BLUEPRINT: The West Coast offense

At the end of 2015, Oaktree Capital Management’s real estate business marked a new milestone – reaching $9 billion of assets under management. Last month, it celebrated another – the ninth anniversary of the firm’s head of global real estate, John Brady, joining the firm.

The correlation between these two numbers is far from arbitrary. The majority of the Los Angeles-based private equity firm’s significant growth in the real estate space, after all, has occurred under Brady’s watch.

“Real estate investing is an area of importance at Oaktree,” says chief executive Jay Wintrob. “It’s an alternative asset class where we can generate alpha for our investors. It’s an area where there’s good growth potential.”

That growth is poised to continue with yet another milestone this year – the launch of a value-added real estate strategy, constituting something of a shift from its opportunistic real estate business.

“The addressable market for value-add is significantly larger than the addressable market for opportunistic real estate,” Wintrob said during an earnings call in February. “And that’s one of the reasons we’re enthusiastic about this area.”

Co-Chairman Howard Marks, however, touched on the potential overlap between the new strategy and Oaktree’s existing real estate business in the same call. “One man’s opportunistic is another man’s value-add,” he said. “There is no bright line demarcation.”

Clarifying the distinctions between the two strategies was first on the agenda when PERE sat down with Brady and managing directors Ambrose Fisher and Keith Gollenberg at Oaktree’s headquarters in downtown Los Angeles last month, with managing director David Snelgrove dialing in from London.

“People do define these things differently,” says Brady. “There’s a continuum, and there are lines where they do bleed over, especially across firms. But we are going to be very careful not to invade into spaces that are already clearly defined and exist for an existing set of clients.”

Generally speaking, opportunistic real estate typically targets gross returns in the high teens to low 20s, with leverage levels ranging from 60 percent to 75 percent loan to value (LTV). By comparison, value-add real estate targets returns in the mid-teens and commonly uses leverage between 50 percent and 55 percent LTV.

In addition to return targets and leverage, occupancy levels are another differentiating factor. In a value-add investment, the building would likely be 80 percent to 85 percent leased, whereas in an opportunistic deal, occupancy would more likely be anything from zero percent to 65 percent. “There is a matrix of variables to be considered in the aggregate,” he says.

However, regardless of occupancy, Oaktree would not invest in hotels under the value-add strategy, given the volatility of the sector. The size and potential growth of a market based on historical trends also need to be taken into account, he adds.

With opportunistic, “the key is it’s broken,” says Fisher. “So whether it’s debt dislocation or the money hasn’t been put into it, it’s underperforming the market in general, whereas value-add will be a market performing deal where we have some work to do, and it’s just to improve its cash flows.”

Adds Brady: “In the opportunistic space, you’re solving serious problems. And every deal that walks in the door isn’t necessarily a serious problem, but it still could be very attractive for lots of different reasons, so our clients want to see that flow. We don’t like the idea of a good opportunity coming in and having to throw it away because it doesn’t fit this really narrow definition of what’s possible in a high return strategy.”

According to Brady, Oaktree’s entry into value-add was largely driven by investor interest. “There’s a lot of demand for real estate cash flow and not necessarily this fix-and-sell type of approach to investing,” he says.

Such demand has come in particular from large international investors. Indeed, as Wintrob noted in the February earnings call, 62 percent of the commitments to date in Oaktree’s most recent real estate opportunistic fund, Oaktree Real Estate Opportunities Fund (ROF) VII, were from non-US clients. By contrast, foreign investors represented only about 30 percent of the firm’s total AUM at the time. Oaktree disclosed in its fourth-quarter earnings results that it had raised $2.1 billion for ROF VII as of year-end 2015, against a reported target of $3 billion.

Other large private equity firms that historically have invested opportunistically in real estate, such as The Blackstone Group and The Carlyle Group, have similarly cited investor demand for greater cash flow-producing investments in launching a lower-risk, lower-return strategy in core-plus real estate. Marks, however, has eschewed the core-plus label for his firm’s new strategy, noting that value-add “is still higher up the alpha trail than core-plus” in February.

Brady, however, perhaps to better highlight the separation between the firm’s opportunistic and value-add strategies, says value-add can blend with core-plus on the lower end of its return spectrum. “Our value-add strategy definition is going to be more of a blend between core-plus and value-add,” he says.

In debt’s footsteps

Value-add represents the second major step-out strategy for Oaktree’s real estate business. The first step-out was real estate debt, which began as a separate account in 2012 and then expanded into a commingled fund in late 2013. Wintrob has said that the firm’s approach in developing its value-add real estate strategy will likely be similar.
According to Gollenberg, who runs Oaktree’s real estate debt business with Justin Guichard, Oaktree has invested in real estate debt since its founding in 1995. Back then, the firm’s real estate debt investments were in loans through which the firm was looking to gain control of the underlying real estate. The strategy eventually became part of Oaktree’s real estate opportunistic funds, where it was defined as “debt that looks like it was having problems and where we would be able to exchange it for equity,” he says.

