Capital Reserves for Capital Calls in a Multifamily Syndication
Investor · Alpharetta, GA · Member since 2019 · 78 posts · 74 votes
Capital Reserves for Capital Calls in a Multifamily Syndication
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Brian BurkePro Member
Investor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votesOne thing to consider is the language in the operating agreement. Some operating agreements stipulate that you are required to fulfill a capital call if one is to be made. While this is common, and acceptable, in a fund where capital is called in stages and you are obligated up to the limit of your capital commitment, it's far less desirable in a typical syndication deal where you've already contributed your entire commitment. Many investors won't invest in offerings that have a mandatory capital call provision.
Therefore, many operating agreements provide that the capital call is voluntary. You can refuse to contribute more capital, but in exchange, the sponsor is allowed to raise additional capital from new investors and dilute you. Maybe that's a better outcome for you rather than throwing good money after bad. Not to say that raising more capital is easy if the deal is in trouble...
Having said that, even if you decided to contribute additional capital, you might be in the same position as flushing it down the toilet. For example, if the sponsor is making a capital call because they can't service the mortgage payment, and the capital call is voluntary, and you are the only one that fulfills the capital call, your small additional contribution is likely not enough to solve their problem. The lender will eat your capital call for breakfast.
This is a bit like closing the barn door after the horses are gone, but the best defense here is to only invest in offerings that are raising a significant enough cash reserve, are well underwritten with conservative debt terms (low LTV and/or low default ratio), and skippered by an experienced and well capitalized sponsor that has survived adverse market cycles before.
There have been comments in this thread about lenders requiring borrowers to put up substantial capital reserves (which is true, for now), and a suggestion that this provides additional safety. Don't be fooled. There is little to no guidance on how that capital can be accessed or how it can be used. Instead, it will get locked up into a lender-controlled account and using it to save your a$$ will be somewhat like squeezing blood out of a rock. Heck, it's hard enough to get lenders to part with renovation reserves for budgeted capital improvements! My guess is these funds will be the last to be drawn, and even if those reserves are there, a sponsor could still have a need for a capital call if they run out of discretionary reserves and have other bills to pay or capital improvements to make.
14 Replies
- Rental Property Investor · North Palm Beach, FL · Member since 2018 · 2k+ posts · 1k+ votes6y
Hi, I would verify the syndication as a whole has adequate reserves. In this COVID era, lenders are more conservative (especially agency debt) so reserve requirements are higher. If you are investing with a more experienced group, the lender may require less reserves. This would be my focus, on the syndication itself. Remember, if hard times hit your project, the GPs can pause your distributions before taping into any reserves.
- Investor · Minneapolis, MN · Member since 2016 · 145 posts · 108 votes6y
@Jordan Burnett
Hi Jordan
We are under contract on a Fannie deal and they are requiring 1year of debt service in reserves. We are also at 65%LTV so the banks think a combination between high reserves and low leverage is a safe play right now.
- Investor · Member since 2020 · 11 posts · 5 votes6y
Originally posted by @Charles Carillo:
Hi, I would verify the syndication as a whole has adequate reserves. In this COVID era, lenders are more conservative (especially agency debt) so reserve requirements are higher. If you are investing with a more experienced group, the lender may require less reserves. This would be my focus, on the syndication itself. Remember, if hard times hit your project, the GPs can pause your distributions before taping into any reserves.
I agree with this approach Charles. I was looking at a deal recently that had about 18 months of debt service reserves in the projections by the GP. That of course drags returns, but is pretty prudent based on where we are economically right now. Front page of CNBC this morning has this article:
https://www.cnbc.com/2020/07/24/28-million-americans-face-eviction-because-they-cannot-afford-rent.html - Investor · Alpharetta, GA · Member since 2019 · 78 posts · 74 votes6y
Hey guys,
Thanks for the responses. I completely understand the reserves part and that agency debt requires a fairly hefty reserve to acquire financing right now.However, I'm curious to get insight from anyone who has actually had capital calls for a deal or deals (although they are likely infrequent and unexpected).
Interesting question. Charles makes a great point that reserves in the syndication should be able to cover cap ex that comes up, but stuff can still happen. This is a question for the cases where reserves and the cap ex budget were insufficient.
For my part I just tend to keep a cash reserve, ready to invest in anything interesting that comes up. If one of my investments were to do a capital call, I would evaluate the situation and decide if I wanted to put more on the table, then go from there.
On a percentage basis for me it's probably 15% or so, but I do not have a hard and fast rule about it. This is the time to have dry powder anyway, and I see this all as the same bucket, since it's all cash and cash is fungible.
- 6yBrian BurkePro MemberInvestor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
One thing to consider is the language in the operating agreement. Some operating agreements stipulate that you are required to fulfill a capital call if one is to be made. While this is common, and acceptable, in a fund where capital is called in stages and you are obligated up to the limit of your capital commitment, it's far less desirable in a typical syndication deal where you've already contributed your entire commitment. Many investors won't invest in offerings that have a mandatory capital call provision.
