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Return Drag From Reserves
April 27, 2020
With the rise of the COVID-19 pandemic, operating and capital reserves have become a topic of discussion for sponsors and investors alike. For some, today’s uncertainty is a chance to tout their foresight in raising a large war chest for tough times, while others fear they will soon pay the price for their lean reserves. You may wonder why sponsors don’t simply raise substantial reserves upfront to better capitalize the investment for potential storms. There are two common answers: 1) Raising money is difficult, so sponsors raise the minimum needed to close the deal. 2) A personally well capitalized sponsor or one confident in their investor relationships may prefer to make a capital call if and when a storm arises rather than keep capital sitting in reserves, earning nothing from day one. This second point raises the question, just how much do capital reserves erode project-level returns?
Before we explore that question, first I’d like to discuss a few points regarding distributions and capital in times of uncertainty. It has been fascinating (and distracting) to watch stories unfold in the media and in multifamily groups on social media about everything going on during the Coronavirus crisis. Many prudent sponsors are suspending distributions right now due to the uncertain outlook for collections in the coming months as millions of Americans have lost their jobs. A few investors have seized on these actions to disparage others. Cardone Capital has been torn to shreds for suspending distributions and for some self-inflicted bankruptcy rumors. Perhaps that’s the downside of the marriage of unsophisticated investors with high profile sponsor-influencers. Overall, though, it’s probably worth it – Cardone Capital has a $5,000 minimum investment, but offers only a 6% pref. I believe it’s only 4.5% for investments under $100,000! So yes, I think they are happy making that tradeoff.
As an investor, however, do you want your sponsor to be making distributions right now? Even if they pre-raised substantial reserves, should they continue to make distributions as our economy nose dives into a recession? And does having such large reserves from day one drag on total returns, perhaps even offsetting any benefits of continuing to receive distributions when most others are not? These are difficult questions that I hope to answer shortly by analyzing a few different scenarios in a spreadsheet. In my view, making distributions in a time like this is likely an unwise use of capital since it may necessitate a capital call should conditions deteriorate further. Delayed distributions are undoubtedly preferable to a capital call.
Capital calls, in this context, are unanticipated requests by an investment manager for additional capital to be injected into the fund or project by investors on a pro rata basis. PPMs (private placement memorandum) vary in how capital calls are treated. For example, some capital calls are mandatory and investors who do not meet the requirements are penalized (sometimes by completely losing their investment). Other capital calls are optional and simply dilute the ownership percentage of investors who do not participate. Point is, investors hate capital calls, are extremely wary of them, and consider them a sign of sponsor’s poor judgment or incompetence. To be sure, some sponsors who pursue higher-risk, opportunistic investments feel they have the trust and respect of their investors and thus are comfortable requesting capital calls when necessary. However, in good times it’s easy to overlook that recessions can bring vicious cycles of deteriorating macro and micro fundamentals, with unpredictable impacts on both investor psyche and capital position, potentially leaving LPs either unwilling or unable to make a capital call. The most certain approach is to have the money up front rather than risk a shortfall in capital needed for operations, debt service, and capex. The certainty of large reserves, however, comes with a cost.
Let’s evaluate a few different scenarios for reserves, distributions, and capital calls. The first scenario is simply to keep one months’ operating expenses and amortized debt service as reserve ($175,187) at the time of initial investment and refund the reserve in full upon a 5-year sale of the property. This is our base case, and gives a 16.1% project-level IRR and a 7.3% average CoC (assuming one year of interest-only payments for all examples) in our hypothetical deal based on a $15,000,000, 252-unit property we recently underwrote in Houston (shoot me an email – firstname.lastname@example.org – for a copy of this model). Now, let’s pare the reserve down to an unreasonable $0 to see how much the returns go up: we jump to 16.6% project-level IRR and a 7.6% CoC. Quite a substantial increase, but not a reasonable course of action, since some operating capital is needed to fund ongoing operations and to maintain a cushion. Digging a little deeper, the difference between net-to-investor IRR (after fees and sponsor promote) is only reduced to 12.4% versus 12.7%, a reminder that marginal returns disproportionately benefit the sponsor while investors experience better downside protection with a proper preferred return hurdle.
Now let’s turn to the next example: a very large reserve of three months’ operating expenses and amortized debt service ($525,562), again to be refunded upon a sale in five years: this “sleep well at night” reserve gives a projected 15.1% IRR and a 6.8% average CoC (a 6% decrease in IRR!). Bragging about your big reserve isn’t free, which is why investors seeking stronger total returns would do well to consider a balance between keeping reserves on hand, forgoing distributions in uncertain times, and being ready to meet a capital call if necessary. As a sponsor, it can be difficult to avoid making decisions based on “customer service” or investor-facing optics, e.g., by reassuring investors with big reserves or by making distributions that operations don’t fully support. Sponsors who choose to carry large reserves that allow uninterrupted distributions at all times, understand that they do so to the detriment of total returns and, depending on the structure, even more so to their promote.
So, what’s the right reserve amount? The key factors are the risk of the business plan and property type. For example, larger reserves should be contemplated for a higher execution risk deal with bridge debt than for a newer vintage core investment. I think the answer also depends on going-in DSCR, to account for the debt load placed on the property, and expense ratio, to account for operating expenses. Our rule of thumb is to raise one to two months’ operating expenses plus amortized debt service.