Q: How has the fund evolved since inception?

Duff & Phelps started investing in real estate securities more than 20 years ago and is one of the pioneers in the field. Over time, we expanded our research capabilities outside the U.S. We launched the ex-U.S. strategy in 2007 and the Global Real Estate strategy in 2009.

Our approach to investing in listed real estate securities is based on a global framework. We believe that an allocation to global real estate can tangibly improve an investor’s portfolio by delivering compelling risk-adjusted returns with lower correlation to other investments. Such an allocation provides growth opportunities and the benefit of diversification.

The companies that we select generate their returns primarily from exposure to high-quality, lease-based cash flow with strong dividend growth. The portfolio is inherently diversified across property sectors, while the global orientation provides diversification across a number of countries as well.

Q: Why do you consider REITs to be a good investment opportunity?

The global real estate universe offers large, attractive and growing investment opportunities. The REIT structure was first introduced in the U.S. in 1960, but over time we have seen its adoption throughout the world.

Today, there are about 40 countries with REIT-like legislation. We believe that the opportunity will continue to grow as the securitization of real estate in different countries increases, or as real estate moves from private hands to the public markets.

Q: What are the main characteristics of the REIT structure?

The REIT structure is a corporate wrapper, similar to other corporate wrappers, but with some distinct attributes. These attributes may vary in different countries, but there are universal features, such as the taxation benefits for investors. In the U.S. a company that adopts a REIT structure is a single tax payer, which means that no corporate tax is paid. There is tax only on the distributions from the REIT company itself. To receive that benefit, the companies are required to pay 90% of their taxable income as distributions to the shareholders. Some other features include limitations on the amount of leverage and active earnings associated with development.

Overall, the REIT vehicles are created to provide individual investors with an efficient way to access commercial real estate. As we know, it is difficult for a person to invest directly in real estate assets and to build a diversified portfolio of meaningful scale. In essence, the REIT structure gives investors an efficient way to build a diversified portfolio of quality properties that can provide stable cash flows and dividends.

Q: How do corporations raise capital if they distribute 90% of their income to shareholders?

In the U.S. the distribution requirement refers to the net taxable income. Technically, there is a difference between the operating cash flow and the net taxable income. There is a large non-cash expense, the depreciation expense, which lowers the net taxable income.

The operating cash flow generated from the properties is well in excess of the net taxable income. So, the companies actually have fairly conservative dividend payout ratios. That allows them to retain capital for reinvestments and for maintaining the quality of the properties.

Q: What differentiates you from other funds in the space?

A major differentiator is our consistent approach to defining the investment opportunity set. We primarily seek companies that generate most of their revenue via rent from their owned properties. So we do not invest in homebuilders, commercial merchant builders or real estate companies that depend primarily on management fees.

According to our research, the companies we invest in have historically delivered superior risk-adjusted returns. They offer the characteristics that investors seek when making an allocation to global real estate, such as stable cash flow and dividend growth, low correlation to other asset classes, and some degree of inflation protection.

Another unique feature is our fundamental approach that enables us to identify some of the small and mid-cap opportunities available on an ex-U.S. basis. That has benefited our security selection over time.

The other differentiator is the structure of our team, which is based in Chicago and consists of professionals with deep experience in both private and public real estate markets. In our structure, we have global property sector generalists, so individuals are covering companies across multiple property sectors. This structure has helped our investment and research process by prompting debates around investment ideas.

Q: What core beliefs drive your investment philosophy?

Our investment philosophy is based on four pillars. First, we are bottom-up investors, who rely on a fundamentally-driven investment process. Second, we believe that the value of a real estate security goes beyond the underlying real estate owned by the company, so we focus on companies with strong capital allocation track records and superior returns on invested capital.

Third, we believe that a successful real estate investment strategy requires patience because of the multi-year nature of the value creation opportunities. It is important to identify and invest in the right management teams and businesses at the appropriate point in the economic cycle, but then we must have the patience to allow the opportunity to play out. That belief is reflected in our lower turnover ratio.

Lastly, our core philosophical pillar is being active managers and maintaining that ability. The global real estate investment universe consists primarily of mid and small-cap companies with a handful of large-cap names in the mix. We believe that we should maintain our flexibility to invest, so we’ve committed to a threshold of assets under management. Ultimately, if we reach that threshold, we would close the Fund to new investors.

Overall, the key philosophical aspect is the focus on companies with a strong capital allocation track record, superior corporate governance, a thorough business strategy combined with the appropriate staffing levels, a well-located competitive position in enduring real estate, and a balance sheet that supports the business strategy and the growth of the business over time. Those are the types of companies that we seek to identify, because such companies have outperformed their peers historically.

