Q: How did the fund evolve?

Janus Henderson was formed by the merger of Janus Capital Group and Henderson Group in May 2017. I came from the Henderson side together with the seven other members of the current real estate team. We had a global real estate product at Henderson since 2001, while Janus also had global real estate products, including the U.S. mutual fund, which was founded in November 2007.

The global real estate team consists of eight full time investment professionals. I am based in Chicago with two colleagues, following North American real estate. There are also three team members in Europe and two in Asia, following these regions. The legacy Janus team consisted of two professionals based in Denver. Although the two teams had a different approach, setup and investable universe, we shared a focus on bottom-up stock picking. The two teams had similar inception dates, track records, and a good amount of overlap in portfolio holdings. After the 2017 merger, the legacy Henderson global real estate team assumed management of the legacy Janus U.S. mutual fund. 

Q: How is the fund different from its peers in the REIT space?

The main difference from our competitors is our highly concentrated portfolio construction and targeted active share of greater than 75%. We aim for 50 to 60 listed real estate holdings on a global basis, which is different from most of the fund managers in the space, who often own100 names or more.

Being truly active, investing in high-conviction names, and not being beholden to the benchmark, is at the core of what we do. For example, through our bottom-up research on companies’ fundamentals, we have established the view that retail real estate is a challenged industry, at least for the medium term.

In many markets, especially in the U.S., there is an issue of oversupply, which is reflected in our company models. We don’t find any value in many of these companies. As a result, our exposure to global retail real estate is about 12%, compared to the benchmark weight of 25% in retail.

Many of our competitors, and clearly passively managed funds, tend to build sector-neutral portfolios closer to the benchmark weight. That would mean an exposure of 25% to retail real estate, a level of exposure we find inappropriate on a forward-looking basis. Actually, over time we expect retail to become an increasingly smaller portion of the benchmark through continued underperformance.

On the other hand, we have an exposure of about 18% to industrial real estate globally, while the sector represents about 10% of our benchmark. The sector is attractive from a supply/demand perspective and is driven by logistics and supply chain improvement from retailers’ ongoing investment in ecommerce. In the industrial space, we find many undervalued stocks which we expect to benefit from long-term secular growth.

We believe industrial real estate could become the largest sector in the benchmark over time and our portfolio’s meaningful overweight positioning reflects this. Our goal is to have the right exposure today so that we can benefit from the shift in the market instead of just following it.

Q: What are the advantages of REIT investing? How does it differ from investing in other publicly traded stocks?

REITs were created to provide individual investors with access to commercial real estate. That is an asset class with a lot of advantages, including steadily growing income. Compared to other equities, REITs have the advantage of being exempt from corporate income tax as long as they pay a certain portion of their income to shareholders in the form of a dividend.

Over time about two-thirds of REITs total returns have come from reinvested dividends, so it is an important component of the asset class. We also focus on earnings and cash flow growth, because paying dividends requires supportive cash flow, while growing dividends requires growing cash flow.

REITs have many inherent advantages versus other forms of real estate ownership as well. One big advantage is liquidity, because REITs trade daily on stock exchanges around the world. With listed REITs, you can change your allocation, take out capital or invest more at any time. With private funds or direct ownership of real estate, you clearly can’t do that. If you want to monetize a holding in a building, it takes a long time to list it, sell it and go through the legal process.

Another big advantage of listed real estate is transparency. Major stock exchanges require their listed equities to file audited and regulated financial statements. That’s a level of disclosure that investors can’t get with many other real estate vehicles. Another key advantage is the cost, which is attractive compared to the management fees charged by private fund managers.

I would also mention the high level of diversification across property types and geographies which can be efficiently achieved through global REITs from the first dollar of capital invested. Overall, REITs offer a lot of advantages relative to direct real estate ownership as well as tax and diversification benefits not available with general equities.

Q: What core beliefs drive your investment philosophy?

First, we believe in being truly active and expressing our views in a meaningful way through portfolio construction. We believe that we need to have a deep understanding of companies and real estate markets to take significant positions. Our first tenet is that we are high-conviction managers and we don’t want our portfolios to look like the benchmark.

Second, we believe that there is opportunity in volatility. About 80% to 90% of our commercial real estate is still privately owned in various forms, meaning that we have a lot of data on the private market value of these assets. That gives us confidence in our valuation estimates, because we can clearly observe where the stocks we follow trade relative to the private market value of the assets they own.

Listed REITs can be subject to the short-term volatility that affects all equities and is not specific to their underlying business. An indiscriminate selloff in the equity market, with no corresponding change in the private market value of the real estate, is a real opportunity for us.

Third, we believe that it pays to be selective. For decades, there were no big changes in the real estate sector across the core property types. Now it is different, because the advent of new technology has changed the way people do things. It is beginning to impact the needs and usage of real estate in significant ways including falling demand for retail space, increasing demand for industrial space, changes in the way office space is being utilized, and the advent of entirely new property types like data centers and cell towers. We try to be forward looking and we believe that it pays to be selective. In the current environment, we need to be really careful about what we invest in, not just to follow the benchmark.

