know this. I'll give you an example. We have a multifamily fund right now that has capital calls and they're required. But people know that before they go in. The main reason is it's a fund. So we don't want to tie up people's money. We don't want them. We don't want to take their money till we have the deal. So basically, we're saying you just put 5%, 10 % in right now. But then over time, you're going to have to keep putting more. and this is our agreement up front. They know it. They've got that money maybe in a, I don't know, a savings account where they could make money on it while they're waiting for this, but it's expected.

3:31I was in another deal where the document said there could be a capital call, but you're not required. But if you don't bring the money in, you will be diluted. Basically, the new money kind of gets priority to yours. Again, you know, I knew that going into it. And sure enough, the project ran out of money, and they wanted us to put more money in. And I said, no. And I'm telling you right now, this operator is trying to blame me because my group was one of the larger investors in this. And so for us to not put more money in was pretty serious. But I didn't see any reason to. I asked for an updated pro forma.

4:14I asked how our new money was going to save the project. There was no answer. So this guy's trying to sue me, even though the documents make it very clear that we were not required to make that capital call. And we certainly weren't going to do it unless he could show us that it would make any difference at all. This was a construction project. And I mean, it was like 10 years into the deal. It was still dirt. So it's like, what is another 60 grand going to do? We're not going to get there. Show me that this new money is going to get us there. And really, when I asked him, where's the money going?

4:49It was going to him. It was going to his management fees. So it was just to pay him back. I couldn't believe it. It was so blatantly selfish. But now, anyway, he has no lawsuit because the documents spell it out very clearly that we weren't required. So that's the first thing people need to do is look at your documents if you're already in a deal. And what does it say about the capital call section? Well, let's break that deal down a little bit. So developer is in a project for 10 years, I'm guessing when he came to you guys to raise capital, right? And we all do that passive income. You know, there's many reasons of why you want to invest in deals like that, right?

5:28Like if you don't want to take on a big development site. Or I invest in some syndications because I wanted to invest in different markets, but I'm not an operator in those markets. And so, you know, it allowed me to take my investment, spread it out into different assets, whether it's development, location, and it's a way to get a tax write-off and spread your money out. Now, this developer brought you a deal. They had a performa when you looked at that originally going, hey, here's what you can invest in. If you bring in this much capital, you'll have this much ownership, and here's the structure.

6:02And that's all put in, like you said, the PPM, the private placement morandum, which spells everything out. During that time, they're giving you a performa, which is going to be how long is this deal going to take? How much cash does it need? What's the anticipated profit? And as the investors, what are we anticipating to make by putting money in the deal. Now, I'm guessing this deal wasn't projected at 10 years. I mean, literally, he was supposed to break ground that year. And that's what was presented to us. You know, and I get it. The project is in California, and there's all kinds of things that can stall your projects.

6:39And I think at one point, there was a fire that came right through, you know, California. So a lot of unexpected things. So I, you know, I get it. This project got delayed. Costs went up dramatically and the numbers just didn't work anymore. But when we looked at it, it just didn't look like it was salvageable. So you have to make that decision as an investor. Do we just keep pouring money into this to the point where, you know, it may or may not still get it off the ground? We may or may not get our money back. Does it make sense? And that's the pressure that a lot of people are feeling right now.

7:14With multifamily, we're seeing this all over the place because a lot of those deals were underwritten, not expecting rates to go up as dramatically as they did, not expecting rents to stay stable. A lot of these were just projecting that rents would go up a certain amount every year, which is just no guarantee. So, you know, they're in a situation where costs have gone up, income hasn't gone up. And the way a bank looks at things is they look at the NOI, the net operating income. So what's left over? And if it's not enough, the bank's not going to lend, you know? Or they're going to offer a much lower LTV, which means that the group has to bring in more money because the bank is going to be at a lower LTV than expected.

8:00So does it make sense or does it not make sense? That's what people have to figure out. Yeah, and that's basically the deal needs more capital to complete it or to get it where the projections were supposed to be. And, you know, like on a development deal, a lot of times it is always time in building costs. You know, this guy bought this property 10 years ago. Building costs were a lot different 10 years ago. Yes. I mean, you're probably looking at a 35, 40 % increase on your build cost just based on time. Oh, yeah. And there's debt on the property and permitting timelines and survey. And this requires more capital.

8:35Now, when you get this call back, you know, and the developer ran into some snags, you know, they're in a jurisdiction that's tough. They need more money. But then we have to make a decision as the investor of, do we put more money in? And where's it going? I mean, this is the first thing I said, where's it going? Show me exactly where this money is going. I get it. Costs have gone up. It's delayed. Much of that was not your fault. But now give me an updated pro forma with the new costs. when he finally did show us where the money was going. And like I said, it was going to his management fees.

9:08Absolutely not. And that's what we have to do as investors is, you know, let's say we put a hundred grand in that deal and your projection, your pro forma, let's say it was 20%. That's a smart investment for me to take as long as I go through all the steps and procedures, underwrite it, look at the documents. Fast forward, a capital call is when the operators are then going to say, hey guys, look, for us to complete the deal, we need more cash. The steps you always want to take is to look at what is that going to make me? If I got to put in another hundred grand and now the profit looks like it's going to be 5 % on the deal on the new Performa.

