Kaufman Organization’s Fred Leffel Talks Midtown South, Acquisitions and Off-Market Deals

He was lured to the Kaufman Organization—after a long stint in investment sales at London-based services provider Savills—eight years ago by its chairman, George Kaufman, to head up the firm’s then-new ventures platform. The company may have found its perfect match. Leffel’s background coupled with his personal philosophies on how to operate in the industry gel well with that of Kaufman Organization—one of the oldest (founded in 1909) and most reputable real estate companies in New York City. Neither are willing to engage in overly aggressive or stubborn deal-making.

Kaufman closed six Midtown South acquisitions in the last two years—most recently a 99-year ground lease at 236 Fifth Avenue between West 27th and 28th Streets—and eight since the division was launched in 2009. Commercial Observer met with Leffel at his office at 450 Seventh Avenue between West 34th and West 35th Streets to discuss the company’s Midtown South footprint, acquisition strategy and penchant for off-market deals.

Commercial Observer: What’s your focus as the head of the new ventures division at Kaufman?
Fred Leffel: We acquire office properties on a value-add basis in New York City. We look to reposition, upgrade or repurpose those buildings to a higher and better standard. It involves a business plan, physical work to the building, new leasing and a marketing strategy for the building. We have to know who our tenants are to attract them—or if there even are any tenants to attract for a project.

Why office assets specifically?
In creating this division we wanted to take advantage of our strengths and our core competencies—to use an overworked phrase—to try to attract institutional capital. That was what we were most comfortable with because we already had so much knowledge in house.

We haven’t done as many deals as a lot of people, the deals aren’t as large as a lot of people, and we don’t get as much publicity as other firms—but we’re just careful. George Kaufman was not a cowboy and [Kaufman Organization President] Steve Kaufman is not a cowboy—he’s very careful about what he does.

How does that approach fit with your knowledge and background?
I worked at CIBC [Canadian Imperial Bank of Commerce], which is one of the biggest banks in Canada and, in fact, one of the biggest banks in North America. If you know anything about Canadian banks, they’re very stodgy and very conservative. The bad news is that, from 2000 to 2008, they made a fraction of what Lehman Brothers made. The flip side is they’re still around. They didn’t suffer the [same] problems. There’s a good and a bad side [to it]. You have to tone it down when everyone’s going crazy [doing deals]. On the other hand, you survive for a long period of time. From time to time, I’d like to do more deals, but my time at Kaufman has been very good.

It’s interesting that you took on a role in a division for new ventures in the middle of the 2009 recession.
The recession was in full swing, but we were starting to come out of it. At that point, Kaufman had a long history and pristine credit rating. We’ve never defaulted on a loan and have never given back a property—and that’s going through many cycles. So we were trying to leverage off of our terrific reputation and capabilities. Many other real estate companies—to put it lightly—weren’t doing well, so the idea was to leverage off of the capabilities here because we operate a legacy portfolio of many buildings and have done so for a hundred years. We’re full-service: leasing, management, fixing up buildings, developing. We thought we’d be able to attract capital so we’d have a competitive advantage in trying to seize on some of the opportunities that would be coming up.

Was it smooth sailing for Kaufman at the time?
Well, what we did with our new ventures platform was create a different model than what the firm had been operating under for all those years. It had operated very well, but essentially [we had] a portfolio of properties that had been acquired over the course of many years with small family partnerships. Going forward, if we were going to take advantage of the opportunities I mentioned before, we’d have to do that with institutional capital partners—which is something the firm had never done before. So, understanding how to attract capital to deals—and also underwriting those deals because the firm wasn’t used to buying distressed properties—was us putting together a new business and a new psychology and way of looking at things.

Kaufman has a long history in Midtown South. Why?
It goes back to when there really were garment factories in the Garment District. Having loft buildings in that area was sort of an outgrowth, historically, based on the way the firm has grown. Those areas—particularly Midtown South, Madison Square and the Flatiron District—have blossomed in the past 20 years or so. I think it’s largely a function of the change in the nature of the area to a quality residential area. That brought retail and restaurants to an area that was pretty moribund for decades, then the offices followed.

How has demand for specific asset classes shifted in the area?
One of the fascinating dynamics about Midtown South, particularly the Flatiron and Gramercy areas, is that there has been so much residential conversion there that any building that came up for sale that was zoned for residential was converted to residential—apartments and in some cases hotels. [Historically] nobody would’ve bought an existing building to convert it to office space because the residential values were so much higher. The inventory for office was shrinking dramatically, but at the same time the demand for that kind of space was exploding, which created a terrific dynamic that is still going on. As time went on, the demand rose because the residential [product] was bringing in certain types of people. There is a little bit of new development, but it’s just a drop in the bucket. By far, there is more demand than there is supply. We saw that early on.

How early?
The first deal was in 2009, and at that point, buildings were cycling through the downturn, so there were actual foreclosures, and there was blood in the water. The timeframe within which there were opportunities was very brief because word got out fairly quickly and so investors from all over the world were looking to snatch up buildings—and they still are. Midtown South is, I believe, the tightest office submarket in the country, if not the world, which is surprising because it’s not a big market and there are very few buildings of size.

From your standpoint, how’s the health of the Midtown South office market today?
The market caters to an entrepreneurial segment of businesses in New York City as well as some other larger corporations that now want to relocate to the areas we’re in and into the kinds of buildings we’re in. I think it’s the growth segment of the New York City economy. Our office business is very strong. It’s slowed down from the hyperinflation of a few years ago, but it’s very landlord-favorable. Looking forward, I think that’s going to be true for a while. When it comes to the capital markets, I think it’s totally out of whack. There’s too much capital chasing too few deals, and the pricing is disturbing. The debt providers haven’t been crazy, but equity investors have paid too much and they’re going to be disappointed.

