Q: How has the REIT industry evolved in the last two decades? A: The real estate investment trust market has grown at least by a factor of 10 in the last two decades. The modern era of the REITs was launched in the early 1990s, when Kimco Realty Corp. went public, followed by a wave of new companies listed on the stock exchanges. After the real estate recession in the early ’90s, banks suffered heavy losses, and there was no financing available to many overleveraged, privately owned real estate companies. The only way for these companies to repay debt or find liquidity and take advantage of current market opportunities was to go public. At the time, there was talk about market status and most experts held the view that family owned businesses were just dumping their weak enterprises on gullible investors. In reality, these once privately run real estate companies were over-leveraged, and public investors were able to get access to them when they needed to restructure their balance sheets. During the next two decades, the real estate business transformed from a private cottage industry, where the developer and the broker had a unique advantage in a local market — and it was a local game where financing was done by the bank, leverage was very high, and there was direct investment in properties with really no liquid alternative — to a public industry where information is uniformly available to all investors, companies have access to multiple channels of financing, balance sheets are less leveraged, and a high level of overall professionalism runs throughout. Today, the REIT industry owns about 10% of the entire investment market cap of the United States and has gone from $50 billion in market cap to $600 billion. These companies are accessing capital on a global basis. Today they have numerous ways to grow — internally and externally, from joint ventures and development, through acquisitions, and even by taking some overseas risk for a number of the healthier companies. As the industry has evolved and expanded, it has become more professional. Investors are not just REIT-dedicated investors; there are at least 22 real estate companies in the S&P 500® Index, and REITs are a mainstream investment today. There are multiple domestic funds, global funds, and income funds all dedicated to the REIT space. In the last decade, we have seen a surge in REIT legislation in a variety of worldwide jurisdictions that has created an even larger market that’s close to a trillion dollars in global real estate value. So REITs have come a long way, and the industry can continue to grow because this is the most efficient way to own and operate real estate. I think the public market places a governor on capital allocation and REIT management behavior, which is good. These are now companies that happen to own real estate, and they have to act in and follow the orders of the capital markets. Q: How has the management of these companies evolved in the last two decades since the industry has grown from a local to global stage? A: We believe this is an ongoing issue in some cases. Many real estate companies are very good real estate operators, but they are not necessarily the best capital allocators. Coming into the recession, they were overleveraged — they had too much development both in the U.S. and Europe, but I think they have learned a lot. Today, the leverage levels are down, the development pipelines are far smaller as a percentage of assets, and these companies seem to have learned their lessons. Q: How is your investing approach in REITs different, and how securitization has changed the industry? A: We believe real estate pricing is driven by two factors: first, the fundamentals, which are a lagging indicator, and second, the capital markets, which are a leading indicator. The fundamentals are determined by local demand and supply factors, whereas the capital markets — specifically the changes in the cost of debt and equity capital — directly affect real estate valuations. The reason we think about it this way is that previously, as a primarily private industry, it had little worry about the capital markets. Now that it is a participant in the public domain, where there is access to unsecured debt, securitized debt (like commercial mortgage-backed securities), convertible securities or preferred, REIT management teams have to understand when capital is cheap and available and take advantage of it compared to what the stock price is doing. Q: Why are the capital markets important? A: Many investors look at the world of real estate securities and believe it’s all about the real estate, but that’s not the whole picture. Investing in real estate securities is really about understanding the real estate fundamentals, combined with how the capital markets view real estate. Capital markets are important because real estate securities, REITs in particular (in which we primarily invest), are leveraged six times debt-to-EBITDA and by law they have to pay out 90% of their taxable income. The REIT structure forces this, so we believe that understanding access to capital and how that re-prices real estate is essential to a comprehensive approach to investing in the sector. Most corporations have very high free cash flow. They’re not forced to pay out 90% of their taxable income, they’re not leveraged six times debt-to-EBITDA, and many don’t have any debt, so they don’t have to worry about the view the capital markets are taking on their stock. They can generate cash and have financial flexibility during difficult times whereas REITs cannot. REIT earnings fell only 11% from the fourth quarter of 2006 to the first quarter of 2009, which was basically the extent of the downturn. Not that bad given the severity of the recession, but REIT stock prices fell 72% peak to trough. Why? Because the capital markets cut them off. They couldn't refinance debt, couldn’t fund development, and couldn’t spend money on cap ex to improve properties, so