Soon after joining, Brady sought to tackle a developing opportunity within the legacy CMBS space. He assigned a large team to underwrite the 50,000 loans – which in turn were backed by approximately 55,000 properties – in the 200 securitizations they were focused on. “The design there was twofold,” says Gollenberg. The underwriting allowed the team to identify the problems within the underlying loans, and also understand which of the 200 securitizations were the most and least safe from a credit standpoint. “As those bonds decreased in price, we were able then to find attractive purchases,” he says.

Oaktree launched its first real estate debt-related vehicle after being selected in 2010 as one of the nine original asset managers of the so-called Public-Private Investment Program with the US Department of the Treasury, according to documents from the Treasury. Under the program, Oaktree managed approximately $2.3 billion in total commitments through its Legacy Securities Public-Private Investment Fund, through which it invested exclusively in bonds backed by AAA-rated commercial mortgage-backed securities.

By 2013, the opportunity in CMBS had largely disappeared, but there was a lot of opportunity for private lending, Gollenberg recalls. “We sold all our bonds and CMBS legacy funds, because we didn’t see any value on the public side,” he says. “But in our real estate debt fund, we not only did private lending, we also could go right back into CMBS and corporate debt.”

He says that Oaktree’s real estate debt portfolio currently is close to evenly split between public and private debt. But “if you had taken a snapshot a little over a year ago, it would have been virtually zero in public debt,” he notes. “We’re always looking across the entire real estate spectrum where the best relative value is. We need that spectrum in order to effectively manage risk.”

In its fourth-quarter 2015 results, Oaktree reported that it had raised $1.1 billion for Oaktree Real Estate Debt Fund as of December 31. In the February earnings call, Wintrob said that the firm was planning to launch its second commercial real estate debt fund, with a reported target of more than $1 billion.

A history of change

As Fisher points out, creating new business lines is nothing new for Oaktree. “If you think back just over the history of Oaktree, it’s all a step-out,” he says. “Initially, we were seven businesses when the company started in 1995. Today we’re 25 businesses or strategies. And they’ve all stepped out of the original seven. Real estate was a step-out from distressed debt.”

Oaktree’s first real estate fund was raised in 1994, while Marks and co-chairman Bruce Karsh were still at TCW Asset Management, where Marks led the groups that invested in distressed debt, high yield bonds, and convertible securities and Karsh was portfolio manager of the company’s special credits funds. The fund’s strategy was to buy non-performing mortgages, which led Marks and Karsh to hire its first real estate-focused professionals. Fisher, who today is the longest-standing member of Oaktree’s real estate team, joined in January 1995 as the fifth member of the group. Over the course of the next decade, the firm went on to raise four additional real estate funds through which it executed smaller commercial real estate transactions in office, hotels, retail and multifamily.

In 2005, however, Oaktree experienced a shakeup in its real estate group, when then-leader Russ Bernard left the company due to a disagreement with Marks and Karsh over the direction of the business. In a 2013 memorandum, Hershel Harper, then the chief investment officer at South Carolina Retirement System Investment Commission, wrote, “Howard and Bruce’s macro outlook in 2005 led them to conclude that there was a lack of compelling real estate opportunities in the market at the time, despite the easy fundraising environment. Russ ultimately disagreed and left the firm, along with several other senior professionals from the real estate group.”

Fisher recalls the period as a tumultuous time for Oaktree’s real estate business since a number of team members had worked together for 10 years. “It was a difficult decision for the five of us who stayed, because they wanted us to go with them, but Oaktree wanted to keep us,” he says. “There was litigation going on between Oaktree and Russ, so it was a difficult time. We lost friends who left and were mad at us.”

After the departures, Oaktree was left with half of its real estate team and an approximately $2 billion property portfolio. In early 2006, Karsh stepped in and took over the OCM Real Estate Opportunities Fund III, which the firm closed in September 2003. According to Fisher, Karsh detected signs of an oncoming global macro dislocation, as companies did highly leveraged deals amid a lending environment characterized by cheap debt and no covenants. He then directed the group to sell as much of the real estate portfolio as they could, ultimately reducing its property holdings by half.
“We sold a significant amount of the portfolio and really de-risked ourselves,” says Fisher. By the time Brady joined in the spring of 2007, Oaktree’s remaining real estate assets had very few legacy issues, he adds.

