Real Estate

What to Know About Capital Calls As Multifamily Syndications

Multifamily syndications are getting squeezed. With short-term financing coming due and mortgage rates at multi-decade highs, syndicators are calling on their original investors to raise more money so they don’t lose the deal. The problem? If you’re an investor, how do you know if your additional investment will ever be returned? Could a syndication simply burn through your money without making any promising changes to the investment? What should you know BEFORE you put up the cash for a capital call? We brought two syndication experts, Brian Burke and Mauricio Rauld, on to share their tips for navigating capital calls.

Before we start, let’s clarify this isn’t exclusively a syndication or multifamily problem. Much of the commercial real estate market is facing financing problems as loans come due and mortgage rates stay high. However, this problem has become a lot more common for syndication investors since rates started rising. In this episode, we’ll break down what a capital call is, why syndications do them, whether or not you’re obligated to invest more, and what investors MUST look for before putting up cash.

If a capital call comes your way, we have the exact questions you should ask the syndicator to ensure your money is being used correctly. Plus, if you’re a syndicator or plan on being one in the future, we share the steps to pull off a capital call the right way and make your investors whole. Making the wrong move could cost not only your investor’s money but also your money and lead to serious legal consequences. Don’t get stuck in that spot; stick around!

Dave:

Syndications are high risk, high reward types of investments. If you’re not familiar with this type of investing, it’s basically when a group of investors pool their money together to buy large commercial assets, like a hundred unit multifamily property or something like that. And when syndications go well, they can go really, really well, like 20 plus percent returns, but sometimes they go wrong. And with commercial real estate in such disarray right now I’m hearing of more syndications gone astray. Even going so far as the dreaded capital call, a capital call is never good. It’s basically when the syndicators run out of money and they need to ask their investors for more capital in an attempt to salvage the deal. And today we’re going to learn all about this. We’re going to understand what happens when syndicators run out of capital to complete and exit a project. What if you’ve invested in a deal and will you have to give more money? And if you don’t give more money, will you still get the same return? So we’re going to be digging into all of this today. Hey everyone, I’m your host, Dave Meyer, and today I am joined with Kathy Fettke. Kathy, thanks for joining us. Thank you.

And today we’re also going to be bringing on a couple other people. BiggerPockets a fan favorite, Brian Burke, who actually wrote the BiggerPockets book called The Hands-Off Investor. It’s on syndications. We’re also bringing on Mauricio Rauld, who is a real estate attorney who focuses specifically on syndications. Before we bring on Brian and Mauricio, Kathy, I think we should probably spend a minute to just giving some definitions to everyone about some terminology that we’re going to use here. Specifically. Let’s define LP and gp. You want to take ’em?

Kathy:

Yeah, sure. Usually when doing a big deal like this, you open up an LLCA limited liability company, and within that you have the gp, the general partner who’s managing and running the deal. And then you have the limited partners, the lp, who are usually just giving their capital. They’re not operating in any way, they’re not painting walls or negotiating terms or anything. They are passive investors generally. So understanding the difference, the gp, the general partners also have some form of liability if they do something wrong. If times are tough and the deal doesn’t go as expected because of things out of their control, that’s different. But if they do a fraud for example, they’re certainly liable. And then a question that the LPs have a lot, the limited partners is, well, am I liable if things go wrong? And as I understand it, I’m not an attorney, but it’s in a limited liability company, which means that the LPs only have the capital they put in at risk. It wouldn’t go outside of that to their other assets.

Dave:

I think that’s plenty of background information, but I guess one more thing is that just know syndications generally speaking, are for more advanced investors. And if you are considering investing in a syndication, make sure you learn the terms that Kathy just threw out there, plus many more go on BiggerPockets, learn about them. They’re not something that you should just throw money into without fully understanding. So with that, let’s bring on Brian and Mauricio. Mauricio, welcome to the show. Thanks for being here.

Mauricio:

Oh, thanks for having me, Dave. Really looking forward to this.

Dave:

Absolutely. Brian, welcome back. Always a pleasure.

Brian:

Oh, it’s always fun to be here,

Dave:

Dave. Alright, Mauricio, let’s start with you. Can you explain to our audience just the general structure of a syndication for those listening who haven’t participated in one?

Mauricio:

Yeah, so a syndication is essentially the pooling of resources. So somebody gets together and actually pools usually capital. So somebody wants to go buy a piece of property, for example. They want to go buy something that they either can’t afford themselves or maybe they don’t want to put in all of their money, they’ve got their money somewhere else. And so they go out to their friends and their family and people they may know or may not know and they raise money in order to go buy that piece of property or at least put the down payment and any additional value add. And that’s really all it is. It’s the pooling of resources so that you can then go do either something bigger or something without your money and using what we call OPM or other people’s money.

Dave:

Okay, got it. And why would an investor choose this structure of all the different ways to invest in real estate?

