For the past 15 years, Chicago-based Waterton Residential has followed its business plan pretty much true to form. As conceived by co-founders and managing members David Schwartz and Peter Vilim in late 1994 over a box of Pop-Tarts in Schwartz’s office at Equity Residential, Waterton has raised and deployed 10 successive discretionary real estate funds into multifamily, all of which paired a small percentage of skin-in-the-game personal capital with an equity stack from an evolving roster of single-sponsor investors beginning with Chicago’s high-net-worth Pritzker family and ending with the California State Teachers’ Retirement System (CalSTRS) pension fund.
After tours of duty on the executive roster at Chicago-based AMLI Residential in the ’80s, Schwartz and Vilim found themselves in the mid-’90s as acquisition point men for Equity Residential and Berkshire Realty Co., respectively, when Schwartz approached Vilim with the Waterton proposition. “He called me up and said, ‘I have an idea; let’s meet for dinner.’ So I met him at his office, and he pulled out this box of strawberry Pop-Tarts,” Vilim, now 55, recalls. “Luckily his idea was a lot better than the dinner.”
Leadership Lessons: David Schwartz
TITLE: Co-Founder and Managing Member
AGE: 46
FIRST PROFESSIONAL JOB: Lifeguard
BEST BUSINESS DECISION: To start my own business
FAVORITE QUOTE: “Take advantage of every opportunity.” —Schwartz’s 6th grade English teacher
GREATEST BUSINESS CHALLENGE: Entering the Great Recession in 2008
PEOPLE YOU MOST ADMIRE: My family
LEADERSHIP PHILOSOPHY: Surround yourself with people smarter than you.
BEST ADVICE EVER RECEIVED: “Nothing matters more in business than your good name.” —Sam Zell
LAST BOOK READ: Homer & Langley by E.L. Doctorow (Random House, 2010)
WHAT’S PLAYING ON YOUR iPOD: Eclectic mix of ’70s rock, as well as Pearl Jam, Nirvana, Pete Yorn, Radiohead, Kanye West, Jay-Z, Drake, The Beatles, Rolling Stones, Asleep at the Wheel
The idea was also fortuitously in synch with Vilim’s take on a real estate market dominated by the Resolution Trust Corporation (RTC) liquidation of apartment assets coming out of the savings and loan collapse. “In the ’90s, creative people would go out and buy these RTC deals, fix them up, establish a new rent threshold, and then sell them to REIT investors like us,” Vilim says. “From a dealmaker’s perspective, they were making all the money and having all the fun.”
The launch of Waterton in 1995 aimed to bring Vilim and Schwartz out of their REIT offices and into a newly-minted entrepreneurial real estate sector earning opportunistic returns on a concept known today as multi-family value-add. Based loosely on the AMLI model, Waterton was conceived as a private real estate company seeded with the partners’ investment capital and augmented with high-net-worth investor contributions to create discretionary funds for buying, improving, and reselling distressed real estate. “We saw the smaller guys in the RTC-era buying assets and fixing them up with cosmetic rehab, which was kind of a new phenomenon in the ’90s,” explains Schwartz, age 46, of the emerging value-add profit model. “I was at Equity, and we were regularly buying properties from these guys. They would buy the RTC, put the lipstick on the pig, and sell the property to the REITs.”
The Waterton planned business model was a solid one, though Vilim and Schwartz did ultimately get two things wrong: that the value-add multi-family investment firm was never going to need a property management platform, and that all of the company’s repositioned apartment communities would be gobbled up at a premium by the publics. As it turns out, today, Waterton manages all of its 14,000 assets for its own account and has only sold one property to a REIT over the course of 15 years and some $3.5 billion in multifamily investments, 112 acquisitions, and 62 dispositions.
Nevertheless, Waterton’s evolution into an accidental apartment operator is about to make a huge difference in the company’s approach to equity raise. How the firm continues to deploy that capital—into value-add debt acquisitions versus its traditional rehab/resell model—could also bring it back onto REIT turf sooner rather than later.
