#203 What are Capital Calls & How to Protect Your Investments

Hey, everyone, Hope you've had another great week or a great weekend. Whenever you're listening to this, I hope things are going well in your part of the world. I know life out there is quite crazy. Many of you are working to the bone, working really hard, but you're taking the time to listen to this podcast in between cases in your car. So I really want to honor you. This week we're going to be talking about the two words that no passive real estate investor wants to hear. What are those two words? Capital and call. The dreaded capital call. We're going to talk about what they are, why they happen, and how you should be thinking about them. So stay tuned. Welcome to the Passive Income MD Podcast, where we talk about creating your ideal life through multiple streams of income. If you enjoy hearing about this stuff, make sure to hit subscribe. Now, let's get on with the show. All right, everyone, this is the time of year depending on when you're listening to this. Well, you're starting to think about your year in review. I'm talking about your financial year, the prior year. You're probably doing your taxes. You're working with your cpa. You're seeing some of the numbers. I'm just curious, how did that year go for you? Did it go as well as you wanted? Maybe it was a little bit less than expected. All I know is that the economy and the market, things have been quite crazy over the last 12 to 18 months. As we all know, inflation has gone crazy. Interest rates have been super high and they still haven't come down yet. And that's caused a ripple effect in the economy, especially in when it comes to real estate and in the commercial real estate. I'm talking about multifamily, office, industrial. All of these places are where you've seen an effect when, especially when it comes to interest rates. What it did in 2023, by the way, is that it froze the markets, meaning that there were very, very few transactions when it came to real estate. People were waiting to see what would happen with interest rates, would it come down? And the few people that had to sell in that time unfortunately had to take major losses. And when someone saw other groups taking major losses, they didn't want to happen to them or their investors, so they would do everything they could not to sell. So it can be a scary time. I'm just curious, how are you feeling about everything that's happened and what the current economy is today? Cause ultimately, it's not about what's happening out there. It's about how it affects you, how you feel. Because no matter what's happening out there, you might feel scared or anxious or worried, or you might be on the other side of the spectrum where you might think it's a great time to have an opportunity, it's a great time to be aggressive, and this is what you've been waiting for. So which side of the fence are you on? I've been on both sides of it. I will tell you that surrounding yourself with the right people that are opportunistic, that are optimistic, that have been through this type of experience and know how to take advantage when the market is going crazy, those are the people you want to spend time with. As you may have heard, Warren Buffett, one of his famous quotes is, be fearful when others are greedy and be greedy when others are fearful, meaning that being a contrarian in a way, not just following the tide, that's how people ultimately do well in all parts of the market. So in any case, because the commercial real estate market has undergone so much upheaval, there's been so much volatility, there's this thing called a capital call that many of you might have heard about. I want to talk about what they are, how it affects our investments, why they might happen, and ultimately how you can react to it and take action on it. So what is a capital call? It's when an investor gets a call or a notice that they need to put more money into a deal. They probably made their initial investment, they expected that investment to go well. What they didn't expect was to have to pony up more money into the investment for whatever reason. Now we're going to talk about why these capital calls happen, especially when it comes to real estate, and particularly, I'm just going to talk about how they happen in the apartment or multifamily market, just because it's easy to explain. And then you can extrapolate that to the other asset classes. In real estate, capital calls essentially happen when there is a cash shortfall that the property itself can't operate and it can't sustain itself in terms of, you know, managing their expenses and their income and be able to pay off all their obligations, pay the debt to the bank, their mortgage, their interest, all of that. If the property can't pay for itself, you're going to have to go back and figure out ways to get more cash. Oftentimes that means going back to the investors and asking them to put in additional capital. Now, why might this happen? Now it all comes back to the equation of what Profit is in real estate. Profit is income minus expenses. What's income? Those are your rents, maybe laundry, parking, whatever that might be. Expenses on the other side are taxes, your mortgage, the interest on your payment, maintenance. And it's a balancing act. And what do we see in today's world? We're seeing rents that have gone pretty flat. We haven't seen a lot of increase in rent, so the income has remained relatively stable. On the other side though, we've seen rising interest rates, which means that the mortgage payment, the interest payment has gone up significantly. Property taxes continue to go up. Insurance costs have gone through the roof, especially in certain areas because of all the natural disasters. The cost of renovations, supply chain issues, cost of maintenance, all the supplies have gone up. So expenses have gone up there. It's put that equation, income minus expenses out of whack. So properties that maybe were cash flowing when you first bought it or two, three years ago are not cash flowing now and might have a negative cash flow situation. I also want to take a moment to talk about the financing and debt in a lot of these properties. You and I, when we bought our home, we probably bought a long term fixed loan, meaning that we bought it like for 30 years. It's at a low interest rate, 3 to 5% and it remains fixed throughout the entire term. In a lot of these commercial properties, people often buy shorter term loans because they don't expect to be in too long or they expect to refi at the end of this. And these, these loans are often have what's called variable rates, meaning they go up or down according to what the standard