Ron Zeff, CEO & Founder of Carmel Partners, joined us on the heels of raising $1.58 billion for the firm’s Investment Fund 8. We discussed his background, the multi-family sector, and how he plans on deploying capital in this environment.
Daily Beat: Can you please share the firm’s background?
Ron Zeff: Carmel Partners is a successor firm to my father’s company. He was a large apartment developer and property owner in the Denver area.
After a stint at Trammell Crow, I started Carmel in 1996 with the idea of following the DNA, experience, and values of my father, while bringing on institutional partners.
By 2003, the firm got into the fund business and had done around 19 large transactions, including buying Parkmerced with JPMorgan from Leona Helmsley in 1999.
The main investors at that time were endowments and foundations that were looking to disintermediate the allocators. They were looking for fiduciary minded managers in a given segment, and a number of them selected Carmel to be their exclusive vehicle for multi-family.
We were given flexibility within the U.S. multi-family sector to pursue development opportunities, value-add deals, and sometimes opportunistic debt investments. This exclusive mandate has led to a series of funds.
Carmel has been fortunate to broaden our investor base to include state and corporate pension funds, insurance companies as well as foreign investors. We just closed Fund 8 at $1.58 billion, our largest fund to date.
The last fund was a little over $1.2 billion. By dollar amount, we had a 100% investor re-up rate.
Daily Beat: CBRE put out a report last month that cap rates for prime multi-family assets are starting to stabilize. They found that going in cap rates for those types of assets in Q1 was 4.72%. What are you seeing?
Ron Zeff: I think that’s a pretty good estimate if you were going to come up with an average. There’s still a pretty wide bid-ask spread. I don’t think people are really willing to sell at a 4.7 cap rate for a property that would deserve that. Obviously secondary properties and secondary locations are going to have a higher cap rate than prime newer properties in excellent locations.
Daily Beat: How are you thinking about national rent growth in the next few years?
Ron Zeff: Cap rates are a function of discounted cash flows. Your future rent growth assumptions are key to that.
Most people are underwriting fairly flat rent growth over the next two years, but I think it’s a market where we’re going to see declines in rent, which is going to push cap rates higher. It all depends on what happens with long-term interest rates. In general, if people don’t have to sell, I think to a large extent they’re not selling. Carmel is looking for forced sellers.
At the same time, there’s a lot of dry powder that wants to own apartments at that yield. Buyers are underwriting to achieve positive leverage by year two, which is hard to do.
Daily Beat: How much of the fund have you already deployed? Blackstone just raised a $30 billion fund and they were very happy to promote that fact that was mostly dry power. I’m wondering what about your latest fund?
Ron Zeff: We raised most of this money a year ago, and kept the investment period open to allow a few select investors to come in.
We started making investments out of the vehicle more than a year ago and are slightly more than half committed. Prior to this fund, we tended to do more development because we could find those big margins of safety, which turned out to be a positive from a valuation standpoint because we could withstand cap rate increase without being hit with write downs. Now, the quality of existing deals is really improving.
I am skeptical about what other people are doing on their marks. We have taken significant write downs in terms of our calculation of higher cap rates. All that points to declines in value. I’m somewhat surprised that some of our competitors are not taking those hits on their current funds and then raising capital on the premise that everything’s going to be cheap. It’s kind of hard talking out of both sides of your mouth.
Daily Beat: It’s always fascinating to observe how the mark-to-market system of PERE works. REITs tend to be a couple quarters ahead.
Ron Zeff: Carmel has been more aggressive on that front. We just closed on a 3,000-unit property in Daly City, which is just outside of San Francisco. The asset traded at $925 million. When you study the appraisal from the fall of 2019, the property was valued at over $1.3 billion. The seller was a foundation that inherited the project from a long-term owner and they were content to take market value.
Daily Beat: What’s the breakdown for this fund in terms of how you deploy the capital? I gather that there’s an equity focus with existing assets and new development, but there’s also a debt component.
Ron Zeff: On the debt side, we don’t invest in those deals too frequently. It needs to be a special situation where we think there’s equity like returns. There are a lot of highly-qualified debt funds in the marketplace that are more aggressive than we are, so it really needs to be a special situation. Our focus is on equity.
