Financial setbacks can be scary.
Not only do you lose money, the feeling of volatility stemming from the loss can be intimidating—possibly preventing you from getting back into the investment market.
But the truth is this: Setbacks can be an excellent learning experience. They present the opportunity to examine what may have gone wrong, to talk to other investors, and to get better equipped for future investments.
When you know how to properly react to a financial setback, it can change your life and help you continue to meet your financial goals. By lifting your confidence and continuing your education, you’ll meet setbacks head on while becoming a better investor.
There are a few common setbacks to prepare for. One consists of the two words that no real estate investor wants to hear: capital call. Today we’ll be looking at how to prepare for potential future losses from capital calls and the actionable steps for moving forward after they occur. So get ready, get your game face on, and let’s learn!
Confronting Financial Loss
Before we begin talking about capital calls in detail, I want to speak about financial loss. I think there’s a lot of hesitancy to talk about our investment losses and also a fear to confidently continue investing after an unexpected loss. It’s understandable. We live in a world that glorifies the accumulation of wealth, not the loss of capital. There is an implicit shame in financial loss, but there doesn’t have to be.
The fact of the matter is investing has its ups and downs. Ignoring the downs often prevents us from achieving the ups. So let’s reframe our mindset. As Warren Buffet once said, “Be fearful when others are greedy and greedy when others are fearful.”
Find ways to feel confident about investing after a loss. For example, don’t get stuck thinking that investing is wholly dependent on how the market is fairing at any one time. When we think investing is market-dependent, our lack of a perfect crystal ball into the future can prevent action. Instead, thoughtfully charge into investing knowing that potential mistakes exist and, if they come around, act as learning opportunities to help you build your expertise. Learning on the go will help you shore up potential holes in your overall strategy (and prevent future loss) while building up an enduring wealth on the way to financial freedom.
Okay, with our new mindset ready, let’s talk about capital calls.
What is a Capital Call?
For those not familiar, capital calls are the act of collecting funds from limited partners (LPs)—or investors—for a property when the need arises. Sometimes they are called “draw downs.” Not all capital calls are unexpected, and they are necessary to stabilize properties, especially if they are planned for sale or refinance.
How might this work? Let’s say you’ve committed $10,000 to a limited partnership fund, and the Limited Partnership Agreement (LPA) states that you must contribute $3,000 immediately and hold onto the remaining $7,000 until it’s called. Ideally, you’ll receive your return on investment from only kicking in the $3,000, but sometimes you have to pony up extra capital from what you committed.
You might find yourself asking, “Why would a sponsor need to draw down and collect more cash?” I’m glad you asked! There are a number of scenarios that might require an influx in capital to protect an investment. They include but are not limited to the following.
- An unexpected and sustained drop in occupancy leads.
- A redevelopment project if the cost of capital renovation goes over budget.
- A need to satisfy the property’s changing financing requirements, which might include rising interest rates, increased insurance costs, higher property taxes, inflation, and others.
Looking at the market conditions of 2023 and 2024 (and the near future), increases in capital calls have become a natural reaction to the Fed raising interest rates. This froze the commercial real estate market and made real estate more volatile in general—meaning it’s harder to make the right investment decisions when capital calls are more frequent or uncertain.
How to Prepare for Capital Calls
Depending on the investment agreement, capital calls could dilute your total ownership of the property. If more people are putting in money, their increased stake could lower yours. In other cases, equity stakes will remain the same. Make sure you know how capital calls work on any deal you are thinking about pulling the trigger on.
You may have read that some sponsors or General Partners (GPs)—or the investment partner who is also the property manager—will “weaponize” capital calls. Be on the lookout for this. One example is when LPs are told that participation in capital calls are voluntary but, in reality, the fine print states that non-participation in a capital call could lead to 100% dilution of ownership rights.
For this or any other possible problems, it’s crucial for LPs to carefully read the LPA documents and understand a deal’s implications when it comes to capital calls.
After you’re fully aware of how capital calls work in a particular investment, you have to prepare the choice you’ll make. Are you okay with diluting your investment? Can you put in more money if a capital call happens? Ask yourself important questions like these.
Ultimately, you are relying on the investment’s operator, and there’s very little you can do about preventing capital calls once you’re invested in the deal. So due diligence is key. You must trust the operator.
