BLUEPRINT: Rocket man

Joseph Azrack was hired to head up Apollo Global Management’s new real estate operation – Apollo Global Real Estate (AGRE) – at the beginning of August 2008, he was sold on a strategy the private equity firm had mapped out based on its understanding of the market at the time. Indeed, that strategy was primed to focus on distressed equity recapitalisation opportunities, as there already was a great deal of stress among real estate owners and lenders that had acquired or financed assets earlier in the decade.

With the collapse of the financial markets the following month, however, it became apparent to Apollo that the equity real estate market was seriously dislocated and probably would not be able to transact at prices that the firm considered attractive for some time. This was due primarily to the magnitude of re-pricings required and weakness in economic fundamentals. 

“As soon as everybody came back from vacation, the world fell apart,” Azrack says. “The first real week of business at AGRE was September 2008, which saw AIG’s meltdown and the demise of Lehman Brothers. It was one thing after another, which was sort of an interesting baptism. We had this investment strategy and business plan that was all thought out based on a ‘normal’ distressed real estate market because the correction already was underway. However, that went into the circular file by early 2009.”

For Azrack, it was interesting to observe how Apollo reacted to that extraordinarily stressful environment in the financial markets and the economy. “My partners in the private equity and the credit area bought more than $20 billion in assets from the middle of ‘08 through the middle of ‘09, which was a very tough time to be investing,” he says. “They were targeting deep discounts on corporate paper, distressed for control corporate investments and the like, which really speak to the sort of deep value orientation and contrarian orientation of the culture of the overall firm. Obviously, these are promising investments, but they took a huge amount of intestinal fortitude to make at the time.”

According to Azrack, one of the main things that attracted him to Apollo was the firm’s integrated business model. “We work very closely with our partners in the private equity and capital markets credit areas, so we have the benefit of their experience and relationships in the financial markets, as well as in different industry categories,” he says. “For example, Apollo has people in the private equity area who are responsible for portfolio companies that are tenants in a shopping centre we may be underwriting, so we’ll get real-time information about how the sales trends are going and things of that nature. That is helpful to have such real-time data.”

Apollo’s disciplined approach to investing and its deep value investment philosophy also were attractive. “It’s relatively easy to be a momentum player, but that doesn’t usually last for more than a few years,” Azrack says. “It’s a very economic fundamentals and deep value investment orientation that we have here, which would be extraordinarily useful in what we anticipated would be a distressed investment environment.”

An opportunity in debt

With equity real estate less likely to trade at acceptable prices, Apollo looked around at the carnage in the market and perceived an opportunity to achieve favourable risk-adjusted returns in the near term in the real estate debt markets, where traditional mortgage, CMBS and mezzanine debt providers were on the sidelines. Therefore, in the fall of 2009, it created Apollo Commercial Real Estate Finance to serve as a permanent capital vehicle and come into the market as a portfolio lender in the absence of traditional players, such as banks and the securitized market. 

“There are these periods in the market, which are usually pretty short-lived, where you can achieve equity returns from the debt part of the capital structure,” Azrack says. “In the corporate market, that was 2008 and the first half of 2009. In the commercial real estate debt market, however, that started in 2009 and continues. Indeed, the real estate debt market at $3 trillion is three times the size of the CRE equity market and an immense opportunity set in today’s dislocated capital markets.”

According to Azrack, if you ask a pension, endowment or sovereign what kind of a real (inflation adjusted) return they want from equity real estate, they might tell you 5 percent to 8 percent over an intermediate to long investment horizon, depending on their risk and return objectives. Those are the types of returns that the commercial real estate debt market has been offering for the last two years and what he thinks is going to continue for the foreseeable future. 

“My crystal ball is not good as it used to be, but I’d venture to say it’s another several years because of the dislocation of the traditional providers of debt capital, the volatility in the commercial debt markets, the fact that the securitized market is still a fraction of what it was over the past decade and banks are beginning to come back but more as syndicators or securitisers of loans than as principal lenders,” Azrack says. “In addition, the life companies can’t do more than $50 billion per year as a portfolio lender, and there’s probably hundreds of billions of dollars in newly re-underwritten performing loans that need to be made each year for years to come in order to refinance and extend maturities in the commercial mortgage market.” 

As a result, Apollo Commercial Real Estate Finance has been able to make investments – whether it’s buying triple-A CMBS and putting on a moderate amount of leverage or by being a mezzanine lender – and obtaining yields from 8 percent to 13 percent over a five-year timeframe. That translates into a real return somewhere in the range of 6 percent to 10 percent, Azrack notes. “There is this window in the market where there is excess return because of the capital markets dislocation and you’re able to be senior in the capital structure,” he adds.