Mauricio:

Yeah, from a passive investor standpoint, this is a really attractive model because number one, you get to leverage the experience of the main sponsor or the real estate investor. I may, for example, I am a limited partner in some deals and I invest in multifamily and I don’t know the first thing about underwriting a piece of property or managing a piece of property or figuring out how to get the rents up or how to get occupancy. That’s not the business. I mean, I’m an attorney, that’s what I specialize in. And so for me to be able to hand that over to a sponsor so I can leverage their expertise and their knowledge, not to mention I get to leverage all the other benefits from real estate. So all the amazing tax benefits for example, that I get from buying a huge building, whether it’s multifamily or self storage or something that’s as large than single family, there are tremendous amounts of tax benefits and I get to participate in that through a syndication, through the expertise of another sponsor.

Dave:

So that makes a lot of sense in terms of who would want to do this and why. But for most syndications, people do have to be accredited investors, is that correct?

Mauricio:

Not necessarily. So when the important thing to understand about a syndication is when you are syndicating, when you’re the person putting the structure together, you are in the business of selling securities, issuing securities, which I know it doesn’t make a ton of sense because wait a minute, I’m just buying a piece of property. Why are securities involved or why is the Securities and exchange commission involved, which is the company, the governmental entity that regulates this? And when you understand that you have to either register or find an exemption to the registration. And so depending on what exemption you select will dictate whether you can be an accredit investor or non-accredited investor. There are some exemptions that do allow non-accredited investors to invest, which I think is a great thing because it allows the little guy or the little gal to get involved in some of these deals with really experienced syndicators.

Kathy:

Well, Brian, all that sounds really fabulous. How often does it actually go according to plan?

Brian:

Probably more often than people think. I mean especially in an upmarket when the last 10, or actually probably the last 14 years have been a continuous bull run in the real estate market the last two years accepted. So things went according to plan or even better than plan for over a decade. And now the market has shifted and this is the kind of time when you discover the value of all the things that I’ve said on countless of these BP podcasts about investing very carefully looking at who you’re investing with and what assets you’re investing in and how the capital stack is structured. All those things I’ve been preaching this whole time. If you ignored all of that advice, these are the kinds of markets where that could get exposed. So more often than not, they go quite well, but in times like this, a lot of these deals are going to run into trouble.

But this is the same as with hands-on real estate investing. Investing in a syndication is still a real estate investment. You’ve just outsourced it to someone else. Like a stock investor might invest in individual stocks. A syndication would be investing into a mutual fund. So if the stock market goes down, it’s going to take down the stocks and it’s going to take down the mutual fund. Same goes with real estate. If the real estate market turns adverse, it’s going to create difficulties for syndications. But the same would go if you invested in that apartment building on your own, you could still run into the same problem. So people want to say like, oh, syndications are a problem because the real estate market went down. No real estate’s a problem because real estate window,

Kathy:

We do have to take a quick break, but when we get back, Mauricio and Brian are going to break down the main causes of a capital call. So stick with us.

Dave:

Welcome back to On the Market podcast.

Kathy:

Brian, you mentioned the real estate market and of course we all know there’s no such thing as a real estate market. There’s just a lot of different asset classes. A lot of our listeners are in one to four unit real estate that hasn’t been as affected because they’re on fixed rates for the most part, 30 year fixed rates, but the commercial market has been different. So if you would just kind of explain that difference with the loan structure on these bigger deals versus the one to four unit.

Brian:

Yeah, I love it when people ask me what my thoughts are on the real estate market as if there’s such a thing as the right, because as we sit here right now it’s middle of 2024, single family residential real estate has held up quite well throughout the last couple of years. In fact, in some markets it’s up, but office properties are completely in the, I mean, there’s office buildings right now selling at 20, 30 cents on the dollar from past trades. So yeah, that’s a massive correction. Multifamily kind of sits somewhere in the middle where prices are definitely down. I think prices in multifamily are down 30 to 40% from where they were at the very peak in 2022. So there has been a big correction in multifamily real estate and that’s going to create issues. But real estate is a resilient asset class and eventually real estate has a tendency to recover.

I remember in 2009 everybody said, real estate’s never coming back. It’s never going to hit the 2006 price peak. It’s like catching a falling knife. And then by 20 13, 14 prices were back above where they were in the oh six peak. There’s two things that you can’t do in real estate if you want to survive market cycles. One is you can’t run out of time, and the other is you can’t run out of money. And if you can satisfy those two things, you can survive a real estate cycle and get to the next one. I think that’s a lot about what we’re going to talk about today in talking about capital calls is the whole running out of money thing, but you also can’t run out of time. So when you talk about financing structures, Kathy, you were asking about commercial real estate. There’s no such thing as the 30 year fixed rate loan, a fully amortizing thing like you have in single family.

In the commercial real estate finance world, these are really big dollar loans. Lenders want to get their money back and hedge their bets against interest rate movements. So they tend to have maturities in the 3, 5, 7 or 10 year scale. Three years is extremely short, it’s a blink of an eye. 10 years is a long time. In commercial real estate world, it’s like dog years. So you find yourself facing these loan maturities and if you face a loan maturity at the wrong time, it can be very problematic. And that’s kind of a lot of what you see going on in the marketplace right now.