the bottom fell out. I think this is extremely important and, when you look at it historically, that’s what has driven real estate securities. Over the last two decades, the cost of capital for REITs has fluctuated quite a bit, but the fundamental cash flow in the industry has been fairly stable. Our ability to look at real estate securities from two angles — fundamentals and capital markets — is one of the things that differentiate us from other real estate investors. At Delaware Investments, we look, as I said, not only at the fundamentals, but also at the capital markets. Securitization and technology have made information far more available to all investors. When this was a private industry, the broker and the developer had all the information, and they weren’t forced to reveal it. Having people on the ground and seeing every property was essential. Today, whether you have offices in Tokyo, New York, or Sao Paulo, the information disclosure allows all investors to have access to the same information in real time. That allows us to execute our investment process with far fewer people, and to be more nimble and flexible within our process or in response to a specific opportunity. That’s our approach and some of the factors that differentiate us from our peers. Q: How do you translate this investment philosophy in the investment process? A: First, we want to understand what is happening in the real estate markets. Where we differ, and as we begin the investment process, is that we believe that real estate is inherently a spread business, not a growth business. It’s similar to a bank where you want to finance at 4%, where a lot of REITs are getting 10-year money and cap rates are at six — a positive spread. You can make a lot of money levered up six times, so you don’t need growth as a critical success factor in real estate; you just need inflation-type bumps in your leases to do well over the long term. So you finance it at four, you invest at six, lock in the spread — meaning the duration of your debt is equal to or close to your lease duration — and then you manage the credit. It’s a very straightforward business, and understanding where we are in the cycles is of utmost importance. We begin by asking: Are the credit markets favorable for real estate? Then we go through a decision tree. If they are, how wide are the spreads? If they are very wide, then we want to invest in stocks that have cheap valuations and are trading at the largest discounts to net asset value (NAV). If they’re at average spreads, which is where they have been historically, we just want to identify the best overall relative value and have a healthy balance of conservative and aggressive types of positions. If the markets are not favorable, like in 2007 and 2008 when spreads were tight, or when actual cost of money is higher than the investment yield and you have a negative spread, you’re financing at six, investing at five, and hoping for growth. First, hope is not a strategy. Second, any time you invest based on growth in real estate, it generally doesn’t end well. If the environment is like that, this tight-to-negative spread, what we want to do is focus on available cash flow, increase the duration of the portfolio (meaning longer leases), be wary of balance sheet risks and those companies with short duration lease rollovers or high development, and don't bet on growth, just bet on spread. It’s important to understand where we are in the cycle. Based on that, we begin the investment process to try to take advantage of the current environment. I can’t predict the future; all I can do is observe the environment today and build a portfolio to best take advantage of that. So that’s our macro view and it’s really the same when we’re investing globally. If anything, we need to be even more careful about the credit environments in smaller jurisdictions, because their financing isn’t as sophisticated as it is in highly developed countries and localities. Our valuation screens typically begin with a minimum of $100 million market cap; that’s the cutoff. We look for liquidity of 10 days, so buying and selling within that 10 days, and data availability, or how much information or disclosure companies are willing to provide. I started in this business in 1993 before the two decades of IPOs. I talked to a lot of these management teams about the need for more disclosure. I asked for lease information — how much is rolling over, what’s the current rent, what are spot rents in the market. I asked for more information about external development pipelines, external growth, and debt maturity. Unfortunately most of this information was not available during those early years. Now most REITs provide a supplemental package that’s a half an inch thick every quarter. It’s important to really understand the data they provide. We begin with the screen of about 150 to 160 domestic REITs. Then we begin screening for relative value based on price to NAV, relative multiples, cap rates, price per square foot or unit — is it above or below replacement cost? We focus on those stocks that sell at a compelling relative valuation to their history and their peers based on these metrics and, most importantly, we want to understand if these companies generate a return above their cost of capital. So as we go down the valuation screen process, we should have stocks that are statistically cheap with good downside protection. We spend 80% of our time on step two of our investment process: fundamental research. We look at three key questions: Why is this stock cheap and is it temporary or permanent? Meaning, is it a value trap or is it a value and what’s the event or change element that’s going to create some upside in the stock? As we go through our screening process, we’re generally looking at about 75 or 95 names with which we’re very familiar. It’s not as if REITs pop up every day. They are in and out of the market cap range the way small or mid caps