Therefore, many operating agreements provide that the capital call is voluntary. You can refuse to contribute more capital, but in exchange, the sponsor is allowed to raise additional capital from new investors and dilute you. Maybe that's a better outcome for you rather than throwing good money after bad. Not to say that raising more capital is easy if the deal is in trouble...
Having said that, even if you decided to contribute additional capital, you might be in the same position as flushing it down the toilet. For example, if the sponsor is making a capital call because they can't service the mortgage payment, and the capital call is voluntary, and you are the only one that fulfills the capital call, your small additional contribution is likely not enough to solve their problem. The lender will eat your capital call for breakfast.
This is a bit like closing the barn door after the horses are gone, but the best defense here is to only invest in offerings that are raising a significant enough cash reserve, are well underwritten with conservative debt terms (low LTV and/or low default ratio), and skippered by an experienced and well capitalized sponsor that has survived adverse market cycles before.
There have been comments in this thread about lenders requiring borrowers to put up substantial capital reserves (which is true, for now), and a suggestion that this provides additional safety. Don't be fooled. There is little to no guidance on how that capital can be accessed or how it can be used. Instead, it will get locked up into a lender-controlled account and using it to save your a$$ will be somewhat like squeezing blood out of a rock. Heck, it's hard enough to get lenders to part with renovation reserves for budgeted capital improvements! My guess is these funds will be the last to be drawn, and even if those reserves are there, a sponsor could still have a need for a capital call if they run out of discretionary reserves and have other bills to pay or capital improvements to make.
- Investor · Alpharetta, GA · Member since 2019 · 78 posts · 74 votes6y
Originally posted by @Brian Burke:
One thing to consider is the language in the operating agreement. Some operating agreements stipulate that you are required to fulfill a capital call if one is to be made. While this is common, and acceptable, in a fund where capital is called in stages and you are obligated up to the limit of your capital commitment, it's far less desirable in a typical syndication deal where you've already contributed your entire commitment. Many investors won't invest in offerings that have a mandatory capital call provision.
Therefore, many operating agreements provide that the capital call is voluntary. You can refuse to contribute more capital, but in exchange, the sponsor is allowed to raise additional capital from new investors and dilute you. Maybe that's a better outcome for you rather than throwing good money after bad. Not to say that raising more capital is easy if the deal is in trouble...
Having said that, even if you decided to contribute additional capital, you might be in the same position as flushing it down the toilet. For example, if the sponsor is making a capital call because they can't service the mortgage payment, and the capital call is voluntary, and you are the only one that fulfills the capital call, your small additional contribution is likely not enough to solve their problem. The lender will eat your capital call for breakfast.
This is a bit like closing the barn door after the horses are gone, but the best defense here is to only invest in offerings that are raising a significant enough cash reserve, are well underwritten with conservative debt terms (low LTV and/or low default ratio), and skippered by an experienced and well capitalized sponsor that has survived adverse market cycles before.
There have been comments in this thread about lenders requiring borrowers to put up substantial capital reserves (which is true, for now), and a suggestion that this provides additional safety. Don't be fooled. There is little to no guidance on how that capital can be accessed or how it can be used. Instead, it will get locked up into a lender-controlled account and using it to save your a$$ will be somewhat like squeezing blood out of a rock. Heck, it's hard enough to get lenders to part with renovation reserves for budgeted capital improvements! My guess is these funds will be the last to be drawn, and even if those reserves are there, a sponsor could still have a need for a capital call if they run out of discretionary reserves and have other bills to pay or capital improvements to make.
Hey Brian, thanks for the comment. Is the implication here that essentially if an unexpected capital call on a single asset deal is made, the deal is completely dead? Or rather that if an unexpected capital call is made there has to be a significant justification for a LP to contribute the additional capital?
I guess I'm curious because I have talked to other investors who have had unexpected capital calls on a single asset deal and have made it out of the deal okay, even if it performed under pro forma and the business plan went awry. Though it's rare, I'm just curious if it's something that should be allocated for (similar to an emergency fund for a particular property).
- Investor · Greenville, SC · Member since 2016 · 5k+ posts · 13k+ votes6y
Many investors perform extensive diligence on the property and the sponsor so that a subsequent capital call would be extremely unlikely regardless of conditions. They don't invest in start ups, marginal locations, risky debt, or "opportunistic" offerings during peak pricing.
Many accredited investors have multiple sources of liquidity (cash, brokerage accounts, retirement accounts, HELOC, business lines) for whatever may come up...disaster or opportunity.
- 6yJay HinrichsBusiness MemberReal Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
in my limited experience when syndication's had issues early 90s.. when a capital call was needed.. it was a mixed bag some were capable of the Cap call others were .. and others were like Brian said i am not doing that, its good money after bad..
going forward seems like with such tight underwriting cap calls would be rare for the well positioned experienced company. for those projects done with newbies and sponsors not well capitalized and using underwriting of 2 years ago some of those are probably stressed right now and frankly could be the next opportunity if they fail.
