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Third Avenue's Jason Wolf Talks Hong Kong Real Estate

In Third Avenue's eyes, these real estate stocks are among the most attractive in the world.

Bridget Hughes, Associate Director of Fund Analysis, 06/21/2011

Third Avenue Value TAVFX and Third Avenue Real Estate Value TAREX both maintain large commitments to a handful of Hong Kong real estate companies. The management teams on both funds discuss them regularly in their quarterly shareholder letters, including their most recent submissions, but with exposures of more than 40% of assets and about 20% of assets, respectively, questions about them abound. At the recent 2011 Morningstar Investment Conference in Chicago, I caught up with Jason Wolf, who comanages the real estate fund and is also the firm's resident expert on Hong Kong real estate companies.

Q. When it comes to investing, Third Avenue's mantra is "safe and cheap." What makes its Hong Kong real estate investments safe?

A. Certainly, these companies have all exhibited financial strength through our investment horizon. The second element of safety is a strong and experienced management team that is incentivized through either stock ownership or stock options, and one that has historically been a quality steward of capital for shareholders. When you look at the aspects of Cheung Kong, Henderson Land, Wheelock, Hang Lung--they're all led essentially by rags-to-riches-type guys that have built these businesses over a period of going on 40 years. We get comfortable because so much of their financial net worth is tied up into these businesses and they have grown them for such a long period of time that they offer fantastic financial disclosures, which is the third element of "safe" in being able to analyze a company through the public filings that a company provides.

Q. So, they meet the "safe" criteria. But considering the recent headlines of fraud among Chinese companies, is there any level of skepticism, even for companies like this, when you are looking at those financials?

A. There's never a guarantee that there's not a fraudulent situation. What we hold in high regard is the substantial ownership stake that these guys have in these businesses, unlike some of the businesses that you're referring to, some of which have been reverse takeovers of shell companies that are relatively new to the capital markets. [Our] companies not only essentially founded the Hong Kong stock exchange, but these management teams are also part of the development of the capital markets in Hong Kong.

Q. Separately from any sort of fraudulent activities, can you speak to what kind of skepticism you put to these companies' publicly available [net asset values] and how reliable you think that they are, because there is some level of subjectivity when appraising real estate.

A. International accounting standards allow these companies to hire external appraisers to value their income-producing portfolios, and increasingly over the next year and a half, they will expand that into some of their development properties that are more than 50% complete.

At Third Avenue, what we do is use those numbers as a starting point, try to understand where the appraisers are in their assumptions being made for the real estate, and then do our own research to determine what we feel like certain aspects of the businesses are. The complication in Hong Kong is that many of the businesses have three or more operating segments and the accounting for each may vary.

Obviously the income-producing real estate is the most relevant. The second element that is highly scrutinized is the residential land bank, which is typically valued at cost on these companies' balance sheets, and that is where we as analysts at Third Avenue try to analyze to the best of our ability what the true value of those two segments [are], which usually weigh in at 75% of the NAV.

For the income-producing portfolio, we typically use long-term historical cap rates or even more conservative cap rates than what the market would indicate. For example, in Class A Hong Kong office space, the long-term historical cap rate, and by long term I mean since 1997, is 4.5%. This is on gross revenues, and that's the market convention in Hong Kong. What we do is value the real estate on net operating income to the best of our ability through the public disclosures and come up with a cap rate. We use anywhere from 5 to 6 percent on net operating income, which would equate to 6 to 7 percent on gross revenues when you do the adjustment. So, we think we're being more than conservative.

Q. Have you found that you're generally taking a haircut to most of the NAVs?

A. There sometimes is a substantial haircut to the NAVs on the income-producing portfolio. Some of the [residential] land bank has been acquired 20 years ago, so the land values on the balance sheets and their current market values are wildly different. There's no perfect way to estimate what land values are, but comparable transactions happen in Hong Kong quite often, meaning land auctions for assets that might be in the general vicinity.

Each business is different. Cheung Kong tends to have assets all over Hong Kong and in China. Henderson typically does it a different way, which is they own an agricultural land bank, which was bought back in the 1980s at a very low cost, and they acquire redevelopment properties, so they don't actually participate in land auctions. This is a long way of saying that each company's investment in residential inventory is varied, and what we do is try to conservatively estimate [their values]. In some cases it is a 15% average premium to book value, sometimes it's a 10% discount to book value, or in some cases it's a 30% premium to book value. For example, Hang Lung Properties owns two high-end residential properties in Hong Kong that are on the books for 8 billion HKD, and they're worth 22 billion in the market today.