are. We know the names; historically we know, but we’re just trying to look for that edge. Next, we go through this dual bottom-up process. We begin with the property analysis. What is the franchise on the ground worth today? We retrieve private market cap rates. We get background from current transactions. We have lots of discussions with brokers and with management. We look at sell-side research, at supply and demand metrics. We ask lots of questions. For example, what is the inventory of apartments coming up in Texas today? What’s the demand? That’s really based on the job market. What’s going to drive higher use for real estate? If needed, we’ll conduct an onsite property assessment, which is basically one trip a year to different regions domestically and globally. We feed all of that analysis into our financial model (Net Asset Value model) and try to understand the value of the franchise today. Is the stock price above or below the NAV? Once we have an understanding of where the stock is valued, we begin this overall capital markets view, which is really the security analysis. We look at lease rollovers and internal growth, and we project external growth through the company’s ability to acquire and to develop, and potential joint ventures. In that external growth analysis, we’re looking at the capital structure. This is where we’re different from many other managers At Delaware, we manage $125 billion in fixed income assets (as of Dec. 31, 2013) and have a great deal of expertise in the unsecured debt markets of REITs, CMBS, convertibles, and preferred. Our discussions with our fixed income colleagues help us understand the cost of capital for every REIT that we’re analyzing and the potential cost given where the debt is traded. We get a full understanding of debt maturities, cost of money, and, given that, if a firm can execute on an external strategy. While we’re doing this, we’re also talking with management teams to make a qualitative assessment of them. We try to meet at least twice a year or talk on the phone. During this process we’re trying to figure out two things; does the management team have a strategic vision and what are their long-term goals? The way we qualify a management team as good or subpar is determined by how skilled they are at the real estate level. Are they good at leasing, acquiring, developing and managing assets? How good are they at capital allocation? We feed all of this into our financial models, and then we have a team discussion about the potential opportunity in this particular security. We’re always talking informally, but we have a formal Friday morning meeting where we go through this analysis. The goal is to understand the overall business model and look at the valuation on a relative basis. This gives us the ability to make a good decision. Once we go through this process, we have a good relative valuation stock with low downside. We’ve done a fundamental review and answered the three questions, and now we use the same metrics of price to NAV multiples to try to calculate and forecast the upside for this particular security. The portfolio construction is the third part of the process. Our portfolios typically hold 45 to 55 stocks. We identify those companies with the most upside and weight them accordingly. We’re usually well diversified across sectors and regions, at least here in the U.S. We have some hard rules to manage risk. We have a maximum stock weight of 5% or 250 basis points over the FTSE NAREIT Equity REITs Index, whichever is greater, and our sector weight ranges go from 50% of the index weight to 150%. We live by these rules — they’re guardrails that help keep us in check. We also have a strict sell discipline that’s based on price to NAVs and multiples of cash flow price ranges. While we don’t get fixated on one price, and our sell discipline is based on relative pricing versus other opportunities, we focus on other factors including (negative) changes in fundamentals such as a cost-of-capital disadvantage or a deterioration in cash flow, very limited growth internally or externally, or management changes we see that are not to our liking. So that’s our investment process in a nutshell. It’s a four-step process that begins with screening. Step two is fundamentals, step three is portfolio construction, which, to me, is about managing risk, and step four is being strict about the sell discipline. We use proprietary software to monitor performance attribution, what factors are working and not working, and our quant team helps us try to decompose risk as well during that process. Q: What real estate do you consider to invest? A: We’re invested across the board in all sectors: retail — both shopping centers and malls — office, industrial, multifamily, manufactured homes, healthcare, lodging, self-storage, specialty, and freestanding buildings with triple net leases. We are diversified across various types of real estate and across various geographies. The companies may change but geographic exposure hasn’t changed markedly. There may be a few percentage points difference, but around 50% of the portfolio has always been in the Northeast, the Pacific, and the mid-Atlantic. Why is that? In those locations, the properties tend to hold their value better over the long term because they’re bounded by oceans on one side. In the middle of the country, there’s land everywhere. Now, there are periods where Texas will do very well because it’s an energy growth market, but you can also get a lot of supply coming online in the Sunbelt, Texas, and Florida. In Southern California, New York, Boston, and Washington, D.C., supply is more limited, it’s more expensive, permitting is more difficult, and there is less space, so it tends to hold value. Supply is not the determinant of value over time. Diversification by property, by property type and by geography are also important. Q: How have real estate development concepts changed with the emergence