To summarize, our philosophy is based on conviction, being opportunistic and being selective.

Q: How do you define your investable universe?

Our universe includes more than just the REITs in the benchmark. We also look at sectors including homebuilders, hospitality management companies like Marriott and Hilton, and data centers to name a few. Our focus is on companies who derive their revenues directly from the control of income producing real estate, not simply just those who have elected REIT tax status. We wouldn’t invest in McDonald’s, for example. Although it owns a fair number of its stores, its business is clearly about more than controlling income-producing real estate. Our overall global universe includes more than 500 stocks. We stick to investing within our expertise, but we will invest up to about 20% of the fund outside of the benchmark.

Q: What is your investment process? How do you narrow down the universe?

We make our stock selections at the regional level, North America, Europe, and Asia, because we believe that the people in the region best know the companies and should be the ones who underwrite and evaluate them. We have three teams responsible for their respective global regions – one in Chicago, Illinois, one in London, U.K. and one in Singapore.

At the regional level, the investment process is a combination of quantitative screening and qualitative stock selection. We make a valuation forecast on each of the 500 companies in our universe across all the regions. The valuation metrics include premium discount to net asset value, or NAV, and the earnings multiple. Overall, both metrics are important, but the weighting may be different depending on the regional characteristics.

At the core of our investment process is our quality adjustment. We assign a quality score to each of the 500 companies. That score is the output of 20 or 30 different metrics. Some of these metrics are more quantitative and some are more qualitative, but they fall across the same broad categories for all three geographic regions. The broad scoring categories include property quality, management, balance sheet quality and trading liquidity.

The quality score is then combined with our valuation forecast for every company and the outcome is warranted valuation. Companies with a better quality score deserve a premium, while those with a weaker score deserve a discount. The warranted valuation level gives us a target price, which we combine with the expected dividend over the next 12 months. That gives us a forward 12-month expected total return, or ETR, for every name in the universe on a quality-adjusted basis. We are somewhat agnostic about investing in companies with higher or lower quality scores. Our goal is to ensure we have captured all the relevant variables in our warranted valuation and then identify and take advantage of mispricing in the market.

The ETR is the starting point for our debate within the team about potential holdings. Through this screening process, we remove a lot of names that aren’t worth further analysis. Then we debate and explore the names that screen well to decide which ones we should own and why. Ultimately, stock selection is a subjective decision, but we have a process that narrows down the field of contenders.

Q: Would you explain the quality adjustment process? What are the key factors in the four categories?  

Property quality encompasses our assessment of the locations of real estate that a company owns within its submarkets, the physical state of the assets, and the point within the property cycle for these assets. Around the globe, every city, submarket and property type can be at different points of the property cycle, so we spend a lot of time evaluating this metric in particular. Those companies owning properties which are in the upward portion of the cycle would get a better score than companies with assets in a down cycle.

The second broad scoring category is our assessment of the management, its strategy, its capital allocation history and its shareholder friendliness. Corporate governance, environmental, and social policy also falls into this category. Our team spends a lot of time visiting company management, touring properties and markets, and understanding the real estate dynamics to produce the property and management scores. Although there is subjectivity in the scores, there are also rigorous rules and definitions behind them.

The third broad category is the quality of the balance sheet, which is mostly a quantitative metric. It includes assessment of debt-to-assets, debt-to-EBITDA, near-term maturities, etc. All these factors result in a balance sheet score.

The final broad category is trading liquidity, which is a key benefit of listed REITs. Some REITs, especially in Europe and Asia, can be thinly traded, so we need to take that into account when arriving at a warranted valuation. While we do invest in less liquid names, we believe that we should be compensated for illiquidity with a discounted valuation

Q: Could you illustrate your research process with a couple of examples?

Rexford Industrial Realty has been in our top 10 holdings for several years already. It is a U.S. owner of industrial logistics real estate in urban, high-density locations exclusively in the Los Angeles region. We believe Los Angeles is among the most favorably positioned industrial real estate markets globally.

We originally identified Rexford in 2015, when its market cap was about $800 million. There wasn’t much sell-side coverage; we learned about the company through our normal investment screening and monitoring process. The first step in this was building a financial model based on company reported financials and using forward looking assumptions informed by our own industry knowledge and research. We spoke with the few sell siders who knew the name and we routinely kept up with private market property brokers knowledgeable on Rexford’s markets as well. The initial output of this activity led us to believe Rexford was trading at a very compelling valuation.

In the next step, we met with the management to further explore its strategy and views on future growth and capital deployment. We toured a number of their assets in Los Angeles. The buildings were not impressive to look at; they were old industrial buildings. But their biggest asset was the location. Rexford probably has the best located portfolio of industrial buildings globally. There was actually negative supply growth in LA, especially in Rexford submarkets. Industrial buildings were being destroyed and the plots were being converted into apartments and offices.

