
When we look for operators to work with, specifically those that specialize in the acquisition of value-add multifamily properties, primarily in high-growth markets like Texas or Arizona. These markets are experiencing robust population and job growth, making them highly attractive but also increasingly competitive. As a result, finding exceptional value has become more challenging, and forecasted returns for these assets are now somewhat muted compared to previous years.
To address this evolving landscape, a private equity firm introduced an innovative strategy that aligns investor preferences with tailored investment structures. Instead of accepting returns that may fall short of past performance or providing a single blended investment option, this approach offers investors the flexibility to choose between cash flow-focused, growth-focused, or hybrid investment opportunities based on their individual goals and equity positions.
Meeting Investor Expectations in Competitive Markets
In markets like these, where fundamentals remain strong and investor demand keeps prices elevated, it is critical to balance conservative underwriting with attractive return profiles. Investors in such markets often expect:
- 15-17% or higher IRR
- 18-22%+ average annual returns
- 7-8% cash flow
- 7-8% preferred return
While these metrics were achievable from 2015 to 2018, the competitive nature of these markets has made achieving these returns more challenging. Instead of settling for lower returns, such as a 12% IRR or 15% average annual returns, we propose a dual-class equity structure to provide investors with more choice and control.
Dual-Class Equity Structure: Customizing Risk and Return
By introducing two distinct classes of equity, we cater to the varying preferences of our investor base:
Class A Investors – Focused on Cash Flow
Class A investors prioritize consistent, reliable cash flow, making this an ideal option for retirees or those seeking passive income. Features include:
- 10% preferred return (paid quarterly or annually), with priority over all other equity classes.
- Limited upside participation in the deal; instead, the focus is on stability and income.
- Full tax benefits as limited equity partners, including flow-through deductions.
Why Class A is Secure:
- Class A equity is capped at 25% of the total equity stack, ensuring sufficient cash flow for consistent payouts.
- Even in adverse scenarios, such as an 81% occupancy rate (well below historical lows), a 2.5% property-level cash flow is sufficient to meet the 10% preferred return.
- In a “black swan” event, the cumulative preferred return ensures investors are made whole before any distributions are paid to Class B investors or general partners.
Class B Investors – Geared for Growth
Class B investors are willing to forego some cash flow in favor of higher overall returns. Features include:
- 6% cash-on-cash return and 7% preferred return, with participation in all upside from appreciation and profit at sale.
- Potential for 15–16% IRR and 18–20% average annual returns, exceeding blended rates typical of single-class structures.
This structure appeals to growth-oriented investors seeking higher returns and willing to prioritize long-term gains over immediate income.
Hybrid Option – Blending Cash Flow and Growth
For investors seeking a balanced approach, a hybrid option allows them to allocate capital between Class A and Class B equity in any proportion:
- A 50/50 split offers a blend of predictable cash flow and long-term appreciation.
- Custom allocations, such as 25% in Class A and 75% in Class B (or vice versa), enable investors to tailor their exposure based on their individual financial goals.
Why This Strategy Stands Out
In today’s “hot” markets, where strong fundamentals continue to drive growth but returns are slightly compressed, this dual-class equity structure provides a competitive advantage by addressing diverse investor priorities. Whether an investor values stable cash flow, long-term capital appreciation, or a combination of both, this approach ensures their preferences are met without sacrificing the deal’s overall appeal.
Additionally, the structure enhances the syndicate group’s ability to attract and retain capital in competitive markets by aligning investment opportunities with the expectations of sophisticated investors.
Conclusion
This innovative strategy of breaking out the equity stack into cash flow- and growth-focused classes offers unparalleled flexibility for discerning investors. Whether you prefer consistent income, long-term growth, or a combination of both, the choice is yours.
In light of this tailored investment approach, we invite you to consider: Would you prioritize cash flow, growth, or a hybrid strategy for your next investment?