As an Investor, we all love good returns! And the main reason why we’re all fascinated in investing in real estate syndications is because of its magic in giving back our hard earned money with great passive income returns.
While most of us are concentrated on this wonderful benefit, there is one most important thing that we need to focus on in real estate syndications, and that is CAPITAL PRESERVATION.
This might be boring as it may sound, but we need to learn this on how we will NOT LOSE OUR MONEY.
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
Here are the five capital preservation pillars that are at the core of every real estate syndication deal:
#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 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 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. 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 team should be rooted in preserving investor capital.
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
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.