Funding the Future
Freddie B positions and debt acquisitions have been successful in driving the lower double-digit returns sought by Waterton’s JV partner, but that isn’t to say that CalSTRS hasn’t been skittish about real estate capital allocations given the economy. Like most major institutional players, the behemoth pension fund is scaling back on all-in JV commitments similar to the half-billion dollar funds it has been successfully riding out with firms like Waterton. Coincidentally, Waterton itself is looking to take a step forward in the world of real estate equity to establish new commitment thresholds and investor diversity in its sourcing of capital.
Executive Decisions
The iconic Presidential Towers in Chicago is emblematic of the past, present, and future of Waterton Residential.
Talk about an important first decision. On Greg Lozinak’s first day at Waterton Residential, he walked into an investment committee meeting that was nearing a final vote on whether or not to purchase Presidential Towers, a four-tower, 2,346-unit complex in downtown Chicago. Lozinak was handed all the underwriting, pitched with the pros and cons, and asked to cast a vote.
“It literally was the first thing I did at Waterton,” recalls Lozinak, who was brought in as executive vice president and chief operating office to help build out the firm’s property management and operations platform. “I walked into the meeting, and they said, ‘Here’s Presidential Towers, should we buy it?’”
Lozinak’s answer (and the unanimous answer of the Waterton investment committee, necessary for moving forward on all firm deals) was a resounding yes. Although dauntingly large, Presidential Towers—or PT as company insiders call it—was a classic Waterton deal: an asset in a prime location but past its prime in terms of design and amenities. The previous owners had run a value-add pro forma at both $20,000 and $12,000 per door but couldn’t make it work. Waterton execs figured they could do it for approximately $6,000 per door, and purchased the property in 2007 for $470 million.
Then the recession hit. As PT unit rehabs slowed from 200 units in 2007 to just 40 in 2008 and 2009, Waterton shifted focus to the property’s $24 million retail component. “In a down market, redeveloping a unit with falling rents doesn’t work,” says Waterton co-founder and managing member Pete Vilim. “But with an asset this size, you can adjust the throttle back and forth on those improvements without changing the actual delivery. We are 97 percent occupied, all of our rehabs are leased and are getting premium rents, so now it is time to flick the switch again. We’ve budgeted for the rehab of 300 units in 2011.”
Waterton executives are well aware of the critical importance of PT to the firm’s portfolio. In fact, co-founder and managing principal David Schwartz is reminded of the property daily as he parks there for work. The firm’s investors are likewise keeping an eye on the asset as value-add efforts recommence, with a target completion of 2017.
“PT is our biggest ship: probably about 20 percent of our total property NOI,” attests Waterton chief asset manager Phil Lukowski. “As CalSTRS would say, ‘Where PT goes, you go.’ I’ve heard that each of the three years since we started redevelopment. We’re all invested in PT reaching its full potential of success.”
The result is Waterton’s Fund 11, expected to close by the end of the year and comprised of eleven separate institutional investors (one of which remains CalSTRS). While the size of the fund and the identities of the investors remained confidential as this article went to press, Waterton executives expect Fund 11 to be the firm’s largest ever with likely at or more than $500 million in total commitments from “CalSTRS-like” institutional investors. “We have had a goal for the past five years to increase the number of institutional investors within Waterton,” Schwartz says. “CalSTRS is a critical investor who we have a great relationship with that hopefully continues for a long time. We want to create more of those. It improves the franchise value of the company to have diversified investments and investors.”
General terms of Waterton Fund 11 will change little from prior funds: Deployment of equity will be discretionary and will seek similar opportunistic rates of return, keeping the firm in the debt acquisition game likely through 2011 and into 2012. That’s just fine with Schwartz. “It’s much more exciting than just winning auctions like we did between 2005 and 2007. That to me was very uninteresting, while this involves a lot of creativity and skill sets. And there’s nothing wrong with getting equity returns for debt risk,” he says. “We are perfectly satisfied with that.”
Acquisition of debt—particularly distressed construction debt on failed condo and condo-conversion deals—is also bringing a new asset pedigree into the Waterton portfolio. Traditionally dominated with value-add B deals in various stages of repositioning, note purchases are landing Waterton Class A assets in high growth, high-barrier-to-entry markets such as Raleigh, N.C., and the San Francisco Bay area. “Our portfolio age is certainly decreasing,” Lozinak explains. “We are becoming a younger portfolio because of these opportunities to buy new assets, and I think you’ll see a focus on core, urban markets which historically we have not done.” Couple a Class A asset portfolio with an institutional-grade operations portfolio, and you might even have the makings of an IPO (see “Public Possibilities” on page 26).
For two deal guys originally looking to capitalize on the buying power of the REITs, Vilim and Schwartz surprisingly recognize (and are even open to) the prospect of an IPO, should the opportunity present itself. The continued deployment of Waterton Fund 10 and the closure of Waterton Fund 11, however, provide Waterton Residential with a capital stack that likely precludes the need for accessing public equity markets. Plus, you get the idea from spending even a small amount of time with Vilim and Schwartz that—even if the strawberry Pop-Tart days are long behind them—they are still having way too much fun (and IRR success) to submit to the somewhat analyst-dictated trend adherence of Wall Street.
“I think Fund 10 and Fund 11 will be our best vintage ever. We are already seeing that in the appreciation of Fund 10 assets that we bought over the past 18 months,” Schwartz says. “We are looking for an opportunistic return, which requires creativity and initiative. If you just follow the herd, you are not going to get it—the markets are just too darn efficient.”