interest rate in the market is at that time. And, and that situation was great. When the fed funds rate was basically zero, which it was after the pandemic, they wanted to juice the economy, they wanted to increase lending and get the economy moving, especially after what happened there. And so interest rates were dropped to zero. And so what happened? People started going and using that money and buying up properties. What happens when you start throwing a lot of money at something? The price of that goes up, the demand went up, so the property values started to go up and up and up. And so there are significant amount of loans in 2020, 2021, even 2022 that were bought at these extremely low interest rates. A lot of these loans were three years long. So what happens now when those loans start to get close to being due? You've either got to refinance or you got to sell the property and move on. The issue is that a lot of these properties aren't able to be refinanced because the value of them have actually dropped quite a bit. Meaning that the operations have dropped, the market's gotten colder. So it's very difficult to refinance these properties unless you put more money in. There's also something called an interest rate cap. I know I'm talking a lot about different things, but this is important for you to know about, which is with these variable rate loans, usually the lender requires something called an interest rate cap. It's basically an insurance that you have to pay for so that if interest rates rise rapidly and it basically caps how high they can rise. And that was great in the time when interest rates were low. However, as they started to rise, they started making sure that these caps were in place and they would get more expensive as the rates would go up. So maybe an interest rate cap that might have cost like 40 to $50,000 two, three years ago in today's market, especially because interest rates are so high, they might be close to a million dollars. And for you to continue with your loans, these lenders will require you to have it. Otherwise they put you in default. So let's lay out the situation. You're an operator or sponsor. You've got a property, income has gone flat or down, expenses have gone way up. The lenders requiring you to pay for an interest rate cap, maybe 800,000 to a million dollars, or you want to have to put more money in to try to refinance the property, you got to put a couple million dollars more in to actually be able to refinance this loan. Where are you going to get this cash when the property is not performing that well? Now, be great if you had some sort of reserve to pay for that. But this is a significant amount of money. It's not a, you know, a few $10,000. This is talking about hundreds of thousands of dollars to even millions of dollars that these operators have to come up with. So they have a couple options. Either they can sell the property at a loss, which will ultimately impact investor equity, they can actually go into default and get foreclosed on, which will impact investor equity as well. Or if they believe in the long term success of this property, they think that if they can just get through the next year or two with these high interest rates, with the market where it is, if things will change, this property will turn around. Maybe they just need a little bit of extra cash to get through this period. So what do they do? They go back to the investors and make a capital call, meaning they ask investors to put in extra capital and extra cash. They're usually very, very specific about exactly how much they're asking for from each investor. They're going to let you know what they're going to be using this money for and what the new projections are for this building. Moving forward, they should set some new expectations. They might be using this money to pay for that interest rate cap. They might pay to refi the property. They might need to do some rehab and renovation to be able to turn some of these units around so they can charge more rent. They might need the money to just cover operations in the time being while things are short, so they can get to the other side of what's happening in this market. So you as an investor have to make a big decision here. Do you want to put more money in to help this property or do you not want to put more money in and invest anymore? Now, there are consequences to both actions. If you decide to invest more, of course you got more skin in the game now. But if you decide not to invest, what happens? You might get diluted out, meaning that other investors are putting in more money and so their equity stake remains the same. But if you're the only person or you're one of the few people that don't put in the money, you get diluted out. It's as if you have a smaller equity stake because now the total capital in the deal is higher, but you didn't participate in that. And you have to decide if that's okay with you, that your money got diluted out because of what happened to the market and the property. Because it may be a situation where you don't want to put more money in. Number one, you don't have it. Or number two, you don't want to chase this deal anymore. You don't want to have more skin in the game. In fact, you'd rather just keep where you're at and you don't care about the equity stake. The other side of that is you decide that you believe the operator sponsor will be able to get this property through this situation, that they just have a little bit of a cash shortfall and that if you can help them and other investors can help them get through this period, that there is going to be a good amount of success on the other end, or you'll be able to preserve your capital or the deal is going to be able to do well and that will happen. If everybody can put in their money, they can get the money necessary to fund this capital. Call to fund their operations or pay down the debt or whatever it might be. So really it comes down to another decision. It comes down to doing some more due diligence on the property, figuring out what happened wrong. I will tell you, I've seen so many experienced syndicators, operators that have been around for 20, 30 years, through all sorts of markets, even get caught in this time. Interest rates rose faster than they have in 40 years. I would say very few people expected it to rise that quickly. And even if that, if that was the only factor, some of these properties could sustain themselves and do well. But they didn't expect insurance costs to quadruple. They didn't expect all the maintenance costs to go up so much. And it's almost like a Swiss cheese model where if one or two things go wrong, that's okay, things can survive. But