Q. Are you worried about the air quality in Hong Kong, and that it could negatively impact the office and residential markets there if residents and workers move to Singapore?

A. As an analyst traveling to Hong Kong over the past five years, I can tell you that from the first year that I went to Hong Kong to the [most recent] three trips over the past year and a half, there is clearly evidence that manufacturing is moving away from the Pearl River Delta region to northern and western China, because the air quality has improved significantly.

I think the bigger issue is the cost of office space in Hong Kong, which is getting exceedingly expensive, specifically against Singapore and Shanghai. The problem [with moving] when I talk with brokers in the market is that it's really hard to do business in China from Singapore. So, businesses really use Hong Kong still as the gateway to the expansion in the mainland, and then they'll have a second office in Shanghai.

But most of the individuals in the financial-services sector want to live, raise their children, educate their children in Hong Kong still, and have the benefit of the higher-quality health care that's available. So, there are some subtleties to why Hong Kong is still a desirable place to operate.

Q. So, one risk is the exceedingly excessive cost of the office space. What are some of the other risks that you acknowledge but feel the discounts on these stocks is still big enough to cover?

A. When you think about our Hong Kong exposure ... Marty [Whitman] is on record as saying he doesn't think it's an economic [risk] as much as it could be potentially a political [risk] that we'll face in Hong Kong.

From a net asset value perspective, there's interest-rate risk in that part of the world. The Hong Kong dollar-U.S. dollar peg has artificially lowered interest rates in a market where GDP growth has been 6 to 7 percent, and so our interest-rate policy in the United States is probably not appropriate. Interest rates are a concern because they could obviously impact cap rates. We feel like we're being adequately conservative with the use of NOI [net operating income] cap rates of 5 to 6 percent, which are on the high side of history since 1997.

The other risk is government-policy risk. The government has a heavy hand on making down payments much more stringent and increasing interest rates. That impacts the pricing level of developers. While [the government has] tried to slow down the residential market through some prudential measures, they haven't seemed to work. One of the reasons for that is because demand has so outstripped supply. When you think about the Hong Kong property market, you really have five, six strong competitors that dominate the residential housing market, and they release homes when they feel like they need to. So, if there are no homes for sale, obviously the few homes [that are] get bid up.

What has really been a game-changer over the past 12 months particularly in Hong Kong is that the tightening measures of mainland China have resulted in the mainlanders coming to Hong Kong to buy property instead of buying property in China. That has created this second layer of marginal demand that has kept residential prices at levels that we would deem to be high or excessive based on the recent growth trajectory.

Q. The history is not particularly long. Can you think of any analogous situation?

A. I believe that what goes on in China as far as the residential market is very similar to what occurred in the United States in the 1930s and '40s. You had a large number of immigrants coming from Europe, getting their first jobs, making money, and not having full confidence in the banking sector. There were essentially two asset classes for these people, and one was cash and the other was property. As you built up a nest egg and saved your money and put it in your mattress, the first major acquisition that you would make for your family would be a home. And you did everything within your power to pay off that mortgage. Once you owned your home, then you had excess cash, and I believe that that is what is exactly occurring in China. Now China is a market that was just opened to private residential houses in 1998 essentially, and so you still have this lack of investment alternatives because there is no capital market as we know it in the United States. There is no free flow of capital. Money is captured in China, and it's cash and property.

Q. How do you factor in the other operations that come along with these real estate conglomerates? It seems like they trade with real estate. Are those other operations valued at all?

A. Think about Cheung Kong, Henderson Land, Wheelock--three large positions within Third Avenue. Cheung Kong is much more than a real estate company, though it is absolutely correct that it does trade with the real estate developers. Cheung Kong owns a 50% stake in Hutchinson Whampoa, which is essentially a conglomerate, almost like a private-equity company for Cheung Kong. They own energy businesses, they own telecom, they own a retail business and the largest port operator in the world. When you strip through and value all of these independent businesses, you get to a significant increase in value compared with book value.

Henderson is a real estate company first. But it has a 40% interest in Hong Kong and China Gas, which is a publicly listed gas-utility company in Hong Kong with an expanding presence in mainland China, which at the current price, is roughly 50% of the market cap of Henderson Land. It's on the books at cost. Its net asset value per the balance sheet would indicate a 20 billion dollar value, and it's actually worth in the market about 52 billion dollars. You have to make adjustments.