9:44Like Kathy, you wouldn't even get a Performa. So that's, that's, that is like, if no one's giving you a Performa, then definitely don't put the money in. Make sure also, if you're in a deal that you understand other ways that the operator can get money. For example, if your, if your documents allow them to get a loan, If nobody wants to do a capital call and instead they're going to get a private loan or private equity or what they're calling rescue equity, rescue loan or anything like that, we're seeing a lot of that right now. You've got to, again, read the documents. That is the rules of the game.

10:17The game that you signed up for, it should be spelled out very clearly of what the operator can do and what they can't do. And if it's not spelled out, then they can't do it. Or if it says they can't do it, they can't do it. So understand your documents. And if it allows the operator or the syndicator to get a loan, there's a very good chance that rescue loan is going to take priority to your equity. So if you don't know this going into it, you might just, you know, have put more money in on a capital call only to have rescue money come in ahead of you. And so, again, we're seeing that happen a lot where people are, you know, initially a couple of years ago, we're just going to do the capital call, but rates are going to come down.

10:57Rates are going to come down. It'll be OK. And now fast forward a couple of years, now they got to go get this rescue money that takes priority to everybody except for the main lender. You know, you've got to know where you stand in the capital stack. And so many people don't understand that oftentimes, most of the time, debt gets priority. And if your loan documents allow this, you need to know that. No, yeah. How is that operator going to bring in the cash no matter what they need it to do the deal? And if they're bringing in that third party, it's going to dilute your ownership. But sometimes that's OK.

11:28hey, the right call is like what you did was to not put more money in, right? Because it's also time value of money. Can you take that money and put it somewhere else? And a lot of times, I talk about this a lot too, like sometimes you just have to take it on the chin and move on. We're gonna hit pause for a quick break. More from Kathy just after this. Summer bookings sound great until someone slips by the pool, gets hurt on your dock, or damages your property during a long holiday weekend. A lot of short-term rental investors don't realize their standard policy may leave gaps when it comes to short-term rental activity.

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14:31Welcome back to the On The Market Podcast. I'm James Daner with Kathy Fecky. Let's jump back in. We're hearing a lot about this in syndication, especially right now, right? We've had market change dramatically. Interest rates shot up at the fastest rate anyone's seen in years. And we have the economy and rents were growing at like 10 % at a time. And certain markets were on fire. And a lot of syndicators out there were chasing those markets because they had high rent growth. Rates were really low. And they saw that these deals could be very profitable if it kept the same metrics. But as we know, they're historically low rates, historically high rent increases.

15:15And once everything cools out, the numbers start changing. And so, Kathy, what do you see on the multifamily side? There's, I mean, a lot of deals are going to zero right now. That means the operator called capital and no one would put more money in or they couldn't raise enough capital to keep the deal alive. And at that point, then operator is now selling off the asset. and a lot of investors are getting wiped out because they have to sell it on a cap rate and the cap rate only supports a certain price. And so if you're a multifamily investor and you're in a syndication, I mean, what should you look at if someone is getting a capital call and whether they should put the money in or not?

15:57Yeah, it's a really, really difficult situation. In a lot of cases, what's happening is, depending on the purchase price, Let's say somebody just overpaid. There was a bubble. There was a frenzy. This always happens at the top. It almost always happens when money is cheap. So let this be the lesson for everybody. Money fluctuates. It goes up. It goes down. The cost of money. This is historical. At least in America, when we have a Federal Reserve, when we have a system where rates go up and they go down depending on inflation and different variables, who's buying bonds, who's not. There are lots of reasons why rates go up and down.

16:40But the fact of the matter is they don't stay low forever. But when they are low, it's a frenzy because everything's cheaper. And when everything's cheaper, then people are willing to pay more. Because if the loan is so low, 2%, you can afford to pay more for a property because the numbers still work. Now, if you're buying, like a lot of what I do and you do is single family, one to four unit. So you're in fixed rates. So you don't have to worry so much. If you get a 2 % mortgage on a property and that's a 30-year fixed, you're golden. You know, like get that all day long. You don't care if rates go up.

17:18In fact, it's good for you, right? You're locked into this low rate. But if you're on an adjustable rate and you're getting a super low rate, we've seen this time and time again, it's going to adjust. And by the time it adjusts, it could be much higher. And this is where so many people got blindsided, mostly new investors because they haven't been through it, but also a lot of experienced ones were somehow mistakenly thinking that they were going to stay low forever or only go up a little bit. And if you look at averages, we're kind of at an average. We're at a normal rate right now. So to not think that things would sort of buoy back up to normal was just poor foresight is the best I can say.

18:03So when rates are low, it drives prices up because people can afford to buy a higher priced property and have the numbers still work. But as soon as the rates go up and they have to refi, well, the values come down because now people can't afford it. So in a lot of cases, these multifamily properties are 30 % lower than they were in value, maybe even 40 % in some areas. It's going to take a long time for those values to go up again, and they may never. It may have just been a moment in time where it was a bubble, that bubble has burst, and you have to understand the current value of that property.

