Q: Why should an investor consider investing in REITs?
Our view on the Lazard Asset Management Global Real Estate Securities team is that real estate investment trusts, or REITs, can play a role in every investor’s diversified portfolio. Over the period since their creation in 1960, equity REITs have produced a return superior to the S&P 500 Index, while also providing dividend growth ahead of the rate of inflation.
The potential advantage of REITs is that they can produce both alpha and total return, as well as diversification, which may lower their risk. Investors have daily liquidity as well. That’s why we believe REITs are an important resource to consider for every investor who wants diversification and risk management.
Historically, real estate investors had the choice of investing directly in property or in private partnerships, so they were missing the characteristics of liquidity and transparency. In our view, the beauty of the public REIT structure is having liquidity and SEC-regulated disclosure.
The typical public REIT, similar to other publicly traded corporations, reports earnings on a quarterly and annual basis. Investors have the benefit of voting each year for the board of directors and other corporate matters. Over the past 50 years, the transparency and the liquidity of the REIT structure has truly revolutionized real estate investing and the disclosure continues to improve.
Q: How has your strategy evolved? What makes Lazard US Realty Equity Portfolio different from its peers?
Our strategy is focused on REITs based in the U.S. only. Our strategy invests in all property types, including office, industrial, retail, residential, and specialty real estate in all regions of the United States. The strategy originally launched in December 2008 as the Grubb & Ellis Alesco US Realty Fund and was later purchased in September 2011 by Lazard Asset Management.
In terms of differentiation, it is important to note that the Lazard US Realty Portfolio is a fundamentally-driven, high-conviction, highly concentrated strategy. We typically own 30 to 35 common stocks and most of our positions tend to be overweight relative to the benchmark, which has delivered strong active share. These qualities differentiate the strategy among its peers.
Q: What core beliefs drive your investment philosophy?
Our philosophy is driven by and begins with property-level rental performance. We aim to select outperforming stocks, primarily by measuring the fundamentals at the property and the portfolio level. Our view is that rent growth, which is faster than the rate of inflation and the growth of peers, drives net operating income growth, which drives earnings, which drives superior dividend and net asset value growth.
Ultimately, we believe rent growth drives outperformance.
Our philosophy has both growth and value biases. The growth bias is to own the companies that are growing their rents, earnings and net asset values faster than their peers over the long term. That often leads to selecting stocks that trade at a discount to future net asset value. In these cases, the inherent growth of their rental portfolio is undervalued. We believe that, ultimately, some catalyst or investor realization will move the share price up to par or in excess of par value.
Our approach is bottom-up at the property level, but it also has a top-down component. We analyze regional fundamentals and base part of our investment decision on the fact that regional fundamentals can vary widely. We may decide we would like to overweight West Coast or Northeastern property companies, for example. Then, within that framework, we would search for the shares in the individual asset classes, such as apartments in San Francisco and New York, offices in Silicon Valley, hotels in the Northeast, or industrial buildings in large U.S. ports. However, if no quality investment options exist, we generally do not build positions on the sole basis of an “ideal” regional exposure.
This balancing of a top-down and bottom-up approach is essential to our overall philosophy.
Q: How important is the macroeconomic picture for selecting REITs?
Macro analysis is a key part of our approach as well, as our statistical analysis shows a strong correlation between economic growth and property performance. Our core investment principles include real estate analysis and valuation, macro analysis, comprehensive screening, securities analysis and in-depth valuation of senior corporate management, particularly at the CEO position. So, we value at the property level, analyze at the macro level and then evaluate at the human level by analyzing the senior management team of the REIT.
Q: What are the critical steps of your investment process?
Our process is both quantitative and qualitative. The first step is the initial fundamental and valuation screening. The second step is the in-depth growth and valuation analysis. The valuation analysis is both absolute at the company level and relative to the prices of competitors. The third step involves in-depth meetings and discussions with the senior management. Step four is working on the price targets and the total return analysis. Finally, our fifth step is the periodic refreshment of our analysis, which happens at least once a quarter, or upon the occurrence of significant events, or upon the achievement of the share price targets ahead of schedule.
