Choosing Your Investment Strategy Preference: Higher Monthly Cash Flow or Potentially Higher Long Term Growth

The operators we work with purchase properties in high population growth markets with strong fundamentals. That means the long term prospects of the property are good, but it also means there is a lot of competition to buy those assets. It takes look at a lot properties to find one that is a good fit for our model and our investors. 

After a conversation with a trusted private equity firm, one of our partners is implementing a strategy for these hot markets that where projected returns have decreased. Rather than offering investors returns that are lower than what’s been achieved previously, this strategy will offer a choice, or a blend, of cash flow or growth to allow investors to select their preference, and keep the overall returns on par with previous experiences.

To date when we’ve shown investors a deal in a great market high population growth driven by high employment demands, an experienced operator and conservative operating, projected returns have been 15-18% annual returns or greater, 7-8% preferred returns with a similar rate for annual cash flow. This became more difficult after 2018 as the multifamily market really started to heat up and most for sale properties elicit a bidding war.

So the thinking involved was rather than accepting lower returns (15% annualized or 6% cash flow for example) for all investors under a single class, why not create two classes, one with the cash flow investors in mind and the other class targeted for long term growth/potential upside, then let the investors choose their preference.

The cash flow investor

For reasons unique to the individual, this investor wants the predictability of steady, monthly cash flow. She may be looking to replace other income, retire, supplement retirement income, etc. In most of our deals we title this model as Class A, an equity investor who will receive a high rate of preferred return (10% being fairly typical) paid each month, beginning right at the beginning of the hold period, and paid through the duration of ownership. However, that preferred return is the full extent of the potential gain on the deal as this class will not participate in the upside that the property may produce. She still receives the same tax benefits as a full equity partner in the entity, including the flow through deductions like depreciation.

We don’t call this a guaranteed return and it’s not a guarantee since this is an owner and not a lender position, but the consistency is high since this class is prioritized over all other equity partners. One reason for the consistency is that this class will be limited to at most 25% of the equity pool. Another reason is that it only takes a 2.5% cash flow during the year to ensure a 10% payout.

Occupancy could drop to 81% for our complexes to only produce 2.5% cash flow (75% to break even). Even in 2009, worst case scenario for our asset class was 85%, so dropping below that means the world likely has bigger problems! And keep in mind that the preferred return would accrue in the event it wasn’t met in any given year. That would have to be paid before an other investors could get paid. This “catch up” could happen at a refinance or at sale of the property. All this consider makes this class very attractive for the conservative investor profile. 

The growth investor

This investor group receives lower cash flow during the hold period of the project, taking a back seat to the cash flow class. These investors still receive a preferred return, perhaps 6 or 7% but they also receive all the upside of the deal once the business plan has been fully executed, putting them back at the target of a 15 to 16% IRR and 18 to 20% average annual return like what they have been accustomed to. 

The preferred return for this class is likely not to be met by monthly cash flow distributions, and thus will accrue over the hold period. This leads to more variability and unpredictability of those distributions. That means this class is suitable for those individuals who have other sources of steady income and are able to be patient for the big payoff at the end of the project.

Or, why choose when you can have both? 

For those who like a little bit of risk coupled with a sure thing, our investors have the opportunity to select a combination of growth and cash flow. We’ve seen choosing to invest their dollars 50% Class A and 50% Class B be very popular. 

We’re happy to discuss these options with you in regards to your unique situation and make sure you have all the information needed to make the choice that’s best for you.


You may also like

From email archive: February Happenings – Land Entitlement Fund Launch + 2 Apartment Deals

Direct Your Visitors to a Clear Action at the Bottom of the Page