“I think Waterton is clearly taking their game up. There’s no doubt that they understand the need for a high quality, effective operations platform,” says AMLI Residential chairman and CEO Greg Mutz, who continues to watch (and compete against) Waterton. “They are not bogged down with a lot of overleveraged assets or any sort of legacy problems. Waterton has a lot of opportunities and little headwind to slow them down so I think they are likely going to do quite well.”
Institutional Mindsets
Waterton’s core expertise, according to Vilim, has always been finding overlooked deals in great locations and strategically improving the quality of the real estate and its underlying finance structure. The contemplation of building a national management team surprisingly wasn’t on its early radar but quickly became an inevitable evolution of the firm.
Public Possibilities
An IPO could be the perfect exit strategy for Waterton and its investors—if the price is comparatively right.
What do you say when you have reservations about the transactional restrictions on REITs but an investment bank nevertheless claims they can take your multifamily real estate firm public at a 27 multiple? “We said ‘Wow,’” says Waterton Residential co-founder and managing member Pete Vilim of the proposal his company received in 2007 at the height of pre-recession economic optimism. “When it comes to some crazy number like that, we would have to consider it. If our investors knew they could sell out at a 27 multiple they would all elect to sell, and you can’t ignore that.”
In fact, Waterton has conducted three “go public” pro forma analyses of the company since 1995 and regularly watches its REIT peers to determine if an IPO could be a strategic move worth considering. Waterton co-founder and managing member David Schwartz even sat on the board of Atlanta-based Post Properties for two years, offering Waterton a REIT refresher from the company’s executive origins at Equity Residential, Berkshire Realty Co., and AMLI Residential. “An IPO could be a great exit for us someday, so to understand how the board works and to understand the operational platform is a great knowledge base if ever that becomes our exit strategy,” Schwartz adds.
Of course, the biggest reason to go public is to access capital, and with the close of Waterton’s 11th equity fund, capital raise isn’t a critical issue at the firm. In fact, fundraising activities for Fund 11 acquainted Waterton executives with foreign investors, who could trump an IPO depending on future market conditions. “The next future expansion could be foreign capital,” Vilim says. “We made numerous trips abroad to understand foreign investor demand and structure issues with Fund 11 and that would be the much more logical next step [compared to an IPO].”
Still, Schwartz and Vilim are of the mind that you never say never, and Waterton’s efforts at honing internal property management capabilities and fine-tuning systems to meet intuitional investor expectations would serve the firm well should they ever decide to take to the street. “Periodically there are windows of opportunity to take your assets and sell them as a public company, and your investors would make out better than they would as a private company,” Schwartz says. “Everything here is already set up to public company standards, if not higher, so if the window opens up, we should be pretty turnkey.”
“Over the course of 10 funds, we have continually moved up the equity food chain from high-net-worth, high-octane investors like the Pritzkers all the way up to our last four funds with CalSTRS,” Vilim says. “The demands on our ability to leverage technology, deliver information, and provide bottom-line transparency have increased with each fund and have consequently necessitated the development of a best-in-class management platform.”
Waterton used fee managers for the first three years of its existence, but soon wanted portfolio-sized attention from third-party managers even though it was only wielding one-off property contracts. “We were always one of the smaller [accounts], and we felt like we never got the ‘A Team’ on our properties,” Schwartz recalls. “I admit we were a tough, demanding client, but we never got the attention that we wanted. Between our own internal desire to have greater quality control at the asset level and the Pritzkers’ needs from an informational standpoint, we were forced to become quasi-institutional almost immediately.”
In 2007, Waterton moved to permanently shore up its operations unit with the hiring of Greg Lozinak as executive vice president and chief operating officer. A former ING Clarion senior vice president and asset director of multifamily properties (as well as an Archstone executive and retired U.S. Army Captain), Lozinak has spent the past three years increasing resident survey frequency via Lutherville, Md.-based SatisFacts Research, deploying LRO revenue management technology across the Waterton portfolio, and establishing a procurement platform with Carrollton, Texas-based RealPage’s OpsTechnology.
