What was it that caught your attention with real estate syndications? I’m guessing the exciting opportunity to build your wealth through passive income piqued your interest.
Honestly, the first question investors usually ask us is how much they could make when investing $100,000 in real estate syndication.
Receiving great returns is one of the main reasons why we do this. However, there’s more to it than just the returns (and it has nothing to do with passive income, taxes, or K-1’s).
Our primary focus is protecting a real estate syndication investment from loss of investor capital or capital preservation. It’s not glamorous, but it is the truth.
So What’s So Important About Capital Preservation?
As I said before, capital preservation isn’t the glamorous part of real estate syndication investing, but it is incredibly important.
Many investors center their attention on the possibility of excellent cash flow and earnings without considering how returns might be affected when unfortunate circumstances happen. That’s where having a dedicated sponsor team that focuses on capital preservation comes into play.
The purpose of capital preservation is about reducing risk, and Warren Buffett has two noteworthy rules about investing:
Rule #1: Never lose money
Rule #2: Never forget Rule #1
You need to know what questions to ask, and what to watch for, no matter who you invest with or what you invest in. You want to invest with confidence with people who have you and your money as the top priority.
5 Capital Preservations Pillars
Capital preservation is our number one priority at the core of every investment in which we participate. Five building blocks make up our 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, 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. So, for 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 excellent 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 before investing lets us 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 lovely when featured in fancy marketing brochures with attractive proformas (i.e., projected budgets). Still, stress testing those numbers helps us 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. For example, you want a door and window as options if you need to escape from a fire. The same goes for real estate syndications.
Even if the plan is to hold the property for five years, no one really knows what the market conditions will be at that 5-year mark. So, it’s crucial 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
The most critical pillar of all is having 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 challenging situations, the better and more likely they will be able to protect investor capital.
It May Sound A Bit Boring, But…
While far from the most alluring part of real estate syndication, capital preservation is definitely one of the most crucial parts of a great transaction. It is the sponsor team’s job to preserve investor capital.
We include these five capital preservation standards in our real estate syndication deals:
- 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
Establishing these five standards reduces risk in the best way possible and helps ensure that our decisions keep your money and your investments secure.