Q: Would you discuss the important metrics in your screening and due diligence process?
A: We screen for both growth and value, based upon year-over-year earnings growth and projected net asset value growth. We also screen on valuation and we use the price-to-net asset value metric. All these factors play a role in our stock selection. Ultimately, for each security that we select for deeper analysis, we make our best projection of 12-month total return and periodically refresh that analysis.
Other fundamental screens, like those based on market capitalization and liquidity, help us to eliminate companies from our analysis. Typically, we do not invest in companies with market cap of less than $500 million. We constantly monitor market cap and liquidity, because when the companies grow, they may enter our investable universe. We make investments when we believe that the security has the right total return characteristics and can produce outperformance.
Along with the analysis, our research process also includes property tours and company visits. We really incorporate both the bottom-up and top-down approach to the selection process. My team benefits from the knowledge and expertise of the over 170 research analysts at Lazard Asset Management, as we are a highly collaborative business. Benefiting from insights across the business, we then take a team approach to both stock selection and portfolio construction. We believe that the contribution of every team member is important and every idea deserves reasonable analysis.
Q: What is the decision-making approach that your fund team employs?
We have weekly portfolio review meetings, where we discuss both macro and micro analysis. We use our screens and we look at year-over-year earnings growth and net asset value growth,
Within that framework, we interact with research analysts across the Lazard Asset Management platform. We are a global platform and have analysts worldwide across industries. We also have a global real estate strategy and the interaction with property analysts around the world keeps us on top of global trends.
Our team has been investing together both in the US and globally for over 10 years. Often we provide input to global analysts and portfolio managers, who invest in property stocks as part of a larger strategy. I believe that this collaboration gives us a meaningful edge over our competitors.
Lazard Asset Management has an inherently team-oriented, highly collaborative investment process and every member of the team is learning every day. We have rigorous analysis, open discussion, as well as honest and robust investment debate.
Q: Could you illustrate your research process with a few examples?
We have been overweighting a few areas for a while and one of these areas is the San Francisco Bay Area apartment real estate. We continue to be impressed by the supply and demand fundamentals in Northern California, particularly around San Francisco and the Silicon Valley. On the one hand, there is explosive job growth and high-paying jobs. On the other hand, there are high barriers to entry for building new housing. That has resulted in dramatically higher year-over-year rent growth for Northern California apartments versus any region in the country.
Our analysis is based on both proprietary and subscription data, actual company visits, property tours and interaction with local brokers and developers that operate in the private market. That’s an example of how we aim to get an edge on property-level developments in terms of actual rent growth.
Another example is the self-storage sector. After extensive industry and property research, we concluded that the rent per square foot in the sector is equivalent to local apartment rents, but the margins are higher. Essentially, the self-storage sector represents concrete and steel buildings, which have twice higher margins than the average apartment, simply because the buildings are relatively unimproved.
Also, tenants tend to stick. Once a tenant rents a self-storage facility, even if they start with a short-term plan, they usually become long-term renters. That results in high margins and dramatic year-over-year rent growth relative to the rate of inflation. Self-storage stocks have outperformed over the last 10 years and we have a long-term overweight in that space.
Q: How do you identify and explore turning points?
We believe the key to identifying turning points in property fundamentals is to keep a close eye on supply and how that supply is delivered relative to the demand and the growth in demand. Once supply and demand are in equilibrium, we try to see where the next change in fundamentals is going to be. If we believe that we are heading towards oversupply, based on our macro analysis and forecasting, then we would decrease or exit a position. Supply and demand fundamentals in the individual markets are at the core of our analysis.
Q: How do you apply that thinking to the retail sector, especially the malls?