- Investor · Norman, OK · Member since 2017 · 75 posts · 53 votes6y
@Jordan Burnett - I have personally invested in almost 40 separate deals and have never had a capital call. This is undoubtedly a last resort for a sponsor as it will all but assure that those investors will be extremely reluctant to invest with that sponsor again.
I would focus on a few things the front end to mitigate the chances of this ever happening. While, as we are seeing with COVID, unforeseen circumstances can happen, there are some things to consider.
- Day 1 cash flow: We focus on deals that have very strong day one cash flow. This alone greatly de-risks the chances of a capital call.
- What level of occupancy is required for adequate debt coverage?
- As some have already mentioned, how much is the sponsor holding in reserves?
- The market: How diverse is the local employment? I would be leery of a market that is reliant upon only 1 or 2 strong employers.
Hope this is helpful and I wish you luck!
- 6yBrian BurkePro MemberInvestor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
Originally posted by @Jordan Burnett:
An unplanned capital call doesn't always mean the deal is completely dead. But it most likely does mean it is out of cash. Why? Did the sponsor fail to plan? Did the sponsor not raise enough reserves to begin with? Is the property struggling because the sponsor is poorly managing it? Or is it struggling because of factors beyond the sponsor's control?
Certainly not every deal goes exactly as planned. Some turn out to be a total disaster. Even the best sponsors can have bad or difficult deals, I know I have. I also know that I've never made an unplanned capital call in 20 years as a syndication sponsor. In the few cases where I've had a deal running short on cash I've just loaned money to the deal to shore it up until things turned around. In one case that even meant that I had more money in the deal than my investors--not a good place to be, but it saved the day and saved my investor's principal. I wrote about it on the BP blog, here.
A capital call means the sponsor is unwilling or unable to step up, so the investors are the last line of defense. It doesn't mean the deal is a complete fail, but it sure is teetering on the edge in many cases. I suppose in many cases things turn out fine, too. There's no single answer here.
- Investor · Alpharetta, GA · Member since 2019 · 78 posts · 74 votes6y
Originally posted by @Brian Burke:
Originally posted by @Jordan Burnett:
An unplanned capital call doesn't always mean the deal is completely dead. But it most likely does mean it is out of cash. Why? Did the sponsor fail to plan? Did the sponsor not raise enough reserves to begin with? Is the property struggling because the sponsor is poorly managing it? Or is it struggling because of factors beyond the sponsor's control?
Certainly not every deal goes exactly as planned. Some turn out to be a total disaster. Even the best sponsors can have bad or difficult deals, I know I have. I also know that I've never made an unplanned capital call in 20 years as a syndication sponsor. In the few cases where I've had a deal running short on cash I've just loaned money to the deal to shore it up until things turned around. In one case that even meant that I had more money in the deal than my investors--not a good place to be, but it saved the day and saved my investor's principal. I wrote about it on the BP blog, here.
A capital call means the sponsor is unwilling or unable to step up, so the investors are the last line of defense. It doesn't mean the deal is a complete fail, but it sure is teetering on the edge in many cases. I suppose in many cases things turn out fine, too. There's no single answer here.
As always, thanks for your input Brian!
- Investor · Alpharetta, GA · Member since 2019 · 78 posts · 74 votes6y
Originally posted by @Josh Walker:
@Jordan Burnett - I have personally invested in almost 40 separate deals and have never had a capital call. This is undoubtedly a last resort for a sponsor as it will all but assure that those investors will be extremely reluctant to invest with that sponsor again.
I would focus on a few things the front end to mitigate the chances of this ever happening. While, as we are seeing with COVID, unforeseen circumstances can happen, there are some things to consider.
- Day 1 cash flow: We focus on deals that have very strong day one cash flow. This alone greatly de-risks the chances of a capital call.
- What level of occupancy is required for adequate debt coverage?
- As some have already mentioned, how much is the sponsor holding in reserves?
- The market: How diverse is the local employment? I would be leery of a market that is reliant upon only 1 or 2 strong employers.
Hope this is helpful and I wish you luck!
Thanks for your input, Josh. I was most interested in whether folks who have been participating in syndications for several years have found it best practice to have cash reserves for their holdings in case of a market downturn like in '08 as I know this was a common fault for many involved in direct ownership of properties (especially in single-family). That is no doubt a downside and risk of having many single-tenant properties is that your occupancy can go from 100 to 0 instantly.
It sounds like a capital call would be unexpected as long as the sponsor has vetted the deal properly and you have vetted the sponsor properly. A more common scenario would be a pause of distributions for a while as long as the debt service is covered to build capital reserves.
As @Brian Burke points out above, make sure you read the Operating Agreement. It should discuss many fine points re: capital calls, including what happens if an investor doesnt pony up.
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