Rather than structure the new venture as an investment fund, however, Apollo decided upon the framework of a real estate investment trust. “We knew we were going to start small, but we thought that, over the course of five or 10 years, this could be a multi-billion dollar portfolio lender,” Azrack says. “You can’t do that through a private fund because it has a finite life as well as all sorts of constraints on what you can do as a lender.  So, we looked at the different vehicles vis-à-vis the market opportunity and the time period over which we thought it would play out, which was not going to be a short cycle. ” 

In this manner, AGRE’s debt investment team has created a portfolio in excess of $3 billion over the past two years for its mortgage REIT and managed account clients. The total portfolio represents a combination of whole loans, mezzanine loans and high-quality investment grade CMBS, which are producing high single-digit and low to mid double-digit rates of return. 

Beefing up for equity

Meanwhile, a little more than one year ago, Apollo saw that the US equity real estate market was beginning to show signs of life. That’s when the firm brought on Raymond Mikulich and his partners from Ridgeline Capital to bolster its capabilities in that segment of the market and subsequently completed its acquisition of Citi Property Investors (CPI) to expand those capabilities globally.

AGRE officially closed on its deal to take over Citigroup’s CPI platform in November 2010, roughly eight months after being selected as the preferred bidder. Apollo is believed to have paid a nominal fee upfront for the platform, as well as agreeing to an earn-out structure that will allow Citigroup to benefit from future positive performance.

Apollo’s success at winning the platform also can be attributed to the firm garnering support from the LPs in CPI’s three funds: the €1.16 billion CPI Capital Partners Europe; the $600 million CPI Capital Partners North America; and the $1.29 billion CPI Capital Partners Asia Pacific – each of which closed between 2006 and 2007. Furthermore, Citigroup and CPI senior executives being major investors in the funds – their typical capital commitment per fund was $200 million – had a significant say in Apollo’s final selection.

Despite the perception of the deal as rapid external growth through acquisition, Apollo and Azrack saw the CPI takeover differently. “I created that business at Citigroup starting in 2004, so I knew the people because I had hired them directly or indirectly and I knew all of the assets because I chaired all the investment committees for those deals,” he says. “There wasn’t the usual opaqueness and risks associated with external growth versus organic growth. As far as I was concerned, CPI was organic growth. Even before I left CPI, I’d hoped to be able to bring the business with me, but Citigroup wasn’t quite ready to part with it at that time.” 

The attraction of the CPI acquisition for Apollo was that it gave the firm an immediate footprint and critical mass in Europe and Asia. “While Apollo has maintained a significant private equity and capital markets presence in Europe, we did not then have a meaningful real estate business in Europe. We had just brought on Grant Kelley and his firm, Holdfast Capital, earlier that year to start up our Asia business based in Hong Kong, where the CPI management team also was based,” Azrack notes. “Through the CPI acquisition, we added about $1 billion of assets in Asia and about $1.5 billion of net assets in Europe, along with proven teams that we knew well and more than 40 institutional client relationships.”

Furthermore, integrating the CPI platform into AGRE was a pretty painless process. “When you think about the two firms and their history, there really wasn’t much of a need for integration,” Azrack says. “In Europe, Roger Orf has been running the business for CPI since ’05, so there was really little to integrate. In Asia, CPI had Peter Succoso, who is the senior portfolio manager, and he stepped in and became a partner to Grant Kelley, whose team was mainly acquisition-oriented, not having assets to manage at the time. Last but not least, in the US, CPI added an experienced portfolio and asset management team with Bob Scoville and Tom Carey.” 

A return to real estate

Of course, AGRE isn’t the first time that Apollo has had a formalized real estate effort. Apollo Real Estate Advisors was Apollo’s real estate vehicle for much of the ‘90s before the two entities parted ways about 10 years ago. 

Sources familiar with the situation suggest there was a philosophical difference over how the organisations would evolve. In the end, there was an amicable parting of the ways facilitated by the fact that the two firms operated as separate business lines and the fact that Apollo only had a minority interest in Apollo Real Estate Advisors.

Several years later, as opportunities in distressed real estate began to materialise, Apollo decided to launch its own real estate business, necessitating a name change by Apollo Real Estate Advisors to AREA Property Partners in 2009.

Although Azrack could not comment on the history given his relatively recent arrival at Apollo, he categorised the relationship as amicable. “In my prior business life, we enjoyed a very good relationship with Bill Mack, Lee Neibart and Bill Benjamin, now of AREA,” he says. “Over the years, we purchased some companies together, and I consider them high-quality and friendly competitors. Moreover, I know that the principals at Apollo only have good things to say about the AREA people as well.”

