“Rule No. 1 is never lose money. Rule No. 2 is never forget Rule No.1.” – Warren Buffett
If one of the greatest investors ever tells us the MOST important rule to reach our financial goals is to NEVER lose money, do you think we should pay attention?
He didn’t mention about investing in real estate, bond funds or mutual funds. Instead, he started with NOT losing what you already have.
Think about it. When you’re first starting out with zero, who cares about losing money, right? What’s 0% of $0…it’s $0!
Here’s something else to consider. Younger investors get so hung up on returns yet have little to no money saved.
Who cares about earning 8% or 12% on a total nest egg of $10,000?
Is the difference between $800 or $1200 that big of a deal at first when the value of your portfolio is low? I don’t think so.
Yet, many people spend all of their time initially focused on the wrong things.
As a general rule, we should be focused on getting better at our jobs (providing MORE value) to increase our income so we can invest more for the future.
Something else to consider. We’re told by financial advisors, that we need to accumulate millions of dollars in our retirement savings ( I was told $9 million).
If that’s the financial strategy you want to pursue (get rich slowly), then NOT losing what you begin to accumulate should be an important part of your investment decisions.
(As a side note, I don’t need anywhere near $9 million as we’re investing for cash flow using real estate syndications.)
One of the most common questions new Passive Investor Circle members ask is regarding the rate of return can they expect investing in the passive real estate deals I invest in.
Again, returns ARE important to investing, but there’s something else I look for before investing in a particular project.
That’s right, you guess it, I’m talking about capital preservation.
Whenever I invest money in a syndication, I want to do everything I can to make sure that I won’t lose money BEFORE I get into the deal.
Not sure what a real estate syndication is?
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Even if I don’t get the expected returns, I want to be sure that I can at least get the original investment back.
But as you know, nothing in life is certain, so let’s find out how we can move forward to help prevent investment loss.
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What is Capital Preservation?
Capital preservation is an investment strategy focused on preserving capital to help prevent loss of a portfolio.
In layman’s terms, “it’s all about playing it safe“.
Typically this type of investment is meant to be a short-term strategy for those that are nearing retirement and/or investors wanting a safe place to park their money.
This capital is usually kept in bank accounts, certificates of deposit (CDs), or United States savings bonds as these investors tend to be risk-averse.
An example would be someone in their early 70’s planning to retire at the end of the year. This person would normally choose to give up potential returns in exchange for the security of their current savings as they want access to it when they need it.
If this is the case, then there are certain things that should be considered when choosing this type of investment strategy (i.e. lower-risk investments).
Let’s take a look at a few of the key considerations when it comes to preserving capital.
Key Considerations for Preservation
If you’re thinking about a conservative approach and selecting assets for capital preservation, the key consideration is volatility.
Volatility (expressed as a percentage of the original cost basis) is the fluctuation in value of your securities.
It’s also important to take into consideration your time horizon as well.
For those that need immediate access to their capital, consider investing in safe assets such as those insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 such as:
- checking accounts
- savings accounts
- money market funds
If money will not be needed for a few months, then consider:
- money market accounts
- Treasury note
- short-term Treasury bills
The U.S. Treasury also sells Inflation-Protected Securities (TIPS), which offer both capital preservation and immunity from inflation.
If money will not be needed for a few years, consider investing in:
- short-term municipal bonds
- short-term corporate bonds
- U.S. savings bonds
- U.S. agency bonds
Disadvantages of Capital Preservation
The biggest drawback of a capital preservation strategy is when INFLATION rises.
Even though fixed-income investments are generally safe and promise foreseeable returns, inflation can wipe out those returns.
As you know, $100 today will NOT have the same purchasing power 30 years from now. This is due to the fact that time erodes the value of money.
Related article: The Importance of Time Value of Money
The longer a capital preservation strategy is employed, the more likely inflation will diminish the value of your securities thus giving you low yields.
