Protecting Your Investment: 5 Ways We Mitigate Risk
by | Mar 30, 2021
Let me ask you a question. What first interested you in real estate syndications? Most likely, it was the potential to grow your hard-earned cash while also creating time freedom.
I bet you’re busy with your own business, a growing family, and while you’re acutely aware of how fast the clock is ticking, you just don’t have time to manage investments day in and day out. You needed something that could seemingly run on it’s own and build your wealth while you just live life.
While questions about returns and appreciation rates are the most common subjects of questions asked, there’s an even more important aspect I focus on when evaluating a deal.
Believe me, 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 a crucial underlying factor that deserves a front-row seat no matter the market, the economy, the asset type, or anything else.
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 making sure that the deal has multiple plans in place to protect from any loss of investor capital. That’s my number one priority, as boring as that might sound.
Why Capital Preservation Gets A Front-Row Seat
Sure, capital preservation isn’t the most exciting part of investing in real estate syndications, but it is one of the most critical pieces. Nobody wants to lose money, ever!
It’s easy to just focus on projected cash flow returns, potential earnings, and brightly colored marketing packages, but when an unexpected situation arises, you’ll be thankful (I shared this insight 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 Capital Preservations Pillars
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.
#1 – Raise money to cover capital expenditures up front
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 potential variability in 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 at 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.
How We Mitigate Risk And Protect Your Investment
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/operator 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
By putting these five pillars in place, we minimize risk as much as possible and ensure that every decision we make during the acquisition, hold, and sale of each asset stems from making sure that we are protecting your money, first and foremost.
Great returns are SO fun, and we love being able to produce sky-high returns on deals, but if things were ever to go sideways, at least you can find comfort in knowing that all our efforts lay on a foundation of capital preservation.