of, first, direct mail and now, online retailing? A: There are certain concepts that are hurt, like Best Buy, and you can see what’s happening there. Lots of consumer electronic goods can be sourced without touching and do not need a physical retail format. If you look at a store like Best Buy, it could probably be a third smaller. The bookstore has largely migrated online. But this has been happening all along. When the catalog business came along, people said, “This will be the end of retail; I can just sit at home with a catalog.” But that hasn’t really happened. It’s just an evolution of the business model. This is not different from where we are today with the Internet. Certain concepts will go away, and others will come to the forefront. There are always new concepts coming. If you have well-located real estate, class A, malls like here in King of Prussia (PA), the Mall of America, the Mall at Short Hills (NJ), or Dolphin Mall in South Florida, which are destination areas that provide great shopping experiences, they’re going to do well and thrive regardless of the environment. You also have some shopping centers, the necessity shopping, that still needs to get done. Most people buy groceries in store. You can’t go buy cupcakes online; you can’t get your nails done online. Certain necessity-based shopping isn’t going away, but consumers can go on Amazon and see what concepts they can buy online and what they can’t. There’s always change, and if we’re buying companies that have well-located real estate with good capital structures and management teams who see these changes, we can take advantage of the changing landscape. Q: What is your research approach? A: We understand that we’re investing in companies, not directly in a building or mall. Those companies might own many, many direct real estate investments, but we’re looking at the company. We let that company do the work of deciding in what real estate to invest, while we implement the process we just described to evaluate the company itself. As a portfolio manager, I might visit a few properties of any given firm in which I’m investing to get a solid sense of how that company operates. But our approach is really centered on the fact that our investments just happen to own real estate, and by understanding management’s views, visiting a few properties, and not spending our entire time on the road trying to understand every property, we can make an educated and informed decision about that investment. It’s a different analysis. It’s not direct investing; it’s investing in securities, and so our focus is on understanding managements and their strategies. We get the financial information as quickly as anyone else. We have the expertise in unsecured debt, CMBS, preferred, and convertibles equities that more fully inform our research on any given company. While we also have real estate expertise, we believe that to be successful over the long term, our research approach has to look at the entire cap structure as well as the capital markets. When you’re investing in real estate securities, you have to invest in the entire capital structure, and you can just ignore it and say “I know the real estate, because the real estate is no longer just priced at the real estate level, it’s priced in the capital markets, and at the end of the day that’s what we’re buying.” This is what has allowed us to be very competitive and outperform our peers over the last five and 10 years. That differentiated approach is based on the fact that changes in the direct real estate market lag the credit markets. Q: How were the two real estate crises of late ’80s and six years ago different? A: The REIT industry really didn’t exist in 1989. It was very small and more private, so you can’t really compare what happened. However, during the recent housing market crisis, clearly we overbuilt and extended credit to individuals and entities that should not have received credit. We were too aggressive and overleveraged. And the commercial real estate crisis of the late ’80s wasn’t a real estate crisis; it was a liquidity crisis. So when the spigot was turned off, these companies were over-levered; there had been too much development, and they had nowhere to go. They couldn’t go to the equity market, they couldn’t go to the unsecured market, and they couldn’t go to the banks. There was no financing channel. This is why understanding the capital markets is so important. A real estate guy will say there’s 95% occupancy in the building, so you don’t see any issue, but the stock is down 72% from peak to trough. You missed the whole point. It wasn’t a real estate cycle that went down; it was a recession in real estate fundamentals. It was really no different from 2002, the last recession we had. It was a capital markets crisis, a crisis in confidence in the system, and real estate took the brunt of it because at six times debt-to-EBITDA, those conditions don’t generate cash flow. Q: Why did real estate stocks rebound sharply in 2009, soon after the crisis? A: They rebounded because the liquidity mechanism reopened through different liquidity instruments, and the U.S. lowered rates and created the Troubled Asset Relief Program (TARP). It all helped. So when you think about cost and availability of capital, the cost didn’t matter in this case. Just the fact that capital became available made everyone breathe a sigh of relief. They said, “Oh we’re going to survive,” so the stocks took off. It didn’t matter what the cost of the debt was, that you could just access it meant you were going to be around and, yes, maybe things were more expensive for you in terms of financing, but you were going to survive. The stocks were still oversold, but that’s what caused them to come back. I just want to point out something about risk management. It’s not just in the portfolio but it's how we think about it. It’s not just the real estate. We think about three arrows of risk management. One is the market. What’s