What first interested you in real estate syndications? Most likely, it was the potential to diversify your wealth away from the stock market and the potential to even double your money.
If you love the idea of accelerating the growth of your money and giving priority to earning a solid return, you’re not alone. Returns are the primary focus of most of our investors.
However, an often overlooked tenant of investing is capital preservation. Before our team brings any opportunity to investors. we first focus on how not to lose money on the deal.
The IMPORTANCE OF Capital Preservation
Capital preservation isn’t the most exciting part of investing in real estate syndications, but it is one of the most critical pieces.
While it can be exciting and fruitful to focus on cash flows, earnings, and fancy marketing packages, capital preservation becomes of utmost importance when unexpected situations arise. It’s critical to have a sponsor team that gives capital preservation the attention it deserves. This is even more important as we head into the unknown headwinds of the current economic enviornment.
Capital preservation is all about mitigating risk. Warren Buffett claims 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 aligns with your interest.
FIVE PILLARS OF Capital Preservation
Capital preservation is our number one priority at the core of every investment. Our core tenant: First – return OF capital. Then, return ON capital.
The goal is to make money, but we must ensure we don’t lose investor capital. There are five building blocks that make up our capital preservation strategy.
#1 – Have enough available capital to start and continue the business plan.
We consider our liquidity and capital reserves at the start of every investment for items such as capital expenditures, debt payments, and contingencies: Contractors need mobilization payments, projects may run into costly unknowns, etc. In addition to ensuring we have adequate funds for renovations, we raise enough working capital to cover six months of debt payment.
#2 – Purchase cash-flowing properties
Purchasing properties that produce immediate cash flow also helps to preserve capital. If units don’t fill as planned or the business plan isn’t going smoothly, we still want to be able to see positive cash flow by just holding the property as is. We always seek to understand the property’s breakeven occupancy — the point at which an asset swings from an operating deficit to a profit.
#3 – Stress test every investment
Performing a sensitivity analysis on the business plan before investing allows us to see if the investment can weather the worst conditions. What if the vacancy rose to 15%? What would the returns be if the exit cap rate was higher than expected?
We run sensitivity analyses of exit cap rates, rent growth, and vacancy projections since these variables seem to affect returns significantly. Under stress, we’d expect to see lower returns, but does the asset survive under pressure? Does it still preserve capital in addition to returns?
#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.
The type of debt on the deal holds significant weight over the exit strategy. If the operator is pitching a 3-year exit but has a 10-year loan with a high pre-payment penalty, your ability to exit and/or return will be affected. Investors should ask sponsors why they chose the debt and how it affects the business plan, as well as what other exit strategies are available.
#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, both at the sponsorship and property management levels. They 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.
Capital preservation is not the most exciting topic in investing, and its one my investors tend to overlook when vetting a sponsor team. Still – it is a critical building block of any deal, and every decision by the sponsor team should be rooted in preserving investor capital.