Q: What are the main steps in your investment process?

We have a fundamentally-driven, five-step investment process, which has been in place for more than 20 years. The first step is identifying the opportunities in the real estate market and the property sectors. We do this by focusing on the interaction between the macro environment, the real estate rental market and the real estate investment market.

The second step is filtering the investment universe through a proprietary ranking system that helps to identify our research focus list. The third step is utilizing our fundamental research for analyzing multiple factors, such as property management, portfolio analysis, cash flow drivers and growth opportunities. Through our multi-valuation process, we come up with an intrinsic value for each business. The fourth step is the portfolio construction process. The fifth step is exercising our sell discipline to make sure that the portfolio contains our best ideas.

Q: How do you identify opportunities at the market and sector level?

We focus on the interaction between three variables - the macro environment, the real estate rental market and the real estate investment market. In the macro environment, we take a global view to identify the better economic and real estate fundamentals that provide the backdrop to the investment opportunity.

Then we focus on the real estate rental market, or the supply and demand in the buildings themselves, to find superior rental rate growth outlook. We always look for opportunities for increases in occupancy. Ultimately, we try to identify the markets and the property types that will deliver superior revenue growth.

On the real estate investment side, we focus on the actual transaction market. We follow where the money is flowing, into what geographies and property types. We want to see if capital is growing for the buildings themselves, because we aim to have a good understanding of the trends of capital appreciation for the buildings.

On the basis of the interaction of these three pieces, we determine our preferences for the geographic location and the property types. We also examine the lease duration, which is an important concept, because the different lease durations imply different levels of economic sensitivity inherent in the cash flow streams. At different points in the economic cycle, we would emphasize shorter or longer lease durations to be more offensive or defensive. It depends on our view about the stage of the economic and real estate cycles.

This step provides the foundation to the rest of the investment process. Our views on the rental markets help our analysts in modeling the cash flows of the individual companies. Forming our views on the real estate investment market helps us with the valuations of the companies as well.

Q: How do you narrow down your investment universe?

We screen for market cap and liquidity at the company level to make sure that the companies are truly investable. We primarily invest in companies that trade at least a million dollars a day and have a market cap greater than $500 million. Next, we screen for business model suitability, which relates to our philosophy of investing in true owner/operators of commercial real estate. Importantly, we apply our proprietary fundamental and valuation scoring system to each company.

We rank the companies on a variety fundamental and valuation metrics to identify the more attractive opportunities and to set our research priorities. From a fundamental perspective, we look for above-average cash flow and dividend growth on a five-year forward basis. Through a proprietary balance sheet scoring process, we look for superior growth, supported with a well-structured and high-quality balance sheet. The companies we look for should provide superior returns on invested capital.

Then we combine the fundamental view with a view on valuation. The idea is not only to identify the high-quality companies, but also the investment opportunities that will provide superior returns. Our goal is to access the better structured growing companies at good relative valuations.

Q: What are the key elements of the third step in your process, the deep research?

The hallmark of our fundamental approach is our property due diligence and the modeling work on the companies. We spend a lot of time visiting the companies, the real estate market participants, the competitors and the private market players, to gain a good understanding of the markets on a local basis. Then we dive deep into analyzing the management teams and the property portfolios of the companies.

The next step is the modeling work. We focus on the cash flow growth potential through the three legs of the cash-flow growth stool, where the three legs are internal growth, external growth and the balance sheet. Internal growth is about rental growth and increasing occupancies that drive the cash flow growth from the existing properties.

The external growth opportunities typically come in the form of property acquisitions, redevelopments, or ground-up development. The third leg, the balance sheet, can either support or be a detractor of growth. We seek companies with well-structured balance sheets, which would support the growth and the business strategy.

In the valuation stage, we focus on four key valuation tools. We combine a forward-looking discounted cash flow analysis, a dividend discount model analysis, a relative multiple analysis and a net asset value analysis. These four tools help us to form a view on the intrinsic value of the business and the total return opportunity.

Q: What is your portfolio construction process?

Once the analysts have completed their fundamental and valuation analysis of the individual companies, they pitch their investment ideas to me and to my co-portfolio manager. The two of us synthesize the analysis of the real estate market with the bottom-up work of the team. We vet each recommendation and the views of other analysts on the team. Ultimately, our objective is to build a portfolio around the highest conviction ideas, while taking into account individual security risk, the fund’s risk management guidelines and other portfolio risk controls.

