September 22, 2014
Interviewed by: Privcap
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Capital Market and Geopolitical Risk in RE

Capital market movements and geopolitical unrest are two big risks facing real estate investors today, says Rockwood’s Walter Schmidt. He and colleague Tyson Skillings tell PrivcapRE why there is bound to be another property market downturn.

Capital market movements and geopolitical unrest are two big risks facing real estate investors today, says Rockwood’s Walter Schmidt. He and colleague Tyson Skillings tell PrivcapRE why there is bound to be another property market downturn.

Capital Market and Geopolitical Risk in RE
With Rockwood’s Walter Schmidt and Tyson Skillings

Ainslie Chandler, PrivcapRE: I’m here today with Tyson Skillings and Walter Schmidt of Rockwood Capital Partners. Welcome to PrivcapRE.

Walter Schmidt, Rockwood: Thanks, Ainslie.

Tyson Skillings, Rockwood: Thank you.

Chandler: Would you like to start by giving me an overview of Rockwood and what it does, Walter?

Schmidt: Sure, I’d be happy to. Thanks for having us. Rockwood Capital is a U.S. real estate investment manager. We’re privately held and have been so since our inception. We invest on behalf of about 84 investors. Our current assets under management are about $8.4 billion and we do that through a variety of vehicles, mainly our commingled value-add fund series. We’re currently investing our ninth fund on behalf of our investors and we also have select separate account relationships and assignments in the U.S. real estate space. We have three offices in the U.S.—New York, L.A., and San Francisco—and an investor relations office in Seoul, Korea, which we just opened.

Chandler: Can you tell me why you’ve chosen to open that office?

Schmidt: Absolutely. Rockwood has a very significant domestic investor base; however, we have been working over the last five years to expand that internationally in Europe, the Middle East and Asia. We’ve found a tremendous amount of interest in our products with the investors through Korea, first through some select debt investments, and then through our value-add commingled fund. It’s an investment in expanding that market there for investors only—not for investment, but for investors.

Chandler: In terms of the markets you invest in, can you give me an overview of the geography? Which areas do you invest in, Tyson?

Skillings: Within our value-add fund business, we focus primarily on 10 to 12 markets that are predominantly the gateway cities on the east and west coast. On the east coast, we focus on Boston, New York, Washington, D.C. and Miami. On the west coast, in Seattle, San Francisco, Silicon Valley, Los Angeles and San Diego. What we like about these markets is really three things. They all have inherent supply constraints, such as physical land constraints, and most have onerous entitlement processes you have to go through. They also benefit from strong demand drivers, both from a demographic cohort—whether it’s Millennials or Baby Boomers—as well as from knowledge-based nodes in the urban centers that really spur innovation, and entrepreneurialism, which ultimately creates a high quality of jobs in those markets. Lastly, they benefit from global capital flows, which provide a deep buyer pool for our end product at the end of the day.

Chandler: Has there been any temptation to move into secondary markets?

Skillings: We’ve been very cautious to stick to our knitting. There is no question that, as the markets continue to recover, it’s getting more competitive across all the markets, but we’re staying disciplined and sticking to our core markets.

Schmidt: We look at the secondary markets at tactical markets coming out of a recovery. Sometimes there are good purchases or good buys to be made there, but we don’t stay there too long.

Chandler: Is there a particular asset class that you think is offering really good opportunities at the moment?

Schmidt: Our thesis has been along with what Tyson said about being in those deep economies, deep markets: that they are fundamentally mixed-use environments. And the quality of the office product, the residential product, the retail offerings and the lodging product work together to create that environment, and that attraction to the demand. We’ve learned long ago that we need to understand all of them; therefore, we invest in all of them in our major markets. As far as which one is the most attractive, it depends very much on the market, but we look at the mix of each of those product types. The beauty of a big market like New York or Boston or San Francisco is that in your one investment you don’t need all those product types, because you’re in the middle of a market that has them.

Chandler: Are there any asset types or geographies that you think have peaked and aren’t offering any value at the moment, Walter?