Mauricio:

Am I allowed to challenge Brian or is that, I’m probably going to regret that the minute this thing comes to my mind. Oh, that’s why you’re

Kathy:

Here. Let’s do it.

Mauricio:

Brian mentioned that it’s not, I completely disagree. Brian mentioned that the real estate is the problem, but I think he just touched upon what I think is the real problem, especially when it comes to multifamily because again, just like there’s no, the real estate market, whenever you hear the word commercial real estate, that’s also an extremely broad category. There’s office, there’s retail, there’s multifamily, there’s self stories. I mean there’s 10 industrial, there’s like 10 or 11 different categories. But when it comes to multifamily, the main issue I see is the debt is the loan amount that these syndicators have to pay in order to get to service the mortgage. Because if you look at multifamily specifically, if you look at occupancy rates, if you look at rents, those have held up really, really well. If you’re just looking at specifically at those two pieces, that’s held up really, really well in the multifamily space.

But what’s challenging is probably a lot of you guys know that are listening here is that interest rates not only that increased over the last 18 to 24 months thanks to the Fed increasing rates from basically zero to wherever we are today, five, five and a quarter. But the speed at which they’ve increased that rate has been unprecedented. And so that’s really the squeeze that you’re seeing in multifamily specifically because multifamily, as you guys know, is valued on net operating income. And one of those big provisions is obviously the amount of expenses that you’ve got going on there. So I think the debt is really the main problem in multifamily and that’s really what’s causing a lot of these. I know we’re going to be talking about capital call, but that’s the primary driver of all these cash calls is the problem about servicing the debt.

Brian:

I’d love to fight with you about this, Mauricio, but I actually think we really agree here. The issue is the debt, but what’s happening is that, as you said, the rental market fundamentals are fine, but the resale market has fallen out and the resale market’s fallen out because of the cost of borrowing capital and that sort of stuff. So that’s making it difficult. If people could sell their assets on a snap of a finger, they could three years ago, nobody would be in any trouble.

Dave:

So just so I summarize to make sure everyone’s following here, basically you guys are, I think agreeing that the general situation here is that with interest rates going up and due to the nature of commercial debt, it often adjusts and a lot of operators are facing a situation where even though rent has grown in a lot of cases or at least been relatively stable, occupancy rates are relatively stable. The new increased debt service, the amount you pay on your mortgage every single month has gone up to the point where a lot of operators are losing money. Now, normally or during different market conditions, what an operator might do is say, Hey, I’m going to just go sell this asset because it’s no longer performing for me. But Brian, your most recent point was basically that there’s no volume, there’s no one who wants to buy these assets. And so operators who are losing money are essentially in a situation where they’re stuck with an asset

Brian:

And there might be a buyer for it, but maybe not at a price that recovers the investor’s capital or even pays off the debt in some circumstances. And that puts ’em in this position of what do we do? Do we sell at a complete loss or do we try to buy ourselves time? Remember, you can’t run out of time and you can’t run out of money. So do we ask investors to give us money so that we have money? And then that gets us time if your loan has time. Now, if your loan is also maturing, that’s a big problem. I think we should probably get into that a little bit later, but just to kind of outline what I think are the three main causes of a potential capital call. One is that you have negative cashflow, right? Maybe rents have dropped or occupancies dropped.

We aren’t really seeing a lot of that now, but there is some rent declines in some markets, but you also could have increasing interest expenses or insurance is a big one, increasing insurance expenses and you run into negative cashflow and you have to get additional cash in order to get the investment to the other side of the market cycle. That’s a big one right now. But there’s also another one, and that is that you have to restructure the capital. I mean, if you’ve got a adjustable rate loan that’s due in six months and the property isn’t worth enough to go get a new loan, you have to bring in new capital to pay down the existing loan balance to get a refi. So you might have to restructure the capital, that’d be another reason for a capital call. And a third is just unplanned capital improvements. You could have a property that’s on a fixed rate loan, has great occupancy and rent increases, but then something happens like an uninsured loss, a pipe break, bold breakout, something like that, and you have to fix it and you don’t have the capital, so you might have to issue a capital call for that reason. So there’s a lot of different reasons why additional capital might be needed.

Mauricio:

And one of the thing I also wanted to, I think Brian, you touched on it right before you went into that, but one of the things I wanted to clarify from the beginning is when you’re raising capital for some of these deals, you’re typically raising about 30 to 35, maybe 40% of that capital from investors. And so when the property goes down 30, 35%, like Brian was saying this morning, that generally starts to wipe out a significant amount of the investor’s equity and maybe even all of it. So if a property’s down 30%, that 30% may be the equity or the LPs money in there. So even though you still have the property, the LP investors may have already lost their money at that point.

