If you have invested in a number of syndications as an LP (limited partner) over the last couple of years, then you have likely heard or experienced a capital call. My wife and I are in over ninety investments as an LP and we have had our fair share of capital calls over the years so I thought it would be helpful to share a few things that we consider when making a decision to invest additional capital when there is a capital call. 

What is a Capital Call? 

A capital call in a real estate syndication is when the GP (general partner or operator) needs additional funds to continue the operations of an investment. In general, these funds are for general operating expenses, negative cash flow situations, major capex (capital expenditures) items, or funds needed related to a loan modification. 

Each of these scenarios takes a different set of considerations as to whether you should invest additional capital into a deal. In most partnership agreements, these capital calls are optional. However, if you choose not to participate you risk your shares being diluted and getting pushed down in the priority of the capital stack for the return of your original capital. 

Most Common Need for Capital Call in 2024 

Over the last several years, the macroeconomic landscape has been rapidly changing and has had a major impact on real estate syndications. The greatest impact has been on assets that have been acquired using floating rate loans. 

The Federal Reserve has raised interest rates at an unprecedented rate and has continued to hold them higher for longer than anyone had expected. This has created an issue where real estate investments are paying more for their debt service than was originally underwritten. 

In addition, the values of assets have dropped due to the cap rate decompression when interest rates rise. When values of assets drop, this causes the lender to want to do a loan modification with a pay down of the loan to get the LTV (loan-to-value) within a certain range to make them feel more comfortable with holding the note on the asset. 

The most common reason for a capital call in 2024 has been GPs that have assets where the operating reserves have been eaten up by the higher debt service and the lender requiring them to pay down a portion of the loan along with extending the interest rate cap. 

Although rare, I have personally seen several GPs lose assets, including a wiping out of all LP equity, when a capital call is not successful.

Should You Participate in a Capital Call

Choosing to participate in a capital call is certainly a personal decision and you should seek legal and professional advice from a qualified professional prior to making a final decision. 

The first question you should ask yourself is whether you feel like you are throwing good money after bad. After all, if you are at risk of losing all of your LP money and the deal does not look good over the next couple of years then it might be best to just take the loss on the current investment and move on. 

However, you should consider 3 things when making a decision here in 2024: 

1. Does the GP have a solid plan with the capital call funds? If the funds are being used to pay some large capex bill or just covering operating reserves, then it might not be the best option. However, if they are paying down the loan and extending the interest rate cap, then this could be a good situation since the equity is being built up in the asset with a loan pay down. It would be good to see at least one to three years left on the loan to allow time to improve the macroeconomic environment. 

2. Do you have the additional capital to contribute personally? This might seem like an obvious question, but definitely worth considering. It is best to always reserve about 20-30% of your original capital into a liquid investment if a capital call does occur on an asset that you are invested in. However, you may find yourself in a situation where you don’t have enough cash to participate in the capital call. 

3. Do you trust the GP to properly execute the new business plan after the capital call is successful? When you originally wired the funds for the investment, you had to have a high level of trust and confidence with the GP to execute the business plan. Now that you have seen the GP perform up to this point, do you continue to have that same level of confidence and trust in their ability to perform on the new business plan?

So, if you trust in the new business plan, have the additional capital, and continue to trust the GP to execute on the new business plan, then you should consider participating in the capital call.

What Happens When You Don’t Participate In a Capital Call

If you choose not to participate in a capital, then there are a few risks to consider. 

1. Losing all or a portion of your initial capital: If there are a large number of LPs that choose not to participate, then the investment is in risk of a failed capital call. If the capital call is unsuccessful, then you risk losing all or some of your initial capital. 

2. Dilution of your shares: If you choose not to participate in the capital call, then the GP will be forced to bring in outside investment dollars to ensure a successful capital call. When this happens, they dilute your shares in the investment to bring on those additional LPs to ensure a successful capital call. This means that your original shares are now worth less than when you originally invested. 

3. Change in capital stack priority: In many capital calls, the partnership agreement will be amended to allow the LPs that are participating in the capital call to receive their initial capital, called capital, and preferred return ahead of LPs that chose not to participate in the capital call. This may seem counterintuitive to those LPs that are not participating in a capital call,  but the non-participating LPs would not likely receive any of their capital or preferred return if it were not for those LPs that chose to risk additional capital to make sure the capital call is successful. So, you can think of this as an incentive and “special thank you” from those that didn’t participate in the capital call to those that did by allowing them to receive their initial capital, called capital, and preferred return ahead of non-participating LPs. The profit equity sharing would still be in the same priority as originally planned but the initial capital, called capital, and preferred return would be paid ahead of those not participating. 

In conclusion, you certainly should not invest in a capital call if you feel you are throwing good money after bad. However, if you have the funds available and you trust in the GP to execute on the new business plan, then it is in your best interest to participate in a capital call to ensure to get original capital back as well as a return on top of that return of capital. 

Like I said earlier, my wife and I have had our fair share of capital calls with our passive investments in our portfolio. Capital calls are certainly part of a real estate private equity investment, and you should properly plan for these when you are investing at the outset of any investment. 

I truly believe there is a higher level of trust in the beginning when you first wire out $100,000 to a GP to initially acquire an asset in a syndication. You likely did lots of research and due diligence prior to wiring those funds. I truly believe that you should trust in your initial due diligence to have the confidence in the GP to make the right decision for your preservation of capital. If you made the right decision from the outset and the GPs are invested alongside you as an LP, then you can also trust in the fact that they have a significant amount of capital to lose as well as their reputation if they lose your capital. 

At the end of the day, as a GP myself, we are always making decisions on our investments to ensure capital preservation for all LPs in the assets while also maintaining returns as a secondary goal.