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 with and grow your wealth. Right?
That is the number one question that most of our investors ask us when they first consider investing in a real estate syndication. They want to know, if they were to invest $100,000, how much money could they generate in passive income each year.
I love good returns, and those returns are a big part of why I do what I do. However, while returns are certainly important, there’s an even more important aspect that I focus on when I 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 I focus on in a real estate syndication is capital preservation. In other words, I focus on how NOT to LOSE money. That’s my 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 Pillars of Capital Preservation
At the core of every investment in which I participate, capital preservation is the number one priority. There are 5 building blocks that make up my 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 repair 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, I 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 to fund the renovation / capital improvements. Your cash returns are more reliable and as an investor, predictability of cash flow is important.
#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. Again predictability of cash flow and risks are mitigated that the property’s bills could not be paid.
#3 – Stress test every investment
Performing a sensitivity analysis on the business plan prior to investing allows me 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. They will underwrite the property and should apply conservative underwriting. 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 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 I do include:
- Raise money to cover capital expenditures upfront
- Purchase properties that cash-flow from the beginning
- 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.