18:44If it's gone down 30%, why put more money into it? You've lost your equity? What are you going to sit around and wait for a couple of decades for the values to come up? I mean, so that would be the first thing I would do is really try to understand what the current value of the property is. I mean, what would you suggest for people to understand the value of the current investment that they're in? Well, you want to look at the current cap rates in the market. And each market is going to offer a different cap rate and what actually building you're in. And, you know, typically right now, you know, rates are high.

19:16They're five and a half, to 6%, right? And so your cap rate in theory should be around 5.5 % to 6 % or higher, really. It should be actually higher than that. And so, you know, a lot of these projections of performance, right? You were talking about overpaying. People were running their exit caps at like four caps. Oh, I know somebody who did a syndication in Houston and they bought a one cap, a one cap. And again, now a lot of people might not understand what that means, but that basically means that you think you're going to improve this property enough that it goes up in value. A one cap means you're getting a 1 % return.

19:52I mean, there's like no room there for improvement. And especially in a place like Houston. I mean, San Francisco, that's kind of normal to find a building like that. But Houston, no. So there was no chance of that ever going up in value. You don't have much room when you're at a one. Well, that's what you want to check out for is if you get these projections, you're invested in a deal and someone says, hey, look, we have a capital call. This is why. Rates went up and we need more cash to bring in to keep our balance low. So we cover our debt service and get to our NOI. Now, you wanna look at those projections.

20:28So if you get the projections from your operator and it comes in at a five cap right now and go, well, the building's worth this based on a five cap. Well, I don't believe the market's trading at a five cap right now. And that's what you wanna do. is look at what is that market trading for in today's market. It could be a six cap, it could be a seven cap, it could be an eight cap. The higher the cap rate, it's gonna bring the pricing down and the value down. That's the first thing I would look at from the offering is what are they projecting this building's worth based on what cap rate? And if they're giving you pie in the sky cap rates that aren't doable today, it is not a good investment.

21:03And that's why you, if you don't understand it, get someone who does. There are so many commercial brokers out there that would love to just help you with that. Just take a look at your project and give you a rough estimate of what they think it's worth. The easiest way to describe it is if you and I were to buy a single family home for$100 ,000 and we put$20 ,000 into it. You put 10 and I put 10 and that, and then we financed the rest. And then values went down. Now the property is worth$80 ,000 and there's no equity left. So why would you, and then you come to me and say, yeah, but we need to fix it.

21:42We need to, you know, we need to pay the mortgage. We don't have the money for the mortgage. Well, okay, but if I give you money now, what about next year? You know, are we still not going to have money to pay? I mean, at what point do you walk away? Or you might come to me and say, you know what, Kathy, I know we've lost our equity in this moment, but if we put another$10 ,000 in and add an extra room and we increase rents, we're going to be okay. It will be worth it. Then we can save this. And over time, it will go up. I would look at that plan and say, yeah, you're right. I'd look at the rent comps and okay, if we increase the value here, we'll get through this difficult time.

22:20And eventually, eventually the values will come back. We paid a hundred thousand at some point, it might be worth that again. That's what we're talking about here. In most cases, there's no equity left. So you have to determine if any more money going to go into to improve the property such that rents will go up? Or is this just trying to kick the can down the road? Are we just trying to make payments? But then what about next year? Because a lot of people, a lot of multifamily operators took the income from the rents to pay the debt, right? They didn't make distributions. They're like, or to execute their plan.

22:57Maybe they bought this apartment, paid way too much for it, but thought, okay, we're going to improve it. Now, in many cases, improving it wasn't still going to increase rents. So many of these business plans were, okay, we're going to buy this, we're going to improve it, and then we're going to raise rents, and everybody's going to make a bunch of money. But then rates went up and they could no longer make the payments. So they had to use all the money instead of improving the property just to float, just to be able to survive. Because the capital call is supposed to fix the income issue and the debt coverage issue.

23:30And that's what you want to look at when you get your capital call. What is the money being called for? And how is this money, like Kathy said, fixing the issue? Not putting a Band-Aid on the issue because a Band-Aid is going to require more cash. And it's going to require more cash probably in 12 months. So you don't want to keep feeding a deal bad money. But you also want to see, is it the right move to actually invest in it? Because sometimes it is. When capital calls happen is because a lot of times the bank, you've got to have a certain debt coverage ratio. And it's inside your loan docs.

24:00and the bank audits a lot of multifamily or almost every property every year going, hey, let me see your income. Are you covering the debt coverage? And the reason they're doing that is they want to protect their loan because a lot of times they're financing at like 1.25 DSCR. That's where the NOI is at 125 % of the expense. If the debt goes up, property taxes have gone up, insurance has gone up, and the income has gone down, it can be detrimental to a deal. Yeah, the bank wants their safety. They're going to want more money from you. They're going to want to see their LTV come down. And so that's not fixable.