Kathy:

So Mauricio, in the original documents that you help many of these syndicators draft, there is sometimes a provision that there could be a capital call and you need to be aware of that. And if you don’t do it, there would be repercussions. So in some cases, the investors would need to be prepared in those initial documents that it could happen. And then there’s other times where it’s not written in there or it just doesn’t make sense. And the reason this is kind of a story and a question at the same time, we did a deal in 2013 where it didn’t go as planned as a development deal, California slow in every which way possible with more regulations and more regulations. So then the developer had the right to call for a capital call, but I kind of raised my hand and said, well, if we do this, is there any chance we’re ever going to get our money back either the original capital or this new capital? And he couldn’t answer that, and he never gave us a proforma, so we didn’t do it and there were repercussions, but it was like, what? I’m not going to get any profit. There’s no profit anyway. So if you would explain what investors should look for in the initial documentation of whether they would be required to do a capital call and when they should or should not.

Mauricio:

Yeah, I mean I like to talk through, so there’s five factors that I think LPs should be looking at, but one of those is definitely looking at the operating agreement because you said sometimes they’re there, sometimes there’s not. They should. In my book, it should always be in the operating agreement. So there should be a section in the operating agreement that you signed as part of the most likely the limited liability company that you’re a part of that has a section called something like additional capital contributions or maybe it’s underneath the capital contributions. And in there is literally a roadmap of what the process looks like in the event that the manager of the sponsor believes that there’s additional capital that’s required. And so you just got to read it. To your point, Kathy, even though it’s in there, which I think every single operating room should have it, the actual roadmap, the steps might be slightly different.

Some might mandate, for example, that a capital call that you’re obligated to do one, the ones that we do don’t obligate an investor to put more capital in, but most likely there is a dilution provision, meaning if they don’t put capital in their interest in that syndication may go down or there may be other repercussions. But that’s definitely one of the things that you want to start with is looking at the operating room because if there’s no obligation for you to do that or you just look at the other potential options, then that’s something where I would probably start. But I think even before then, or maybe right after that, right before that or right after that, I would argue that one of the things you need to start looking at is what are the reasons for the cash? Brian brought up a bunch of ’em.

I think that’s really, really important. If you’re an LP and you’re trying to decide whether to put more money into the deal, and sometimes people say putting good money after bad if that’s even the right way of saying it, but what is the reason? Because if the reason is some unexpected capital, there was a hurricane that came through your property in Houston or there’s a tornado, we just had one not too long ago and the roof gets torn off and look, nobody could have anticipated that and they need more capital for that. Okay, that’s one thing. But on the other hand, if the property hass just been completely mismanaged by the operator, they’ve just a poor job or they haven’t, they’re just really sucked. If that’s a legal term at running the property, then that’s a complete different situation. So understanding the reason for the capital call I think is number one.

Number two to your point is is there a clear path to an exit? Meaning if I’m going to put more money in, let’s say I initially put in $50,000 and you’re asking me to put in additional 10 or 15, the question is, well, what’s the game plan? How am I going to get that money back out? Is there a new and updated business plan? Because that’s really what’s going to be required. Whatever business plan you gave me two, three years ago, obviously it’s out the window. So what’s the new plan? What are you going to do with my money? And do they have a concrete exit? Again, if it’s something simple as not simple, but the roof got blown off because of a hurricane, well great, I’m going to use the money, we’re going to put another roof in there and we’re going to be back in business.

Or is it just, and I’ve heard some people say, well, we just need to continue to float the note for another three or four months and then we’ll see. I mean, that’s not a very good exit strategy. So having a clear exit strategy, I think is the second of my five factors. Number three is obviously the impact on the returns. Am I going to get a return, not only my new money coming in, which is maybe less important, it’s how much of my money that I think I’ve already lost in the deal. I’m like, what are the chance of me getting some of that back or a lot of that back? Because if I can put in 10,000, let’s just say I put in 50,000 and it’s all pretty much gone, the property’s gone down, it’s basically worth zero, but if I can put in $10,000, I’m going to get half of that money back.

Well, that starts to look like a good return on investment. I’m putting in another 10, I’m getting 25 grand back that I wouldn’t have otherwise gotten. So you just got to look at the numbers and figure out what the impact on the returns is. Number four I would say is do you trust the operator? Because again, if they have done a crappy job up to now and you just have no faith in them, that’s one scenario. And again, to Brian’s point, if it’s something else that just, maybe you do need to restructure it, you want to get some investors out, or maybe there’s an unexpected capital that nobody could have figured out that maybe, hey, not a big deal, and maybe they’ve been communicating really well and you like them. So maybe that’s another factor that I would look at. And then the last one I would look at also is has the sponsor themselves?

Has the operator put any of the capital themselves? When I talk to sponsors, which is usually where I’m on the other side of this, I encourage them that number one, they should communicate early, not late, but early on in the process, they should try and fix the problem with their own capital first. By the time you get to a cash call to LPs, at a minimum, you should either be putting in money with alongside V LPs during the cash call, or ideally you’ve already put in money like, Hey, look, we tried to avoid the cash call six months ago. We funded this with another half a million or a million bucks or 200 grand, but hey, that money’s now run out. So now I’m going to the next step, which is I’m fortunate having to come to you guys because the money we put in only lasted three to six months. So I think those five factors, plus obviously checking the operating room and make sure what the actual rules and steps are, kind of those critical factors.

