10 Ways to Avoid Unplanned Capital Calls in Your Real Estate Syndication

Unplanned capital calls can be disruptive. They can become a real challenge for both sponsors and investors, sparking anxiety and potentially hitting a dent on the trust you’ve built so far. 

Let me put that into perspective. Due to a sudden, unexpected expense and delay in construction, you are required to call for an immediate capital.  Investors, unprepared and uncertain, can start questioning the financial stability of the syndication and your management. 

Now, I must put it out there that capital calls are indeed a common scenario in real estate syndications. So, while capital calls can be necessary for keeping a project on track, unplanned calls can erode investor trust, impacting the syndicate’s credibility and reputation. To avoid unplanned capital calls, I have some tried and tested methods outlined for you in this blog.

10 Strategies to Avoid Unplanned Capital Calls

1. Perform Comprehensive Due Diligence Before Acquisition

I can’t stress this point enough as to why due diligence is the most important part of the acquisition phase. This stage will determine whether or not the property you are looking to take up is profitable. It can help you identify potential pitfalls early on.

2. Build Contingencies Into the Budget

Including a contingency fund, generally 10-20% above projected costs, ensures that unexpected expenses won’t derail the project. Additionally, ensure the following two:

• Reserve Allocation: Budget reserves should match the project scale, risk level, and market conditions.

• Avoid Underestimating: A small buffer could lead to financial strain, whereas a robust contingency fund adds a layer of security.
  

2. Stress-Test Financial Models

Stress-testing financial models involves evaluating how a property or investment would perform under various adverse scenarios. This practice is crucial for understanding potential vulnerabilities in your financial plans. Here’s how you can implement them:

• Scenario Analysis: Run simulations that include worst-case scenarios such as significant rent reductions, increased vacancy rates, higher operating expenses, or a sudden economic downturn. For instance, if you anticipate a 10% drop in rent, assess how this would affect cash flow and debt service coverage.

• Resilience Assessment: Determine how much reserve cash is needed to cover potential shortfalls. If the stress test shows that cash flow remains positive with a 15% drop in rents and an increase in expenses by 20%, this indicates strong financial resilience.

• Investor Confidence: Present these stress tests to investors to demonstrate proactive risk management. Transparency about potential risks can enhance trust and assurance among your investor base.
  

3. Secure Flexible Financing Structures

Flexible financing arrangements can provide leeway to manage cash flows without necessitating a capital call, especially in turbulent market conditions. Here’s my take on how to implement this:

• Revolving Credit Lines: Establish a line of credit that can be drawn upon as needed, allowing you to cover unexpected costs without seeking additional capital from investors.

• Interest Reserves: Negotiate terms that allow you to set aside a portion of financing to cover interest payments during periods of low cash flow.

• Extended Loan Terms: Structure loans with longer terms or adjustable rates to give the syndication more time to generate income before repayments become due. This can be especially beneficial during economic downturns when cash flow may be tight.
  

4. Cross-Collateralization

Cross-collateralization involves using equity from one property to secure financing for another. While it can enhance borrowing capacity, it also increases risk if one property underperforms. You can implement it in the following ways:

• Evaluate Portfolio Equity: Identify properties in your portfolio with substantial equity that can be leveraged without jeopardizing their financial stability.
  
• Cautious Approach: Use cross-collateralization judiciously to avoid over-leveraging. If one property faces unforeseen expenses or market challenges, the financial burden can spill over to other properties, leading to cash flow issues.
  
• Diversification Benefits: While leveraging equity can provide needed capital, ensure that it does not link the financial fate of disparate assets in a way that could trigger multiple financial problems simultaneously.
  

5. Implement Subordinate Financing (Mezzanine/Preferred Equity)

Subordinate financing, like mezzanine loans or utilizing preferred equity, can help raise funds without diluting the ownership of existing investors. That said, there are certain things to keep in mind:

• Risk Assessment: Before introducing subordinate financing, carefully evaluate the terms and potential impact on overall leverage. The higher the leverage, the higher the risk if the property does not perform as expected.

