Q: How has the fund evolved over time?

The fund opened in late 2009, when we were just coming out of the global financial crisis, which had significant impacts in the real estate arena. As an investment management firm, we have been around for over 40 years and we had evaluated and invested in real estate, but we did not have a dedicated real estate product. In 2008, when we saw the developments in the real estate markets, we began to prepare for what we thought was a good buying opportunity. We didn’t view it as a trade but as a good time to start.

Our approach towards real estate is based on the fundamental investment philosophies of our firm. For example, when we consider purchasing an investment, we look at the cash flow that the investment generates today and going forward. We also examine what factors may affect that cash flow stream. We are looking not only at the sustainability of cash flow, but at the potential for growing it. The important factors include the competitive alternatives, whether there is new supply coming, whether demand is greater than supply, and how that affects the pricing power.

Real estate is a highly cyclical industry, so we need to be aware of our position not only in the economic cycle, but also in the various property cycles. In 2009, we were in the midst of a large residential housing crisis, which certainly had an impact on the way we initially positioned the fund. I believe that we are experienced and adept in managing through cycles.

Q: What are the core beliefs behind your investment philosophy?

We are cash-flow driven, price sensitive and focused on quality. Our investment philosophy is driven by a cash-flow framework, where we need to understand the size and the growth potential of the expected cash flow stream. Then we can decide what we are willing to pay for it today.

For us, real estate is all about the cash flow and, more specifically, the cash flow that the owner gets to keep. That means not only the earnings but looking at required reinvestment that reduces the cash flow available to investors. Well-positioned real estate represents a unique asset with a contract, which guarantees revenues for a period of time. So, there’s some degree of expected certainty in the cash flow. Hence, we try to understand the long-term, free cash-flow generating capabilities of an asset.

We evaluate the entire spectrum of real estate, including residential, retail and office real estate. Within the residential segment, there are apartments, single-family rentals, manufactured housing and some would include student housing. There are many different categories and subcategories. We break them down and we try to understand where the free cash flows are likely to be sustained and growing.

I think that it is essential to be fundamentally driven and to keep the focus on the business and the cash flow drivers. The qualitative aspect makes sure that the investments are in areas that we view are the strongest. We look at fundamental drivers and we make active investments only if they fit our strategies and match our pricing discipline. We look for opportunities to overemphasize these sectors and property types in our portfolio. Conversely, we avoid or de-emphasize the areas, where we believe that the valuation is excessive and the opportunity for decent returns is poor.

For us, it is important not only what we own, but also what we pay for it. We look at the universe of attractive investments and compare them with their current valuations to find opportunities for investment. So, we are valuation driven and we need to know each investment qualitatively and quantitatively. The idea is buying the REITs when they present an opportunity to earn risk-adjusted returns.

Q: How does your investment philosophy translate into an investment process?

We have a team of analysts dedicated to the fund and a group-based decision making process. Each of us covers different sectors in the market, but we have the broader portfolio responsibility as well.

We build the portfolio one security at a time, although certain sectors will have a bigger weight sometimes. So, we select the securities one at a time; we build a model and we make individual recommendation for each security. We come up with analysis about the economics of the property type and the financial model; we evaluate what the cash flows are likely to be. Then we come up with a discounted format of what we think the asset is worth today. We do that for every REIT or security that we own. Then each recommendation is reviewed by all the members of the group.

Q: How important is the macroeconomic environment? Do you look for themes or trends?

There are three “environments” that you need to be aware of: 1) the real estate cycle for the property you are evaluating; 2) the macro environment which can impact demand 3) the interest rate environment. There are inter-relationships between all three of these factors.

Regarding individual themes, we have evaluated all the individual property types historically. We have ranked them from the most consistent, highest-quality property type, to the most cyclical, lowest-quality, commodity property type. To quantify the quality, we need to look at which property type is likely to generate the most consistent, least-cyclical, growing stream of cash flow. That’s our goal on the quality metric.

