Thomas Carroll, managing partner, Watermark Partners Real Estate
Thomas Carroll, managing partner, Watermark Partners Real Estate

Just five years ago, Watermark Partners Real Estate was a friends and family fund with a handful of investments in Michigan. Today, it is a private equity fund platform with $300 million of assets under management and 6,500 apartments in five Midwest and Southeast states. It has accomplished all this with an investment thesis that many firms might find constraining. Watermark strives to create high-income, tax-shielded diversified funds with a positive social impact. Or in the words of the company tagline, Watermark is Managing for Investor Income and Community Growth.

In workforce housing, Watermark found a way to reconcile these two objectives. “Workforce housing is not necessarily exciting and can be challenging to operate, but it is consistent and high-income generating when operated correctly,” says Thomas Carroll, Watermark’s managing partner. Over the last five years, Watermark has assembled an organization with the skills, systems, and talent required to create safe, clean, affordable places for working families to live while generating attractive returns for their investors.

So far, this thesis has stood up well in the face of an economic meltdown that has devastated other property types. In fact, Carroll believes that steady, unpretentious workforce housing will prove to be one of the most resilient sectors in commercial real estate.

Carroll sat down with me to talk about the challenges of working in this demanding corner of the multifamily market, the adjustments Watermark has made to its operations and underwriting in the wake of the COVID-19 crisis, and the value-add that the good financial partner can provide.

Messier: Where did Watermark’s emphasis on having a positive social impact come from?

Carroll: Watermark has had a community focus from the very start. When they launched the first fund in 2014, our founders—John Nechiporchik, Elan Ruggill, and Stewart Beal—bought properties just blocks from where they lived. As a result, they could see firsthand what a difference good housing could make to a neighborhood. They decided to try replicating this experience in other communities. Over time, this emphasis became self-reinforcing. It has become even more deeply ingrained in our culture as we successfully attracted employees and investors who value having a positive social impact.

Messier: Let’s look at the elements of your investment strategy. What sort of properties are you looking for?

Carroll: We buy assets that are capable of generating income from the moment we purchase them. At the same time, we are also focused on long-term income generation. Although a property may be 90% or 93% occupied at acquisition, there is often significant deferred maintenance to take care of. We renovate units, add playgrounds, improve the landscaping, and get pools back online. We want to make our communities nicer and more enjoyable places to live, which is good for current residents, the surrounding community, and ultimately for investors.

Despite our focus on a positive social impact, however, we are not a charity. When you create a nicer community, you can eventually charge higher rents and reduce turn cost, improving income generation and ultimately property values for investors.

Messier: This strategy might not work everywhere. You are focused on the Southeast and Midwest. What is the rationale for that decision?

Carroll: We are looking for locations where there is a significant spread between retail-sized deal cap rates and the cap rates on institutional-sized deals. In places like the New York metro area, there is zero basis between these deal sizes and no ability to capture cap compression by going smaller. We started in the Midwest, which was harder hit by the recession in 2008 and slower to emerge than the rest of the country. At the time, there was some cap rate compression to be had. Currently, the area with the widest differential and some of the fastest population growth is the Southeast.

Messier: Drill down even further. What are your criteria for choosing a market for investment?

Carroll: We are constantly debating the merits of geographic diversification versus geographic concentration and operating scale in a given city. We know that part of what gives us better performance is being able to pool our resources. This is particularly important because of the number of properties we own. We have executed more than 100 transactions in the last four or so years, and they are relatively small properties.

We look for cities with a number of well-defined attributes. They should have a significant industrial presence, a strong workforce, and a diversified economy. We favor towns with universities, health care, government, and S&P 500/national corporations as significant employers. Together, all these factors contribute to a stable or growing resident base. In the Southeast, we are concentrating in such cities as Columbia, S.C.; Valdosta and Macon, Ga.; and Fayetteville, N.C. In the Midwest, we are in places like Akron, Ohio, and Lansing, Mich.

Messier: How do you find your deals?

Carroll: We buy low- to moderate-income housing, usually from individual owner-operators. Our transactions are typically small, in the $3 million to $15 million range. We have developed a broker network that consists of a mix of larger companies and local independent brokers. In addition, we proactively reach out to owner-operators and smaller real estate investment groups.

Deal flow is extremely important to us. In the last two years, we’ve underwritten more than 250 properties in the Southeast alone. If we think a deal has legs, we visit and do on-site initial due diligence, and, eventually, if we get into contract, we go through a very exacting due diligence process.

Messier: This has obviously changed with the coronavirus crisis. What happened to deals you were working on when the crisis broke out?

