The Importance of Focusing on Capital Preservation
Let me ask you a question. What first interested you in real estate syndications? Most likely, it was the potential to put your hard-earned money to work for you to create a good return and thus grow your wealth over time.
And in fact, that’s the number one question that most of our investors ask us when they first consider investing in a real estate syndication with us. They want to know, if they were to invest $100,000, how much money they could stand to make.
And believe me, we love good returns, and those returns are a big part of why we do what we do. However, while returns are certainly important, there’s an even more important aspect that we focus on when we evaluate potential deals.
Can you guess what it is? I’ll give you a hint. It’s not nearly as exciting as passive income and double-digit returns. In fact, it’s more boring than taxes and K-1’s.
The most important thing we focus on in a real estate syndication is capital preservation. In other words, we focus on how NOT to LOSE money. That’s our number one priority, as boring as that might sound.
Why It’s Important to Talk About Capital Preservation
Sure, capital preservation isn’t the most exciting part of investing in real estate syndications, but it IS one of the most critical pieces.
It’s easy to just focus on cash flow returns, potential earnings, and brightly colored marketing packages, but when an unexpected situation arises, you’ll be thankful (for this article and) for a sponsor team that gives capital preservation the attention it deserves.
Capital preservation is all about mitigating risk, and as Warren Buffett puts it, there are two rules to investing:
Rule #1: Never lose money
Rule #2: Never forget Rule #1
No matter what you invest in or who you invest with, you should know what to ask and what to look for so you can invest confidently with a team that holds your best interest.
5 Capital Preservations Pillars
At the core of every investment in which we participate, capital preservation is our number one priority. There are 5 building blocks that make up our capital preservation strategy.
#1 – Raise money to cover capital expenditures upfront
Imagine the avalanche of problems that can accumulate when capital expenditures (like renovations) must be funded purely by cash flow. In this case, cash-on-cash returns, which vary based on occupancy and maintenance costs, would have to fund sudden HVAC repairs instead of unit renovations according to the business plan. In this case, the business plan falls behind schedule, units aren’t ready as planned, and vacancy persists.
Instead, we ensure the funds for capital expenditures are set aside upfront. As an example, if we need $2 million for the down payment and $1 million for renovations, we will raise $3 million upfront. This means we have $1 million cash for renovations and won’t have to rely on monthly cash-on-cash returns.
#2 – Purchase cash-flowing properties
One great option to preserve capital is to purchase properties that produce cash flow immediately, even before improvements. If units don’t fill as planned or the business plan isn’t going smoothly, just holding the property would still allow positive cash flow.
#3 – Stress test every investment
Performing a sensitivity analysis on the business plan prior to investing allows us to see if the investment can weather the worst conditions. What if vacancy rose to 15% and what would happen if the exit cap rate was higher than expected?
Properties look wonderful when they’re featured in fancy marketing brochures with attractive proformas (i.e., projected budgets), but stress testing those numbers helps us take a look at how the performance of the investment may adjust based on potentially unpredictable variables.
#4 – Have multiple exit strategies in place
In any disaster or emergency, you want to have several ways out. In case of a fire, you want a door and window. The same goes for real estate syndications.
Even if the plan is to hold the property for 5 years, no one really knows what the market conditions will be upon that 5-year mark. So, it’s important to account for contingency plans, in case you need to hold the property longer, and the possibility of preparing the property for different types of end buyers (private investors, institutional buyers, etc.).
#5 – Put together an experienced team that values capital preservation
Possibly the most critical pillar of all is to have a team that values capital preservation. This includes both the sponsor and operator team(s) and the property management team. All of these people should be passionate about their role and display a strong track record of success.
The more experience they have in successfully navigating tough situations, the better and more likely they will be able to protect investor capital.
While capital preservation may not be very exciting, it certainly is one of the most critical building blocks of a solid deal. Every decision and initiative by the sponsor team should be rooted in preserving investor capital.
The five capital preservation pillars used in real estate syndication deals we do include:
Raise money to cover capital expenditures upfront
Purchase cash-flowing properties
Stress test every investment
Have multiple exit strategies in place
Put together an experienced team that values capital preservation
When browsing for your next real estate syndication investment, go ahead and soak in the pretty pictures, daydream about the projected returns, and imagine how smoothly that business plan might go.
Then, take a second pass, read between the lines, and look back through the deck with an investigative eye. Look for hints that capital preservation is as important to the sponsor team as it is to you.