Dave:

Alright, so that’s super, super helpful. Thank you. I just have two logistical follow-ups here. First is when you invest in a syndication, the gp, the operator is usually responsible for giving you financial statements, a whole business plan. When a capital call happens, should an lp, a limited partner, expect the same level of projection and analysis as the initial PPM,

Mauricio:

When somebody invests for the first time and gets those freshly minted securities that you’re buying, you get a full set of disclosure documents. You get a business plan very detailed with the performance. You get all the risk disclosures in a document called A PPM, A private placement memorandum, which discloses all the risks to the investors all the way your deal can go wrong, very similar to those medical consent forms when you go in for surgery and they have you silent little yellow form and all the risks involved. So they get that, but on a cash call, they’re not issuing new securities, they’re asking for more money, they’re not actually selling you any additional shares, so to speak of the company. And so there is no requirement for the sponsor to give you a full set of disclosures. My clients are not calling me and I’m not drafting an updated PPM to provide those to the investors.

And so they don’t necessarily have the same, so to speak of the disclosures at the time of a cash call as they do at the time of a new issuance. Now, and again, they’re not even required to give you a business plan. So that’s not even in the, they could literally just say, Hey, Dave, I need 10 grand. Give it to me. I mean, legally they could probably do that, but I think it’s obviously best practice not only for the sponsor, but also from an LP perspective. Before committing any capital, you’re going to want to see the updated business plan. And I’m telling you, some of them do not give you that. They’ll just say, oh, yeah, yeah, we just need more money to be able to pay the debt service for the next three or six months and then we’re going to be fine. Just let’s do it. And then other people give you a full-blown business plan with updated projections, updated performance, and showing you, hey, if we raise an additional $500,000, this is what it’s going to look like in year one, year two, and then we’re going to refinance out and this is what it’s going to look like for the next until whenever we sell the property. So that’s an excellent distinction on the difference between investing new money from the beginning versus a capital call or a cash call.

Kathy:

Yeah, one of the things I’ve noticed is that investors also need to be aware of what the documents say in terms of that and bringing in more money. And if it comes in as a loan, will that take priority to your equity that’s maybe been in the deal much longer than this new money? So Brian, have you seen that? I have personally been in that situation. It worked out because like Mauricio said earlier, the operator put in the money that was needed, but it was a loan, so he got paid out first with an interest rate that was actually pretty high, but it saved the project and now investors are going to make what they expected. But Ryan, have you seen that kind of solution where just a new loan comes in? I mean, I think that’s happening a lot these days, right?

Brian:

It is, and I, I’ve actually done it. I mean back in the oh nine, great financial collapse. I had a property that was massively negative cashflow and I loaned a lot of money. In fact, at the end of the deal, I had more money and loans in the deal than the investors had in capital in the deal. Now I loaned mine interest free. I don’t know about the high interest thing. That’s an interesting angle on it I suppose. But at the end of the day when the market came back and the deal finally sold, I got my money back first. Yes, that was true, but the investors got all of their money back. Now, me just being the way I am, I would’ve given my investors their money back first and I would’ve took whatever was left over this deal happened to have enough for everyone to be made whole.

That just depends on the sponsor’s level of commitment to their investors and that sort of stuff. But it is actually quite common for sponsor loans and debt to come into play. Now, that also can create interesting conflicts of interest too because now the sponsor gets inserted ahead of investors, which is a conflict. They might issue a capital call and attempt to recover their loan funds and then ultimately then later bail on the investment and let the investor suffer a hundred percent loss, which would be a major conflict. So there’s issues that I think could come about with that, especially with unscrupulous sponsors. Now, fortunately there aren’t many of ’em, but there could be some out there. There’s another kind of an in-betweener and that’s called preferred equity. And this is another concept that’s being introduced in a lot of these deals lately where they go to some institutional investor or maybe even individual investors and they raise this tranche of preferred equity.

And what this is is it’s kind of like a loan, but it’s kind of like equity. It’s not secured by anything, but there’s usually a current pay component and then some kind of backend participation usually to specified rate. And that equity is ahead in line of the common equity that does create issues because let’s say you get a capital call, you’re an LP investor as common equity, and they issue the capital call and nobody participates. The sponsor says, well, we still going to try to save this thing, so we’re going to go get a bunch of preferred equity. We’re going to insert that ahead of you. Now you’re almost certainly wiped out at today’s valuation. Now of course, if the market comes back later and everybody’s happy and everybody gets paid back, there’s no problem. But that’s certainly not a guarantee. I mean, the sponsor could still end up defaulting the loan could foreclose, the preferred equity might have takeover rights where they get to kick the sponsor out and take the project over and they’ll sell it the minute they can get their money back and they’ll wipe you out no problem as a common LP investor.

So there’s a lot of different capital structures that come into play. It’s important to understand how not participating in a capital call could adversely affect you if the sponsor does things like that, which is within their right to do so if the operating agreement allows it.