For example, index funds typically average a 7% annual return yet capital preservation assets usually rely on much-lower interest rates (> 2%).
This is the main reason that this type of strategy is usually recommended on a short-term basis.
Capital Preservation With Real Estate Investing
One of the main investment strategies that I personally use is passive real estate syndications.
As a busy professional (periodontist), I do NOT have time to treat patients AND deal with tenants. Being a landlord is NOT something I want to do at this point in my career.
With regards to real estate, I invest with a sponsor (General partner) that leads the syndication. They find the deals, manage them, and then sell them after the projected hold period.
One of the reasons why I invest in these types of deals is capital preservation. Who wants to invest $100,000+ in a project and lose it? I don’t. So yes, the returns are important but I want to do everything I can to also make sure my money is protected.
Here are five capital preservation pillars that are at the core of every real estate syndication deal I invest in and that I look for when investing in deals.
Top 5 Capital Preservations Pillars
#1 Cash reserves
One of the first recommendations I have for people starting off in their careers is to set up an emergency fund.
Unexpected events will show up and we want to make sure we’re prepared when that happens.
This is no different when it comes to real estate. Unexpected things happen and it’s important that cash reserves are in place for when it does.
It’s also important, when purchasing a property, to factor in for capex (i.e. capital expenditures, like renovating the units). This should be something that the sponsor of the syndication allows for.
The majority of the apartment syndications I invest in are value-add projects and cash flow can vary month to month based on things like occupancy and maintenance costs.
Related article: 3 Reasons Value Add Real Estate Investing Can Work For You
Watch out for sponsors that expect to rely on the monthly cash-on-cash returns to pay for capex.
What happens if the unknown occurs such as an HVAC unit goes out that wasn’t predicted in the business plan?
I want to ensure in the deals I invest in that there’s a certain amount of capital set aside for these what-ifs. This allows the cash-on-cash returns to go directly to you, the investor, and not have to fund the what-if scenarios.
#2 Purchase cash flowing properties
After the capital reserves budget has been addressed, the next way to ensure capital preservation is by investing only in cash flowing assets from day one (even without having to improve the property).
The reason being is that an income-generating property adds a layer of protection to any capital investment.
If worse comes to worst and the business plan has to be placed on hold, the sponsors can hold the property and it would still be cash flow positive.
#3 The stress test
Typically, a good business plan showcases not only the best-case scenario but the worst case scenario. By doing this, the sponsor can develop a plan for the worst possible event(s) that could take place.
Basically they’re trying to answer the question, “what happens if things don’t go according to plan“?
Most pro formas (future projection of a property’s cash flow or net operating income) should take into consideration if certain “unexpected” issues happen. This could be things such as:
- vacancy rates drop 15%
- natural disaster damages 30% of the units
If issues such as these happen, we want to know how it would end up impacting cash flow.
By conducting multiple stress tests of the investment, we can test our assumptions and make sure that the investment can weather tough conditions.
#4 The exit strategy
Similar to the stress test, developing multiple exit strategies is a crucial piece of preserving capital.
Even if the sponsor is projecting the project to be a 5-year hold investment, much can change in the market and in the property itself.
Having multiple exit strategies in place, allows the sponsor to account for things such as:
- contingency plans in case the property needs to be held longer than expected
- preparing the property to sell to different types of end buyers (private investors, institutional buyers, etc.)
#5 Work with an experienced team focused on capital preservation
One of the most critical parts of having a capital preservation strategy is working with an experienced sponsor that values capital preservation.
You also want to look for a team that has a strong track record of success.
Related article: 7 Ways To Evaluate a Real Estate Sponsor
You want to work with a group that knows what to do once something unexpected pops up. The key is that they know how to navigate the situation and are always operating from a place of protecting investor money.
As you begin to review different investment opportunities and determine how to best invest your money, always consider capital preservation.
Projecting high returns looks nice yet hedging the downside risk should also be a strong consideration.Join the Passive Investors Circle