What We Do To Mitigate Risk And Protect Your Investment
Take a walk down memory lane with me. What was your initial attraction to real estate syndications? I’m willing to bet, it was the allure of stability coupled with steep returns and the excitement of your hard-earned money working as hard as possible for you, with the potential to grow your wealth over time.
In fact, that’s the number one question we hear from new investors when they first consider investing in a real estate syndication with us. They want to know, if they were to invest upward of $100,000, how much money they could expect to profit. They’re typically comfortable with and well versed in standard retirement plan accounts and the stock market, but real estate has them shooting pop quiz questions in our direction.
And believe me, I love good returns, and those returns are a big part of why we do this. However, while returns are certainly important, there’s an even more important aspect that we focus on when evaluating potential deals.
Here’s a nerdy riddle for ya. It’s not nearly as exciting as passive income and double-digit returns but it’s more boring than taxes and K-1’s.
The most important thing I focus on when evaluating a real estate syndication deal is capital preservation. In other words, the deal must have multiple plans in place to protect from any loss of investor capital. As boring as that might sound to you, that’s my number one priority and a large part of why syndications provide the stability they are known for.
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 Preservation 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 up front
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 potential variability in 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 at 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/operator team should be rooted in preserving investor capital.
You’ve dedicated thousands of hours to your education, your practice, and your patients and you’ve earned a nice bit of income as your reward. Our focus on capital preservation helps you invest confidently, knowing that while all investments carry risk, the deals we present to you are structured to include protection for your hard-earned cash, and with us, it’s as much about protecting your initial investment as it is about generating wealth while improving the community.
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
By putting these five pillars in place, we minimize risk as much as possible and ensure that every decision we make around the property stems from making sure that we are protecting your money, first and foremost.
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