One of the most common questions we get about investing in a real estate syndication is around the types of returns to expect. Yes, returns are important, there is something that’s even more paramount to our strategy when we put together a potential deal and when we look to invest in a deal ourselves. That’s right, I’m talking about capital preservation. The number one thing we focus on when putting together or investing in a real estate syndication is making sure that, above all else, we don’t lose money. Even if we don’t net the expected returns, we want to be sure, at the end of the day, we at LEAST get our original investment back. I know I know, you must be dying of utter excitement right now. You came into this blog post thinking you’d get to read about super sexy investing things like the number of zeroes you can expect on a cash flow check and instead, you got…capital preservation.
Why It’s Important to Talk About Capital Preservation
I get it. Capital preservation is not the sexiest part of investing in real estate syndications, but it IS one of the most critical pieces. Because after all, how can we possibly deliver on those cash flow returns if we don’t have strategies in place to protect your original investment when those pesky unexpected situations inevitably pop up? Unfortunately, not all sponsor/operator teams give capital preservation the attention it deserves. Some sponsors focus primarily on cash flow returns, the fees they stand to earn, or creating the most attractive marketing package they possibly can.
But when you neglect capital preservation, your whole investment rests on a rocky foundation.
Because, at the end of the day, capital preservation is all about mitigating risk and ensuring that your ship can stay afloat, no matter how stormy the real estate syndication seas get (okay okay, I’ll quit it with the corny analogies).
As Warren Buffett puts it, there are two rules of investing: Rule #1: Never lose money. Rule #2: Never forget Rule #1. So, whether you invest with us or other sponsors, we want to be sure you know the questions to ask and what to look for in a potential real estate syndication deal so you can be sure that the team you’re investing with has your best interests at heart.
5 Capital Preservations Pillars
In every investment we do, we always make it clear to our investors that capital preservation is our number one priority. Sure, we talk about the returns and the growing market and the business plan, but at the core of everything we do is always making sure we protect investor money. There are a number of building blocks that make up our capital preservation strategy. In this article, we’ll go through the five capital preservation pillars that are at the core of every real estate syndication deal we put together and that we look for when investing in deals ourselves. #1 – Raise money to cover capital expenditures up front One big red flag to watch out for is when sponsors decide to rely on the monthly cash-on-cash returns (aka cash flow) to pay for capex (i.e. capital expenditures, like renovating the units). This is a big risk, especially for value-add projects, because as you can guess, cash flow can vary wildly month to month based on things like occupancy and maintenance costs. Imagine. The HVAC suddenly goes out, requiring major repairs. Because of this, there is no excess cash flow to pay for the five unit renovations planned for that month. Because of that, the business plan falls behind schedule, and by the time those five units become available, it’s the holiday season, so they sit vacant for longer than projected.
As you can see, relying on cash flow returns to fund capex can be a real house of cards.
Instead, we always ensure that the funds needed for capex is covered up front. In most cases, we raise the money needed for any renovations or improvements. In other words, if we need $2 million for the down payment and $1 million for renovations, we will raise $3 million up front, so that we have that $1 million for renovations in cash and don’t have to rely on fluctuating monthly returns. #2 – Purchase cash-flowing properties Speaking of cash flow, another capital preservation strategy we use is purchasing properties that produce cash flow right off the bat, even without us having to improve the property. That way, if worse comes to worst and we have to halt our business plan or aren’t able to fill the units as quickly as we wanted to, we can just hold the property, and we would still be cash flow positive. #3 – Stress test every investment Most properties look great when the sellers are trying to sell. The brokers put out gorgeous marketing packages with really attractive pro formas (i.e., projected budgets). But what happens after we acquire the property and things don’t go according to plan? One valuable tool we use to stress test our investments is what’s called a sensitivity analysis. A sensitivity analysis takes a look at how the performance of the investment would change based on different variables. For example, if vacancy rose to 15 percent, how would that impact cash flow? What would happen to the overall returns if the exit cap rate ended up being higher than expected? By conducting multiple stress tests of the investment, we can test our assumptions and make sure that the investment can weather tough conditions. #4 – Have multiple exit strategies in place During a zombie apocalypse, would you want to have one exit strategy or multiple? The same goes for real estate syndications. When we put together a real estate syndication, we often project that we’ll hold the asset for five years or longer, and as far as I know, none of us have a crystal ball that will tell us the exact market conditions at that five-year mark. That’s why it’s so important to have multiple exit strategies in place, so that you are accounting for things like contingency plans, in case you need to hold the property longer than expected, and preparing the property to sell to multiple types of end buyers (private investors, institutional buyers, etc.). #5 – Put together an experienced team that values capital preservation If you’ve made it this far, you’re probably starting to see just how important it is to have capital preservation at the core of any investment. One of the most critical parts of our capital preservation strategy, perhaps even trumping the previous four strategies, is having an experienced team that values capital preservation. And by team, I’m referring to both the sponsor/operator team (i.e., the people who will be overseeing the asset management and the business plan), as well as the property management team. You want both those teams to be full of people who are not only passionate about what they do but also have a strong track record of success. They’ve been doing this successfully for a while, so when something unexpected pops up, they know how to navigate the situation and are always operating from a place of protecting investor money.
Conclusion
Capital preservation may not be the sexiest topic in the real estate investing world, but it is certainly one of the most critical building blocks. Every decision, every strategy, every initiative should be rooted in capital preservation, first and foremost. The five capital preservation pillars we use in the real estate syndication deals we do include:
- Raise money to cover capital expenditures up front
- Purchase cash-flowing properties
- Stress test every investment
- Have multiple exit strategies in place
- Put together an experienced team that values capital preservation
The next time you look at a potential real estate syndication deal deck, go through it once to look at all the pretty pictures, take note of the projected returns, and read through the business plan. Then, take a second look, and read between the lines, searching for hints that capital preservation is the cornerstone of the investment strategy. That way, you’ll know that, no matter what, the team will work as hard as possible to make sure they are protecting your hard-earned money.
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