Investing for Capital Preservation | Real Estate Syndication

By Christopher Levarek

“Buy real estate in areas where the path exists and buy more real estate where there is no path, but you can create your own.”

– David Waronker

Did you know returns are not the only aspect of investing? Ok, by far, the return on investment gets the most attention for considering a good investment but what else is there? This happens to be the earliest question or topic on discussions I’ve had with new or experienced investors. What is my ROI?

However, let’s look at this from another angle. We know that getting a good return on your money is important but what about the aspect of risk? What about capital preservation?

Consider one of the most famous quotes by Warren Buffett, a very successful investor, “Rule #1 : Never lose Money, Rule#2 : Never Forget Rule #1”.

So how does one not lose money? Obviously, making a good return is of importance but how can one not lose money as well? This is the subject of capital preservation.

Capital preservation is all about mitigating risk or lowering the risk profile of the investment. It may not be the flashiest or shiniest part of an investment, but it is by far the most important. Let me ask you this, if someone came with a 28% return on investment with a 30% possibility of success or a 12% return on investment with 95% degree of success, which is the better investment? I would argue the latter and I think Warren Buffett would agree.

In our investment opportunities we make capital preservation our number one priority. This is one of the reasons, most of our investments have a higher than normal preferred return. Yet, let’s look at 5 main aspects of how we value capital preservation for our investors.

How to Prioritize Capital Preservation:

Aspect # 1 - Cash Reserves

In every good business plan, having cash reserves is paramount. In our real estate deals, this is always our first concern when vetting deals. How much in cash reserves are we setting aside? If you’ve been following us for a while you know that we invest into cash-flowing assets day one. Yet, what happens if the unknown occurs? What happens if an HVAC unit breaks down that wasn’t predicted in the business plan? What happens if there is suddenly a major insect problem in unit #101?

This is why in all our deals we ensure there is a certain amount of capital set aside for the what-ifs. This is called a capital reserve budget and it is set aside upfront. This allows the cash-on-cash returns to go directly to the investor and not have to fund the what-if scenarios.

Aspect # 2 - Cash Flowing Assets Day One

After we’ve addressed the capital reserves budget. Another way we ensure capital preservation is we only buy cash-flowing assets day one. If the investment property doesn’t already generate cashflow for our investors, we rarely look at them. The reason for this is that an income-generating property adds a layer of protection to any capital investment.

The property is a positive performing business and should continue to generate positive cashflow all things considered. This means that any capital invested should, day one, generate a positive return and is thus insulated from loss from the start.

Aspect # 3 - Preferred Return

Every investment inherently has some degree of risk and investment opportunities into syndication are no difference. However, one way real estate investors in syndications can further be insulated from potential downside is through a preferred return. A preferred return being simply a first position on any returns generated from the investment. In many of our deals we focus on putting our investors first by offering a double digit preferred return (typically 12%), something which is uncommon in the real estate syndication space.

As we buy cash-flowing assets day one, we always look to have a margin above the preferred return as a buffer of safety. Meaning we ensure the property is providing cashflow above the stated 12%. So not only do we validate that we can provide a preferred return but we allow for room for downside if something unforeseen occurs. All this allows for meeting stated returns and preserving capital.

Aspect # 4 - The Stress Test

A good business plan should showcase not only the best case scenario but the worst case scenario. Finding the happy medium between the two or having a plan for the worst possible scenario is essential. This is why on investments into apartments, it is important to underwrite or run analysis on what the property would look like if rent collections drop to 75% or an unforeseen natural disaster causes damage to 40% of the units.

Everything looks fine when everything is operating in a perfect world. However, a stress test helps showcase what happens in a non-perfect world for the property. Being able to then buy the property and prepare for such scenarios further insulates investment capital. Surprises are then no longer as much of a surprise and returns are not affected as the investment has taken such surprises into account at the start.

Aspect #5 - The Exit Strategy

Similar to the stress test, having multiple exit strategies is a crucial piece of preserving capital. The idea is that when purchasing a 5 year hold investment, much can change in the market and in the property itself. Property values go up in a market, employers build job opportunities, natural disasters occur, presidents change, etc. What might have been the exit strategy 5 years ago, might not be the best course of action at the actual exit.

This is why it is important to have multiple exit plans. A good syndication group looks to create multiple scenarios whereby capital is preserved and investor returns are prioritized. Perhaps it makes better sense to sell in year 3 and return investor capital plus return or maybe it’s worthwhile holding the property until year 6 due to a market downturn. With this being said, communication to partners should be a strength for the syndication team. Investors should be well aware of what is going on and the reason behind selecting a specific exit strategy before or as that date is approaching.

In Final

As you review multiple investment opportunities and determine how to best invest your hard-earned capital, always consider capital preservation. The high and flashy returns can look nice through the rose-colored sunglasses yet shouldn’t hedging the downside risk also be a strong consideration?

Hopefully after reading this article you have picked up some things to look for in real estate syndication investments with regards to capital preservation. Perhaps, picking an investment opportunity that demonstrates 3 out of the 5 aspects is enough, that is up to you. At the very least you should be well-equipped to make some aspects of capital preservation part of your criteria for a good investment.