Mitigating Risk And Protecting Your Investment: How DIG Helps
Typically, investors are attracted to real estate syndications because of their potential for impressive returns paired with their hands-off characteristics. The chance to put your hard-earned money to work, growing your wealth over time while your current lifestyle remains unaffected, is very alluring.
In fact, the number one question on soon-to-be real estate syndication investors’ minds is how much money they might make from their investment. Everyone wants to know details about potential returns, IRR percentages, and other details that would generally be projected.
And believe me, I love good returns. Those returns are a significant factor in why I started this business and why I want to spread the word about real estate syndication opportunities. However, while returns are undoubtedly important, there’s an even more critical aspect that I focus on when evaluating potential deals.
It’s nothing fast or shiny, and it’s not nearly as exciting as passive income streams or double-digit returns. What can you think of that’s more boring than taxes and K-1’s?
Capital preservation is the number one thing I focus on when evaluating a real estate syndication deal. In other words, I focus on making sure that the deal has multiple plans in place to protect from the risk of loss of investor capital. But, hey, sometimes the most critical detail might also be the most boring, right?
Why It’s Important to Talk About Capital Preservation
Sure, capital preservation isn’t the most exciting part of investing in real estate syndications, but it is one of the most critical pieces.
It’s easy to just focus on cash flow returns, potential earnings, and brightly colored marketing packages. Still, when an unexpected situation arises, you’ll be thankful 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
Now, with a focus on Mr. Buffett's rules, how can you ensure you’re making investment choices that prioritize capital preservation?
More importantly, how can DIG Capital commit to exploring protection strategies within each commercial syndication deal so we can protect everyone involved as much as possible?
No matter what you invest in or who you invest with, it’s essential you 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. 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, 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. 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 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 lovely when they’re 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, 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 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
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 challenging situations, the better and more likely they will be able to protect investor capital.
How We Protect Your Investment By Mitigating Risk
When a patient walks into the ER, yes, we want to solve their ailments and relieve them from all discomfort possible. However, the baseline absolute must-do involves preserving their life. Life preservation on its own isn’t that exciting, but without it, there’s no point in performing any other procedure or issuing any medication. Therefore, every doctor and nurses’ decision throughout the hospital must be rooted in saving lives. Once we cross that threshold and have things stabilized, we can focus on patients’ ability to achieve true health and comfort.
It’s the same when it comes to real estate syndications. While capital preservation may not be very exciting, it certainly is one of the most critical building blocks of a solid deal. Therefore, 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 around the property stems from a focus on protecting your money, first and foremost.
There are numerous risks with owning physical real estate via private placements including weather and natural disaster risks, interest rate risk, operator and business risks, and overall real estate market volatility which can effect the performance of the investments. Investing in private placement securities entails a high degree of risk, including illiquidity of the investment and loss of principal. Please read the offering document before investing.
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