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November 10, 2011

Capital Call – Good Money After Bad???

Capital Call – a two word term that has struck fear, anger and even confusion in the hearts and minds of investors for decades. Just a few years ago, to many real estate investors the idea of a capital call…

Capital Call – Good Money After Bad???

Capital Call – a two word term that has struck fear, anger and even confusion in the hearts and minds of investors for decades. Just a few years ago, to many real estate investors the idea of a capital call may have seemed like some far-fetched nightmare scenario that “could never happen to me.” Investment properties were underwritten with “conservative” assumptions that generally projected modest rent and expense growth, allocated reserves for capital expenditures, leasing commissions, and tenant improvements, and even set aside some cash in what I’ll call a “rainy day” fund. These were just some of the steps taken to ensure that the asset manager had the means to smooth out any momentary hiccups that the property may have faced during the hold period.

Unfortunately even the most conservative underwriting that I saw as a lead real estate analyst during the go-go lending era of 2003 through 2007 neglected to include protections against the tremendous destruction of wealth and destabilization of our domestic and global economies over the years that followed. In many areas of the country and across a number of real estate sectors, we not only did not achieve the “modest” rent growth but actually saw effective rental rates decline. Occupancies also struggled to hang on as new developments spawned when construction financing was cheap and easily attained added competition that most markets simply could not absorb.

So here we are today… the old pro forma assumptions used when your properties were purchased should be removed from your consciousness and replaced by a realistic picture of the property and its surrounding market in the here and now.

I draw your attention to this issue because it seems more and more investors are seeking advice on what to do when the previously unthinkable – Capital Call – finds its way to your doorstep. The idea of writing a check to support a property that is in some state of duress is scary which is why the decision to participate in the Capital Call should be an educated one. I don’t know anyone that wants to “throw good money after bad” into an investment beyond salvation, but how does an investor figure out whether there’s light at the end of the tunnel or simply more despair.

I’ve created a list of steps that I feel can provide the necessary perspective to make an informed decision to participate in the
Capital Call or to simply walk away. So here goes: Take an honest look at how your property has performed since 2008. This will help you identify the sources of the challenges that your investment now faces. Was it new competition across the street? Or an explosion of unemployment in the market around your asset? Or was your property acquired with an unhealthy
amount of leverage that created a much more volatility in the cash flow?

  1. Once you have identified some of the problems, the next step is looking at the performance over the last year. How did your property perform relative to its competitive set? Is the property gaining traction or losing ground? For  information about specific property types or local markets, you can visit the Research Center provided by Marchus & Millichap.2
  2. Now it is time to review how the new funds will be used. Is the money being used to buy down a note to reduce debt service to achievable levels, or to clear up some outstanding accounts payable, or to simply cover monthly operating
    shortfalls until the property can “turn the corner” to profitability? The intended use of the proceeds is one of the most important factors to determining the value of an additional capital outlay.
  3. Now, the BIG question: With the new funds, what is the likelihood that the property will remain solvent long enough to recoup your new capital invested, let alone the original equity invested years ago?

Step 4 is really when the rubber hits the road. You should have an idea about the issues that landed your investment in hot water in the first place, whether those issues are showing signs of resolution, and whether the new monies will accomplish their stated goals.

Now, before you gloom and doomers give up on your property as well the other investors that may be in the mix along with you, there are other items you must take stock of. For example, what will happen to the investment without a cash infusion? Will it be lost to foreclosure? What are the consequences of defaulting on the loan and what if any potential adverse tax ramifications are you up against if the property is lost?

All of these issues should be researched before a decision about a capital call is made. If you need assistance with any of the
steps I’ve listed above or have a special situation that you just can’t wrap your head around, please feel free to contact the South Coast Team and we, along with our network of attorneys and accountants, are here to help you through this often trying event.

  1. http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm
  2. https://www.marcusmillichap.com/services/research/reports/default.aspx
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