BLUEPRINT: Wide and deep

Och-Ziff Capital Management’s headquarters is found on the 39th floor of Manhattan’s imposing Solow Building and today’s interview with the senior executives of the hedge fund manager’s real estate division is taking full advantage of this lofty position.

Division president Steve Orbuch and three of his trusted lieutenants, senior principals Josh Kirkham, Nicholas Hecker and Cory Perlstein, are sitting panel-style with their backs to a grandiose view of New York’s famous Central Park, an island of green encased by some of the most expensive real estate in the world.

Not that these guys are interested in such property. Quite the reverse in fact. Och-Ziff Real Estate is about deploying the institutional dollars it raises into a wide array of property types. It might buy an office or a hotel, but is just as likely to finance a Native American casino, a cell tower or a specialized medical property. If it does select from property’s traditional menu, it will most likely have identified some complex credit structure, a prohibitive regulatory barrier or maybe a personal angle for which to make an investment.

“They are all over the place. Contrarians. Different. That purveys how they think about real estate,” comments one rival fund manager.

“I would describe our investment approach as relatively simplistic,” explains Orbuch. “Wide and deep. We go very wide in terms of asset classes and geographies. Then, once something interesting is targeted, we dig deep.” Since inception in 2003, Och-Ziff has completed nigh on $7 billion of transactions across 100 deals in 18 different real estate-related asset classes. In addition to Native American casinos, cell towers and medical facilities, the firm has invested also in island hotels, golf courses, single family residential properties, even car parks among other sectors. Says Orbuch: “If you look at what we’ve done since inception, maybe we’ve bought three or four office buildings. We just haven’t seen the right revenue risk-adjusted returns from those.”

By Orbuch’s reckoning, a portfolio as uncorrelated as can be is the most effective way to offer investors real diversification. “If you do 15 office and hotel deals in Austin, San Francisco and Midtown around here, I would say you are completely undiversified and correlated,” he says. Investments made across a wide range of types, despite being harder to benchmark versus the wider private equity real estate universe, is a defensive measure in and of itself.

In defining the firm’s philosophy in these terms, he draws a clear distinction between his current and former employer. Orbuch was a senior executive of Och-Ziff’s far bigger neighbor, The Blackstone Group, which has since his departure firmly ensconced itself as the world’s biggest buyer of traditional property asset classes like offices, shopping malls, multi-family residential properties and logistics warehouses.

Orbuch talks fondly of Blackstone. His affection extends to recruitment too: Perlstein is a Blackstone alumnus; Boris Michev, a recent hire in London, is another.
Nevertheless, his platform operates on the other side of the sector’s opportunistic universe. “When I left Blackstone, I believed that was where the business was heading. It was my belief we needed a broader definition of real estate to be competitive and differentiated.”

Blackstone is today widely regarded as the most successful of the large-scale opportunistic real estate investment managers and has gone on to raise record-breaking global funds. Nonetheless, Och-Ziff has also made its mark as one of the better performers. According to company filings, Och-Ziff Real Estate Fund I attracted more than $400 million in 2005 and produced gross returns of 25.1 percent percent IRR and 2x equity, while Och-Ziff Real Estate Fund II generated 35.5 percent gross IRRs and 1.7x, numbers appreciated by the firm’s predominantly US cast of investors. Their exponential support has enabled the division to double its fundraising totals twice in a row, a feat not lost on folk in the sector.

“Steve’s a really smart guy and a good person. People want to do business with good people,” says one of Orbuch’s former Blackstone colleagues.

Blind pool

The firm is today little more than $300 million committed on its third fund, Och-Ziff Real Estate Fund III, for which it held a final closing of $1.5 billion – 50 percent more than originally targeted – in October last year. Early outlays have followed familiar themes: senior housing, car parks, cell towers and specialty medical properties. Where will the remaining $1.2 billion go? While the team has a deal pipeline it cannot conclusively forecast the destination of each dollar.

One Fund III investment was a portfolio of car parks, primarily located at major US airports, such as Denver or Oakland-San Francisco. “We partnered with a best-in-class operator that was looking to start a new platform and was willing to seed it with high-quality assets that were recently developed or acquired,” Orbuch explains. “At the same time, we structured the transaction with both subordination and a series of earn-outs to provide meaningful downside protection.” Och-Ziff was able to acquire the initial portfolio at a going-in unlevered yield in excess of 10 percent, and has a first look on future acquisitions. “With a little leverage we’re generating mid-teens cash-on-cash returns from a business we think is still ramping up, he says. “Did I think for Fund III we would buy this type of portfolio? No. But then we have been active in parking and look to invest in unique types of situations.”

