Every investor has a differing degree of risk tolerance. In clearer economic times, the discussion of capital preservation is very different from the one today. Passive Investors are more interested in vetting the sponsor. The question around the sponsor running away with capital is the biggest concern from a passive investor. But as economic uncertainty becomes more prevalent, passive investors need to start asking many more questions. As the saying goes. A good operator can turn a good deal, great. A bad operator can turn a good deal, bad.   

For definition, capital preservation means protecting the investors seed money. Capital preservation is all about mitigating risk. If you are a Warren Buffett student, let me remind you. Buffet’s #1 rule is never lose money. But what does capital preservation entail? No matter what you invest in, you should know what to ask for, so you can invest confidently.  Capital preservation is the number one priority. The goal is to make money, but we must ensure we don’t lose investor capital.

#1 – How well capitalized is the investment to withstand economic swings? 

You need a source of capital, whether it comes from a bank or is raised from investors. Projects need strong contingencies for expensive unknowns and contractors need mobilization payments. Raising enough working capital to pay debts for six months, while also making sure the investment has enough money for repairs. Stress testing an investing will provide foresights on how well an investment will need to be capitalized.

#2 – What is the breakeven point for the investment?

Buying assets that provide cash flow right away aids in capital preservation. Even if units don’t fill as anticipated or the business strategy isn’t working out, holding onto the property would still produce a profit. Always be aware of the property’s breakeven occupancy, or the point at which an asset turns a profit from an operating loss. Understanding the breakeven point will dictate what measures will be needed to avert capital calls. Your sponsor should be able to explain the breakeven point and its contingent plans, like reserves, line of credit, credit extensions.

#3 – Was the investment stressed tested?

It is necessary to conduct a sensitivity study on the business plan to determine whether it can withstand the worst-case scenario. What if there was a 15% vacancy? If the exit cap rate was higher than anticipated, what would the returns be? Since exit cap rates, rent growth, and vacancy estimates appear to have a considerable impact on returns, a sponsor should prefer to see a sensitivity study of these factors. We would anticipate reduced returns under pressure, but does the asset still return capital plus a return?

#4 – What are the investment’s exit plans?

You want to have many exits available in case of unknows. The exit strategy is heavily influenced by the type of debt in the contract. Your capacity to exit and/or return will be impacted if the operator is proposing a 3-year departure yet has a 10-year loan with a significant pre-payment penalty. Investors need to ask as to the reasons behind the debt decision and how it will affect the business plan.

As the saying goes, its not return ON capital, but return OF capital. This should be paramount in any investor discussion.