Dave:

Thank you for sharing that. And it brings up a question here, Brian, that I kind of want to understand logistically, because imagine I am an LP and a sponsor comes to me and says, Hey, we want to do a capital call. Here’s some information. Are you in? Are you out? Do I have to make the decision before I know if everyone else is participating? Because to me, if a GP came to me and said, Hey, I need 5 million bucks and I’m going to put in a hundred thousand dollars and I’m the only one who participated, I’m like, wow, I just threw a hundred thousand dollars at this and the GP can’t do anything. So is there any protection there that would ensure that the capital call reaches sort of a critical mass that the GP can actually execute their business plan?

Brian:

That actually is a great question, and in fact, I encourage people, I actually have this in my notes to talk about this very thing because what happens if you say, yeah, I’m going to participate and not enough other people participate. So therefore the plan that they so carefully laid out is not executable because they never raised enough capital to properly execute. What will the sponsor do? Will they just burn through the cash they did get and then the plan ultimately fails and then the deal tanks? Or will they send that money back to those investors and say, Hey, we tried, we didn’t get enough. Here’s this money back, or would it be a combination of the two where they’ll say, okay, we’ll take this money and then we’ll inject half as much preferred equity ahead of everyone because we only raised half as much as we needed in the capital call.

How are we exactly going to structure that? So I can’t give an answer to this because every sponsor could react differently. So what I would encourage you to do is if you’re facing a capital call, this is one of the questions you’re going to want to ask the sponsor that’s asking you for money. Remember, this is a two-way communication. You have the right to ask questions, and if the answer isn’t given to you, you should solicit the answer. And I would ask them, if you don’t raise what you’re intending to raise to fulfill this business plan, what will you do and what will you do with my money? And that answer is going to be really important and you making your decision whether you contribute that capital.

Kathy:

I have a question for Mauricio about this because it’s my understanding that as LPs, you should have access to each other. You should be able to see who invested and be able to communicate, and there should be meetings where you can discuss these things. Maybe that’s just something we do because I thought it was required, but I remember asking a sponsor, Hey, I want to talk to the other investors to see what they’re doing, and he wouldn’t do it. I had to drive. I had to send somebody to drive to his office to get the documents so that we could communicate with the other investors. And I just thought, what a jerk, not to let us decide. But Mauricio let me know, is this something legally that a sponsor should be required to do is to let us communicate with each other?

Mauricio:

Yeah, obviously sponsors don’t want all the other folks to communicate with each other. This is such an interesting topic that’s come up a lot and I’ve got some very strong thoughts that actually go against a lot of what a lot of sponsors like, but I do think it’s required and the reason, and people come back and say, well, what about privacy? All the other investors don’t want to divulge all of your mailing address, your email address, and I get that. So my argument is yes, some states actually require it. Some states require, requires part of your operating agreement or your documents that you need to provide is a list of all of the members that are in the deal with you along with their last known address and their percentage ownership. And the reason that’s important is that most operating agreements, almost certainly the ones we do, even though it’s very difficult for members to have certain votes, it’s very difficult for a LP to vote the manager, for example, off the project, very, very difficult.

But it’s not impossible. And so if they wanted to try that, so in your case, Kathy, if you said, look, I really think Brian’s doing a terrible job at this deal, so we want to get Brian off of this deal. You’re going to want to call a meeting of all the members to vote. Now forget about the communicating and starting a Facebook group. I’m talking about voting on whatever limited rights you have in the operating agreement. You have to have the right to be able to call a meeting and follow the procedures that are outlined in the operating agreement. And if you don’t all of those people’s information, at least the last known legal address or mailing address, then how are you going to be able to fulfill your obligation? So I do believe, and again, some states require it where you do provide the name, the address.

I’m not saying you have to give emails or phone numbers, but at least the address so you can at least mail them a notice. And of course from there you can go get their information and then their percentage interest. And again, the percentage interest is important because if they’re voting and you need to get a 90% approval rating to get Brian to vote Brian off the island, you need to know what percentage voting rights they all have. So I do believe that in our documents, it absolutely is there. And in a lot of the states, especially the common states that you hear, like Wyoming for example, is one of ’em, Nevada is the other one. They are required and it’s actually listed in their statutes if that’s part of the corporate records that they’re required to keep in the company and that the members have the right to ask for when they want it. So

Kathy:

If there’s one thing our listeners are hopefully getting from this syndications aren’t as easy as just sending a check. You have got to understand the capital stack, which means you’ve got to know who gets money first and what a preferred return means. What preferred equity means, what preferred debt means, what all of these things have somebody review your documents before you sign them. It’s a lot of legal stuff that most of us regular folks do not understand, and it’s not interesting or fun to read. These are very thick, they’re

Speaker 7:

Boring, they’re very boring, they’re

Kathy:

Boring, they’re awful, they’re

Mauricio:

So boring. But as an investor, as a limited partner in one of these syndication, the only thing you should thing you can do, because again, once you write the check, you’re really hands off. You don’t have any say in the operations of the company. So your work is before you write the check, is the due diligence on the sponsor, the due diligence on the project, asking all the right questions that probably don’t have time to get into, but that due diligence on the sponsor, can they pull off the pretty brochure they gave you? The brochure is easy. Anybody can make up numbers and pictures, and here’s the plan. Do you have faith that the sponsor can pull off that business map? Those are all questions you’ve got to figure out ahead of time, either by yourself or with somebody who has experience so that by the time you make that decision, you write the check, now you’re along for the ride. There’s not too much involvement you’re going to have once that check is