In walking PERE through its investment in car parks, Orbuch also demonstrates two of Och-Ziff Real Estate’s strategic preferences: low leverage and high cash-on-cash returns. Both Fund I and Fund II have fund-wide loan-to-values of below 50 percent, while 17 percent of Fund I’s gross return came from the firm’s current returns alone. “The second fund already crossed the 15 percent current cash return mark,” Orbuch says, “That too speaks to how we’re operating in a world where we are concerned about rising interest rates.”

While Orbuch declines to divulge the details of Fund III’s next deals – “we don’t want to give people our best ideas” – he says: “Fund I was about 80 percent non-traditional. Fund II was about 45 percent non-traditional. Given current capital flows to traditional real estate sectors, we think Fund III will be again more heavily weighted to non-traditional.”

Story time

To get more of a sense of how Och-Ziff’s real estate business thinks about investments, Orbuch invites his colleagues to share anecdotes of previous conquests.

First up is Hecker who talks about the division’s investments in Native American casinos. “It was something we started looking at in 2006 when it became increasingly obvious to us that within traditional asset classes, values didn’t really correspond to fundamentals. They were just leverage driven.” Hecker explains how the division decided instead to research other real estate asset classes that, firm-wide, it had some institutional knowledge of.

The bigger, public markets business – which today accounts for about two-thirds of Och-Ziff’s $45 billion of assets under management, had garnered expertise in the gaming industry via investments made in gaming equipment companies. Through interdivisional intelligence sharing, the real estate division’s focus turned to the high level of leveraged buyouts happening in the sector at the time. “There was really no difference there to what was happening in the big real estate asset classes so again we passed on that stuff. What seemed more interesting, however, was the Native American space.”

Hecker recalls how that sub-sector was growing rapidly but yet it had relatively little institutional investment. “Why? It was difficult to understand, it was relationship-based, it was subject to different regulatory frameworks,” he recalls. “But the locations benefited from huge barriers to entry, attractive deal structures, low leverage and high current returns.” From 2007, after a year of research, Och-Ziff invested heavily in the sector and today Native American gaming constitutes 18 percent of the real estate division’s total assets.

“By doing so, we developed a deep operational expertise within gaming,” he adds. Subsequently, when a post-global financial crisis US started to regard the granting of gaming licenses as a means of plugging damaged local authority balance sheets “we took what we learned and then expanded into different asset classes within gaming.

Ironically, this was happening when the public gaming companies had unbelievably messy balance sheets. They were on the sidelines and couldn’t go after some pretty unique positions.”

Perlstein is invited to introduce an Och-Ziff investment in the hotel space in Waikiki, the popular neighborhood of the Hawaiian capital Honolulu. Via initial investments made in 2005 and 2006, Och-Ziff had determined the sector was ripe for trading. Timing would be crucial. The firm sat on the market sidelines between 2007 and 2009 as the market overheated, but in 2010 it noticed opportunities to buy assets via debt positions and through the acquisition of management companies. Perlstein’s case study is the purchase of Maile Sky Court, a 600-room condominium hotel which was two-thirds owned by a local investor and one-third owned by a group of Japanese investors. Their third was subject to a master lease and the entire property had a ground lease too. The asset epitomized the sort of complex structure that Och-Ziff wants to engage. Having acquired its management company Och-Ziff was well positioned to be “first receiver” when the asset was eventually put in play. “We had front row seats on a non-marketed project and could step into the transaction. I like to describe it as putting humpty dumpty together again,” quips Perlstein. In separate transactions, Och-Ziff was able to buy out both the two-thirds owner, the one-third owners and the underlying land on a blended basis of $110,000 a room. “The market was trading at two times that,” recalls Perlstein. The property was sold for $76 million to California-based Clearview Hotel Capital in August and a sizeable profit was made.

Kirkham describes investments in US single family housing shortly after the financial crisis. “While I don’t think we appreciated the severity of the looming crisis we saw signs of what was to come and thought about a strategy about how to attack the space.” Then, between 2008 and 2009, as the impact of the crisis was beginning to be realized, Och-Ziff decided there must be value in acquiring and aggregating vacant development lots where the amenities and infrastructure already was established. “We were able to buy at 10 percent to 15 percent of replacement cost while assuming no value for the land. In that market, there was literally no capital.” Kirkham recalls buying in empty auctions, certainly as far as institutional capital was concerned.

