Q:  What is your investment philosophy?

We manage three funds, Grubb & Ellis AGA Realty Income, Grubb & Ellis AGA US Realty, and Grubb & Ellis AGA International Realty. Our investment philosophy is centered on the fact that, in the long-term, stock price performance follows fundamentals, and stock picking rooted in value discipline can help generate additional return to the passive indexes.

Q:  How do you turn this into a successful investment strategy?

Our strategy is to identify both the strongest fundamentals and areas where fundamentals are improving, then weight our investments in those areas. Later on we identify where fundamentals are weakening in order to underweight or take profits in those sectors. That flows down into our research process on a weekly basis, monitoring the top real estate markets in the country by size while having a direct contact with our national research team as well as key brokers in each of these markets. That helps us understand what is truly happening in terms of real estate fundamentals. Within that process, though, we get further into stock selection and portfolio construction because they are related as we look at real estate fundamentals. We look at an individual company’s portfolio quality, management quality, balance sheet quality, and valuation. Our goal is to try to identify companies with the best or improving fundamentals and companies where we find the greatest disconnect. In terms of valuation, we use a Benjamin Graham or Graham and Dodd approach of finding and identifying intrinsic value in a company and comparing that to its public market value, and try to find the largest disconnect or the best mispricing we can find to take advantage of that. That drives directly how we construct our portfolios. When we talk about our income fund, which is managed differently from the two other funds that are total return funds, we take a barbell approach to managing that portfolio. The primary objective is income and the secondary objectives are appreciation and value preservation. To achieve what we think are the best results for our investors in that fund, we build a portfolio that has high quality, lower-yielding investments with extremely safe dividends. On the other side of the portfolio, we will add both preferred and common stocks that have higher than average dividends. This is where we have done that extra level of fundamental research, where we make the determination that we believe that that dividend is safe and that the security is mispriced in today’s market. We believe by doing that we can provide our investors with a higher than average dividend yield compared to our competitive funds. At the same time, this is a fund with lower volatility than competitive funds. Over time, this fund would also deliver a respectable level of appreciation and preserve capital. The total return funds are both managed for total return. Total Return is income generated by dividends and appreciation. That’s driven by the fundamental approach we take. The five factors that we look at are the portfolio quality, management team, balance sheet, fundamentals, and valuation of the company. None of our funds use leverage as we do not have the benefits of leverage on the upside but we do not have the risks and negative effects of leverage in down or highly volatile markets either. In each fund, we will typically limit investment in an individual security to 5% of the fund assets. In addition, we do a weekly call with Grubb & Ellis’ real estate research team and the senior brokers of a selected market. We monitor real estate valuation and transaction data in the nation’s top 50 markets through information that we receive from real estate research. We also talk directly to individual real estate brokers in each market to get a sense of the trends in both transactions and valuation for the major real estate sectors. That helps us concentrate our portfolio in areas where we see real estate fundamentals strengthening. Our strategy is to do that faster and more effectively than our competitors do.

Q:  Based on your experience, how does investing in real estate differ from investing in REITs?

First, we take a real estate approach to evaluating each REIT. We calculate our estimate of the total value of the real estate that any particular REIT we invest in owns. We subtract the debt and divide by the number of shares to come up with what we think is a market net asset value for the company. We use the same method that is typically done to evaluate an individual real estate asset or a portfolio of real estate. We calculate our best estimate of annualized net operating income and select a blended capitalization rate then divide the Net Operating Income by the capitalization rate to come up with the total value of the portfolio. A major difference is that REITs have daily liquidity whereas a direct real estate does not, and every investor can clearly see the benefits of daily liquidity in a market like ours now. If you were an individual investor and bought a shopping center, it could take you months to sell that asset today if you wanted liquidity. Over that period, you would suffer potential risk in the pricing of your asset, particularly in a market where you are finding that debt financing for acquisitions is quite difficult. Another difference is whether you keep a regional or a national portfolio of assets. By making a very small investment, you can enjoy the benefits of diversification by geography as well as by real estate product. You can own REITs that own multiple product types and multiple locations or you can build a portfolio of REITs.

Q:  The current financial crisis has its origins in the method in which the real estate was financed. Even though some of the REITs are liquid, as an investment many of them have had leverage that may or may not be appropriate for investment. How do you analyze these situations?

All REITs are required to show their maturities on a quarterly basis. We first analyze the debt maturity schedule of every REIT that we invest in every quarter. We make the judgment whether or not we believe that a particular REIT can either pay off or refinance its debt as it comes to maturity. Secondly, we look at fixed charge coverage ratios; that is net operating income divided by both preferred dividends as well as debt interest and principal repayments. We try to concentrate on companies that have over two times fixed charge coverage. Our portfolios include some companies where we have done deeper research and we believe that they can adequately service and refinance their maturities. We tend to focus most of our investing where we believe there is a significant margin of safety on the coverage side. Also, we tend to look at debt and preferred stocks to total market capitalization. That is a less important measure of leverage in a market in which either share prices are trading at significant premiums in net asset values, or, in this market, where you have share prices trading at a near 10-year low and at significant discounts to net asset values. The fixed charge coverage ratios and the maturity schedule are two primary forms of ascertaining a level of leverage risk in each individual company.

Q:  What is your research process?

