The Los Angeles-based manager launched the open-ended fund in May last year, raising approximately $200 million from two anchor Asia-based financial institutions and a series of high-net-worth clients. Cottonwood has made 14 investments with the fund’s capital so far, founder and CEO Alexander Shing told PERE in an exclusive interview.
The firm has exited five of the 14 investments thus far: four debt and one equity investment. Debt investments made up 60 percent of the fund as of the end of July. Debt investments have shorter time horizons, typically one to two years, and consequently were divested within a shorter timeframe, Shing said.
The equity investment the firm exited was a result of a “lightning” pace of lease-up in a multifamily asset the firm had purchased. The firm’s in-house property management team contributed to the speed of execution, Shing said.
Cottonwood’s position in the investment ultimately was sold at a premium, he added: “On a risk adjusted basis, we think that we were able to capture some alpha.”
When the fund launched, Cottonwood promised investors between an 8 percent to 12 percent net-of-fees return. One of the debt investments, however, has produced a return of over 30 percent, Shing said. In that investment, the firm purchased a non-performing loan on a life sciences property being developed in Boston.
Buying the loan allowed Cottonwood to work with the sponsor and give the borrower more time to entitle and complete the master-planned development. The original lender was not keen on taking over the property, meaning the loan was sold at a discount. Cottonwood was also comfortable taking ownership of the property should the sponsor ultimately fail to pay back the loan.
While the majority of investments so far in the fund have been in debt, Shing sees the vehicle’s allocation to debt and equity becoming more balanced over the course of future investments.
“We think the allocation will be more 50 percent in equity and 50 percent in debt going forward because the opportunity set has gotten way richer in equities,” Shing said.
That equity opportunity is most prevalent in two property types. Shing sees multifamily as a great play right now, explaining that prices are beginning to fall because of the cost of debt rising and market uncertainty, which has caused a number of buyers to pull out in the last 75 days. The firm favors a value-add strategy in multifamily, where assets are already income producing but allow for some rent growth and therefore alpha generation.
Office is the other major area of focus for equity investments. While the firm is being selective, avoiding Class B and C offices, it sees prices falling in Class A product, again due to a lack of willing buyers, providing an attractive basis with which to invest in high-quality properties. This is particularly the case with assets that were purchased pre-covid, when offices in major cities like New York were still trading at a sub-4 percent cap rate. The interest rate and rent growth assumptions for those properties have now been upended by the pandemic, meaning borrowers can no longer meet their debt obligations and the assets are now being offloaded through distressed sales, Shing said.
The original $200 million was raised via existing investors in other parts of Cottonwood’s business. That equity is currently around two-thirds invested, Shing said, noting that money is recycled because of the vehicle’s open-ended structure. Cottonwood plans to begin a new round of fundraising toward the end of this year and will be marketing the vehicle for the first time to non-existing investors.
The firm is still sticking to its initial $750 million target but could potentially increase the fund’s size given its open-ended nature, Shing said.
He wants to avoid having the fund become too large, like some non-traded real estate investment trusts that now are paying portfolio premiums and leveraging investments in order to generate returns, he said.
“We don’t want to overextend ourselves by raising too much capital that we can’t perform for the investors,” Shing said. “The key is to scale gradually.”
Cottonwood has closed around $1 billion in transactions value since the inception of the fund. Alongside the fund’s capital, the firm also invests via separate accounts and co-investments. The firm was founded in 2012 and has offices in Boston and New York, along with its Los Angeles headquarters. The firm primarily invests in those three markets but will also look at opportunities in other markets such as San Francisco, San Jose, Las Vegas and Seattle.