Andrew Gogerty: This is Andrew Gogerty for Morningstar, and we're here talking the real estate sector at the 2011 Morningstar Investment Conference.
Real estate funds continue to be in demand from investors, having enjoyed positive flows again so far this year, and joining me today with a global perspective on the real estate sector is Jason Wolf, the co-manager of the Third Avenue Real Estate Fund.
Jason, thank you for joining me today.
Jason Wolf: Nice to be here Andy.
Gogerty: Going back to the demand in the U.S. for these funds, obviously flows have been strong. You guys have a global mandate, and you only have a third inside the U.S., and you have almost two-thirds of the fund positioned outside of the U.S. I wonder if you can give me your perspective broadly on the opportunity set of U.S. versus non-U.S. right now? What's driving that U.S., non U.S. I know its stock specific, but maybe even from a macro level, what's driving that allocation right now, because it seems like on an asset basis, you're finding more opportunities outside the U.S. to deploy your assets.
Wolf: The Third Avenue Real Estate Value Fund about seven years ago really started to gradually move its assets overseas, and it started with Hong Kong. But when you look at the opportunity set today, particularly since the great financial crisis, real estate stocks in the U.S. and the U.K., particularly real estate investment trusts, have risen quite considerably in comparison to the fundamentals that you would think would be supporting them.
The complete opposite has happened in the international markets or Asia ex-Japan, where you've seen fundamentals, strong office, retail, residential growth and cash flow growth, and you haven't seen the same type of pricing increases that you would have thought would've occurred.
Gogerty: So, the exact opposite of the U.S. the fundamentals go up but the prices are staying down.
Wolf: Exactly, and so this has led us to these areas, where we're finding very strong fundamentals, better pricing and long-term growth prospects, because when we think about Hong Kong, China, we think about a 10-year period of very, very strong dynamics for growth in real estate values.
Gogerty: For investors that may not know Third Avenue Real Estate, but know Third Avenue and Marty Whitman: safe and cheap, hardcore strict-value strategy. How are you applying that to one specific sector here? What are some of the tenets that you're looking at, because obviously you're not sticking to mainstream REITs like a lot of your peers, but you're looking at related companies, traditional corporations. How are you taking that basic value philosophy and executing it inside the real estate sector?
Wolf: Sure. We think that there are some real advantages to being a real estate value investor in the securities markets. One is that our opportunity set is pretty large. We'll buy REITs, we'll buy real estate operating companies, and we'll buy real estate related entities. We will also invest throughout the capital structure, so we'll also buy equities and debt, and in some cases the distressed debt of companies that may be entering bankruptcy. And this is also done without a constraint that most real estate funds have of being benchmark focused, market caps or geographies.
So, we're just really trying to find where the opportunities are and go to those places. The other part of it is that we're very price conscious, and being price conscious will sometimes lead us to a lack of opportunities, and so cash will build up in a portfolio.
Then the third part of it is, we're more capital appreciation focused than most real estate funds that are more dividend focused, so it's more of a total return outlook, where we're looking for companies that can compound value over a long period of time.
Gogerty: Two things I wanted to pull together as maybe a follow-up: total return opportunities and geography. One of the areas that the fund currently has a material stake is Asia, ex-Japan, and obviously there has been a lot of headlines, job growth, inflation, what's happened in Japan, how that's going to spread. There is a lot of moving parts there, and it seems like that part of Asia ... pick the day and it's going to be in the news.
You guys have a material stake there. What are you seeing past maybe the near-term headlines that is giving you confidence that that's a good long-term investment play for the fund?
Wolf: The history of our investments in Asia--and it was primarily started in Hong Kong property developers--started about five to six years ago and that was ... off the heal of the SARS epidemic, which lead to a big sell-off in the market. And what we found there is examples of our safe and cheap approach that we couldn't find anywhere else in the world at the time, and that is you found businesses that were extremely well financed, businesses that were owned by control groups that had huge ownership stakes that thought long-term like we do, and had business fundamentals that appear to be able to grow value over 10% for the next 10 years given the backdrop of the growth of GDP in Asia. So we found that very attractive, and we could buy them at very cheap prices. So, the elements really came together, and Third Avenue had a big push across our platform into these stocks.
What has happened over the course of the seven years is that business fundamentals have been better than we've expected, asset values have grown, stock prices have performed pretty well, and we've been very happy with our holdings. This has led to us looking around the region, into Japan, we made some investments there. We still believe that it's one of the cheapest real estate markets particularly when you compare the public market to the physical market, there is in the world--but it has issues, and some of those issues are top-down with the economy and general supply issues in the Tokyo region.
But recently what we've been interested in is the macro headwinds of China slowing down has had an impact on Australia, and Australia is a market that has a bunch of real estate investment trusts, some of which are very attractively priced, have very good financial positions with a good-quality asset base that we believe could go through some type of resource conversion over the next three to five years.
Gogerty: What do you mean for investors or advisors that aren't familiar, what do you mean by resource conversion? Is it a capital change, is it maybe like a merger and acquisition, is it selling off non-core assets? What do you mean by that conversion of resources, because we think real estate, we think buildings, we're not thinking natural resources, so what do you mean by that resource conversion?
Wolf: Resource conversion can mean many things. But primarily in a real estate context it is the divestiture of a business unit, a merger with another entity, a special dividend, or some type of refinancing of the business and a special dividend payout. There are all sorts of issues. In Australian case, we believe they have a U.S. industrial business that needs to be spun out and then it would be a sector-focused REIT that would then revalue towards what other peer group real estate investment trusts will be trading at.
Gogerty: So like a pure play, like getting rid of maybe the conglomerate tag and being more of a pure play, and they would get re-priced to their peers.
Wolf: That's exactly right.
Gogerty: Got you. You know one of the things you said, you're taking the combination, you're obviously not investing in a black box, you understand the macro environment, the headwinds and then also the physical property and the opportunity.
I wonder if you could give me just a quick glimpse into how you're looking at the U.K. or Europe as a whole? Obviously, they have their own macroeconomic, their own financial headwinds just as the U.S. does--but there is still a pretty large property base there, and it's a big portion of a lot of global indices when it comes to real estate. I wonder if you could give us a minute there?
Wolf: I think when you talk about the macro and how we marry it with our fundamental analysis is, it's really too facets. One, there is the security analysis and then there is the portfolio construction process. In the securities process analysis, it's really getting a handle on what the various macro environments will do to your determination of value and the different scenarios.
From the portfolio construction side, we've tried to look at it and marry what are the risks that we would be taking given a sovereign debt crisis or some type of economic slowdown due to austerity measures, and how would it impact the business.
So far what we did in continental Europe last year was during the heat of the crisis in April and May, we bought into three businesses and have subsequently sold two of them, one of them just got taken out as a takeover. So, it's really playing it more on a temporary [basis] as something being fixable over a shorter period of time. It's a special situation for us. By and large, we haven't been fully invested in Europe or the U.K. as much because prices have been pretty elevated.
Gogerty: Okay, so it's really just those specific opportunities where you see a nearer-term catalyst unlocking that value.
Gogerty: Great. Thank you for your time today, and your perspective. I definitely appreciate the insight that you're willing to give us.
This has been Andrew Gogerty at the 2011 Morningstar Investment Conference with Jason Wolf, the co-manager of the Third Avenue Real Estate Fund. Thank you for joining us.