Daily Beat: Can you please discuss a few of the deals in the fund?
Ron Zeff: We have our large Long Island City project at 43-30 24th Street. The 66-story, 938-unit residential development is grandfathered in under the old 421-a program, so we are excited about it. If the project was finished today, the yield would likely be 5.6%, so we have lots of margin there.
Daily Beat: When you buy a property in this environment, what’s your ideal capital stack? Are you buying all cash and refinance later? Or what type of debt are you looking at?
Ron Zeff: For operating properties, we are doing a mixture of both floating and fixed. We really focus on obtaining loans with term, so we don’t have to have to be forced to refinance in the near future.
The idea is to push out those refinances five to seven or even 10 years. We’re mainly going with Fannie or Freddie type loans.
For new construction, we’re talking to bank lenders and insurance companies. This is a good environment for Carmel where most people are struggling to get debt and might have to go to the debt funds, which can be very expensive. We’re still able to get debt, although lower proceeds than you could get before.
Daily Beat: What type of LTV are you looking at when you go to the traditional lenders for construction?
Ron Zeff: Maybe 50 to 52% on the low end and maybe 60% on the high end. Occasionally there’s a 65% out there. It depends on the margin of the banks’ underwriting of the deal. Spreads are probably closer to 300 than 200, so we have to put a little more equity in, which makes the deal safer, but the IRR underwriting is a little bit lower.
Daily Beat: What do you closely monitor in the debt markets daily?
Ron Zeff: For me, it’s understanding what that long-term Treasury is and thinking about what rate we can borrow and what’s happening to spreads. Essentially, we are looking at what our borrowing costs are from a long-term standpoint. That becomes the rate that you have to manage around and understand that on a valuation basis in this notion of getting positive cash flow by year two. For development deals, we obviously want a positive margin from that underwriting. We pay a lot of attention to the SOFR curve because that’s the market’s estimate of the floating-rate cost over time, which has a big impact on our construction loans.
Daily Beat: How do you approach hedging when locking in debt?
Ron Zeff: We obviously have hedging costs. Fannie and Freddie require hedges and also require that you reserve cash flow to buy your new hedge that’s coming up.
If the strike price is below the current interest rate, that’s just like pre-paid interest. Your biggest worry in this market are buyers who have borrowed money on two- or three-year, floating-rate loans from debt funds under a very aggressive business plan at low cap rates. Those are going to start blowing up over time.
Daily Beat: Would you infuse equity in those deals, or are you looking to eventually buy them directly? How creative do you get with deal structures?
Ron Zeff: We look at all that. During the financial crisis and the pandemic, we picked up some opportunities that were really buying from debt sources and getting to the properties that way. We sometimes bought properties directly from lenders.
Just like last time, I think there’s going to be a tendency to kick the can down the road, so I’m not sure how much stress there’s going to be. Often the ones that are stressed are questionable properties in secondary markets and you don’t want to necessarily own those.
Daily Beat: Redfin recently found that rents in Austin are down 11% over the last 12 months, which contrasts with New York where rents continue to hit record highs. Do you think rental trends are going to continue to revert back to the mean? How do you view that moving forward?
Ron Zeff: That’s been our thesis all along. In the Sunbelt I think there will be rent declines, while in the coastal gateway markets, except in a few individual pockets, there will continue to be rent growth. I think people are underestimating the wall of supply that’s going to hit the Sunbelt.
Although some people only focus on multi-family supply, it’s important to think about all the single family supply. When people move from being renters to buyers, they’re permanently out of the rental market. That’s going to surprise people as to how much rents could move downwards and vacancy rates could climb.
If you have to be a seller at that time, you’re going to be very unhappy, and if you’re honest with your marks, they’re not going to look good on paper either.
Long term, most markets will recover and do well. The reason people like apartments from an inflation standpoint is the idea that you can move rents to market every year. However, the only way you can move rents is based on local demand and supply. These gateway markets like New York, most of the supply was started pre pandemic, so there’s not a lot delivering.
Daily Beat: What are you seeing in San Francisco?
Ron Zeff: San Francisco is coming back slowly. I think work-from-home trends are taking a toll, but it’s starting to come back. Presumably when companies require employees to return to the office – even only a few days a week, you are going to start seeing these markets improve.