In the public eye

Being a publicly traded firm, one might expect Apollo to run its private equity real estate business somewhat more openly than its private counterparts. According to Azrack, however, all firms – public and private – are required today to meet certain standards for investment performance, good governance and transparency.

“If you’ve been in the business for any amount of time, you crossed that bridge awhile ago,” Azrack says. “The ILPA standards that most of the institutions are adopting and expect their managers to adopt are the right standards. The industry needs to have increased transparency and alignment of interests. I think that perhaps a public company, because it is accustomed to dealing with some of the regulatory and disclosure requirements, might be ahead of that curve, but you need to subscribe to those principles in any event in order to be competitive in the market today.”

Azrack points out that there are three things that are important for success whether you’re public or private and whether you’re a boutique or an established investment manager. One is superior investment performance, and another is having excellent client relations and transparent communications. The last thing, which is achieved if a firm is successful at the first two, is building trust with its clients. 

“Whether or not an investment manager is public or private is not really relevant,” Azrack says. “It’s the investment performance you produce for your clients, the communication and transparency you offer, the best practices you follow and the trust you build over time with your investors based on your conduct and the results you produce.” 

While converging operating standards may not be enough of a reason for private equity firms to consider the public route, consolidation may be. “One of the things that we’ve seen in real estate – and more broadly in the investment management industry due to the economic cycles, the regulatory environment and the product and service demands of institutional investors – has been a trend toward consolidation,” Azrack says. “One of the things you observe is that investors’ desires for more information, better service and fewer manager relationships has led to industry consolidation.”

Indeed, there are few private organisations that can self-fund their operations, even the most profitable ones. “ The co-invest capital required for alignment of interests, the infrastructure for reporting and client communications and the cost of developing a new product that’s not going to pay for itself for three to five years – all of these take greater capital resources,” Azrack says. “It simply requires more capital in order to be competitive in the market and that, along with the economic cycle, is driving consolidation. The investment banking industry went through that about 15 to 20 years ago, the investment management industry has gone through that over an extended period of time and now you’re starting to see it within the alternative investment businesses.” 

Strategic choices

If there is one word or phrase to describe how Apollo thinks about investing and how it formulates its strategy, it’s value creation. That strategy has expressed itself in different ways.

Initially, with the market in a real trough and future alternatives so opaque, Apollo sought to get more senior in the capital structure. “We knew we didn’t have to take the equity risk to get equity returns, which is a manifestation of the firm’s deep value orientation,” Azrack says. “The way it’s expressing itself now on the equity side of things is that almost everything we are doing involves some form of recapitalization of over-financed assets. As a result, we are looking for good markets, good properties and/or good sponsors with broken (i.e., improperly capitalised) financial structures.” 

Other than trophy properties in gateway cities that today are trading at very high prices and very low yields, Azrack points out that the values for most properties that were bought and financed between ‘05 and ’07 are off 30 percent to 50-plus percent, depending upon what it is and where it is, which means the debt is probably 10 percent to 30 percent underwater on average. “Most of what we’re doing is working with sponsors and partners that we’ve done business with before, as well as various lender relationships, either to commit to buy back debt or to provide the equity capital – and/or the debt capital – to recapitalize those assets,” he says. 

That’s one way AGRE looks at getting into assets at a cost basis at which it can make money based on the prevailing economic environment. “Consistent with our deep value orientation, we are not projecting meaningful growth rates for rent in most of the markets that we’re active in,” Azrack notes. “Therefore, we want to be sure that, based on purchase price and current market conditions, we’re getting an acceptable rate of return, which on an unlevered basis would be cash returns in the high single digits to low to mid teens after the property is stabilised. Obviously, if we can later finance the property in this interest rate environment, that’s going to give us very high cash-on-cash returns and total returns that are going to be quite attractive for our investors.”

Given its focus on looking for opportunities where it can reset the basis in terms of cost and make money based on today’s conditions, one of the things AGRE is looking at is where the mortgage delinquencies are. “If you look at the data in the US over the past year or two, not surprisingly, you’ve seen multifamily and hospitality have the highest delinquency and default rates because they don’t have long-term leases,” he says. “As a result, we’ve been active in those sectors primarily because we’ve been able to acquire assets at knocked-down values.”

Indeed, PERE reported in early July that Apollo had struck up a joint venture with Florida-based Driftwood Hospitality Management to purchase, renovate and reflag full-service hotels across the US. The venture, which initially contracted to acquire $45 million in hotels, plans to acquire up to $400 million in hotels over the next two years.

