The Importance of Capital Preservation

Why Capital Preservation Is Important

In the 90's, psychologists Amos Tversky and Daniel Kahneman performed a coin flip experiment. They would say the following to university students:

“I’m going to toss a coin, and if it’s tails, you lose $10. How much would you have to gain on winning in order for this gamble to be acceptable to you?”

“I’m going to toss a coin, and if it’s tails, you lose $10. How much would you have to gain on winning in order for this gamble to be acceptable to you?”

How much do you think the students wanted to make the gamble worth it?

How much would you want?

Tversky and Kahneman found that people were more willing to forgo the chance of winning a lot of money to avoid the possibility of losing. The students would want $20 before the gamble was acceptable. The finding were consistent when the same question was asked to executives and the dollar values were multiplied by thousands. The term that was coined for this sensation was loss aversion. This study showed that people inherently felt the pain from loss was greater than the pleasure from gain.

What Is Capital Preservation?

Capital preservation refers to the methods used by investors to secure their principal and mitigate risk of loss and other downside risks in an investment. All successful seasoned investors know the importance of capital preservation (Warren Buffets rule #1 is never lose money), and it’s apparent that this investing advice is wired in our genes so even new investors understand it as well (even if they don’t know what to call it yet).

As an investor capital preservation is of paramount importance and that is why it is always important to think about what we are going to be doing to protect investments before we begin to think about the returns; how do we make sure we don’t lose money before we think about the ways to make money?

In this article we detail some of the ways that we mitigate the risk of loss and prioritize capital preservation.

ACQUISITION

Conservative Underwriting

During the process of qualifying what investment opportunities to acquire and present to investors it is important that the deal sponsor is performing conservative underwriting (financial analysis of the future performance of the asset.). Expectations for how the asset will perform should be supported by appropriate market comparables or already proven in prior execution by the sponsor. The best case scenario would be that the sponsor does not provide you with the best case scenario.

As with all financial markets there may be periods of ups and downs, if the sponsor sets their assumptions below the ideal then there is cushion to protect investors capital. If the deal is conservatively underwritten (use of assumptions less optimistic than what may be known to be best case or achievable) and the deal still makes financial sense then there is more potential upside for the investment.

Stress Test

In addition to using less than best case scenario assumptions in underwriting sponsors should also stress test their underwriting. What is the minimum occupancy needed to break even? What would happen if there is a softening of the market? What if there is a down market at the expected point of exit?

Sponsors who value capital preservation will not only know the best case scenarios but also the worst case scenarios. “Stress tests” refer to the act of changing various variables and assumptions in the deal underwriting to see how the performance of the deal would be impacted so sponsors can identify if the deal still makes financial sense. If a deal sponsor has not thought about these scenarios they likely are not thinking about capital preservation.

EXECUTION

In-place Cash Flow

If a property is cash flowing on day one you know that at a minimum if the business plan fails and the operator is only able to maintain status quo the property will make money. If the property is still making money then at a minimum investors capital is preserved while we are holding onto the property.

Experienced Team

Experience is one of the best teachers. As with any business, new and unexpected things may happen. Experienced deal sponsors and operators will have the knowledge to handle surprises and unexpected events that happen during the hold of the property. An experienced team with a track record for successful performance will be best suited for responding to and resolving these issues.

Capital Expenditures and Operating Fund

Many of the big unexpected expenses that come up can be categorized as capital expenditures. No one knows what day the roof will have a leak and need to be replaced, or a pipe will burst, or the HVAC system will go out or…you get the point. Deal sponsors who prioritize capital preservation will evaluate the need (and potential future need) for capital expenditures and include that in their upfront costs in restoring the property to prevent future issues as opposed to relying on monthly cash flows to execute their business plan. Additionally there should be an operating fund maintained which would available in event of these unexpected surprises occurring. In the sponsors underwriting they should also be making annual reserves for future capital expenditure expenses.

COMPLETION

Exit Strategies

Exit strategies refer to how and when you will be able to get your capital back. When underwriting a deal sponsors are looking into the future and making certain economic assumptions about the future based on information available today. No one has yet developed the technology to accurately predict the future so at the point of exit the economy may not be performing as expected.

A sponsor that prioritizes capital preservation will have considered this and have various exit strategies they can implement in case their initial plan is not viable in the market environment at the time of exit (ironically one may be to not exit; i.e. hold on to the property longer than expected).

The 6 ways an investor can prioritize capital preservation are as follows:

1. Conservative Underwriting

2. Stress Tests

3. In-place Cash Flow

4. Experienced Team Members

5. Capital Expenditures and Operating Expense Funds

6. Multiple Exit Strategies

Interested in learning more about investing in multifamily apartments? Give us a call or check out some of the other free resources we have available at Investupmultifamily.com.