What are the steps in doing a capital call? And, on the other hand, how should investors decide to invest in a deal that is already in trouble? Mauricio Rauld, securities attorney and founder of Premier Law Group shares his knowledge.
A lot of people are in trouble, interest rates have doubled, insurance has doubled in many states, and some people have to do capital calls, how would you approach doing a capital call? And from an investor's perspective, how would you choose to participate in it or not? The first thing we typically advise clients is from my buddy, Ken McElroy, who said this many years ago: When things aren't going well and things are starting to not go according to plan, because cash flows don't happen from one day to the next, those things are going to slowly start happening. The key is to make sure that you double down or triple down on your communication with your investors. A lot of syndicators, especially new ones, tend to stick their heads in the sand a little bit when things aren't going well, they think that the investor is going to be upset at them, and that they should not tell them. If you're communicating once a quarter and things aren't going well, start communicating once a month or once a week or every day, depending on how severe things are. That way, when it's time to do the cash call, it's not a complete shocker, you've slowly been showing that this is what's going on, it's been a tough environment, we need to refinance, and we can't because the interest rates have gone up and whatever the situation is. Letting them know earlier will be appreciated by the investors and you’re going to be in a much better situation.
Try to avoid a cash call in the beginning. Usually, if there's the inclining of issues that happen, let's say, rents or revenue is down because of whatever reason, then the first line will be the syndicator. They'll make a loan to the company, they'll make a capital contribution to the project because: 1) to show faith that they're confident in the project, 2) the cash call is the last thing you want to do. Generally speaking, the sponsor group as a whole are shelling out whatever it is they need to patch and hopefully, they can get from point A to point B and things can turn around before having to go to the investors. By the time you've gone to the investors, you've been communicating with them, but also, you've already infused some capital in there and now you've used up that capital, maybe your team put in half a million because you needed that as a deposit and that was three months ago, or six months ago, and now we need another 500k. Now, we have to go to the membership to get the 500k.
For both syndicators and for investors, you want to look at the operating agreement, I get calls from clients all the time that say, hey, I need to do a cash call, what do I do or how do I do it, that's going be in the operating agreement. There's going to be a section in the operating called cash calls, or additional capital contribution provision and it's going to outline how it's going to work and whether it's mandatory or not. Most of them are not mandatory because if you were going to raise money, and you want investors to be able to write you a check for 50k and know that that's all they have to contribute. We wouldn't recommend drafting documents where they were mandatory but there are going to be what we call dilution provisions, which is if they don't contribute to the capital, depending on where they get the capital from, your two and a half percent ownership in the company might go down to 2%. Those step by steps are going to be outlined in the operating agreement.
Let's say that you need 500,000 and you go out and ask every single investor to contribute their ownership percentage of that money. If I own 2%, and we need 500k, then you're going to give me 2% of the 500k. I would probably request, as a syndicator, a little bit more because you're never going to get 100% compliance even if everybody is super happy. If you need 500k, you may probably want to ask for 750k, that way, if 70% of the people say yes, you get to your 500k, but that's going to be proportional. And then, if you're short, you really want to pay attention to the operating agreement. Our operating agreement actually allows us for other members to contribute additional, let's say my cash goal was $5,000, I could contribute 10 or 20k, and I could contribute more, almost like a loan, on behalf of another member that didn't want to put in the capital and I basically have a lien on their shares. That way, when the project turns around, when distribution starts picking up again, the person who did not give at the cash call, those distributions will be diverted to pay off the loan that the other member gave on their behalf.
Unfortunately, what happens a lot of times is you're still short, so you put in money yourself, you've gone to the membership, and they don't want to. You needed 500k, and you were able to raise another 200k from your membership, you're still short. If you can't come up with the 300k, there's a chance you may lose the property, so everybody loses all of their money and that's when you start going outside of the membership, which is really where the dilution happens, especially if you're desperate enough that you're going to bring in a private equity group that may want to come in, especially these days.