Och-Ziff’s housing strategy was also early to identify the single family rental sector. Och-Ziff looked to buy in bulk and also to renovate assets. But rather than sell, hold and lease them out thereby effectively creating a multifamily income stream akin to the more institutionally-recognizable multifamily residential sector. “We found a firm in Northern California that had internalized all the functions needed to underwrite acquisitions, renovate and sell them. We worked with them to develop the leasing platform and took advantage of their internal operations. That meant we could drive better returns to the bottom line and generate higher yields on an unlevered basis.”

Kirkham says Och-Ziff expected the business to be developed over a couple of years but by 2012 institutional capital had returned to American residential markets and a sale was crystalized. “It demonstrates how we are able to shift in and out of strategies, be nimble, but also keep our discipline.”

Orbuch says he and his team, while unable to foretell the destination of each dollar of Fund III, is confident it will deploy the full $1.5 billion via these distinctive strategies and within its four-year investment period. “If we end up in a position at the end of the fund where we have a little left, if it’s the right decision, we’ll call up and return it.”

Mixed ex-US fortunes

It is unsurprising that Och-Ziff’s chosen investment examples occurred on US soil. Not only has the US been the bedrock from which Orbuch has chosen to drive the firm’s business forward, its prior international endeavors have not been as smooth sailing as personnel related issues hampered its progress. In Europe, former regional real estate head David Gillerman left in 2014 after making minimal inroads. Meanwhile in Asia, a deal to bring aboard former Morgan Stanley Real Estate Investing Asia head Zain Fancy and a small team from the investment bank in 2008, failed to deliver anything but a bitter legal feud that ultimately saw Fancy walk away with a settlement less than two years later. Both Gillerman and Fancy are today running their own private real estate investment businesses.

Orbuch declines to comment specifically about the two episodes, but on the latter, he says: “The firm, in its commitment to real estate, wanted to have a presence in Asia.

They hired a team. It wasn’t the right approach in hindsight and so we ended up going our separate ways.”

Regardless, Och-Ziff Real Estate retains designs to add a meaningful real estate presence to its other business lines in both Europe and Asia and Orbuch wants to do things a different way. To him, a more organic approach of exporting a senior Och-Ziff executive to the region and then hiring local talent around that person is a more effective route to success than appointing a senior name. To that end, managing director David Law relocated to the firm’s London office last year and was joined by fellow Och-Ziff executive Francesco Ragazzi as well three external hires.

And, with 20 percent, or a $300 million, kitty from Fund III to invest, the London team has already been busy. An office from a bad bank in Frankfurt and a family-owned hotel and 189-unit high street retail portfolio in the Netherlands have been acquired so far. Orbuch comments: “When you think about portfolio construction, those types of deals have a different flavor to what we’re doing in the US.”

“Asia is clearly on the horizon,” adds Orbuch. It’s an enormous market and should be part of any platform plus we have an edge by having such a long-dated business there. But I’d put it in the R&D category today.”

When Och-Ziff Real Estate does re-enter Asia, it will likely adopt Orbuch’s organic approach, where a US executive exports the firm’s DNA and then hires local professionals with a view to seeing them stay and grow with the firm. “We’ll find someone who has been trained here and wants to go there and that can be coupled with other people who know the business in that market.”

In the meantime, there is plenty for the US and European teams to be getting on with. Och-Ziff Real Estate has enjoyed a strong first 12 years, successfully circumventing the global financial crisis, and today the division benefits from sizeable capital support. It could have raised $2.5 billion for Fund III but stayed loyal to its hard cap and it has a carried interest hurdle rate of 9 percent – both indicators that things are going the firm’s way. Whether it can keep to its uncorrelated strategy of identifying a wide range of niche strategies as its funds keep growing in size is a question for tomorrow. For now, its efforts are looking as impressive as the Central Park view from its 39th floor meeting room.

Och-Ziff Real Estate

Established: 2003
Headquarters: New York
Other offices: London
Headcount: 30
Key executives: Steve Orbuch, president; Nicholas Hecker, senior principal; Joshua Kirkham, senior principal; Cory Perlstein, senior principal, David Law, managing director
Investments since inception: Approximately $7 billion across 100 deals
Total equity raised: Approximately $3 billion across three funds and other vehicles
Och-Ziff Real Estate Fund I (2005): $408 million raised
Och-Ziff Real Estate Fund II (2011): $840 million raised
Och-Ziff Real Estate Fund III (2014): $1.5 billion raised
Other vehicles (2003-): $229.5 million raised
Assets under management (as of September 30): $1.9 billion