Q:  What is your investment philosophy? A: One of our core beliefs is that equity REITs provide a very efficient way to allocate capital to the commercial real estate market. We believe that investing in a real estate portfolio owned by a publicly traded REIT offers greater long-term return and portfolio diversification. The equity market creates premiums and discounts to the net asset value of each company’s real estate portfolio. This is the basis of our investment strategy. We generate net asset values through meticulous research. There are inefficiencies in the market; our research allows us to exploit those ineffi- ciencies, helping us to consistently beat the passive index. That is why when analyzing active real estate securities managers, Adelante tends to outperform our benchmarks. There is a minority of real estatebased teams like ours. More often, however, traditional equity houses have teams and look at Real Estate Investment Trusts, or REITs, relative to other sectors and use them in their portfolios. As a real-estate based firm, we can be cursed if the tide goes way out for the real estate industry, but my experience in the last downturn in real estate between 1990 and 1992 gives me confidence. Unlike residential real estate, real estate securities can diversify stock and bond portfolios. The last tenet of our philosophy is to strive to be a trusted resource. Over the years we have become a trusted resource to institutional investors in providing research in the real estate market for private equity and institutional funds. Q:  What kind of REITs are you focused on? A: Currently, we are focused on equity REITs even though there has been a proliferation of mortgage REITs. Our focus is on owners and operators of commercial real estate. I look at the world as two asset classes. Either I am a lender, basically a bond investor, or I am an owner and an equity investor. Equity REITs belong in a portfolio because rents come before profits, the basis for equity investing. Q:  How would you define your real estate securities universe? A: We look to the universe or real estate securities as defined by the Dow Jones Wilshire REIT Index. The companies are owners and operators of commercial real estate. The index screens out small REITs with market caps under $300 million. We rank the entire universe based on valuations, quality of cash flow, dividend coverage, and the geographic footprint of relative to underlying real estate value. There is a simple mean reversion theme that plays out within the portfolio. There can be companies that trade at premiums to underlying real estate, and while we might be underweight or not own them, the premiums can grow. The Market may trade this security at a 20% premium to the underlying net asset value and the premium may subsequently jump to 30%. However, avoiding these securities helps to control our portfolio risk and protects our portfolio against a sudden downward revision and loss of the premiums. Q:  What are the key elements of your research process? A: Our research process is straight- forward. We have three analysts that cover the real estate universe by property type. They meet with the management of the companies we follow twice a year to gauge local markets. They compute net asset values by treating the company as an individual building and generate a current value of the real estate on the balance sheet adjusted for stated liabilities. Then we perform sensitivity testing to future cash flow growth assumption as well as to capital rates, which are the inverse of a multiple we use in valuations, to gauge the range of outcomes. That range is revised on a quarterly basis as companies release new information, or if significant acquisitions or transactions occur. Over the years we have identified companies that own assets in markets where landlords can drive rental growth. When you can drive rental growth, you can drive growth in your net asset value. Growth in net asset value leads to higher share prices. Q:  Which are the major categories on your list? A: We invest in the office; apartment; retail, both malls and shopping centers; and industrial sectors. We have stayed in the core property sectors as they have had better risk return characteristics. For example, lodging offers compelling returns, but the standard deviation is so high that we have shied away from including lodging in the portfolio in order to dampen the volatility. Q:  What are the major themes in the last ten years that will continue in your opinion? A: Commercial real estate has been integrated into the capital markets, despite the fact that people presumed it to be immune to stocks and bonds. We now have nine REITs in the S&P 500 Index; however this represents less then 1% of the S&P 500 so integration is a theme that will continue. Additionally company disclosure and their ability to assess the quality of cash flow will continue to improve. In the last fifteen years these companies have matured and found ways to unlock value. They reached a point of consolidation, and due to a period of low interest rates, they have improved their balance sheets. Now we are going to have an interesting period of leveraged growth. We have to watch out for markets with a growing supply of available space. The death nail to real estate is overbuilding. Once you build a building that’s competitive square footage, it is hard to drive rents higher; however, with limited new construction tenants have fewer choices, and if they want a space , they will pay up for it. Q:  What are the perceptions that drive private partnerships and public REITs? A: The number one headwind is always perception. Are they real estate or are they stocks? As long as that uncertainty exists, opportunities and inef- ficiencies in the REIT market will exist as well. As long as there is a healthy individual property and transaction market, sponsors will assemble and offer properties and partnerships as a better means of controlling real estate. This is not going to change for a long time. Some financial advisors have migrated to a private REIT, which offers a more attractive dividend, and there is limited share price volatility. That doesn’t mean it is better. It means you don’t have daily liquidity. The daily pricing of publicly traded REITs creates opportunities to actively manage a commercial real estate portfolio. Interestingly, we feel that there is a preference to pay more for individual buildings and private REIT structures than comparable securities. Q:  How do you go about your portfolio construction? A: Every month we monitor the investment universe for changes in relative value and new companies. Our entire universe is ranked by valuations and quality of cash flow and management. Then we manage the over and underweight, relative to the benchmark, and eliminate the inferior companies. Q:  What is the average number of holdings in the fund at any given time? A: It’s between 45 and 60 names and today we have 48 positions so generally the turnover is less than a third. I’m trying to run a very low turnover portfolio. Unfortunately, it’s driven more by the unit-holders than by the manager because I try to be fully invested all the time. Q:  What kind of risks do you measure and how do you control them? A: The most important risk is valuation risk, and it’s based on our internal views and valuation work. The metrics we look at are valuation within the company, balance sheet, dividend quality and our views of the market place. We don’t start with a macro view that says we want to be overweight in apartments and then view all of them. We build the portfolio from the bottom up, one company at a time. We will diversify by property type and limit our exposure to 1.5 times the sector exposure. Individual security weights will rarely exceed two times benchmark weight. Rising valuation in the markets presents a challenge. In a significant up market, the tide lifts stocks of all kinds of companies. When there are strains in the real estate securities market, this fund does very well so this also creates a downside protection. Q:  Can you give an example of a company you bought in the past and how you benefited from it? A: The portfolio has owned Equity Office Properties for many years now. However, we have been willing to own different parts of the company’s capital structure to reduce the downside risk in our portfolio. Specifically, after Equity Office completed its acquisition of Spieker Properties, it issued a 7.75% perpetual preferred. We swapped out of our equity position, because we felt that the dividend may be at risk and that the current income in the preferred was attractive. While the dividend was being overpaid, the company routinely stated that it would not reduce the dividend, until last fall. The company did reduce the dividend, eliminating a risk, while the preferred had appreciated with seasoning in the low interest rate environment. Subsequently, we have swapped out of the preferred and back into the common. Q:  Do you look at the macro trends by region or by type of property? A: Post 9/11 all risk and spread assets have appreciated with the infusion of capital from the Fed and the collapse of the short-term interest rates. With the Fed tightening the liquidity in the last two years, there is a lag effect in the commercial real estate market, and we are sensitive to the fall in values. We are looking for more downside protection. Different property types have different characteristics. In hotels your leases are daily whereas triple net lease for office properties have 15 to 20 year leases. With a flat yield curve, we think about the property types and the valuation implications. We always return to our net asset value calculations. We’re trying to invest in commercial real estate for the long-term, guard against potholes based on valuations or managements or capital structures. Our core belief is that in times of stress in the securities market, premium valuations evaporate and so does downside risk. Discounts may widen out in the securities markets, which is fine, as long as is the company holds good real estate. Our investment style has a value bias more than a deep value, so we may avoid value traps. This is a conservative fund, in the sense that it focuses on quality of property types.