2022 has been a roller coaster of a year.
Between rising interest rates, inflation hitting a 40-year high and a war in Ukraine, leading economists have been forecasting a recession all year.
As investors, we all love good returns. In fact, passive income is a key reason why many of us invest in real estate.
But the most important thing that we need to focus on in real estate syndications – regardless of what the economy is doing – is CAPITAL PRESERVATION.
Put simply, how do we NOT LOSE OUR MONEY?
It’s still a great time to invest and capital preservation is all about mitigating risk. 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 strategies for capital preservation that will minimize risk in a 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 strategy 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 seem very exciting, it is a key building block of a solid deal. Every decision and initiative by the sponsor team should be rooted in preserving investor capital.
The five strategies for capital preservation we use in our real estate syndication deals 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
So, when you are browsing for your next real estate syndication investment, go ahead and admire 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.
Taking the time to dig into the business plan will enable you to make an educated decision as to whether or not this particular project is right for you.