We keep a handful of proprietary stock screening tools that we use to monitor the REIT space daily as we rank REITs by free cash flow valuation or earnings multiples. We also rank them by Net Asset Valuation, discounts to NAV, dividend yield, and leverage. A REIT can move to the upper tier in terms of valuation, lower earnings multiple relative to the group, higher dividend multiple relative to the group, higher discount to net asset value relative to the group. Once we identify a company that we view as an attractive investment, we will apply a more fundamental analysis. If we believe that the company has an acceptable level of debt to capital ratio, we will do a direct call with the management team. If we have not met them before, we will visit a company directly and we will, at some point, tour some of their assets and ascertain the asset quality of the portfolio. If it looks like its total return will outperform our expectation for the REIT universe as a whole, we will move forward with the investment. We typically start with a 2% to 3% position. One of the areas that we are favoring right now is the apartment sector. It is a sector where the product remains in demand even during recessionary times like the ones we are in now. The three sectors that we particularly like at present are the recession resilient sectors - apartments, healthcare, and one of the specialty sectors, self-storage. The rationale is that these are all sectors that will remain in demand in all types of economies but particularly during recessionary times. We try to understand where the trends are, and if office rents, vacancies, and valuations are increasing or declining, we want to determine where the top locations are. Then we overlay that research onto the equity REIT universe. With about 140 publicly traded REITs, we overlay that research by geography and by profit product type as well as some of the specialty sectors. We think that is a major difference that distinguishes us from our competition. Globally, we analyze macroeconomic and demographic fundamentals and we tend to weight our investments in countries that are either growing faster than average, including areas such as Asia and in some cases Latin America, but also where the barriers to new construction are quite high, for example in Tokyo, Japan.

Q:  Could you highlight your investment process by giving an example of a REIT that you invested in? Why did you like it at the time when you bought it?

One such example is The Essex Realty Trust, a REIT that is focused on investing in apartments in the West Coast of the United States from San Diego to Seattle. During the course of our real estate fundamental monitoring we came to determine that the regions of the country with the least amount of supply growth, with the healthiest job outlook, and the highest barriers to entry are the markets of San Francisco, Seattle and parts of Southern California. In doing our analysis of the 15 or so apartment REITs, Essex along with just one or two others is the only REIT that is concentrated on the West Coast of the United States. At that time Essex was trading at an implied capitalization rate, this is the portfolio now of in excess of 8%. These apartments typically trade at 6% yields in the private market, so you have a significant discount of 25% or 33% discount to intrinsic value. This company has access to up to $600 million of existing cash or borrowing capacity and has no significant maturities over the next two years. Another company that we have identified as recession resilient is Public Storage, which owns the largest self-storage facilities in the nation’s 50 top markets. Public Storage has no near-term maturities. In the current market, this company finances its business entirely with common stock and preferred stock with no significant maturities, has a top quality management team and a property sector that remains recession resilient. In other words, demand for this product type continues in this market.

Q:  What happens when companies that you invest in may not have a debt maturing in the next two years but may have other conditions on the loans, which may force them to mature earlier than before?

That’s a rare condition. We will typically read the filings and footnotes of the companies that we invest in to identify if there are significant debt covenants that could be triggered, causing the company to have to repay debt. It’s a little bit different with Public Storage. They have a credit line that they use for acquisitions and then almost immediately refinance without using any existing debt. Essex will use some of these mortgages on their properties. We generally try to avoid investing in companies that have owners’ covenants on their debt only because those types of covenants can get them into trouble during times like this when it is difficult to get financing from banks.

Q:  How many holdings do you normally have in your portfolio?

We typically have 35 to 50 stocks in a portfolio; more in the income fund than the total return funds.

Q:  What kind of diversification do you have and how many holdings do you have in your international portolio?

We typically have 35 to 40 holdings in the international fund, usually broken down between 14 to 20 countries. The sophistication and the liquidity of the real estate security markets differ dramatically from one country to another. The more mature securities markets like Japan, Hong Kong, Singapore, Australia and Europe tend to have larger holdings in those markets where companies have a longer history, strong balance sheets and where our investments are more liquid. However, we will also invest in smaller companies and in countries where we think, over time, the growth rates will exceed the global averages.

Q:  What are your risk controls?

We manage risk by limiting the size of our positions in individual companies and our exposure to individual countries. We try to monitor macroeconomic data as real-time as possible and try to identify warning signs in individual markets or economies as soon as we can and either underweight or exit those markets. That’s typically how we manage risk internationally. We are also not averse to selling either part or all the position of a stock that hits our price target.

Q:  In your funds, do you invest in non-REIT companies such as real estate operating companies or home builders?

At present, we are primarily invested in REITs but we do have the ability to invest in other types of real estate operating companies and real estate service companies. We believe that right now, given the high level of yields and the attractive valuations, REITs are the best place to concentrate our investments. We have not chosen to invest in homebuilders at this point, which may change at some period. We have definitely not ruled them out over the longterm. In our total return fund, we do own shares of Starwood and Marriott, which are not REITs but lodging service companies with superior management teams. Both companies primarily manage lodging assets as opposed to owning them. As levered players in the sector they are going to experience more rapid earnings growth than the REITs themselves, as the lodging sector recovers. Both Starwood and Marriott have extremely strong balance sheets, which keeps the risk of financial distress in these companies at extremely low levels.