Schmidt: “Peak” relates to three major elements. One is the capital markets are so strong for it that all or much of the future value is already priced in. Another peak could be that the demand side of that product type is really peaking. The other is that the supply line has kicked in full-time, and when those all mix together that would define a peak. Fundamentally, our view is that the real estate market has not peaked yet in the U.S., even though the capital markets have come back very healthy. We don’t think demand has fully come back yet, even though it has been recovering. It’s not there yet. On the supply side, while there is new construction in some of these major markets it’s still rather controlled because the capital needed to put new supply in place is still constrained. It’s opening up, and that’s what we’re tracking, but nowhere near the supply side that these markets have seen in the past. There are elements of going toward a peak, like in multi-family development obviously there is a significant amount of development. It’s a good, complex question, one we track very carefully. But, across the board, we’re not seeing a peak yet in any particular product type.

Chandler: Rockwood does a small amount of debt investing. Can you talk about whether you see any opportunities in debt markets or where you’re looking for value in debt markets?

Schmidt: Right now, we find value in the mezzanine space in income-producing assets. Everyone speaks about the rich valuations of core property, and that maybe it is or maybe it isn’t the time to be in to buy equity core real estate. However, we’re finding in that very core real estate being a part of the mezzanine debt piece, which is 55% to 75% loan-to-value type of debt, that the returns on that debt are actually a good risk-reward. You have the protection of the equity behind you that often will preserve that asset even in a down market. You have in-place cash flow, which gives you immediate coverage; you have current pay, and many investors globally would like that steady income in their portfolio. So, we see that as an element of some opportunity. Why Rockwood is interested in that space is that many of the senior lenders like a real estate-advised mezzanine debt holder, because it’s all a part of the negotiation if things would go wrong that they know who they’re dealing with in the mezzanine debt tranche.

Chandler: Looking back at the downturn, has the market learned its lessons or are we destined to repeat the same problems we had last time?

Skillings: It’s an interesting question. Without a doubt, the groups that have survived definitely have gone back and done a lot of attribution analysis on what worked and what hasn’t and they have changed their organizations in a meaningful manner on a go-forward basis. History typically repeats itself but not usually in the same fashion, so without question, there will be another downturn. The groups that are best positioned for that are the ones who have put in place significant improvements and checks and balances in how they perform and execute on their business.

Chandler: Walter, what do you think? Have we learned our lesson?

Schmidt: The first thing is to understand the lesson, right? For us, this is my fourth downturn, and each one is a big lesson. The capital markets pulled back so dramatically and globally pretty much in all of the broad-based pull-back. We had never experienced anything like that before—the reasons for it are well-known. That actually made the recession, which was coming in any event, much more extreme. Fundamentally, you had a capital market pull-back, made the recession more extreme, which created a demand implosion fundamentally in our space, in real estate. The extent of the demand pull-back was not in any of our models, so while we were watching supply to make sure that was in check, nobody really understood the impact of the demand pull-back. Obviously, looking forward, those are two very big impacts on our business. We are constantly looking for what will impact the capital markets. That might have nothing to do with our real estate industry; it could be other impacts, risks, geopolitical risks, flows of capital or the cost of capital, so we’re very much students of the capital markets. Also, watching the demand side very carefully—the employment growth, the type of jobs (as Tyson said), and the quality of income. We watch that very carefully to see when the next pull-back and recession happens, where will it hit the hardest and what might have a softer impact?

Chandler: What do you think is the biggest risk facing real estate markets at the moment, Walter?

Schmidt: Based on the impact of the globalization of our industry, every year it becomes more global. Capital flows, monitoring the markets, the investors going from region to region, everybody and the industry and the underlying economies are more tied together as we read and understand more in current events and what that means. We consider those geopolitical risks very serious, because something could happen that is not in your market or on your mind that could have major ripple effects throughout the economies. That’s a big risk. Of course, the other risk is both the flows of capital and the cost of capital. Obviously, everybody talks about interest rates, but it’s not just interest rates, it’s availability of capital and how that capital is priced depending on risk and perception of risk.

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