And in Wheelock's case, Wheelock has, through Wharf Holdings, an expanding port operation in Hong Kong and mainland China. That NAV needs to be adjusted when you're trying to estimate the [true] value.

Q. So, one of the things that seem to make this very complicated, maybe a little tenuous, is that these are all volatile stocks. Do these values change much?

A. The utility businesses don't, because they're regulated essentially businesses. The part of the analysis that is a little bit more complex is valuing those businesses independent of the stock market. Sometimes they can have comparables within the market, [sometimes] the comparables are not necessarily very good, either on a geographic basis or within a market. You have to do some estimating of the value of the businesses.

Q. What about the volatility in general of the real estate stocks? Volatility at the fund levels has been a concern for some of Third Avenue's investors. Does the volatility of the stock price factor at all either into the analysis or into the portfolio-construction decisions?

A. Volatility is not risk. We're very focused on protecting our downside. Thinking about portfolio construction, we do take some of the volatility into account. But by and large what we hang our hat on is our independent valuation of each business and where we think they're going to be six months from now, 12 months from now, based on our estimation of how the business is going to grow. What's been phenomenal for us is the growth in these businesses. We're happy to take on the added volatility of the stock market, because it is truly a random walk--particularly in Hong Kong because it lacks a takeover market--but the business growth that we have seen, the value creation that these companies have produced over our holding period, has been phenomenal.

Q. I recognize there's a growth pattern here, but do you run any sort of risk of extrapolating that into too far into the future?

A. Growth stocks get into trouble when the stock prices keep anticipating that growth, and I would tell you that the expectations for these companies have been tempered by the threat of interest-rate risk and government-policy risk. We have always said at Third Avenue, the ideal value investment is when a stock trades at a 15% discount to net asset value and net asset value continues to grow at 15%--and that discount to net asset value never widens.

Q. Over Third Avenue's holding period, there are certain times when these stocks have been good for you and certain times when they have detracted meaningfully. Tell us about your experience overall.

A. We're generally very pleased with the way they've performed since the inception of these holdings. We bought them in the 2005-2006 period after the SARS epidemic led to the big discounts. We tracked them all the way up into the beginning of 2008 and then rode them down. Meanwhile, the financial performance of all of these holdings has continued to go on almost a linear [upward] path, which has been fantastic. So, the ups and downs of the market are going to occur; they lead to some underperformance, but when we think about the 10- to 15-year track of China generally and the long-term growth trends of a developing market--urbanization, rising consumer spending, and a burgeoning middle class--it's hard not to participate in that without investing in real estate. The fact that you can do that through blue-chip Hong Kong developers that are experienced and that have long-term track records, it's really a special case that we feel delighted about owning over the next 10 years.

Q. Let's cover the "cheap" part of the "safe and cheap" mantra. The most recent shareholder letter noted the discounts to net asset value of several of the holdings. Those discounts ranged from 11% to 36%. Is 11% and 16% really cheap enough?

A. In the real estate market today, it is a big discount. We're on record saying how difficult it is to find really interesting opportunities. If you look at a U.S. REIT, for example, say valued at NAV, you're essentially with zero growth or maybe 1 or 2 percent growth on that. [The Hong Kong] businesses have shown the ability to grow at north of 10% a year. When you get a nice discount, assuming the discount doesn't widen, and the discount stays relatively the same, you can still enjoy a very reasonable return.

The real juice comes when the discount closes and the growth continues, and then that's when you have to re-evaluate your position size and react accordingly. It's almost a curse in these investments that they have never truly gone to overvaluation ranges and yet the fundamentals of the businesses have maintained their growth trajectory.

Q. What do you think it takes for those gaps to close?

A. I think a widening of the investor base--more people getting involved, investors really getting a handle on financial conditions of different countries and where the opportunities are for the long term. This is going to be a place where you can participate in the growth in a very conservative way by owning real estate companies with hard assets that are, by the way, pretty inflation-protected given that the lease terms are generally shorter-term.

You're looking at overcapitalized businesses that can grow in the order of 10 to 15 percent depending on the company. For us that is a very conservative way to participate. [These are] standard old real estate companies that happen to be able to grow at double digits, which is really hard to find in the world.

 

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