4 Pillars of Capital Preservation in Apartment Investing
What emphasis do you, as an investor, put on capital preservation? I can tell you that, as general partners in apartment syndications, we put capital preservation as our number one priority. Yes, even ahead of capital growth. Why? Because, if investors and general partners become singularly focused on capital growth, they could overlook or stray from principles of capital preservation–thus exposing investors to undue risk. At New Sight Capital, we believe preserving your capital is always the lens through which we view all opportunities. Once we solidify and adhere to capital preservation (conservative underwriting) principles, then we turn our eyes towards capital growth. But, a syndication must always stay grounded in the intentional process of securing your money against loss.
Here are some of the most important principles of capital preservation in apartment investing?
Always raise enough money up front to cover rehab expenditures, operational reserves, and other predicted/potential costs
Luke 14:28 says, “for which one of you, when he wants to build a tower, does not first sit down and calculate the cost, to see if he has enough to complete it?” Same thing with an apartment syndication. Many of the offerings New Sight Capital brings to investors are “value-add” business plans. Simply, we purchase a property that has the opportunity for rents to be raised significantly if rehabs and physical improvements are executed. The costs must be calculated accurately up front with the help of property managers and contractors. We and our partners take those steps even before we ask investors to partner with us. And, we must take all steps to ensure we are raising enough to cover these costs, as well as operational reserves and other expenses. This helps protect against operational net losses, which could put investor capital at risk or trigger the need for a capital call.
Only acquire cash-flowing apartment assets
We typically bring “value-add’ opportunities to investors. As such, these properties have a certain deficiency–either in operations or they are in need of updates. However, we do not partner in “distressed” properties. There is a very key difference. Value-add have very predictable business plans that allow the operators to improve net operating income (profit). Distressed properties have severe deficiencies. They often have very low occupancy (below 80%) or some other significant issue that is keeping them from generating positive cash flow. They are high risk/high reward type investments. With our adherence to capital preservation, we believe distressed properties to be too risky for our investors. As such, we only partner in properties that already have healthy cash flow with the opportunity for steady and predictable growth of that cash flow.
Incorporate Headwinds and Stress-testing into Underwriting Models
As someone who is both an investor and a general partner, I get to see both sides of the underwriting model. Investors typically see the projections. General Partners are often involved in the underwriting that produces those return projections. There’s the old expression, “garbage in, garbage out.” Underwriting apartment investments is no different. If the underwriting model is only incorporating rosy-pictured variables, it will spit out amazing return projections. Given our capital preservation priorities, we will continue to decline investment opportunities that rely on rosy-pictured inputs. Instead, we underwrite our investment opportunities with several key conservative minded pillars. We put input realistic (maybe even pessimistic) rent growths and we overestimate expense growth and vacancy. In short, we want to underestimate revenue growth and overestimate expense growth. That is one of the best ways to have an underwriting model that reflects capital preservation. Another important aspect of this principle is to “stress-test” the investment. What is the minimum occupancy that would allow us to cover all expenses? What is the minimum rent that would allow us to cover all expenses? These minimums must be well below current values or we won’t invest. To protect investor capital, we want our investments to be able to handle considerable stressors–even if they never occur–and still be able to preserve invested equity.
Formulate realistic exit strategies
Purchasing an apartment asset and hoping that it will be worth more in several years down the road is not enough to protect investor capital. Also, modeling exit strategies is not enough if those exit strategies are not realistic. Right now, the elephant in the room with apartment investing is valuations and cap rates. If you’re not familiar with cap rates, we’ve got a great video that discusses how apartments are valued and how they grow. Reach out to me and I’ll email you a link. Essentially, the lower the cap rate, the more valuable a property is. Cap rates are applied to net operating income to value a property. As such, a property that has no profit growth can still become more valuable if the cap rates are going down. Currently, cap rates have been going down across most markets. A fatal mistake for an apartment syndication would be to assume cap rates will stay low. With our capital preservation priority, we model exit strategies that see cap rates going higher. We must incorporate this headwind if we want to protect our investors. That allows us to see how much growth in net operating income we need to achieve in order to reach our investor return projections. That is the conservative approach to modeling realistic exit strategies.
If you are an investor, please consider making capital preservation the number one priority. If the capital preservation is the basis, the growth thesis that flows from there will be more realistic and better able to navigate headwinds that could put your investment at risk.
As always, feel free to reach out with any questions. If you’ve not registered with us yet, please click here. You can also schedule a call with our investor relations team by clicking here.
Russ.