We are invested in the retail sector, although we have been underweight relative to the benchmark for two reasons. The first one is the disruption brought by online retail. The second reason is that America has been over-retailed in terms of square footage relative to every country in the world. So, we expect consolidation in this space. We believe that in the long run, there are some attractive areas of retail.
There are high-quality, well-located regional malls that will likely continue to have a strong tenant base. Due to their location, they are easily repositioned into another asset type or a mixed-use asset type. For example, they can reposition to add residential on top of the retail facility or to add premium grocery like Europe has done historically.
In terms of location, regional and neighborhood centers should continue to play an important role in retailing, even as online retailing continues to grow. There is growing demand for physical facilities of online retailers, because of the volume of shipments and the high level of returns. We see more online retailer activity within regional malls and neighborhood. Online retailers either take spaces as tenants or organize partnerships with existing retailers that act as a facility for customer returns or foot traffic.
These are areas, where we see future opportunity in retail. But there is no question that the disruption is going on, as evident from the relative underperformance of the retail sector over the past three or four years.
Q: How do you construct the portfolio? Does diversification play a major role?
We manage a concentrated portfolio, where our heaviest overweight investments reflect our highest-conviction, 12-month total return expectations. Nevertheless, diversification plays a meaningful role. While we are concentrated in terms of the companies, we believe we are amply diversified across property types and regions. We own shares in residential, industrial, office, self-storage, manufactured home communities, data centers, healthcare, lodging and retail. We also own companies with nationwide portfolios and built-in regional diversification, as well as companies with concentrated regional portfolios.
Q: How do you identify high-conviction ideas?
We constantly monitor and evaluate company and market conditions, because capital market factors can drive short-term underperformance. More importantly, we believe our knowledge and evaluation of REIT CEOs also give us an edge. We have known most of the CEOs in the sector for the entire length of their tenure, or anywhere between 10 to 25 years. In some cases, we have known CEOs before the company went public.
In our view, that’s a significant edge in investing, because when you understand the CEO’s behavior and decision making through the market cycles, we believe you have the potential to become better at predicting how the company may react to events and what decisions it may make in challenging market conditions.
These decisions can include asset sales, share repurchases, raising or lowering the dividend, raising equity, issuing debt. In some cases, when market conditions are tough, the company may acquire land at a discount and begin a new development with longer-term horizon.
I believe that the better you know the CEOs and senior management teams of the REITs, the better you can predict their key, value-creating activities. That gives us an edge and a significant advantage versus our competitors.
Q: What limits do you have in the portfolio and what is your benchmark?
Our benchmark is the MSCI USA Core IMI Real Estate Index. We are highly concentrated, so we tend to own between 30 and 35 companies in our portfolio.
We have a limit on individual positions of 500 basis points relative to the benchmark, but in reality our highest conviction ideas tend to be 300 to 400 basis points over the benchmark. Typically, we have 10 to 12 positions ranging from 200 basis points to 400 basis points over the benchmark. Regardless of the concentration, the weightings reflect our total return expectations. Upon that framework, there is an overlay of diversification across property sectors and regions as well.
Q: How do you define and manage risk?
Risk management has always played an important role in our investment selection and the portfolio construction process. We have rigorous and regular risk analysis. For us risk is the probability of investment loss and underperformance. That risk is omnipresent and constantly changing, so we regularly evaluate it.
We do this internally and independently as well. One of the advantages of being part of the Lazard Asset Management global platform is that we have a high quality, independent global risk management team, which regularly reviews our portfolios.
We have portfolio review meetings weekly, sometimes more often, and risk management always gets attention and plays a role both at the individual company and the macro level. As part of our risk management, we constantly evaluate supply and demand across property types and regions.
Generally, if we see new supply in a particular sector or region, our awareness of risk increases and we pay closer attention. If we believe that at some point the supply will begin to exceed demand and rent growth will slow down or become negative, we would reduce or exit the positions well in advance. That’s an example of a one-time risk that’s inherent in publicly-traded, property-level investments.