Within the individual property types, there are also factors that are indicative of the quality. For example, in office real estate, the central business district in major gateway markets is perceived as a premium asset. For example, the General Motors Building in New York and the Salesforce Tower in San Francisco would be considered high-quality assets in office real estate. On the other end, a suburban office park in a non-land constrained area could be viewed as more of a commodity type of property.

So, we look for the highest quality property type not only in the absolute sense, but also within the specific property type. Every recommendation that we bring forward has some measurement of quality on both of these formats.

Q: How does the analyst team work? What is the decision-making process?

There are four analysts and there is some overlap in the property types they cover. Retail and office real estate are large areas, so two people may work on them. The primary coverage is assigned to one analyst, who regularly updates the group on the developments in that property type, but everyone is free to make recommendations when he or she finds opportunities. Generally, it is a process where the analyst makes a recommendation, that includes a write-up on the future outlook for this property type, an outlook for this specific portfolio, his or her expectations for earnings, and a cash flow model that we use for valuation purposes.

Then the group discusses the recommendation. We often poke on areas such as the outlook for competitive supply, the effectiveness of the company at re-leasing the existing space, the re-leasing spreads, etc. We check if the qualitative argument stands up to the quantitative result that we see and expect for the future. Then everyone in the group votes. Overall, it is a group process. We don’t need to be unanimous, but we need a majority vote to make a decision.

Q: Could you give some examples that illustrate your research process?

Healthcare REITs represent one of the large real estate areas and there are different variations of healthcare REITs. One group is related to senior housing, which could be everything from nursing homes to assisted living facilities or independent living. Another group, which is a small subset of healthcare REITs, is the research facilities like lab spaces. A third group is medical office buildings such as outpatient surgery centers. They are not in the hospitals, but provide doctor’s visits, minor medical care and outpatient surgery. The final and largest part of the industry is the large conglomerates, which own pieces of all the other three groups.

Right now we don’t want a lot of exposure to senior housing, although the demographics will eventually be a tail-wind. As the population is aging and there are many people in their 70s, the average age of the people in these facilities has been increasing as well. However, many new facilities are being built in anticipation of this growing demographic trend. We feel that there is too much incoming supply for the level of current demand and that’s not good for pricing. So, we avoid that segment of the market. We have limited exposure to the area and we want to deemphasize it because of our expectations.

However, we have a reasonable exposure in other segments, such as medical office buildings and lab space. We believe that they are attractively valued in absolute terms and are in the right place from a qualitative or strategic perspective. That’s where we want to have exposure.

We made a decision based on the top-down thematic view of demographics and outlook for the industry. We looked at the actual data of incoming supply and formulated our investment views on how to position the portfolio. That’s an example of the investment process and the decision making on a whole sector.

We have small exposure in companies like Alexandria Real Estate, but it doesn’t provide enough upside to make it a big position. However, we think it’s a solid, well-positioned company. We also own Physicians Realty Trust and Community Healthcare, which are medical office buildings that we believe are both attractively positioned and valued.

Q: Do you have exposure to areas such as retail or industrial logistics?

We had a healthy exposure to the industrial space in early 2018 for several reasons. First, we believed that certain factors in the U.S. retail space were leading to increased demand for industrial space. That is because online sales require more industrial space than sales at a brick-and-mortar store. So, if online sales were growing, the demand for industrial space was growing more rapidly. The demand for industrial space was just one factor.

There are some regions, where the available space is limited around major ports like Long Beach and some of the ports on the East Coast. It was more difficult to add well-positioned industrial space there. We believed that the demand growth, combined with the limitations on supply, was resulting in a constructive rent environment, so we were positioned accordingly.

As the year progressed and these factors started to play out, some of the industrial stocks were strong performers. However, when the valuations began to get elevated, we started to reduce our exposure from a large overweight position to an underweight. The decision was based solely on valuation, as nothing changed about the companies or the strategy. While we still have exposure to a company like Prologis, which is a large global industrial company, it is smaller exposure than in the past.