Brian:

Cut. Kathy, you said something really important that I want to expand on. You said it’s really important for the LPs to understand where they are in the capital stack, who gets paid first, but the other piece that they also need to understand is when other people need to get paid. So if there’s a lender and the loan has a three year maturity and you’re investing for a five to seven year hold that not only is somebody getting paid before you, but they need to get paid earlier in time than you and how is that going to happen? And if they can’t pay that loan off, then what preferred equity? Sometimes preferred equity is a three year preferred equity tranche just like a bridge loan, and that preferred equity needs to get paid off. If that’s true, there has to be a solid plan for how that gets paid off. And when there’s an adverse market, that payoff is unlikely. So knowing if there’s somebody heavily beating on the door, then that could be a problem for you. And knowing that I think is really important,

Mauricio:

And that’s the main issue we’re having these days, right Brian? I mean because of the interest rates going up, what’s happened is really most people took out bridge debt, the short-term debt that you talked about. So instead of in a single family, everybody’s used to these 30 year mortgages, and even in the commercial world, we were used to more of the seven year loans, or maybe even 10 years or maybe five, but because of interest rates going up, a lot of sponsors, a lot of real estate investors, a lot of syndicators took out debt that literally had three year called bridge debt. So the idea was, Hey, let’s get this thing stabilized over the next three years, then we’ll refinance out, get some permanent debt. And of course, that all happened during this timeframe where interest rates went through the roof and now prices are going down 20, 30, 40% according to you, Brian, so they just can’t refinance, and that’s the problem they’re having now, which is what’s causing a lot of these cash calls that we’re talking about today.

Brian:

On a previous episode of this podcast, I made a comment about the amount of loan maturities, and I think Dave challenged me saying like, Hey, wait a minute. There’s loan maturities all the time. If you’re five years, that means 20% of all debt is always maturing, and that’s not the issue. It’s not how much debt is maturing, it’s when that debt is maturing and the conditions under which the market is in. When that debt matures, it creates the problem. So yeah, there’s a lot of commercial real estate debt, multifamily included that’s maturing this year, next year, and it’s not maturing under ideal circumstances, and that’s why there’s issues in some of these deals. Now, I just also again want to make clear, that doesn’t mean it’s limited to syndications. You could be a wealthy individual that bought a multifamily property on your own with no sponsor, no investor, no nothing, and you could be facing the exact same situation. The difference is you don’t call it a capital call, you just call it taking out your checkbook and writing checks for the negative expenses.

Dave:

Yeah, just selling something to pay for instead selling the second home.

Kathy:

We do have one more quick break to hear a word from our sponsors, but we have more from Mauricio and Brian. After this while we’re away, make sure to hit that follow button on Apple or Spotify so you never miss an episode of On the Market. Welcome back to the show,

Dave:

Brian and Marisa, let me ask you both from the GP side, if you were in this situation, what is a way that you can do a capital call? What’s the right way to do it to not lose credibility from your investor community, assuming you want to continue being a operator and syndicator in the future?

Brian:

Well, I’ll start with the practical and Mauricio, I’m sure we’ll take over the legal, but from the practical perspective, communicate with your investors early. One thing investors really hate is if you say like, Hey, we noticed a year ago we were having all kinds of problems. We didn’t tell you about it. We started putting money in ourselves to try to fix it and hide it from you so you wouldn’t know so that we could keep raising money for our other deals without looking bad, but now we ran out of money and we want money from you. Don’t do that at the moment that you see, hey, there could be a capital call even a year from now. If things don’t change a year from now, we might need cash. Just tell your investors every quarter or month, whatever it is, you do your reporting. If things aren’t going well, just tell people.

Our quarterly reports aren’t fun to read right now because things aren’t going great in every market. There’s a lot of challenges out there, and you just have to tell people, and if you do that when you have a capital call, they’ll go, we were kind of expecting that because you’ve been telling us all along exactly what’s been going on. That’s number one. Number two is communicate a clear and effective plan. Show people like, look, this is the amount of money we need. This is exactly what we’re going to do with it. This is exactly our plan. Number three, don’t have a plan that’s like a short term, like, oh, give us this money and then in six months or a year, the market will change and rates will fall and everything will be fixed, and it all will be well. I would rather see a plan that’s like a 10 year plan.

Look, if you give us this money, even if nothing changes, we’ll be able to get by 10 years without asking you for more money and without running out of money and having this project fail, you need a long time horizon. That would be the third, fourth show a sources and uses of the funds. If you give us $10 million or whatever the number is that they need from investors, this is what we’re going to do with it. You can’t just say, give us the money and we’ll figure it out. This is what we’re going to do with it. Have a webinar or a slide deck or a presentation or a document to show exactly what the plan is, show new financials to show how the project is performing and how you expect it to perform in the future, and how the additional capital is going to help with all that. All of those things are really necessary. If you just send out a letter saying, Hey, we’re issuing a capital call, send us money, you’re going to get a firestorm of opposition and probably no participation.