when you get five or six things wrong, then things start to really fall apart. And that's not a situation where they may not have been able to control for. So you have to figure out, is this a competency issue? Is it an unfortunate circumstance? Is it a situation that can be salvaged? Do you still believe the sponsors are operators? Do you believe in their business plan moving forward? Are they going to be able to get you and the property through this? These are all questions that you have to ask, and it's ultimately whether you believe them or not. And so I know I've been asked, what can you do to prevent these capital calls as limited partner? To be honest with you, there's very little you can do when you make your investment with a sponsor or operator. You're. You're relying on them and you're trusting them to operate the property well. And even in a tough market, you know, you're saying that you're going to believe and trust in them to do their best possible to get through this period. What you can do is figure out whether you're moving this direction before you hear anything. I would say review your quarterly statements, see where the properties are moving, look at the cash flow. If you are very, very concerned about it, talk to the sponsors yourself, get them on the phone. That's your right as an investor. Talk to people, figure out how things are operating in today's. How are they dealing with rising interest rates, with insurance issues? How's occupancy in that property? Are things moving in the right direction? Are they having more evictions? Are they getting increases in rent more than they expected? How are they mitigating risk in this situation? These are all questions that you should consider when you're talking to these sponsors and operators and after you fund the capital call, what do you do next? The best thing you can do is continue to keep a close eye on your investment. Read the quarterly reports, talk to sponsors, jump on the sponsor calls and and webinars to know what's happening with your investment. Obviously, the best thing to do is even before you get into a deal like this and moving forward, learn from it. Learn where the pitfalls are. Learn what could change the pro forma to lead to a situation where there's cash shortfalls. Talk to sponsors for deals that you're thinking about entering. Ask them, what are you doing to mitigate risk moving forward? What are you doing to prevent this situation from happening again? Assume that the property could face difficulties and how well is that operator and sponsor equipped to to handle those situations as well as the property themselves? Also, make sure you're well diversified. And that's the lesson that many people learned at this time to make sure that in different markets, different asset classes, different operators, they'll be able to handle things differently. Ask about the debt. Ask about the loan. What is the situation? Is it a short term loan, a longer term loan? Why are they choosing that debt? What happens if interest rates go up? What if they stay the same? What if they go down? These are all questions that you can ask to get a better idea, especially moving forward, whether this property or this investment will have some more difficulty moving forward. To be honest with you, I'm seeing some more distressed deals coming into the market. Meaning that properties that are being bought now are being bought far under where they were at their peak. I'm talking 20 to 30%. And what it's doing is resetting what's called the basis. It's resetting the base investment. It changes the size of the mortgage, changes the interest. And if the interest rates in the future change do fall, then things only start to look better. That's why I personally believe there's a ton of opportunity. This is a period of time where of course there's a ton of volatility, a lot of uncertainty in the marketplace. But I think that is the time where people, they educate themselves, they partner with the right people, they surround themselves with a great community and then they make bold decisions and take decisive action. That's when the opportunities are created. They say in the downturns, that's when the greatest transfer of wealth happens. Meaning that the money moves from people who make poor investments and poor decisions to people who make great decisions. That moves from people that are extremely emotional with their investments to people who are not going on emotion, but using intelligence to make those smart decisions. You know, these are all things that we talk about as part of Passive Real Estate Academy. That's our four week community where people learn to do the proper due diligence on all of these investments. I think it's more important than ever to learn how to do the proper due diligence so that you can spot the opportunities moving forward. I absolutely believe that you only get a couple periods in your life where you come out of a a period of a downturn. And what we're seeing right now in the commercial real estate is definitely a downturn. I'm not sure how long that period will be, but I will say that the people who have the investment capital, the network, the education right now are poised to go on another run in the future and those people will benefit tremendously. I hope that's you, I hope that's our community and that's what we're here to do, to support each other and help each other through this. So if you're interested in learning more about due diligence of these properties, go to passiverealestateacademy.com join the wait List we're going to start our next course soon. It's going to be a great time of learning and it's a chance to connect with other like minded people and investors. I'm learning a ton from this time and this period. Not all of my investments are doing well, but I believe that ultimately many of them will be pulled out in good fashion, that they'll be successful and then there might be a few that may not do as well, but I'll learn from them and it'll help me make better decisions moving forward. Any case, thanks for taking the time to listen. If you're taking the time out of your day, I really again congratulate you on investing in your time and your future and I wish you all the best this week. Have an awesome week. Take care. Let's talk again soon. Enjoy the show. Let me know by dropping a review in the podcast app you're listening to us at. And if you haven't already, be sure to hit subscribe. Join thousands of physicians who are also on this journey to creating their ideal lives through multiple streams of income. Learn more at our website passiveincomemd.com thanks again for allowing me to be a part of your journey. See you next time.