Q: Can you give a historical overview of the fund?

Cohen & Steers Real Estate Securities Fund was launched in 1997, but since 2008 the fund has followed a total return oriented strategy. Currently, this is our opportunistic fund, which can invest across all real estate securities, all market caps, and internationally. We also have the ability to use options to enhance total return potential. 

Our investment approach relies on a relative value perspective. Our goal is to own high-conviction stocks, diversified by property type and sector, and to generate 200 or 250 basis points of alpha relative to the benchmark. As the original REIT specialists in the sector, we have one of the largest teams focused on real estate securities. We use our accumulated knowledge and long-standing relationships within the industry to aspire to generate alpha in the portfolio.

Q: Why should investors consider real estate as an investment opportunity?

We believe real estate offers several benefits. First, historically, the total returns of the sector over long periods of time have been very effective. Second, REITs offer total return with a healthy component of income and dividend yield. Third, we think investors get the diversification benefit of investing in a property type or a sector that reacts differently from the broader equity market. REITs are not bonds or equities, but they have some of their characteristics, while providing attractive total return opportunity set. So, we believe real estate is a good component of everyone’s portfolio.

Q: What is the role of an active manager in the real estate sector?

We believe that real estate lends itself more to active management than other sectors. Within real estate, the different business models react differently to various economic environments and demographic trends. There can be different supply-demand dynamics in each submarket. That’s why we believe the nature of the real estate business requires in-depth, bottom-up fundamental analysis, while most investors don’t have the resources to do that effectively. As a result, we believe that active management works well in the real estate space.

Q: What are the core beliefs that drive your investment philosophy?

Our guiding philosophy is that real estate securities ultimately track the private or direct real estate market. That means that if we get the fundamentals right, we will be right about the equities, because we believe over time the stocks trade in line with the underlying fundamentals and the asset value growth.

That’s why we spend a lot of time and effort on the bottom-up fundamentals and the supply-demand dynamic of each market. We formulate our views on the direction of rents and occupancies and, therefore, on the future asset values. That view is the basis of our investment decisions. If we are correct about the direction of the fundamentals at the property level, we will likely be correct on our view of the stock and its ability to create alpha. 

The second tenant of our philosophy is that while the companies own real estate, they are still traded in equity wrappers and we believe that creates opportunities for asset management to create alpha. We are focused on finding relative value every day. Obviously, there can be dislocations in equity prices due to market events or current news. For us, these dislocations represent an opportunity to potentially add a stock to the portfolio, if it becomes attractive enough.

Third, we take a broader view of the real estate universe, which includes all income-producing real estate, including data centers and cell phone towers. From our perspective, all the income-oriented real estate is investable and can be evaluated. The different fundamentals might be driven by different sectors or trends and we take advantage of that.

Lastly, we believe that there is a price for everything. We rank the entire universe by value and we typically own the cheapest securities. We wouldn’t own great companies with good fundamentals if the stocks are trading expensively. As long as we are confident in the fundamentals, we don’t mind owning companies that might be perceived as lower quality, because it depends on the valuation. We screen everything versus our view of value, while taking into account geographic and property-type diversification for the portfolio.

Q: Which areas of the real estate market do you focus on?

We invest in REITS and in securities that are driven by the real estate market. For instance, Hilton spun off its direct ownership in real estate to a REIT, but the company is still driven by the fees it generates from managing hotels. These fees depend on the occupancy and room rent in the hotel business. The development pipeline is developing hotels and new brands to clients around the world and these are real-estate driven trends.

On the other hand, we wouldn’t spend a lot of time on a company like Zillow, because it has essentially been just a referral service for brokers. Now it is morphing into buying and flipping homes, but that’s still a small piece of the business. Currently, Zillow is not in our investable universe, but Hilton is, because it is directly tied to the underlying real estate and the income-producing fundamentals. If Zillow converts from an advertising platform and a broker referral business to a company that’s driven by real estate, then we would consider it. 