How to React to Capital Calls
Even when capital calls happen, that doesn’t mean you need to sit on the sidelines. Keep your eyes wide open and stay engaged with the investment.
Capital calls can sometimes arise from poor property management, such as inability to lease units, delayed maintenance, unpaid accounts payable, and difficulties with evictions. If you run into an unexpected capital call, that could be a red flag to reopen your due diligence on the property managers. At the next investment call, make your concerns known to help address any issues that could be harming the bottom line.
There is also something called a Waterfall Split Adjustment. This is when the GP adjusts the waterfall split (or distribution to limited partner investors) to entice additional capital contribution. The GP might offer a higher percentage point on the property as part of this. When this happens, you need to evaluate how specifically a split adjustment could improve your current standing and whether it affects your original investment retroactively.
While these are just two examples, the big takeaway is to maintain your status as an active investor. Always be reevaluating.
How to Offset Potential Loss
You can’t always predict the volatility of the market, nor can you stop capital calls from occurring. So how can you be an active investor? To better project your investments, pay attention to the following things.
1. Review Efficiencies
Always pay attention to the operational decisions on your properties. Could they be more efficient? If so, consider a new property management company to cut down on costs and inefficiencies.
Maybe the inefficiency isn’t related to management. Maybe the property management company runs on a bloated business model. If that is the case, the investment could be made more efficient by streamlining areas of the company, saving on payroll and reducing the risk of a capital call.
2. Monitor Your Properties
LPs and property owners must maintain close oversight of property management companies to address issues promptly and protect investment interests. That could be in person (meaning being able to drive out and have eyes on the property) or on paper (meaning keeping up on things like quarterly statements).
Ensure you have regular communication between sponsors and investors, especially during challenging times, to provide input and address concerns. Contacting the GP or sponsors is your right. Talk to the sponsor and other investors to figure out how things are operating.
3. Read the Fine Print
File this under “apply to every investment, not just partnerships with capital calls.” Whether you run into a GP who “weaponizes” capital calls with dilution clauses in the LPA or something else entirely, always read the agreement carefully before signing onto the investment. Know before you go.
4. Evaluate Capital Call Likelihood
Before partnering on a deal, determine the likelihood of capital calls occuring. Research the property occupancy rates, the GPs and property management companies involved with the deal, and other factors that will lead to the property running smoothly and efficiently. The more a deal is filled with uncertainty or inefficiency, the more likely capital calls will occur.
When you understand that likelihood, you will have a better idea of what to expect headed into a deal, including the potential losses of capital.
5. Diversify Your Portfolio
Although I preach the importance of portfolio diversity, it is especially true of real estate investments that are subject to capital calls. The more you have all of your investment eggs in one basket, the more you put yourself at risk to the negative impacts of capital calls.
Instead, diversify your portfolio geographically. When one market suffers the need for capital calls, your other investments will still be humming along nicely, or at least that’s the hope.
Also, diversify across different asset classes. If all of your money is in workforce housing and that asset class has a bad year, you suffer from a lack of diversification. However, if you have workforce housing, REITs, and syndications, your investments in other asset classes will mitigate those losses. This practice is known as mitigating concentration risk.
Learn Consciously
Physician and philosopher Herbert Spencer once said, “The great aim of education is not knowledge but action.” Today we looked at capital calls not to frighten ourselves out of investing, but to educate ourselves toward action.
Learn by doing, and when you face investment difficulties, face them knowing you will have gained valuable insights that deepen your understanding of passive income investing.
And speaking of education, we hope you continue yours at Passive Real Estate Academy (PREA). There, not only will you learn about what makes a great investment and how to take action, but you’ll be surrounded by like-minded individuals. Together, we bring each other deals, evaluate them, and support each other as we create enduring wealth.
At PREA, we take time out of our curriculum to look at offsetting potential investment loss. We do that by discussing deals that face challenges, consider how they might have fared differently under more favorable market conditions, analyze the actions of the sponsors, and explore potential strategies for mitigating risks in the future.
My hope for you is that you decide it’s valuable to always be learning. That’s how I live my life, and it has served me well. Thank you for visiting Passive Income MD, and we hope to see you again soon.
Peter Kim, MD is the founder of Passive Income MD, the creator of Passive Real Estate Academy, and offers weekly education through his Monday podcast, the Passive Income MD Podcast. Join our community at the Passive Income Doc Facebook Group.
