Do sunk costs matter in capital calls?

On the relationship between capital calls and the sunk cost fallacy

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Do sunk costs matter in capital calls?

Here’s the agenda for today:

1. Introduction to capital calls

2. Why capital calls aren’t created equal

3. Introduction to sunk costs / sunk cost fallacy and how they relate to capital calls

4. Illustration using a model

1 - Introduction to capital calls

Broadly speaking, a capital call is when a real estate transaction runs out of money and needs an infusion of capital.

This should not be confused with a planned capital call, such as the one in a fund structure (e.g. LP invests in a fund and they “call” capital over time as the fund acquires properties, as opposed to calling all of the capital up front before the acquisitions occur) or an ongoing construction project that was intentionally not fully funded at the beginning. For the sake of clarity, the entirety of this article will be discussing unplanned capital calls.

Although unexpected capital calls are indirectly stating that the investment didn't turn out as planned (since the initial capital was supposed to be enough), not all capital calls are created equal.

2 - Why capital calls aren’t created equal

The terms that a GP offers to the LPs when issuing a capital call differ and that won't be the topic of discussion today. With that said, I would like to present two cases to illustrate that capital calls should not carry purely negative connotations because they are not created equal.

Consider a multifamily project that is going according to plan, but the GP ran out of capital as a result of an unexpected cost increase. As an LP, you know that the project is 95% completed and this last amount of capital will get it across the finish line. You also know that if you were to sell the project today your equity is in the money - it is worth the amount that you put into the project, or more.

A different example would be a scenario where an LP invested in a multifamily project and the GP is no longer able to pay the debt service as a result of an expiring rate cap (i.e. the GP paid a certain amount to lock in an interest rate at the time of purchase and this contract that caped the interest rate has now expired). By doing some back of the envelope math based on the income the properties are producing and market cap rates today, you come to the realization that your equity is not worth anything - in other words, you lost the entirety of your investment because the property is worth less than the debt that the property is carrying.