The U.S. retail space is another area, where we have been very selective. Malls are a big part of the U.S. benchmark, but we have had major concerns about the financial health of some mall-based retailers, and the impact this could have on demand for space - especially at lower-quality malls. Instead, we focused on companies like Simon Property Group, the largest U.S. mall retailer, which has done a good job of upgrading its portfolio over time and staying with the highest-class assets. The problems hitting the malls were having a disproportionately big impact on the lower-quality malls, so we focused on investments in the higher-quality areas.

Q: What is your portfolio construction process? Do you follow a benchmark?

We are benchmark aware, but not benchmark driven. We have owned securities that are not in the benchmark, such as timber REITs and infrastructure REITs. Cell phone tower companies are not in the MSCI REIT Index, but we believe are driven by similar factors. Their characteristics are similar to real estate and they provide some unique growth opportunities. On the other hand, we may have no exposure to certain sectors of the benchmark, if we don’t think that they present interesting opportunities.

In our portfolio construction process, we look for dependable and growing cash flow streams and an upside in absolute terms. We use a discounted cash flow model to estimate the discount to fair value. Our position sizes depend on the opportunity and the upside potential. An area may be a large sector of the benchmark, but we wouldn’t own it if doesn’t meet our requirements. The names that we do like may become larger position sizes because we use a quality argument.

The position sizes also depend on the size of the companies. We have invested in companies that have recently come public and have gradually added to them. We have smaller positions in small companies and, as the companies grows, we would add to these positions. I have no problem to have a small position in our portfolio in a small, but high-quality company.

Right now we have about 60 holdings in the fund. Four of our holdings are over 4% each, so they take up quite a big part of the fund. Large positions for us are 5% and we currently have two holdings that are approaching that size.

Q: What are the drivers of your sell discipline?

There are several main reasons to sell a security. The first and the easiest reason to sell is when an investment hits our estimate of fair value or gets overvalued. The difficult reason to sell is when an investment is not playing out the way that we thought or when the original thesis is no longer valid.

In these situations, we revisit our assumptions and our model. When the assumptions have changed, we need to rethink the situation at the current price and to make adjustments. So, for example, if anticipated rent increases are not coming through or new competitive supply is being built, or reinvestment is required we need to re-evaluate. We have the benefit of investing in liquid assets and we can adjust our portfolio at minimal cost. So, if there are changes in the price or the conditions, we’ll make adjustments.

Similarly, if the story starts getting better, we may add to a position. We look for more attractive ideas with more upside, so new ideas may also force sell decisions on the other side. There’s a finite pool of money to work with, so we are always going to invest in our best ideas.

Q: In your view, what is the benefit of active management in this specific field?

Some of the larger REITs have strong influences on the index, but don’t provide the quality metric that we would like and there is no allowance made for over/under valuation. For example, in healthcare, there are diversified big companies, which don’t provide the investors with the ability to target their investments as much as they would like. You often get exposure to assets you would like to avoid. So for us, it is less than an ideal situation.

I think that the only way to make real investment decisions is to know what you own and to be very careful about it. An active manager is crucial for avoiding areas of danger or speculation that we tend to get later in the cycle. Passive investing leads to buying whatever has the biggest weight and I think that is a dangerous approach, especially later in the cycle.

Q: How do you define and manage risk?

We analyze the positioning of our portfolio to be aware of how cyclically sensitive or growth oriented we are. To have a sense of the risk, it is important to evaluate the industry concentrations, the types of companies and the degree of leverage in the portfolio.

I believe that due to our valuation approach of discounting cash flow streams, we are more reflective of the absolute pricing orientation. That gives us a sense of the areas of overvaluation and speculation, so we can tilt the portfolio away from these areas. The absolute pricing orientation allows us to see the risks built into the market in terms of speculation. Through our process, we see when certain areas are becoming very expensive and we can start to decrease our exposure there. And being active is another way of combating risk.

Of course, in investing, by definition you need to take some risk in order to earn returns. But we need to know what risks we are taking and where we are taking them. We do that through a multitude of models that look at sector positioning, asset quality, leverage, and valuation as factors to evaluate continually. A passive investor looks at one thing – weight in the benchmark.