• Use as a Last Resort: Ideally, subordinate financing should only be used when absolutely necessary, such as when facing a liquidity crunch. Consider it a stopgap rather than a primary financing strategy.

• Operational Control: Preferred equity can provide liquidity while allowing sponsors to retain operational control. However, understand that there are higher costs associated with this type of capital and you will need to ensure it aligns with your overall financing strategy.
  

6. Conservative Underwriting

Now, conservative  underwriting is a strategy that involves making cautious assumptions in your financial projections. This approach helps ensure that you under-promise and over-deliver. Here's my take on it:

• Safe Assumptions: Use conservative estimates for key metrics such as rental rates, vacancy levels, and operating expenses. For example, assume a higher vacancy rate than historical norms to buffer against unexpected downturns.

• Stabilizing Timelines: Build in extra time for achieving stabilized occupancy and rental rates. This can help manage expectations and reduce the risk of shortfalls.

• Real-World Application: Highlight case studies where conservative underwriting practices have mitigated financial shortfalls. For example, a syndication that budgeted for 8% vacancy rates rather than 5% can demonstrate how this cushion helped avoid an unplanned capital call.
  

7. Set Up Adequate Reserves

As I mentioned before, setting aside adequate reserves is essential for covering unexpected expenses that may arise during the investment’s lifecycle. This is one of the most effective ways to avoid calling for unplanned capital. Here’s what you can do:

• Operating Reserves: Establish operating reserves equivalent to 1.5 to 3 months of operating expenses. This fund can cover any cash flow shortfalls during tenant turnover or unexpected repairs.

• Capital Expenditure Allowances: Allocate capital expenditure reserves, typically around $250 per unit annually, to address long-term maintenance and improvement needs. This proactive approach helps avoid large, sudden financial demands that could necessitate a capital call.

• Protecting Cash Flow: Emphasize how maintaining reserves can protect the syndication's cash flow during market disruptions or construction delays, reassuring investors that their interests are safeguarded.
  

8. Invest in Robust Growth Markets

Investing in markets with strong growth fundamentals can mitigate the risk of cash shortfalls and enhance overall investment stability. To do so, you can follow the given two methods:

• Market Research: Focus on markets characterized by high liquidity, diverse economic bases, and robust population growth. Evaluate local employment rates and industry diversity to determine long-term stability.

• Absorption Rates: Analyze absorption rates in the local market to gauge the speed at which available properties are leased. High absorption rates indicate strong demand, reducing the risk of prolonged vacancies.
  

9. Maintain Transparent and Frequent Investor Communication

To ensure that your investors don’t feel that you have called for an unplanned capital, regular and open communication with investors is critical. It helps manage expectations and maintain trust, especially during challenging periods. Here’s how you can do that:

• Quarterly Reporting: Establish a routine for quarterly reporting that includes updates on project performance, financial health, and any significant changes in market conditions. This keeps investors informed and engaged. Also, add about any expected delays in the project or any event that may suggest that a capital call may be asked for. 

• Crisis Communication Plan: Prepare a communication plan for when unforeseen challenges arise. Being proactive in sharing both good news and setbacks can help maintain investor confidence.

• Real-Life Examples: Share instances where transparent communication has successfully mitigated investor panic. For example, if a construction delay occurs, a timely update explaining the cause and outlining a revised timeline can reassure investors of your proactive management.

Conclusion

‍In real estate syndications, the ability to avoid unplanned capital calls is a sign of a sponsor’s strategic foresight and careful financial management. So, look into the ten tips I have provided above and you will find your syndication being resilient to market fluctuations. These preventative measures safeguard your syndicate’s reputation and protect investor relationships—both vital for future projects. So, take action now. Evaluate your current strategies, implement these best practices, and position your syndication for sustainable success. With a proactive approach, you’ll be better prepared to navigate challenges, meet investor expectations, and focus on long-term growth.