There are a lot of funds out there that are really targeting such properties, they might come in and say, I know you need 500k, I'm going to give you the 500k or I'll give you a million, but then they insert themselves way ahead of everybody else. Obviously, the lender, the bank is going to be number one always, but then they're going to be second and they're going to have their money out before any of the LP money comes out. Or maybe you get a loan, maybe there's another party that's interested in loaning you 500,000 and you're going to pay them depending on how the situation is, it might be a high-interest rate, a 15% rate, or 20% rate whatever the managers can negotiate. Obviously, the deal is not going well so it's not a super attractive investment under normal circumstances, and you're going to sweeten the pot to anybody that comes in on the outside in the form of preferential treatment or higher returns.
If that doesn't work, then you get the dreaded, foreclosure letters which are starting to come out where the sponsors let their investors know, hey the cash flow didn't work, meaning we didn't raise enough money, we couldn't raise money from the outside so, the bank is going to be taking over the property which has been happening a lot. Let's face it, there are people who syndicated and bought properties in 2021, which is about the peak of the market, and those people who bought in 2020 or 2021, and this isn't to knock on the operators because the vast majority of people doing it was not so much the interest rate, what happened was the property values were going up so much and the rents weren't keeping up, this is pre COVID.
What happened is that the operators were buying at really high prices, and then the rents weren't keeping up so, the debt coverage of the income wasn't covering the requirement that the lenders had. I had several of people on my podcast that were talking about the fact that they're just not lending money, the banks don't want to lend, they think it's already frothy. And they were telling me, if you can bring a deal to them that actually cashflows sufficiently to cover their debt coverage ratio, which is usually one and a quarter, then they're happy to loan you at 80% or 70% LTV. But the problem is the properties weren't cash-flowing enough in relation to the value of the property. The loans they were offering back in 2020 and 2021, traditional conventional lenders were literally 65% LTV or 60% LTV, really low LTVs where the returns just weren't penciling out.
The vast majority of syndicators and operators moved over to what we call bridge loans, or shorter-term loans, which were more in the three-year range. A lot of the properties that were bought in 2020-2021 were bought on three-year loans and those loans are coming due right around now. And as we all know, interest rates have skyrocketed from whatever they were back in 2021. They were getting a loan for 3.5-4%. Those are now 8% in terms of the commercial, so they just can't refinance right now and they're forced to sell. And if the property is down 20%, then there goes all the LP money because generally, you're putting down 20-30%. So, if your property goes down 20% in value, that wipes out 100% of your investor's money.
I heard some properties were down 50%. There's really no such thing as a US real estate market, every market is localized. Some markets are still doing pretty well, some have dropped 30%, and 50%, and others have dropped a little bit depending on the asset class. Commercial real estate involving offices was really taken down, some are down 80%, but there are other markets that are super resilient, and they're still maybe only down a few percent.
If you bought in 2020-2021, your loan is coming due and you can't refinance because your property is down 50% or 30% or 20%, that's a problem. And then, the interest rates are going up, but what most people are doing is they would buy an insurance product in order to protect themselves from the upside. If you bought the property at a 5% interest rate, and you would buy insurance that makes sure that if it ever goes above 6%, that you're covering, the insurance company will pay you anything above that. As we know, interest rates now pretty much doubled since maybe 18 months ago and those insurance premiums are coming up for renewal and it's a lot. It's not as crazy as it was maybe six months ago. Six months ago, if you needed these insurance policies, and you had to go do a cash call just to cover the insurance premium of your insurance policy, then the lenders wanted more protection themselves, they wanted you to escrow a bunch of money in an escrow account, which you didn't have. So, a lot of the cash calls aren't even necessarily, it's that the property isn't spinning off enough cash. It really has to do with these additional requirements that the lender wants me to put another year's worth of rent in escrow and my rate caps have gone through the roof but they were really crazy in terms of what those rate caps were going for. I think they're coming down because I don't think too many people are expecting interest rates to double again from where they are now, but you never know, they can still go up another 2% and if that starts killing your numbers, it starts killing your numbers.
You never know anything so we should account for a black swan in your deal at all times because first it was COVID, now interest rates are doubling, who knows what the next one will be? It's something we cannot predict and that will likely happen as well so we all must be mindful of that.