All of his efforts are ironically designed to alleviate on-site staff of the intricacies of property management. “My focus since I have been here is to create infrastructure,” Lozinak says. “To establish the people, systems, and processes that allow us to focus on the core business and wrap all of these other things around the core business as an infrastructure resource for property managers and service managers to do their jobs. We’re not good at sourcing and collating data. Taking action is what we are good at.”
Translation: Building property management expertise—including establishing industry-leading technologies and efficiencies to alleviate on-site staff of customer service-consuming admin duties—is job No. 1 in effectuating real estate returns for investors. “If we are going to compete in the institutional capital arena, we need institutional operations,” Vilim explains. “And the sideline over the past several years has been to build that as we continue to find opportunistic acquisitions on the real estate side.”
Acquisitions of Note
Finding opportunistic acquisitions in a recession-constricted deal arena hasn’t exactly been easy, however. After laying down virtually the entirety of Waterton’s $460 million Fund 9 on the acquisition of Chicago’s 2,346-unit Presidential Towers in 2007 (see “Executive Decisions” at right), value-add deal flow for Waterton, and indeed for the multifamily real estate sector as a whole, ground to a halt. Waterton Fund 10, the firm’s fourth consecutive joint venture (JV) fund with CalSTRS, was fully committed in 2008 but saw zero capital deployment in 2009. As markets loosened slightly in 2010, Waterton has been able to place $200 million in acquisitions but has not deployed any equity into value-add real estate opportunities per se.
Waterton Residential
Headquarters: Chicago
Year Founded: 1995
No. of Employees: 440
No. of Units Owned/Managed: 14,000
Estimated 2010 Revenue: $175 million
Market Coverage: National
“Instead of a flurry of asset liquidations like the RTC days, there has been a flurry of workouts, and that is where Waterton is stepping in,” Schwartz says. “We have done $200 million in acquisition deployment across seven properties this year, and all seven are debt acquisitions. When we buy the debt, it is a vehicle for us to force ourselves into the workout solution.” It’s also a vehicle for acquiring underlying real estate assets, although Waterton underwrites both loan-to-own and yield-to-maturity possibilities into all of its note purchases and prices the acquisitions to, as Vilim says, “the point of investor indifference.”
Examples of Waterton’s note purchases include the September acquisition of $109.5 million in debt secured by four assets in North Carolina and California: the 274-unit Exchange at Brier Creek in Raleigh, N.C.; the 139-unit Skyline Terrace Apartments in Burlingame, N.C.; the 628-unit Waterstone Corona Point Apartments in Corona, Calif.; and the 296-unit Copper Canyon Apartments in Riverside, Calif. “If the right deal comes along that has a clear value-add execution to it, we are more than happy to do that. Obviously that is our expertise,” says Waterton vice president of acquisitions Max Peek. “The route of purchasing the notes with either the intention of taking title or being satisfied with the yield-to-maturity play has suited us well, though, and we have pretty attractive capital for it.”
According to Peek, Waterton has an additional $120 million pipeline of acquisitions under contract that has yet to be finalized, the majority of which are debt purchases versus traditional fee-simple transactions, and would be happy to deploy up to $300 million into apartment-secured debt. Helping the firm to underwrite all-cash debt deals that often require a 10-day, no asset access due diligence period have been two pools of Freddie Mac “B” notes purchased by Waterton in June 2009. The subordinate debt certificates have an aggregate balance of $2.29 billion and are secured by 130 properties with 34,382 units, providing Waterton with a P&L glimpse into a portfolio twice its size. “We have their financial statements and rent rolls, and we’ve gone through their appraisals, so it has given us double our ownership market insight,” Vilim says. “For less money than we spend on a single property, we control 35,000 units from a financial info standpoint. The ability to gain that info by buying into a debt pool is significant. It gives you underwriting insight that you could not have unless you went out and bought 35,000 apartments.”
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.”