Amazon is now requiring employees to be in the office three days a week, which presumably should help the Seattle market. It’s all local supply and demand, so some markets are softer than others.
Daily Beat: Expenses have increased tremendously ever since Covid. Part of that cap rate conversation we were having earlier is really taking that into account, as income will likely remain flat in the immediate future. What do you make of the operating expenses in your portfolio? Which line items are up the most?
Ron Zeff: We’ve definitely felt the increase in expenses, mainly in insurance and payroll. Depending on the market, you might have some real estate tax exposure. Many of our markets have very limited exposure because of the way their property taxes are calculated, but that’s a big factor.
Regarding rent growth, I think there will be pretty good rent growth in markets like San Francisco and Seattle because of the massive hiring of people that took place during the pandemic. We hear about these 20% layoffs at Facebook, but they still doubled the size of their company during the pandemic, so they are still 60% bigger than they were pre-pandemic.
Where are all those people living when they start to have to come back to the office? That should have a positive impact. I think people are going to be hesitant to buy in this market because of uncertainty, so that should balance out to some degree what you normally see in a tech slowdown.
People without children often like to live in cities. There are parts of San Francisco that the New York press likes to report on, but it really has gotten a lot better and the neighborhoods are quite fun like they are in New York.
Daily Beat: Are you looking at office-to-residential conversions?
Ron Zeff: We’ve looked at a lot of them. Outside of New York, it doesn’t pencil in 99.9% of office buildings. The cost, layout, are very expensive and then you end up with a compromised product.
New York has a little bit of a leg up because land prices are so much higher as a percentage of total cost, but who wants to live in Times Square or in the middle of Midtown around a bunch of office buildings, so there’s that impact as well.
There’s also a lot of risk on the cost side on these conversions. When underwriting that risk, it’s hard for us to find those types of opportunities.
Daily Beat: I gather that the Wardman Hotel would have been more expensive to convert –– and that’s not even an office building.
Ron Zeff: Yes. We just bought the Wardman Hotel in Washington DC. It was an 1,110-unit Marriott hotel and convention center that we bought out of bankruptcy. We underwrote trying to convert the building to residential versus tearing it down, and it was much more accretive to tear it down and build new.
Daily Beat: How do you underwrite political risk, particularly in San Francisco?
Ron Zeff: We pay a lot of attention to it. The asset we bought was in Daly City where the vast majority of its population are homeowners. They have a more conservative bias. It’s on a local and deal by deal basis.
Generally, we found new construction is exempt for a long period of time from these rent control policies because they want to encourage new housing, but that being said, it’s something we pay a lot of attention to.
They recently passed some big transfer taxes in LA, San Francisco, Washington DC, and Seattle and these things really impact your underwriting and hurt your NAV right away. That’s disappointing in the short-term, but from a long-term standpoint it makes it that much harder to build more housing and ultimately helps push rents higher.
Daily Beat: Are you planning to invest in SFRs?
Ron Zeff: We have owned some large projects that are similar to single family rentals in Hawaii and California. They were former military based housing that we converted to regular rentals.
I think it’s a really interesting market, but it’s hard to do it at scale. When you look at it on a micro basis, you really have to look at what you can buy versus rent for similar product.
I think the industry is getting ahead of that and trying to justify build-to-rent type stuff in places where you can buy for similar cost after tax. With the rise in rates, maybe that’s going to have a little more legs to it. I’ve heard there’s some softness there, but we’re really not chasing because we don’t have a clear competitive advantage yet in figuring that out.
Daily Beat: Does fundraising get easier with every successive fund?
Ron Zeff: Most of the people we work with– even if they are re-ups – are fiduciaries and the level of diligence I think they’re expected to do is as high as it’s ever been. Then you add in ESG. We’re also SEC registered. The level of questions that people have has grown.
We’ve had to grow our investor relations team. I’ve generally found that the more educated and thorough the investor is, the more likely they’ll be attracted to Carmel because we’re so transparent and provide a lot of data, but it’s a time-consuming process.
Firms have changes in management and denominator effects, so they have a lot of pressure on them.
Building trust is everything, so that’s great about our existing investor base. For new investors, it takes a lot of time to build that level of trust.
*The interview has been edited and condensed for clarity.