Overall, our investable universe includes anything that is structured as a REIT and anything that is driven by real estate. Gaming companies are also included, because they are often the owners and the operators of the real estate that is integral to their business. Hotel operators and homebuilders are also part of our investable universe, even though they are not REITs. We don’t typically own too much homebuilders because we tend to rarely like the businesses, but they are in our universe.

Q: What are the key elements of your investment process?

We employ a bottom-up, fundamentally driven approach to identifying value and we also have a top-down overlay in terms of understanding the economic cycle. We need to have a view of the economy to understand where we are in the cycle and whether we are heading into a recession or growth acceleration, because the different real estate business models respond differently to the changing economic conditions.

For example, we believe the hotel business is extremely economically sensitive. If we are going into a recession, the hotel business EBITDA could dramatically decline versus the EBITDA of other REITs. On the flip side, net lease businesses can provide bond-like returns for decades. So, we need to have a view of job growth and interest rates to build an understanding from an economic standpoint.

A key element of the fundamental process is getting the supply-demand dynamics correct. We spend the bulk of our time figuring out the direction of rents and occupancies, because that allows us to estimate the value of each individual company. We have a very large team, because we need to have people on the ground to visit properties and markets, to figure out the direction of rents and opportunities, and to form a forward-looking view of fundamentals. 

For example, we may believe that rent growth in a particular market will be 7% per year for the next five years, based on our different view of the supply-demand dynamics. If the stock market expects growth of only 2% per year, then our view on the value of that company will be higher. The stock would be cheaper to us and we would likely consider owning it in our portfolio. If we are correct about the fundamentals and the rent growth is higher than the market expects, the stock valuation will ultimately reflect that.

We look at the companies on three primary metrics. The first one is the premium or discounted net asset value. In other words, if we sold the companies or their pieces, how much money we would get back. Then we compare that value to the level of the stock price. Basically, we calculate the private market value of real estate. The second metric is the dividend discount model that we use to value the equity as a going-concern. The third metric is the multiple-to-growth rate.

We rank the entire universe on those metrics. Then we populate the portfolio with the companies that rank statistically cheap, while taking into account sector and geographic diversification and the impact of the macro picture on the performance of the difference sectors. 

Q: How does you decision-making process work?

We have a very inclusive approach. Everyone can express his or her view on the portfolio or the stock. That includes the analyst covering the stock, the analyst who covered the sector five years ago, or a portfolio manager who covered the sector 15 years ago. We’ve all been covering REITs for a long period of time; we have developed our views and accumulated knowledge. 

Typically, we have an iterative approach where we look at the valuation framework daily and we use a statistical tool to highlight our research agenda. It is not a black box, but it helps to assess if we are underwriting everything correctly. If we go through this process and the stock still screens as cheap, then we will add it to the portfolio. Everyone has a voice, but the portfolio manager owns the decision and has the right to veto decisions. Typically, however, it is an iterative approach, where we come to consensus conclusions.

Q: Would you illustrate your research process with some examples?

The apartment REITs are probably a good example. Our starting point is always about the supply/demand dynamics in the market where the real estate company operates. If it’s a West Coast apartment company, for example, we will be looking at the job growth and the housing affordability for that market. Some of the markets might be driven by tech companies, so we would examine the fundamentals of the underlying tech companies and how quickly they are growing. It always starts with the demand and supply side of the equation. 

We formulate a view of the demand growth for the particular property type in the specific submarket. If the corporations in that market are hiring at an accelerating pace, that may result into job growth accelerating from 2.5% to 4.5%, for example. We compare that to the supply side of the equation and we examine how many new apartments and single family homes are being built and what the propensity to rent in that market is.

If there is a market with unaffordable housing and accelerating job growth from 2.5% to 4.5%, we know that the propensity to rent is extraordinarily high. Probably about 75% of the incremental jobs will rent an apartment and that will create bigger demand. For instance, if the rental pool is growing by 2.7%, but job growth has accelerated to 4%, while the supply for rental housing is only growing by 1%, then we know that rent growth will dramatically accelerate. In that example, in our view, rent growth will likely go from 3% to 8%. 

