Here’s a question for you: What was the first thing that caught your attention about real estate funds?
I assume your answer is something like: I have worked hard for my money throughout my life. Now I want it to work hard for me. I’m seeking more reliable, larger returns than those I am currently earning with my other investments. With that long-term wealth creating power I hope to leave a legacy for my family.
I can assume so because most people turn to commercial real estate because of the high projected returns and because the opportunity to invest in physical assets brings a bit of comfort to the otherwise nerve-wracking investment scene.
In fact, the number one question I receive from potential investors about real estate funds is, “How much money will I make if I invest $100,000?”
I enjoy the ROI (Return On Investment) just like everyone else, and it is a big reason I am in this business. However, while returns are very important, there’s an even more important aspect I focus on when evaluating potential deals.
Here is a hint: It doesn’t have to do with the double-digit returns we plan to make or even the tax benefits or cash distributions we enjoy while our money is invested.
Our number one priorities are actually more boring than watching paint dry and much less exciting than doing your taxes.
The number one aspect we focus on in a real estate fund is capital preservation. At Acrtos Capital, we prioritize protecting investors’ investment capital above all else, in every decision and each property that we place into each opportunity.
One way we do this is ensuring there are multiple exit plans in place at various stages in the business plan. This way, if anything unexpected happens, there are always options to protect from any loss of investor capital (your hard-earned money you have invested).
That’s our number one priority, as boring as it might sound, but it is the most important.
Why It’s Important to Talk About Capital Preservation
Okay, capital preservation might not seem exciting, but it is the most critical part of investing in commercial real estate.
I understand, it’s easy to focus on cash flow returns, potential earnings, and brightly colored marketing packages, but when an unexpected event arises, you’ll be thankful (for this article) for a sponsor team who gives capital preservation the detailed 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 upfront
Imagine the potential issues 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 a sudden HVAC repair 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 have two properties in a fund that we need $3 million for the down payment and $2 million for renovations, we will raise $5 million upfront. This means we have $2 million cash for renovations and won’t have to rely on monthly cash-on-cash returns. Since there are multiple properties being offered through a fund, then ensure we have enough capital between all of the properties to ensure we can execute on the improvements of each property.
#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, 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.
In the case of a fund, we look into stress testing each property within each fund to understand how the performance of each property will impact the overall performance of the fund.
#4 – Have multiple exit strategies in place
In any disaster or emergency, you want to have several escape routes. In case of a fire, you want a door or a window, a predetermined exit, and a meeting place. The same goes for the properties within a real estate fund.
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.
We are here to 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 funds deals we do include:
- Raise money to cover capital expenditures upfront
- Purchase cash-flowing properties within each fund
- Stress test every property and overall fund performance
- Have multiple exit strategies in place
- Put together an experienced team that values capital preservation
By putting these five pillars in place, we prioritize protecting your investment and minimizing the risk as much as possible while ensuring every decision we make around the property stems from the single fact that we are protecting your money, first and foremost.
If you’re curious about how these risk mitigation tactics work in real-life, you’re invited to join the Arctos Investors Club. Inside, you’ll have access to our past and present deals, plus our community of investors. We’ll have calls and various opportunities to dive into risks, tax strategies, and returns.