Overall, we liked the management team, its views and its strategy. We were comfortable with the properties, the locations and the underlying asset value. When run through our scoring process, these factors, combined with Rexford’s valuation level, led to the highest expected total return in our universe. As a result, we bought a meaningful position for the portfolio and it’s been a good performer since 2015. It is still one of our top 10 holdings, because we still think it is trading at a discount to true underlying value.

Despite its strong performance, Rexford still has a compelling expected total return. We have trimmed it and added back as the stock has outperformed and underperformed, but it’s always been a large holding since its inclusion in the portfolio.

Q: Why is Los Angeles such a prime market in the industrial REIT space?

The biggest reason is the supply or the lack thereof. In nearly all the major industrial markets in the world, there is at least some growth in supply, even if it is only 1% to 2%. Los Angeles was an outlier as the only market we could find with negative supply. That was really compelling to us, because negative supply is rare, especially in industrial where the demand is growing tremendously.

The assets that Rexford owns are exactly what seems to be most in demand for e-commerce needs and other uses, because they are close to the consumers. As a result of the huge demand and the lack of supply, Rexford has benefited from rapid increases in market rents. Within that environment, Rexford has been buying small industrial buildings from wealthy families, for example. Often these buildings are not professionally managed, so Rexford has been able to create a lot of value by investing capital to improve these assets, and re-leasing the same building, sometimes for double the rent. Their institutional knowledge about their markets has been very valuable in that environment.

Q: How do you construct your portfolio?

Our basis for buying and selling stocks is the final outcome of our investment process, driven by the expected total return for each stock and the team’s subjective views. Once we have the ETR across all companies, we can use it to help determine portfolio weightings. If everything else is equal, we would have higher conviction in names with higher ETR and would make a larger investment in those stocks. But the inclusion of a name is also subject to the team’s internal debate and how it compares to our current holdings. Overall, we use the expected total return as a guide for the portfolio weighting within the regions.

We also have regular discussions within the global team. We find that many trends exist globally in real estate. Often a trend starts in one region, but tends to carry over into the other regions as well. The global perspective is also important for building a cohesive portfolio instead of three regional portfolios. We allocate capital among the regions based on each region’s bottom-up view of its stocks, but we do have some risk controls related to the geographic allocation of the portfolio.

Our benchmark, the FTSE EPRA NAREIT Global Real Estate Index, has exposure of about 50% in North America, 30% in Asia and 20% in Europe. We aim to stay within these percentages, plus or minus 5%, because we believe that by keeping our regional and country exposure close to the benchmark, we can limit unintended risks, such as excessive currency exposure, political risk, or unexpected changes in central bank policies. This helps us avoid risk in areas where we are not experts, like macro forecasting, but take appropriate risk on real estate fundamentals, where we are experts.

While we stay within the boundaries of 5% deviation from benchmark geographic weight, we still have room to opportunistically allocate capital across geographies. For example, early in 2019 we identified a new investment opportunity in the U.S. and instead of funding this purchase by selling any U.S. holdings that we believed in, we sourced funds from European holdings with lower ETR’s and slightly increased our U.S. weight. Any deviation we do take relative to benchmark regional weights are determined not through a top-down view, but through a bottom-up, organically driven process focused on individual security selection – very much in line with our approach as fundamental stock pickers.

Q: What is your sell discipline?

In an ideal scenario, we identify an investment opportunity with high ETR and buy a large position. Then the name outperforms and, as a result, its ETR goes down. As it goes down, we trim the position and add to another position with higher total return. Ultimately, the name will get sold out of the portfolio when the stock becomes fairly priced, because we want to continuously own the best 50 to 60 opportunities in global real estate. Having a comparable ETR metric across all the stocks and regions helps to maintain the discipline of keeping the best names in the portfolio at all times.

Of course, the ETR could get lower not only because of outperformance, but also if something changed in our underwriting. We may get new information that changes our view of valuation and this could lead us to sell a name. Overall, we would sell a holding if it has already achieved the expected results, the fundamentals have deteriorated, or new information came to light.

Q: How do you define and manage risk?

We view risk and reward as the opposite sides of the same coin, so risk is inherent in what we do and risk management is embedded in the process. Through our investment process, we acknowledge risk and aim to price it appropriately. At the underwriting stage, we factor in trading liquidity risk. We would effectively lower the warranted valuation for an illiquid name through our quantitative process. Companies with weaker balance sheets and lower quality properties are riskier and that is factored into our process from the beginning as well. At the portfolio construction level, we limit the region and country risk through limiting the deviation from the benchmark.

In addition, Janus Henderson has an independent risk team, which is a group based in London. They report directly to the senior management at Janus Henderson and act as an independent third party, which assesses our portfolio at least once a quarter. They produce a highly detailed report about different risk metrics on the portfolio and the names we own. They conduct stress tests to highlight risks and to make sure that we understand the risks in our portfolio and are comfortable with them. The risk management team also verifies that the fund is being managed in line with its investment policy. For us, risk management continues all the way from the security underwriting process through the post-trading analytics, both inside and outside the fund management team.