According to Azrack, the Driftwood venture is indicative of how AGRE seeks to invest in conjunction with experienced partners. “We want to be working with somebody who understands the market, who understands the property type and who has the skill set to execute the business plan,” he says. “We can take care of the capital structure and we will have our own views on the market and asset quality, but there’s usually a significant amount of repositioning, sometimes redevelopment and always a change in the business plan that is necessary. For our value-added strategy, that requires an experienced and proven operator relationship.” 

In addition, AGRE is seeing more US office properties hit the market as leases are rolling over, capital expenditure requirements increase and the delinquency rates are moving up. “Some better quality properties are coming into the market, particularly outside of the gateway cities,” Azrack says. “We’re also seeing some retail opportunities, but it’s very case-specific as to market, the type of property and its tenancy as to whether you want to play in that game.” 

Selective in Europe

In Europe, the issue is the problematic macro picture, including the future of the Eurozone’s economies and the fate of the Euro as its common currency. “We have not seen the price reductions in the most stressed economies to permit us to invest in most markets,” Azrack says. “We are working on a couple of things that would be deeply discounted assets in one or two of the peripheral countries, but it remains to be seen whether or not there will be a clearing price that works. Most financial institutions still are avoiding economic reality as it relates to the value of their real estate collateral.”

That said, the markets that AGRE feels most comfortable in are the UK and Germany. “We’ve been a big investor in Germany over the past decade in the real estate area, as well as the private equity area, and we think it is a strong and viable economy. There also is decent opportunity in the UK, although one needs to be selective,” Azrack says.

In that vein, PERE reported at the end of July that AGRE had agreed to its first investment in Europe since taking over CPI, exchanging contracts with a group of private owners to purchase a data centre in London’s Clerkenwell district for £60 million (€68 million; $98 million). Apollo’s strategy is understood to involve taking possession of the building next year after it is vacated in order to strip down and upgrade the property for occupation by a new tenant. 

Azrack would not comment on that transaction, but he notes that, in general, AGRE has found it difficult to invest in Europe for the macro reasons previously mentioned, as well as the fact that assets have not been selling at prices that he thinks reflect the underlying fundamentals. Indeed, much of the acquisition activity in the region has centred on fully-leased buildings that have sold at yields approaching their peaks. As a result, the firm has turned to opportunities where it can get into assets with a unique competitive advantage at a very attractive valuation basis and execute a plan that it thinks is going to produce superior returns. In some ways, its strategy in the US may be replicated selectively in Europe, albeit some 18 months later.

In the meantime, AGRE is taking advantage of the very trend it is avoiding on the investment side by selling its core assets in the UK and in Germany, where there is strong demand from institutional buyers. “If you are holding an asset in your portfolio, you are a de facto buyer if you’re not putting it on the market,” Azrack argues. “There are times at which property isn’t ready to be sold and you want to create some value, but we’re going to be a seller where we have a stabilized asset and it’s trading at yields that we think are quite dear.” 

An opportunistic Asia approach

On the other hand, Asia is more complicated. “Geographically, it is the largest region, so there are a couple of strategies that we are embarking upon,” Azrack notes. 

First, there are quite a few state-owned enterprises and private developers, particularly in China, that are under a great deal of stress due to the tightening of credit that the regulatory authorities have embarked upon for the past 18 months. “That’s starting to draw some liquidity out of Singapore and Hong Kong to replace what’s being constricted domestically,” Azrack explains. “As a result, there are significant recapitalisation opportunities with real estate companies that are simply over-levered in Greater China and its principal trading partners. They thought that either they had a lending relationship that would be there through thick and thin or they were growing rapidly so that they could go public but the IPO market has been closed to them for most of this year. Therefore, they need to look at other sources of equity capital.” 

AGRE also is finding some interesting recapitalisation opportunities in the region, mainly platforms for public and private companies, and is working closely with its private equity colleagues on those opportunities. “We’re seeing distressed opportunities – where properties are in foreclosure, where they have been in default of their loans or things of that nature or the equity owners simply can’t support them anymore – in other markets, such as South Korea and some of the middle-market assets and companies in Australia,” Azrack notes. “We are not active in Japan, and I don’t think that we will be in the near term because the currency is just prohibitively expensive.” 

The final strategy represents growth opportunities, which are feeding the burgeoning demand in markets like India and China. “There, we are working on follow-on investments with some of our existing partners and a few new ones to create and grow retail, hospitality and residential platforms,” Azrack adds.

Overall, Apollo has a plan that it’s executing on, one which it thinks is going to successfully take advantage of the opportunities the market presents over the next few years. “The good news about Apollo is that, having the global and integrated business platform that we do, it gives us the ability to participate in a new area or market where we are not now represented if we see an opportunity,” Azrack says. “We don’t have any preconceived notions about what that would be, but it would be complementary to our current activities and consistent with the investment discipline and deep value investment philosophy that guides us in everything we do.”