the overall market risk? How do capital markets view real estate? Is capital available? Is it cheap or is it unavailable and expensive? That’s important. So we think about it in a market sense. Then at the company level, is this company selling above or below NAV? Above or below replacement cost? Does it have access to capital? What do we think of management? Then we think about the real estate itself. What’s happening at the real estate level in the markets? How is that going to affect the company? I think that’s important; it’s the way we manage and think about risk. Q: What is your portfolio construction strategy? A: We can take very large bets so, for example, today we’re almost at our trigger point at the far extreme guardrail in healthcare. We’re about 50% of the weight in healthcare. We’re just very negative on healthcare right now, on healthcare REITs, because they don’t have external growth opportunities, their yields and cost of capital are up, and they are selling at very large premiums to NAV. So we can take very large bets in that sense, but the reason we have these guardrails is just risk management for us. Sometimes we overstay our welcome in a sector and sometimes we’re too negative on a sector, and these guardrails — having a range between 50% weight and 150% weight of the index weight — is important. It keeps us in the game. That’s one way we think about portfolio construction and the REIT weight. The weighting of stocks in the REIT indices is very high compared to other indices and so, for example, I think the largest weight, the Russell 2000®, is maybe 50 basis points; the largest weight in the REIT sector is a 8.5%, that’s Simon Property Group, Inc., if we believe in Simon — and sometimes we believe more in Simon and sometimes we don't — but we can only take a bet of no more than 250 basis points over the index weight. The other way we manage risk is through our fundamental work: understanding the company, the real estate, and the market risk these companies face. Our weightings can vary. We’re overweight office and malls; we’re underweight healthcare, triple net companies, and self storage. It is just a matter of what our views are on valuation first and fundamentals, and then how we can allocate capital throughout the portfolio. We have an equity quant team that monitors all equity portfolios. We use performance attribution both at the security and sector level. We look at different quantitative factors from beta and market-cap size to what’s driving our performance. Through our quant team, we’re able to constantly monitor why we’re outperforming and underperforming. We have models on about three-quarters of the companies in the index. We’re always looking at valuations and tweaking our models when we get new information. So there are a lot of levels of risk management that we employ. Some are hard and fast rules; others come through our experience and our persistence in understanding the valuations and fundamentals of our companies. Currently we have about 51 names in the portfolio, and the range is between 45 and 55. And, we are benchmarked against FTSE NAREIT Index. Q: Can you discuss one historical holding? A: Back in early 2011, the commercial mortgage-backed securities (CMBS) market was getting quite frothy and expensive. Class B malls and class B assets such as suburban offices were heavily financed in the CMBS market. The changes in the cost of CMBS capital have a direct impact — positive or negative — in the valuation of class B malls. Class A mall operators like Simon or General Growth Properties are different; they primarily finance through life insurance companies, banks, and unsecured financings. They can get financing almost anytime, other than during the 2008 crisis period. So in early 2011, the CMBS market began to weaken, and our fixed income team saw the spreads starting to widen. Hedge funds were starting to short, and there was a general worry about the CMBS market. We knew right away the class B malls would suffer, so we sold our CBL position. CBL is the owner of class B malls throughout the Midwest and Southeast. As things began to weaken, CBL underperformed the index by 25% in a 10-month period. Simon was actually ahead of the index by 5%, and there was a 30% swing between a class A mall and a class B mall — all because the CMBS market began to weaken. Then in the fall of 2011, the CMBS market began to bottom out. At the same time, we’re looking at CBL and we’re saying, “This stock is getting cheap, almost a 20% discount to NAV.” That meant the cost of capital for CBL was coming down, and the stock was trading below the NAV. So we took a position in CBL in late 2011, and as the company rallied, it outperformed Simon, and from there it went on to outperform the index by about 30% over the next year and a half. So we did very well with it. Now here’s the interesting thing. If a real estate analyst would have said CBL fundamentals are fine — actually occupancies went up that year, FFO growth was about 5.5%, and dividend growth went up by 5% — and would have ridden that stock down 25% on a relative basis to the market. It would have lost money for their investors, because they didn’t understand how the capital market, in this case the CMBS market, was viewing real estate, initially negatively and then more positively as the year went on. So we avoided the downside, but caught the upside, all based on understanding what the risks were for this particular stock — CBL and Associates — and how to handle that risk. I think it's important to understand that in a world where companies are overleveraged relative to other public companies, and they don’t generate free cash flow, you need to broaden your horizons of how you evaluate these companies and incorporate more than just a real estate analysis. These are public companies and they play by public company rules, which means, we believe, a focus on not just the real estate but also on the capital markets.