You closed on a long-term ground lease at 236 Fifth Avenue in September. What’s your strategy there?
This was an off-market transaction. Recently, almost everything we’ve been pursuing has been off-market—not that we won’t look at fully marketed deals through investment sales brokers. But, [the fully marketed deals] haven’t been very productive for us. We’ve had greater results mining the world of transactions below the radar screen. The building was under long-term ownership that consisted of three families who have a small business there—but this is the only real estate asset they own. Initially, they were not interested, but we persisted. We have a great deal of experience with ground leases. The ground lease concept was attractive to them, but in the case of the ownership there was a generational issue—as in the next generation wasn’t interested in being in the business of leasing, owning and operating the building. The ground lease [sale] was appealing to them because they wouldn’t have to pay the tax, they have an income for the next 99 years, which is substantial, and at the end of 99 years, their great grandchildren will get it back. And, if we screw up and can’t pay the rent, they’ll get it back before then.

Why has your organization been more interested in off-market deals as of late?
We’ve found over the past couple of years that too much capital is chasing too few deals, and that phenomenon, coupled with the already low-interest rate and low-cap rate environment, has distorted pricing to the point that it’s rare that we see a fully marketed deal where the pricing is compelling for us. At the same time, the off-market route has yielded better opportunities for us. It takes a lot of extra work to find the off-market deals and a lot more work to drag them across the finish line, but we’re willing to spend that extra time and effort. We’re not fund managers and therefore don’t have the pressure of having to get massive amounts of dollars invested within a limited time frame. That gives us a bit of leeway in waiting to find the right deal and then spending the extra time and effort to get it closed.

How does the firm typically fund acquisitions?
In terms of debt financing, we are very conservative. That’s a legacy of the Kaufman Organization itself. We’ve been around for so long and haven’t lost any properties, and that’s because the leverage has been very low. That’s the way we’ve operated our portfolio. There are many other owners who have the same philosophy as many buildings have no debt on them. In our new ventures, going forward, we try to keep the leverage to 50 or 55 percent. When you’re at that kind of level, with the reputation we have among lenders, there’s no problem getting debt financing, and the debt is very cheap—although it’s cheap all over right now. It gets more expensive as you go up the leverage scale, but if you keep it pretty conservative, lenders chase you to give you money. So, debt isn’t the problem. More interesting is the equity, so we do these [transactions] in an operating partner model with an institutional capital partner. We have relationships with dozens of capital partners. We try to figure out what are the interesting features on this deal and who are the likely candidates as potential equity partners—because they all have their own needs and idiosyncrasies. We have to spend a lot of time to find a partner who shares our vision.

China Orient Asset Management bought a majority stake in Kaufman’s Ring Portfolio of Flatiron District office buildings last year. How did that come about?
We were in dialogue with the Ring brothers for a couple of years before the underlying deal between the Rings and Gary Barnett [the head of Extell Development Company] came to fruition. So we were aware of the properties and the opportunity they represented for us as a company, given our existing presence in the Midtown South submarket and our strengths in office repositioning. After Gary concluded his acquisition of the entire Ring portfolio, we were able to work out a deal with him on long-term ground leases of four of the properties. These were gut renovation jobs as all of the buildings had been vacant for years and were in serious stages of disrepair. After establishing a good working rapport with Gary and his people during the initial stages of repositioning these first four buildings, we were able to work out a similar deal with Gary for a fifth property. Our original capital partner on that first tranche of four properties was Principal Insurance. Principal’s investment objective was a relatively short-term turnaround play, and after we completed the repositioning and lease up of those four properties, we recapitalized the principal with China Orient. In the end, it was a win-win for everyone, including Gary Barnett, who wound up selling his fee positions at a nice profit.

How has the influx of foreign capital in the city impacted the way your division does business? Any more Chinese investment interest?
It’s no secret that there’s a tremendous amount of capital seeking investment in New York City real estate, both domestic and foreign, and we talk regularly to representatives of both. In the past, domestic investors have had an easier time understanding our smaller building repositioning investment thesis. However, that has changed over the past couple of years as word has gotten out about the desirability and return potential of those types of investments, especially in areas like Midtown South. So now we are talking more seriously with Asian and European groups. As you know, we have closed several deals with China Orient. And that relationship has been great. They are smart investors and very reasonable to work with. On the other hand, we’ll have to see how their government’s currency control policies will affect the ability of China Orient and other Chinese capital sources to commit additional capital to U.S. real estate investment going forward.

Are lenders overly aggressive right now?
Lenders are tripping over themselves to put out money. Not in a bad way. From 2005 to 2008, lenders were tripping over themselves to put out money as well, but they were stupid about it. Today, they have a lot of money to put out and rates are very cheap, but they’ve been quite disciplined.

Taking that into account, are you eyeing other acquisition opportunities in the city?
Sure, absolutely. We’re very open-minded. We’ve looked for a long time in the Financial District but haven’t found the right opportunity—although we have placed bids on a couple of buildings there. I think there are tremendous opportunities for our strategy in that area, but the difficulty we’ve found is that so many of the buildings there are poorly designed for what we want to do with them. They have bad layouts and awkward corridors and a lot of windows that look out on a blank wall 10 feet away. That kind of space is hard to lease. There are very few buildings that have a good core and basic design to them. When we are made aware of those, we are very interested, but we haven’t been successful just yet. But, the Financial District, Soho and Tribeca are very interesting to us.