Six focus areas

Brady quickly set out to rebuild the real estate business, structured around six areas of investment focus: commercial, non-US, residential, commercial non-performing loans, corporate and structured finance.

“It was really John’s idea to fan out and make sure we were covering all the different areas,” says Fisher, who heads the real estate group’s commercial business on the West Coast. “Again, because opportunities move around and what’s hot and interesting today because it’s providing cheap assets at good values, a year from now may not be.”

Adds Brady: “It was really designed to focus on lenders that lent too much and borrowers that borrowed too much. We want to follow around credit issues, because credit issues are the biggest source of artificial dislocation, and they’re the best source of discounted opportunities, they’re the catalyst for transactions. So wherever we saw credit issues, we wanted to design specific areas of investment focus.”

Complementing these six areas of focus are geographic strategies. For example, the entire US real estate team works together across their various areas of focus to cover the country’s top 50 markets. “It’s not only covering real estate in these markets, it’s really about covering relationships,” says Brady. “So everybody always has something very significant to do, either in their geography, or in their unique area of focus.”

Of the six investment areas, Brady says structured finance, or CMBS, no longer fits within the scope of Oaktree’s opportunistic real estate strategy, and now is instead part of its real estate debt strategy. Meanwhile, corporates “are like finding a needle in a haystack,” he says. “We’ve done some great large-scale corporate deals, but those are few and far between. Unless we can find proprietary off-market situations, usually those corporate situations are overbid.” As for non-performing loans (NPLs), a number of entrants into the business have made transactions in the space much less attractive, which has led Oaktree to significantly sell down its NPL portfolios.

However, the real estate group continues to pursue its commercial business across the US and in Europe, as well as its residential business, excluding residential NPLs. “What we’re finding today is that high-growth secondary markets are presenting a much better value proposition relative to what I’ll call the top five or six core or primary markets, just based on the valuation gap,” says Brady. “And it’s a rare time in history that that’s true. Normally, one of the fundamental tenets of real estate is buy the best assets in the best markets. Well, you can’t do that if those assets are overpriced and I think we’re in a world today where that is the case.”

Outside views

As an opportunistic real estate investor, “they’re in a nice sweet spot in terms of size,” says one rival manager of Oaktree. “They get the benefit of being a bit under the radar screen of the Blackstones of the world. But they have a lot of capital, so they don’t compete with the smaller guys, either.”

But despite having six focus areas, Oaktree’s real estate business is viewed by some as being too broad in scope, especially among investors seeking more targeted strategies. The manager, which has some of the same investors as Oaktree, adds: “They’re throwing darts all over the place, which makes them look more like a deal shop rather than an investment manager.”

Meanwhile, others view the firm’s performance in the asset class as less typically opportunistic than some of its competitors.

“While Oaktree’s performance has been relatively consistent through time, the absolute level of returns has often been somewhat lower than comparable opportunistic real estate funds,” Harper wrote in his 2013 memorandum. However, he noted that the firm’s results also were consistent with its more moderate use of leverage and conservative underwriting when compared to its peers.

According to Oaktree’s fourth-quarter 2015 earnings results, the firm’s 2011-vintage ROF V was generating a net return of 13.6 percent, with a 1.8x multiple as of December 31. By comparison, in its fourth-quarter earnings, widely-perceived sector leader The Blackstone Group reported total net IRRs of 23 percent and a 1.7x multiple for its 2011 vintage fund, Blackstone Real Estate Partners VII.

Studying abroad

Within its non-US strategy, Oaktree’s real estate group has made Europe one of its most active areas of focus. Snelgrove says that when he joined the firm in 2011 to start up its property business in Europe, he took a page from its US counterparts’ playbook and spent the first 18 months meeting with numerous local contacts to develop market and sector insight and, together with the late Ian Coull, who served as Oaktree’s UK senior real estate advisor, started building relationships with key operating partners in the region.

Initially, the European real estate team focused on the UK, where it struck its first deal in 2012 and spent 75 percent to 80 percent of its time during its first two years of operation. However, “as liquidity started coming into the UK from the US in the second quarter of 2013 and the market started rebounding in the UK, we started spending more and more time on the continent in markets that we thought had good demand/supply characteristics, but where we felt there was an opportunity because there was close to zero liquidity and it was only a matter of time before the liquidity that was coming into the UK would find its way onto the continent,” Snelgrove explains. From late 2013 through 2015, the team spent 60 percent to 80 percent of its time searching for deals on the continent, where it currently is seeing more relative value for the firm’s opportunistic real estate strategy.