Our goal is to build a focused, but not too concentrated portfolio that is going to deliver superior risk-adjusted returns. The global portfolio consists of 50 to 70 names and is diversified by property sector and geography. We typically focus on traditional core properties, but we also invest in some nontraditional types, such as student accommodation and self-storage, if we find good opportunities.

Our benchmark is the FTSE EPRA Nareit Developed Index, which is focused on developed markets. Although we have the flexibility to invest in emerging markets, we primarily invest in developed markets. We maintain an upper limit of 500 basis points relative to the benchmark weight for any individual security in the portfolio.

While we don’t have any limits on the exposure to property sector or geography, over time we have been well diversified. At the end of the day, our goal is to create alpha and that’s driven by our security selection, not by large, top-down country bets. We don’t have large country exposures relative to the benchmark.

Q: What is your sell discipline?

The sell discipline ensures that we remain disciplined around a portfolio of best ideas. Most often we would sell a security when it approaches our view of intrinsic value, when a better risk-adjusted opportunity becomes available, or when there is a change in the underlying fundamental thesis. Then we would rotate the capital out of that position.

Q: Would you illustrate your process with some examples?

One example would be Unite Group, a student housing residential company based in the UK. We started the initial due diligence in 2011 and 2012. Through a combination of meetings and property tours in the U.K., we identified the company as a potentially interesting opportunity.

Initially, we didn’t like some aspects of the business structure. The company was involved in modular construction, which wasn’t a core part of the business and its profitability wasn’t strong. In our meetings with the management we encouraged them to potentially look at divesting and focusing more on the core business. Also, the capital structure wasn’t focused enough, because at the time they were using investment partners in the student housing space. In terms of the balance sheet, the leverage was high and not appropriately structured to maintain the growth.

On the one hand, we were very excited about the U.K. student housing opportunity, but on the other, we thought that the company could make improvements. In 2014, Unite Group divested the modular construction business and assumed more direct ownership of the housing assets it was developing. It enhanced its balance sheet, so we made our first investment in June, 2014. Since then we have built a decent size position. The company remains one of the top 10 holdings in the global real estate strategy as of year-end 2018.

As specialists in global real estate, we are well tuned to the companies and the investment opportunities out there. In some cases, we may spend a year or two doing due diligence on the companies, getting to understand their strategies, types of assets, and competitive positioning. We would spend time with the team to understand its depth and quality. If we don’t like some aspects, we may encourage the company to potentially improve in those areas. That’s when we would actually pull the trigger and include the opportunity in our strategy.

Q: Would you give an example of a U.S. company as well?

I would highlight Prologis, a U.S. company that is actually global in nature and is a top-ten holding of the fund. Prologis is a leading provider of high-quality logistics, industrial real estate. The properties that they own, manage or develop are critical elements of the global supply chain and the logistics of moving goods around the world.

We have been invested in Prologis for a long time. Initially we identified their type of property and the strong secular tailwinds to industrial real estate. Today we see significant demand for these properties, particularly from e-commerce and retail companies, which have had to grow and refine their logistics networks. That trend has contributed to strong rental rate growth both in the U.S. and globally. The growth profile of Prologis is enhanced via new developments for core tenants like Amazon.

As the penetration rate of online shopping continues to grow both in the U.S. and abroad, the need for modern, well-located logistics space is in high demand. In the U.S., Prologis is the largest listed owner/operator of modern warehouse facilities. It also has a strong footprint in the UK, Europe, Asia and Mexico and is concentrated in key distribution markets around the world. It is a multi-year, value-creation opportunity.

Q: Do you hedge currencies as part of your strategy?

No, we don’t actively hedge currencies. We begin with the premise that the exposure to foreign currencies is one of the desired attributes of a global investment. In our experience, tactical currency hedging is a difficult and costly proposition. We believe that when investors have a medium to long-term investment horizon, the currency movement will have a negligible impact on the overall performance, particularly when the portfolio is well diversified.

Q: How do you define and manage risk?

Risk management is embedded into each stage of our process, the structure of the team and our philosophy. In step one, we evaluate the best positioned real estate markets. In the screening process, we mitigate the liquidity risk through identifying investable and liquid companies. Another way to control risk is through the focus on the profitability of the business, the return on invested capital, the quality of the balance sheet and the valuation. In the portfolio construction process, we mitigate risk by building a focused, but not too concentrated portfolio. Imposing exposure limits on individual names is also a risk control measure.

One of the enhancements of our investment approach has been the greater focus on ESG and some of the risks and opportunities around it. While corporate governance has always been critical to our fundamental approach, we have expanded into the environmental and social analysis of the companies. That enhancement may also serve to control risk.