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 solid returns with minimal risk or participation and therefore grow your wealth over time.
And in fact, that’s the number one question that the majority of our investors ask when they first consider investing in a real estate syndication with us. They want to know, if they were to invest $100,000, how much money they could stand to make.
And believe me, we love amazing returns on investments! And those returns are a big part of why we do what we do. However, while returns are certainly important, there’s an even more important aspect that we focus on when we 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 even more boring than taxes and K-1’s.
The most important thing we focus on in a real estate syndication is capital preservation. In other words, we focus on how NOT to LOSE money. That’s our number one priority, as boring as that might sound.
Sure, while capital preservation isn’t the most exciting part of investing in real estate syndications, it IS one of the most critical elements.
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 in (because you are investing in a sponsorship team), you should know what to ask and what to look for so you can invest confidently with a team that holds your best interest.
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.
Businesses and multifamily properties, especially value-add assets, require capital to run effectively. Imagine the avalanche of problems that can accumulate when capital expenditures (like property and unit renovations) must be funded purely by cash flow. In this situation, operational income (which varies based on occupancy, collections, maintenance, etc.) and should be used to fund cash-on-cash returns, would have to be reallocated to fund sudden HVAC repairs instead of unit those essential renovations according to the business plan. In this case, the business plan falls behind schedule, units aren’t upgraded as planned, vacancy persists and property revenue is not growing as needed.
Instead, when we make an acquisition, we ensure the funds for capital expenditures are taken care of upfront. As an example, if we need $2 million for the down payment and $1 million for renovations, we will raise that $3 million upfront. This means we have $1 million cash for renovations and won’t have to rely on monthly cash-on-cash returns. It’s a conscious action taken with the aim of capital preservation.
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%? What would happen if the exit cap rate was higher than expected? What level does occupancy need to be at to still produce cash flow?
Properties look wonderful when they’re featured in fancy marketing brochures with best case business plans and 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.
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.).
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. This extends throughout the General Partnership team with co-GP team members, strategic partners and the extended team working on lenders, legal framework, accounting and renovations. All working together to maximize upside and protect any downside.
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. Because while several solid investments earning 20% average annual returns can win you bragging rights and build wealth, it just takes one underperforming investment to put a big dent in those returns.
And this is why we rely on the five capital preservation pillars for our real estate syndication deals:
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 look, read between the lines, and read back through the investment deck with an investigative eye. Look for hints that capital preservation is as important to the sponsor team as it is to you.