It’s always annoying when more money is needed than was expected for a project. It happens often enough in daily situations; wedding budgets get blown, plane tickets turn out to be more expensive than anticipated, etc. Thankfully, with real estate projects, experienced sponsoring real estate companies generally have a good handle on expected costs and revenues. But unanticipated capital requirements do sometimes arise – and its important that investors in private syndications know that they will be asked to respond to those “capital calls.”
Capital Calls – Generally, an Infrequent Occurrence
Capital calls – requests for an additional equity funding in order to complete a project – occur relatively rarely. In the aftermath of the Great Recession, though, capital calls were sometimes requested by sponsors in order to deal with unexpectedly low pricing power or difficult credit markets. And even in good times, it’s always possible that events require an additional capital infusion for a real estate project.
Experienced sponsors generally know to plan conservatively, and work from budgets that leave a healthy cushion – a capital reserve — for unexpected events. Planned renovations can go over budget, more repairs are needed than were anticipated, or a local market may go into a recessionary environment that dries up demand for renovated rental units. Sharper surprises can also occur – a latent environmental problem may be discovered that needs to be cleaned up, for example.
Even top-notch managers can find themselves leading a real estate project where things go wrong and the project simply needs more funding. In such cases, the sponsor may request that the members or partners in the sponsor’s project entity contribute additional funds. These situations, of course, generally lower the returns on investment that investors had originally anticipated – but saving a project from foreclosure is generally a more desirable option than losing one’s entire investment.
The guidelines for how these capital calls are dealt with are determined at the time of the original investment, when the initial investment funds are raised. This is when the terms of the operating (or partnership) agreement of the sponsor’s project entity are negotiated.
Larger investors expect everyone in a project to “pull their weight” and be willing to step up in instances where additional funding is required. In order to “keep a seat at the table” on these types of projects, then, even crowdfunding investors must similarly be willing to contribute additional capital in the event that a project requires it.
As a result, investors in RealtyShares equity investment vehicles are themselves generally subject to capital calls, just as the investment vehicle itself is. When a sponsor makes a request for additional capital at the deal level, the investment vehicle entity will similarly call capital from its own investors. Investors may thus get diluted at the deal level if the investment vehicle doesn’t contribute its requested share of additional funding, and at the investment vehicle level, if one has not contributed but other investors have.
How Can Dilution be Effected?
Sponsor operating agreements often provide that if a sponsor requests more funding from its existing members, those members who elect to not contribute additional funds will either (1) suffer some dilution of their interests (since members who do contribute will now have proportionally more capital invested) or (2) be deemed to have taken a loan, from the project company or contributing members, at an interest rate anywhere between 5 – 20%, for the amount requested but not contributed. Oftentimes, the non-contributing member must direct the cash distributions it would otherwise receive toward the repayment of that loan.
RealtyShares investment vehicles utilize similar provisions in their own operating agreements. Moreover, if investors in the investment vehicle fail to respond, RealtyShares may raise additional funds from investors – through a RealtyShares investment fund, a third-party capital provider, or even another RealtyShares special-purpose investment vehicle — who might enter the project in a preferred position, so that the investment vehicle is effectively subordinated. Again, larger investors expect everyone in a project to put in their fair share if the need arises, and in order to participate in attractive investment opportunities RealtyShares will need to have several alternative funding options available to it.
RealtyShares will continue to resist more punitive arrangements in sponsor operating agreements. Such punitive penalties might include that a non-contributing member (1) have his capital account in the company reduced by 50%; (2) not receive any further regular distributions; (3) not receive any payouts whatsoever until the company or partnership is dissolved or liquidated; and/or (4) if the manager wants, be forced to sell his diminished interest back to the limited liability company or partnership.
But RealtyShares investors should be aware that if things go wrong and a project requires additional funding, there are consequences for failures to contribute such additional capital. Even with highly experienced project sponsors, projects can go astray; both sponsors and other deal-level investors need to know that RealtyShares will be able to respond to additional funding needs so that the project does not fail entirely. It is important that investors understand, in such situations, they are playing “on the same field” as other investors, and that they will face increased dilution if some investors answer the call and they do not.
A version of this article was earlier published in NuWire Investor.