Then we price this growth into our view of earnings growth expectations and asset value. Obviously, if I think that rent growth is 8%, while the market thinks it is only 3%, I will be ready to pay more for that apartment building, because I believe that growth would be better. If my earnings estimates and my view of asset value is higher than the estimates of other investors, the company is likely to look cheap on the basis of net asset value and on multiples.

The example illustrates that if we have a differentiated view of the fundamentals, the stock would screen cheap to us, because no one else would be pricing the same growth in the fundamentals. It would be a statistical outlier on NAV, the dividend discount model and the multiple/growth ratio. Therefore, we would own a large position in that company. 

Another example is the retail sector. We were early in assuming that retail fundamentals were getting worse for brick-and-mortar retail, so we had a negative view on the mall and shopping store spaces several years ago. Our forward-looking fundamental views were very different from the views of other investors; our view of net asset value was 20% lower than sell-side estimates, because we were expecting more bankruptcies, occupancy losses, rent declines, and growing capital expenses for keeping the facilities competitive. Due to our lower estimates of asset value and earnings, the stocks looked expensive and we’ve been underweight in retail in the last several years. 

Overall, we review the supply/demand analysis for each company and sector and we price these calculations into our view of earnings growth and net asset value. Then, based upon how the stock is trading, we decide whether we want to own it or not.

Q: What is your portfolio construction process?

The first step is the bottom-up fundamental analysis and ranking the entire universe based on the three primary factors that we touched on earlier. But if all the hotels screened cheap, for example, I still wouldn’t want my portfolio to be 100% in hotels, because that would be a single-factor model.

When we construct the portfolio, we maximize the impact of bottom-up stock selection. About 80% of the tracking error, or the risk we take, comes from bottom-up stock selection, while about 20% comes from macro or sector allocation concerns. We do not want momentum or market cap to be a big factor in the portfolio. We try to minimize the bigger trends that can sometimes drive stocks in the broader market, while maximizing the bottom-up stock selection, because that’s where we find the best opportunity to potentially create alpha.

We have constraints on sector allocations and recommendations for each individual stock position. We have set ranges for how overweight or underweight we want to be to a particular sector and where we want our risk to come from. In order to limit the effect of macro factors, we must curtail some of our sector overweights and underweights. 

So, we first look at stock valuations and what they imply for sector overweights and underweights. Then we follow our allowable ranges by sector to manage that element of the risk. We typically own 40 or 50 names in the portfolio. Our goal is to get our highest conviction stocks, which will generate an attractive total return relative to the benchmark, while managing some of the macro risks and factors. Our benchmark is the FTSE Nareit All Equity REITs Index.

Q: What are the sector limitations that you apply?

Our sector allocation is based upon the standard deviation of excess returns of those sectors. Essentially, the exposure depends on how risky the sectors are and how dependent on macro versus bottom-up factors. The biggest allowed range is from 0 to plus or minus 8.5% for each sector. If the malls represent 8% of the benchmark, we can be plus or minus 8% in malls. Hotels are 6% of the benchmark and we would typically be 200 basis points plus or minus in hotels, given their nature and high dependence on macro factors. 

So, our sector exposure depends on the riskiness of the property type and what drives that sector. Areas like apartments, malls, retail or office space, tend to be more about the local supply-demand fundamentals and that’s where we allocate more of our capital from a risk standpoint. In that way we make sure that most of our tracking error comes from bottom-up stock selection and not from being geared to a view of interest rates or GDP growth.

Q: How do you define and manage risk?

We focus on the tracking error relative to the benchmark and the contributions of risk factors. Our goal is to have 80% from bottom-up, supply-demand stock selection and a tracking error of about 2%. We pay attention to the volatility and the beta of the fund versus the broader market. We pay attention to scenario analysis and what would happen if interest rates move up or down, if value versus growth changes, or if momentum changes. We want to know how much risk is in the portfolio from things that we have less control over. These are some of the primary metrics, in addition to property and sector diversification.

We have monthly risk meetings, where we examine exactly where risks are coming from. Through an iterative approach, we constantly review the sources of risk to ensure that we have the appropriate risk tolerances in the portfolio, while still aiming to generate the 2% tracking error to hit our alpha target.