Snelgrove points out a number of attractive drivers of opportunity in the region. One is more than $450 billion of distressed or impaired loans and non-core real estate held by European banks and other institutions, many of which are undercapitalized ‘zombie’ assets. Another is the $500 billion of debt coming due in the region over the next four years. “When you consider that, combined with the fact there’s increased regulatory scrutiny and higher capital requirements that have been applied to the banks, getting a loan is a little bit harder than it was six months ago,” he says. “There’s talk about some lenders retreating from certain markets and certain asset types, so you’ve already started to see pricing widen a little bit, which is creating some opportunities.”

By contrast, Oaktree’s real estate investing in Asia has been “very selective and intermittent,” says Brady. The group has been very targeted in Korea, where it has a team on the ground and exited a number of investments over the past few years. In Japan, deal flow has been light but the real estate team there continues to look for opportunities. The Oaktree real estate team also has now established an on-the-ground presence in Hong Kong and completed its first NPL transaction in China.

Additionally, the firm announced in March the opening of a new office in Sydney. “Do we envision a big team and significant deal flow on a consistent basis?” Brady says. “No, I think more likely it’s going to be very selective and very opportunistic.” However, if the team finds an asset that it is comfortable with as an equity owner, then Oaktree could have an opportunity to pursue real estate lending strategies that a traditional Australian bank might avoid. “That’s a place where lending could be more interesting than the equity side of the business,” he observes.

“It’s maybe a little early in Australia, probably a little early in China, but we want to be in position, similar to the US,” Brady adds. “What’s exciting about Asia is over the long term it’s a wonderful growth story, but there are very significant periods of dislocation.”

The alternative to ‘blood sport’

In addition to its matrix of six investments areas and geographic focuses, what Brady says sets Oaktree’s real estate business apart from the competition is what he calls the “West Coast offense.”

“We wanted to build our business based on the principles of trust and integrity and being user friendly, because the real estate game, particularly in New York, is often played as blood sport, and we wanted to be the alternative,” he says.

“You do what you say you’re going to do,” adds Fisher. “You don’t tell them you’re going to do something and then not do it, unless the facts materially change.”

Brady notes that more than half of Oaktree’s real estate flow has been proprietary, and more than 60 percent of its business is repeat business, resulting in more than 330 transactions since the global financial crisis. On the strength of its relationships, he says, “we’ve created quite a machine.”


Brady and his team

Since joining Oaktree in 2007, John Brady has helped to grow the firm’s real estate team from five to 50 professionals as of press time. Of that number, 13 – more than 25 percent of the total group – are in leadership roles.

“John is not afraid of surrounding himself with talented people,” says chief executive Jay Wintrob. “You can’t be all things to all people. You can’t tackle the entire asset class by yourself.”

According to Wintrob, Oaktree has viewed step-out strategies “as an important career path for our best investment professionals,” by tapping select executives to head up the new businesses. Such was the case with Gollenberg and Guichard for the firm’s real estate debt strategy; a similar elevation of team members is expected for the firm’s value-add real estate strategy in the coming months.

“It’s good to have a large real estate team,” says Wintrob. “We feel more comfortable because of it in having these step-out strategies.”

Commercial Ambrose Fisher (LA)
Mark Jacobs (LA)
Todd Liker (NY)
Ben Bianchi (NY)

Non-US Manish Desai (LA)
David Snelgrove (London)
Toshi Kuroda (Tokyo)
Steve Choi (Seoul)
Yi Zhang (Hong Kong)

Residential Jason Keller (LA)

Commercial NPLs Mark Jacobs (LA)

Corporate Todd Liker (NY)
Manish Desai (LA)

Structured finance Keith Gollenberg (NY)
Justin Guichard (LA)


More than just money

Working with Oaktree enabled one real estate operator to achieve “extraordinary success” on its investments.

Los Angeles-based Woodridge Capital Partners is one of more than 65 operating partners that Oaktree works with globally. For Woodbridge chief executive Michael Rosenfeld, the private equity firm stands out as both an opportunistic investor and a joint venture partner.

“Oaktree clearly has an opportunistic eye towards investment,” he says. “That enables them to step into opportunities that may not be as readily evident to other people.”
Over the past five or six years, Woodbridge has done more than 10 transactions with Oaktree in hospitality, student housing, land development and housing development across the US. Notable investments, which Oaktree made on behalf of ROF V and VI, included the Fairmont San Francisco, Fairmont Orchid in Hawaii and the Century Plaza Hotel redevelopment project in Los Angeles.

“They add more than just money to the equation,” said Rosenfeld. “They add a sense of expertise in the real space, and this enables us to maximize outcomes. We’ve had extraordinary success in our portfolio together with returns in excess of 30 percent on certain assets.” In one recent exit, the partners last year sold three hotel assets – including the Fairmont San Francisco and Fairmont Orchid – for approximately $700 million, for an aggregate net profit of $350 million, according to Rosenfeld.