Q:  What is the mission of the fund?

I view my fund as a proxy for income producing real estate in the U.S., which is unlike some real estate funds that are broadly focused from equity REITs and mortgage REITs to home builders and building supply product companies.

This fund gives individual investors a way to access income producing real estate. It is targeted at individual investors or institutions that do not have enough capital and experience to own office buildings, and shopping centers, and hotels, and apartment complexes.

I have been in the commercial real estate business in one form or another for 24 years, since 1990. I began in real estate as a commercial mortgage lender for a life insurance company and for two years in the mid-nineties helped a publicly traded REIT to raise and manage capital to finance real estate operations and development. As the vice president of capital markets my primary responsibility was structuring the debt side of the balance sheet. I worked for the kind of company that I am now investing in. Real estate is a capital-intensive business and making financing decisions is a really important part of managing the REIT.

In 2005, I joined Eaton Vance in Boston to prepare and launch a real estate fund. We launched the Eaton Vance Real Estate Fund in April 2006. I am the sole portfolio manager.

Q:  Why should investors consider investing in real estate?

There are three reasons why I believe every diversified equity portfolio should have exposure to REITs - dividends, diversification, and inflation hedge.

Real estate is an income-generating asset and therefore real estate funds are also income-generating assets. Particularly in the world we live in now—where rates are so low—it is very hard to get yield on fixed income instruments without taking a lot of credit or term structure risk.

The second reason is diversification. Real estate stocks are not highly correlated to other stocks and bonds. Therefore, in terms of constructing an optimal portfolio from a risk/reward perspective, adding un-correlated assets is always going to be good for an investor.

Third, REITS can provide an inflation hedge. If you believe we are likely to see increasing inflation down the road, then it is hard to find a better inflation hedge in the stock market than real estate stocks. I believe this makes a compelling case to include a real estate fund in a diversified equity portfolio.

Consider this: The population of the U.S. has grown at one percent per year for many decades and is likely to continue on that track for several decades. What that means is that on average, each year the country needs one percent more space in which people live, work and shop. More population means you need more housing units and you need more office buildings to house the workers. Developers will not build properties unless the resulting value is greater than the cost to build the property.

Therefore, as the population grows and the existing stock of real estate becomes fully occupied, rental rates have to move up enough to give developers an adequate return on their investment.

That may not be true in the short term. In the short term things can become disconnected. In the medium to longer term, if you have inflation, property values will rise. If costs are increasing then rents must increase in order to provide developers a return. If we lived in a country where the population did not grow, then that cycle could break down.

For example, pick a troubled country in southern Europe. The population is not growing in many of those countries. Therefore, there is no need for new construction, there is no need for developers to earn a return on their money, and there is no reason why rental rates have to be connected in any way to the costs of building. However, in the U.S., where the population is growing, rents and building values have to stay connected over the medium to longer terms.

Q:  What is your investment philosophy?

We invest in a diversified portfolio of real estate companies that we believe exhibit a capable management team, high quality assets with high barriers to entry, strong balance sheets, and that are trading at attractive valuation. It is my belief that over any long period of time, the stocks of good companies outperform the stocks of bad companies.

Q:  What is your investment process?

The investable universe is made up of about 120 companies. It is not like managing a small cap fund, where you have thousands of companies from which to choose. There are really only are about 120 companies that would be appropriate for this fund. I have met with the vast majority of management teams for those 120 companies.

I try to interact with most of these companies two or three times a year. I use those meetings to make sure my understanding of how they are thinking about running their business, what kind of assets they want to own, and how they are going to finance the company is current and listen to any shifts in philosophy.

Additionally, I travel around the country, tour properties, and I meet with local operating people on the ground. I think many real estate portfolio managers spend little time in the field. For example, in December, I spent three days in Tampa, Florida. I met with regional vice president responsible for operations, acquisitions and development at a number of companies. These meetings give me insight into companies that I think a lot of fund managers do not take advantage of because it takes a lot of leg work. I find this personal interaction is a really important part of my process.

Q:  How do you look for opportunities?

As I said earlier, the investable universe consists of about 120 companies, depending on how broadly you define the universe. Over time I identify those companies that I think are really high-quality companies, and that narrows the list to about 60 to 70. Of the 120, many companies either have real estate that does not meet my expectations or the management team lacks vision or the balance sheet strategy is not favorable. I am not likely to own these companies. At any given time I am generally going to own 40 to 50 companies. I own a high percentage of the high-quality companies that are available to me.

Q:  In your opinion, what is a high quality company?