Kathy:

Oh, Brian, I cannot emphasize enough how important that communication is early on immediately. It’s hard. It’s really hard to say that the business plan isn’t going as planned, but also it’s been an unusual time. There’s reasons. I interviewed someone on the Real Wealth show who I just almost burst into tears when I heard his story. This was in 2008. He did not want to tell his investors, so he started to commingle and he used money from here and there to save projects. He didn’t spend it personally, but he used different investor money, didn’t explain it, didn’t ask permission. And as a result, he ended up in jail for 10 years. His children won’t talk to him, his wife, he got a divorce. Everything in his life was flipped upside down because he tried to save his projects the wrong way. And I just can’t emphasize enough how important it is to do things right and to have great legal counsel. If you’re a gp, and again, a GP is a general partner, the ones running the operation and liable for it.

Brian:

Yeah, that’s a great point Kathy, and I think that’s some Ponzi schemes get started. They get started with well intentioned movement of money, and then it turns into just a massive collapse and ultimately you’ll wind up in prison

Mauricio:

And communication is key. It’s actually, I usually talk about the seven steps to a flawless cash call for my GP clients, and number one is the communication. I mean communication. Ken McElroy taught me this a long, long time ago. Communication builds trust, and so when things aren’t going well, that’s the time to double or triple your communication. It’s not the time to stick your head in the sand and pretend nothing’s going on. And I think the best cash, I’ve seen some amazing sponsors who end up doing a cash call. They’ve been communicating to your point, Brian, a year in advance like, Hey, look, this is coming down the pipeline. I think we’re good right now. We’re working on some alternate funding sources, and they’re literally communicating this all the way to the end where by the time they ask for the cash call, the investors know the 17 steps that they’ve already done trying to avoid at all costs at cash call.

So I think communication is always the first step. And then the second step being a little bit more on the legal side is obviously you want to look at your operating agreement because you want to make sure you’re following the operating agreement to the T. This is not a time to wing it and do, oh, let’s just do it this way. There’s going to be a very, very legal step-by-step process for you to issue that cash call and you want to make sure you’re following it. If you’re a GP, I would highly recommend you reach out to your securities attorney first, the ones that have drafted those provisions. So get some counsel from them to make sure you’re doing it right. And then from a practical standpoint, I think I also, Brian, I’m interested in your take on this as well. This is more on from my side, the theoretical, but I know a lot of sponsors will actually pick up the phone and talk to their investors first before they even issue the cash call.

So they can have these one-on-one conversations with ’em, say, Hey, look, we’re going to issue a cash call. Are you in or not? It’s almost like a soft vote too. It’s like, Hey, this is why we need a cash call. I’m going to need a 10% cash call. Is that something that you are able to and willing to do and sort of take that initial sort of soft commitment sheet? But again, the investors are going to have a bunch of questions and you can do a webinar and I think you should still do that, but a lot of my clients will end up, especially if you only have 10 or 15 clients, they pick up the phone, they do one-on-one calls, it’s that serious. You want to give proper notices of course. And that kind of goes back to this mailing address, Kathy, we’re talking about.

You want to make sure you’re issuing the notice legally and properly, whether that’s through a certified mail or maybe an email’s, okay. But again, whatever’s in the operating agreement. And so there’s all these steps you want to take from a legal standpoint, but I think the overreaching one is just making sure that you are very familiar with that cash call provision in your operating agreement and you’re following it to a T. And I really do think you should be reaching out to your securities council to get advice on making sure you don’t screw that piece up.

Dave:

Well, Mari and Brian, thank you so much for sharing your knowledge with us and everyone listening. I hope that you’re not in a situation where you are facing a capital call, but hopefully now with this information, if you have found yourself there, you have some way of navigating through this challenging time and making good financial decisions going forward. And I think the advice that Mauricio, Kathy and Brian game is sound here. You just have to treat it as a new investment. Get as much information as you can. Talk to the sponsors, talk to the other LPs and see if putting in additional money is actually going to be a beneficial situation for you. And as Mauricio said, don’t throw good money after bad. Brian, Mauricio, thank you so much for being here. We appreciate your time. Thanks for having us. Thanks for having us. If anyone wants to learn just more about syndications in general, what the terms mean, what to look for as a limited partner, how to get into all this. Brian actually wrote a book. He’s too modest to mention it on the podcast, but it is truly one of my favorite real estate books out there. It’s called The Hands Off Investor. Definitely recommend you check that out for BiggerPockets. My name’s Dave Meyer. She is Kathy Feki. Kathy, thanks for being here and thank you all for listening. We’ll see you soon

Dave:

On The Market was created by me, Dave Meyer and Kaylin Bennett. The show is produced by Kailyn Bennett, with editing by Exodus Media. Copywriting is by Calico content, and we want to extend a big thank you to everyone at BiggerPockets for making this show possible.

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