Carroll: All our deals that were under discussion in February, both on the buying and selling side, fell out of contract in March. We communicated with all our brokers and sellers that we were not buying any more properties until we had a firm grasp of April payments. They held up well. We monitor rental collections on a daily basis and found them virtually unchanged from the previous two months.

Our high collection levels were the result of a combination of circumstance and hard work. The Southeast was later to close and earlier to open than the rest of the country, which lessened the immediate impact on the economy.

At the same time, our rents are low, and stimulus checks and additional federal unemployment benefits go much further in the Southeast than in other parts of the country. Our operating team has worked incredibly hard over the last six weeks to educate our resident base about accessing federal funds, making sure they had the information they needed and, in some cases, access to computers.

We learned that stimulus checks were hitting residents’ accounts at the end of April, which gives us confidence that May is going to be strong. June remains an open question for us, but we are pretty happy with our situation. We are now back on the offensive and using the opportunity to go out and make acquisitions. A lot of deals that we were negotiating pre-COVID have come back.

Messier: What’s your sense of how the market has changed?

Carroll: Before the crisis, it was very much a seller’s market. Post-COVID, there has been a subtle shift, though we have not seen significant price changes. After all, the properties we are interested in are cash-flow assets. If sellers don’t like where the market is right now, they can just withdraw their offering. There are, however, fewer buyers out there. Stronger buyers with solid access to debt like us are getting that second callback.

Overall, I would say that we are definitely in a buyer’s market. Deals that might have had a 5% cap rate in January have a 5.5% or 5.75% rate now. Sellers have also become more flexible on deal terms and are more receptive to the provisions we need to make the deals work for us.

Messier: Are you underwriting differently in this environment? Certainly, your inspection process must have changed.

Carroll: Definitely, we are underwriting to no rent growth, lower physical occupancy, and higher bad debt than we had before. We are also underwriting to an 18-month principal and interest reserve on the debt side. In other words, we are adjusting to the economic consequences of the pandemic. This means that we will offer 5% to 10% less for a property than we might have asked before.

The health risks have impacted our inspections. We run at a very high rate, and during a typical week, my team may be in three cities in two states looking at deals. We are still looking at every potential deal, but our approach is very different. We can conduct exterior inspections without much of a problem. However, even though most of our Southeast states are open, I am not going to ask my team to go into a unit that is occupied. It is not the right thing for the resident or for my team.

So, we are inspecting unoccupied units, checking physical occupancy by knocking on doors, and asking for a reserve of a few thousand dollars per unit on a portion of the units just in case there are some that don’t match what we feel the standard for the property should be. If the property is running at 95% occupancy with average rents, we can be reasonably sure that most units will be in good shape, but we want to protect ourselves. That reserve will extend for 12 to 18 months in escrow until we feel comfortable going into these units. We feel that asking for a reserve of $100,000 or $200,000 on a $15 million transaction should not be a deal-breaker.

Messier: It sounds like you’re feeling confident.

Carroll: If anything, the coronavirus crisis has confirmed my belief that we are in the right property type in the right area of the country. You might think our resident base would have been harder hit than those in Class A or luxury properties, but, as I’ve said, the stimulus has been effective in keeping these households afloat, at least in the immediate term. There is also the supply/demand dynamic. For the last 20 years, there has been virtually no investment in workforce housing. As a result, while we won’t be raising our rents in the immediate future, we won’t be dropping them either, and we anticipate our occupancy remaining constant.

As we begin to open up the economy, we expect to see more money flowing to our sector as people exit sectors like hospitality and retail and investors tire of the kind of fluctuations they have been seeing in the equity markets. That’s good for our business. We have a number of active deals right now that we will be pursuing in the next few months.

All told, along with warehouse space and industrial, we believe that workforce housing, after a bit of short-term turbulence, will emerge from the crisis as one of the most attractive of commercial real estate sectors.

Messier: What are you looking for in debt provider?

Carroll: Obviously, we could not do what we do without debt financing. It enables us to create returns that are attractive for our investors. But because of the nature of our business, we are looking for a partner that goes beyond the obvious—competitive pricing, competitive terms—and provides the degree of insight, flexibility, and responsiveness that’s vital for our business.

For instance, our sellers often have very poor-quality financial data. We need a financial partner who can help us work though complicated underwriting and tease out information from sellers. We also need a partner who comes up to speed quickly. We are repetitive borrowers, and we just don’t have the time or patience to answer the same questions over and over again with each deal. And we need a partner who is knowledgeable and responsive, who will answer our calls and get right back to us with insight and information we need.

We’ve explored hundreds of deals in the Southeast and Midwest over the last few years, and just about every one of those deals has some sort of twist or turn that we need to understand. Having a partner that we can bounce ideas off of and ask questions of is critical in determining whether or not we can proceed.