The geographic market and the sub-market inform my assessment of high and low quality companies. Consider these examples of high-quality and low-quality markets. I think there are six great real estate markets in the United States: Boston, New York City, Washington D.C., Seattle, San Francisco and Los Angeles.

These are great markets because there are high barriers to entry in these markets and it is hard to build new properties. The zoning is difficult, the land is generally fully utilized, and the community groups do not like to see new construction. It is ideal to have your assets in areas where the barriers to entry are high.

Also, these markets have high household incomes. There are typically educated workforces with vibrant economies. At any moment in time, any one of those economies may not be doing well. Boston has knowledgeable workforce trained by several universities, as well as life science and technology companies. New York City has the financial services, entertainment, media, and advertising industries to drive the demand. Washington D.C. has the federal government and telecommunications industry that adds to and powers the workforce.

Bad markets are places where there is a flat to declining population, low household incomes, and no barriers to entry so it is very easy to build. Quality does not necessarily mean a good-looking building. It simply means real estate properties have the ability to generate consistent and growing cash flows.

Q:  How do you go about researching and selecting companies?

It comes down to finding a high quality company with good real estate, a good management team and a good balance sheet. Many market participants tend to focus on two metrics, earnings or FFO (funds from operations) multiples and dividend yields.

A lot of portfolio managers want to buy “cheap” companies. These cheap companies are valued low on their stream of cash flow and trade at high dividend yields. My experience has been that more often than not, those companies are cheap because they should be cheap. In many cases, management destroys value through their capital allocation and financing decisions and they do not own quality properties.

Q:  How do you diversify in your portfolio?

I tend to run a relatively sector-neutral fund. From a sector weighting perspective, I generally limit my exposure to somewhere between 50% and 200% of the weight in the index. Shopping centers are about 8 percent of the benchmark. My weighting on shopping centers is therefore generally between 4% and 12% of the fund.

The second constraint is a maximum deviation of plus or minus 700 basis points. Those are both in place. For apartments, which are 18% of the benchmark, I invest between 11% and 25%. I will generally not go outside of that.

I can choose to increase my emphasis on a sector. I do that on a regular basis but I do that in a bounded way. Apartments in theory could be from 11 percent of the fund to 25 percent. More practically, it is more likely to be a narrower range, like between 14 and 23 percent.

My fund has a particularly low turnover rate, with the average turnover since 2006 at about 30%. Typically, when I buy a share of stock, I own that share of stock for more than three years.

Q:  What are the limits on allocation weights?

There is not a minimum position size. I generally want to have at least 50 basis points in a name; otherwise the position is too small to impact performance. There are some names that I maintain between 50 and 100 basis points, but that is a small position. I am constrained by my prospectus not to exceed one-and-a-half times the largest name in the index. The largest name in the index is Simon Properties, which comprises about 11 percent of the index, meaning that 16.5 percent, or one hundred and fifty percent, is the biggest position that I could possibly hold.

The other portfolio constraint is that no position will be greater than 400 basis points overweight—relative to its own weight in the benchmark. So a stock that comprises 3% of the benchmark would generally not exceed 7% of the fund. My benchmark is the Dow Jones U.S. Real Estate Securities Index.

Q:  When do you decide to sell?

I am generally a long-term shareholder and prefer to not sell a security unless the investment thesis is broken. In the end, it is always about relative valuation and if the market price of a security is stretched and I may trim the position or liquidate the entire holding. In addition, whenever management disappoints, generally with respect to capital allocation, financing, or corporate governance decisions, a position is reduced or sold.

Q:  What kinds of risk do you focus on and how do you manage them?

Risk is frequently quantified through standard deviation or volatility. The standard deviation of this fund has consistently been below peers and below the benchmark.

One of the ways I accomplish that is through maintaining a relatively sector-neutral fund and limiting position sizes. It would surely increase the volatility of the fund if I allowed position sizes to be much bigger, or if I allowed myself to make much bigger sector bets. I do not think either practice is a responsible decision for investors in the fund.

The other risk I examine carefully is balance sheet risk, and we saw this very clearly during the financial crisis of 2008 and 2009. There were many REITs during the financial crisis that plunged 95% or more and one large REIT ended up in bankruptcy. My philosophy of owning companies with strong balance sheets results in lower risk.

When the market is going up a lot, my returns tend to lag because in a rapidly rising market, high risk and high beta names tend to lead the market advance. When markets turn negative, these stocks also tend to fall first and fall harder.

We have low beta stocks, which buffets the fund from rapid swings in markets in both directions.