Multifamily Investing: What are “A” and “B” Class Units?
Gray Capital has historically used a straight forward and common private equity economic structure when it comes to structuring multifamily investments with investors. In the past we’ve always had a preferred return between 7% and 8%, followed by a 70/30 LP/GP split. That will change with the launch of The Gray Fund in 2022, the first multifamily equity fund from Gray Capital.
“The primary advantage to both the LP investor and the sponsor of an equity offering with a dual class structure is an overall lower cost of capital. Think about it like getting a lower interest rate, or additional leverage without taking on more debt.”
A question I ask every potential investor I speak with is their weighted preference between cash-flow (income) and capital multiplication (appreciation). Around 80% always prefer a balanced approach: steady cash-flow with potential for upside.
However, there’s 20% that are either totally focused on generating “X” amount of cash-flow from their allocation to real estate, replacing negative real-yielding traditional fixed income products. They want to earn $100k/yr off their $1M investment, if they can safely.
Or, a few of that 20% are high income earners and are looking to grow their wealth and get the highest total return on capital.
I’ve found that the individual preference to return is very often correlated to tolerance for risk.
The Gray Capital team asked: what if investors could dial in their individual economics in a deal that would translate to their own tailored risk / return profile?
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This is where A and B class units come into play. Here’s an example of a dual class equity structure, based on the economics of The Gray Fund:
Class A units: 10% Preferred Return , no additional upside after total return of capital. First position to be paid after debt service. 25% of total equity.
Class B units: 7% Preferred Return, 80/20 LP/GP split, 60/40 after an 18% IRR. Second position after A units. 75% of total equity.
Assume a $100k investment, with both A or B units priced at $25k per unit.
Therefore a $100k investor would have 4 units to choose from between A and B, or all into one.
Of course there is the 20% of investors that will invest only in A or or only B units. All cash-flow, or all upside.
However, the other 80% of investors will invest in a blend of A or B units based upon their individual risk and return profiles and investment objectives. This is where it gets interesting and not talked about enough. But what does that look like?
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Here’s the return and risk profile of the most common A and B unit combinations based upon conservative assumptions, 5 year hold, net of all fees and promote:
- Income: 4/0 (A/B) . 10% pref. 10% IRR 1.5X. Lowest Risk
- Income Weighted: 3/1 (A/B). 9.25% “blended” pref. 12.2% IRR. 1.65X. Low Risk
- Balanced: 2/2 (A/B). 8.5% “blended” pref. 14.29% IRR. 1.81X. Low-Moderate Risk
- Growth Weighted: 1/3 (A/B). 7.75% “blended” pref. 16.44% IRR 1.98X, Moderate Risk
- Growth: 0/4 (A/B) 7% pref. 18.58% IRR 2.14X. More Moderate Risk
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What’s in it for the GP/Sponsor? The primary advantage to both the LP investor and the sponsor of an equity offering with a dual class structure like the above is an overall lower cost of capital. Think about it like getting a lower interest rate, or additional leverage without taking on additional debt. That’s more upside for LPs with B class units as well as the sponsor.
One might ask, “What’s the point in investing in A units?”
The A class units have the lowest risk as they are in the first position to be paid and they benefit from a high (10%) annual preferred return. This preference is offset by having their return limited to 10%, which is still a higher return than the S&P 500 over a long term average.
The upside not going to A flows to the B units, providing an accelerated total return profile for B units compared to a more traditional private equity structure you often find in private placement real estate offerings such as the 8% pref 70/30 LP/GP split that Gray Capital has used extensively in the past.
Using A and B class units maximize flexibility, personalization and returns. The key is to not view a dual class structure as a binary choice, rather an investment vehicle with exponential functionality compared to more simple private equity structures.
This is not an offer to invest. Any offerings from Gray Capital LLC are open to accredited investors only.
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