Choosing Your Equity Position: Do You Prefer Cash Flow, Growth or Both?
Updated: Aug 12, 2019
We're working with a syndicate group that acquires value-add apartments mostly in the Texas market. The markets they focus on like Austin are experiencing very strong growth and hence its often difficult to find good value. A private equity firm approached them on an interesting strategy for markets that are “hot” as overall forecasted returns for apartment assets they like to buy are becoming more muted. Instead of sharing returns with investors that are less attractive than they have been able to achieve in the past, a creative solution would be to give them more choice on what type of investment they desire based on their equity position: cash flow or growth or a hybrid.
Simply, if we show investors a great market / submarket (jobs / population moving in above national averages) like Austin, conservatively underwritten deal with an experienced operator, they have certain expectations. They expect to see 15% IRR or greater, 18% average annual returns or greater and 8% cash flows with an 8% preferred return. This has been achievable from 2015 into 2018 but has become more challenging as we continue to move further along the growth curve and these assets maintain their strong favor with buyers that keep prices elevated. Instead of accepting a lower return of 12% IRR and 15% average annual returns with 6 to 7% cash flow and one class of investor (blended), what if we created two classes of investors, Class A for cash flow and Class B for growth? We could cater more to our investor base looking for one or the other, making the deal even more attractive depending on what equity position they choose.
The Class A Investor – Cash Flow Minded
The A Class investor wants to live on cash flow now. They may be retired or simply wanting to cut back from a full-time job, looking for more predictable cash flow than CDs or bank savings accounts. In our model, we create a Class A equity investor who we target at a 10% preferred return (paid immediately) over the life of the hold – say 5 to 7 years – but gets no upside to the deal. They do get all the tax benefits and flow through deductions as a limited equity partner. The consistency of hitting the 10% as a Class A (prioritized over all classes of investors on payouts) is very high. Not guaranteed but very close. Why? We limit Class A shares to only 25% of the equity stack, Class B is 75%. Additionally, our analysis shows that we only need to produce a 2.5% cash flow in any year to ensure the 10% payout to them.
We have looked at the data in the most trying times and in 2009 for instance, occupancy in the region dipped as low as 85% from 95% during healthy times. We can go to 81% occupancy in our apartment and produce a 2.5% cash flow and 75% to breakeven. That would be quite a “black swan” event. Additionally, the preferred return of 10% is cumulative, in that any year we had the black swan event, we’d still owe it to the investor before any Class B or Class C (General Partners) would get paid. Likely to be caught up at a refinance in a few years or sale when the market recovers fully. An attractive proposition for conservative investors.
The Class B Investor – Growth Minded
The B Class investor gives up some of the cash flow to Class A, say they get a 6% cash on cash return and a 7% preferred return over the hold period but they get all the upside so they can achieve a 15% to 16% IRR up to an 18 to 20% average annual return which is higher than a blended deal rate and right up there with returns growth investors expect.
Blend – a little of Both (Cash Flow and Growth)
Lastly, the investor would have the option to hedge their bets and put some type of combination together such as investing 25% to 75% in Class A and 75% to 25% in Class B; or 50% in one, 50% in the other. You can pick and choose if you want more conservative and high cash flow of 10% annually for 4 to 5 years or growth if you are not needing or looking for a lot of passive income now even though 7% preferred return with a 6% cash on cash is still a good return given the tax benefits and where money rates are in banks.
This is a very interesting strategy for "hot" markets experiencing very strong growth with forecasted returns slightly lower than what we've seen over the last several years. Breaking out the equity stack (cash flow vs growth) this way gives the investor the ability to choose their desired investment position. If you had the choice, which would you prefer - cash flow or growth or a hybrid approach?