Capital Preservation and How to Mitigate Risk

by | Jul 14, 2022 | Investing Advice

When you’re a busy professional, you want to find the most efficient way to put your cash to work in the background to grow your wealth. Whether you’re saving for your retirement or want an additional stream of passive income each month, how you invest is key to meeting your overarching financial goals. 

Most of us spend a lot of time researching the projected returns; we tinker with the numbers when evaluating potential investment opportunities such as real estate syndications and try to figure out the most likely ROI in each case. 

That’s the fun part of investing! And looking at the great returns available is what triggered our interest in real estate. But it’s equally as important to look at the flip side of those potential returns and research the possible risks in any investment vehicle. 

Looking ahead down the line to try and anticipate problems with an investment is like focusing on the cloud when you can already see the silver lining. The upside of real estate syndications is planning how your money will grow without you lifting a finger, and thinking about losses is the downside. 

We are absolutely clear that capital preservation is the most significant part of investing in a real estate syndication. Therefore, our priority is to ensure that there are multiple layers of protection to mitigate against the risk of loss of investor capital in any deal we’re part of. 

How to Mitigate Risk

Capital preservation isn’t a sexy subject. It’s not the shiny brochure, the dreams of a beachfront retirement home, the legacy creating financial growth. But it is something you absolutely have to consider before investing your money anywhere. 

When something totally out of the ordinary happens in the world or the markets, you need to feel safe knowing that you are as protected financially as possible (and you’ll be glad you have a sponsor who’s got your back). 

Mitigating risk is all about looking after your capital, and according to Warren Buffett, there are only two rules to investing: 

Rule #1: Never lose money

Rule #2: Never forget Rule #1

And the man is not wrong. Before you put your money into any investment vehicle, you need to know how to check and double-check that team has your best interests and your financial security at heart. 

The 5 Building Blocks of Capital Investment

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 – Set aside funds for capital expenditures 

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. As a result, 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 – Buy assets that allow positive cash flow

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 – Check the business plan stands up to a stress test

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 awesome when they’re featured in fancy marketing brochures with attractive proformas (i.e., projected budgets). Still, 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 – Know where your emergency exits are 

In any disaster or emergency, you want to have several ways out. For example, you want a door and window in case of 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 the market conditions at that 5-year mark. So, it’s essential 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 – Ensure your team is serious about 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. 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.

How We Minimize Risk To Your Capital

 

Those five building blocks or central pillars of real estate syndication are what make your investment solid. We cannot emphasize enough that capital preservation is the foundation of an unshakeable investment and that every decision taken by the sponsor and operator team should support that.

Russell and Julie, your sponsors, are committed to having a laser focus on the five pillars of capital preservation pillars in our real estate syndication deals, which is why we always:

  • Set aside funds for capital expenditures
  • Buy assets that allow positive cash flow
  • Check any business plan stands up to a stress test
  • Have contingencies in place
  • Ensure any team we work with is serious about capital preservation

Because we ensure that we build all our investments around these five key pillars, we can mitigate risk as far as is humanly possible. We’re serious about protecting your money, and that’s why underpinning every single decision we make is protecting your capital!

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