What first interested you in real estate syndications? Most likely, it was the potential to diversify your wealth away from the stock market and maybe even double your money.
Who doesn’t love a good double-up? We sure do. You aren’t alone in giving priority to earning a solid return. Returns are the primary focus of most of our investors.
However, before we bring an opportunity to investors, our team first focuses on how not to lose money on the deal or, as we call it, capital preservation.
Why It’s Important to Talk About 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.
It’s easy to focus on cash flows, earnings, and fancy marketing packages; however, 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. 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.
5 Capital Preservations Pillars
Capital preservation is our number one priority at the core of every investment. The goal is to make money, but we must ensure we don’t lose investor capital. These are five building blocks that make up our capital preservation strategy.
#1 – Have enough available capital to start and continue the business plan.
Whether from the bank or raised from investors, you need a capital source. Contractors need mobilization payments, and projects require healthy contingencies for costly unknowns. In addition to ensuring we have adequate funds for renovations, we raise enough working capital to cover 6 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, just holding the property would still allow positive cash flow. Always 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 at least like to see a sensitivity analysis 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 return capital plus a return under pressure?
#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.
#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 the sponsorship and property management teams. 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.
Conclusion
While capital preservation may not be very exciting, it is one of a deal’s most critical building blocks. Every decision by the sponsor team should be rooted in preserving investor capital.