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Real Estate Recovery Still Has Room to Build

Josh Charlson, CFA

Josh Charlson: Hi, I am Josh Charlson with Morningstar. I am here at the Morningstar Investment Conference with Jason Wolf. He is a co-lead portfolio manager for Third Avenue Real Estate Value, and we're going to be talking about real estate today. The real estate markets have been on a tear over the past 18 months, and this fund has been one of the best. It was up 36% in 2012, and through May of this year it was in the top 2% of the global real estate category. Welcome, Jason.

Jason Wolf: Thanks, Josh.

Charlson: Most real estate mutual funds focus on REITs, and your fund takes a little bit of a different approach. It focuses more on real estate operating companies. Tell us a little bit about why you take that approach and how it's affected the fund's performance over the past 18 months or so?

Wolf: Yeah. Well, the fund been around for 15 years, and we've always taken a value-oriented approach, similar to the Third Avenue Investment philosophy that Marty Whitman created years ago. And REOCs have always been the preference for our style. And primarily, the reason for this is because REOCs can retain cash flow where real estate investment trusts are required by law to distribute most of their cash flow. And by retaining cash flow, we feel like the REOC model allows businesses to be able to grow through developments and other avenues to create long-term wealth.

Charlson: So one of the areas that's done very well for the fund over the past year and a half or so is sort of the U.S. residential market where you've made a play through various types of holdings. What have some of your investments been in that area?

Wolf: Yeah. Back in 2010, Josh, we invested in a range of real estate in the U.S. and the U.K. residential market really right down the vertical stack, from retailers to homebuilders to timber companies and land-development companies back in the downturn. And the view was that we were going to invest in these businesses that were very well-financed without any kind of prospects for the timing of the recovery. But when the recovery did occur, we've felt like these businesses would prosper. And sure enough, here that we're starting to see some semblance of a recovery in the housing businesses, these businesses tend to lead. The homebuilders obviously led prior to some of the inputs, but we still feel like the inputs, such as the timber companies, the land-development businesses, and the retailers, still have ways to go as the recovery matures.

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Charlson: What are some of the specific names in that area that you hold in the portfolio?

Wolf: Weyerhaeuser, the timber REIT with 6 million square feet of some of the most valuable timberland in the Northwest Pacific area, and Lowe's, the home-improvement retailer, as well as Newhall Holding Company, which is a land-development business in Valencia, Calif.

Charlson: One of the things that's distinctive about your fund is you tend to hold cash when you don't see valuations at the level you like in the market. How did that play out for you sort of from the end of 2011, when there was some volatility in the market, through 2012 and kind of where you are today?

Wolf: Yeah, cash for us, as with most value investors, is a residual of the investment approach, right? If we can't find interesting opportunities, we will tend to hold on to our cash and be patient and disciplined until we find opportunities that are right. A good example of how cash can build up and be drawn down in opportunities is in 2011, where we had about 20% going into the U.S.-debt-downgrade situation in September of that year, we drove our cash balance by investing in new names and existing names within the portfolio down to about 4% by the end of the year, which set us up for the strong performance that we had in 2012.

And while that is a part of the process, the other side of that process is the sell discipline. And as stocks start to appreciate and hit our sell targets, we will trim, scale back positions, and the cash will build up again until we can find other opportunities. And today, we're sitting on about 18% cash, getting ready for the next chance to redeploy that cash.

Charlson: An area that you made some investments in, I believe, late last year or maybe early this year was hotels, which is, I believe, an area you have not invested in for quite a while. So, tell us a little bit about what the story is with hotels and what the opportunity is that you see there?

Wolf: Yeah, over the past year or so, we've started to really think about real estate investing in the securities markets in an environment that might be adverse, meaning, a rising-interest-rate environment. And part of that is understanding how cash flow durations work and being able to offset potential cap-rate rises with cash flow increases. The hotel businesses that we own today, such as Hyatt and Millennium & Copthorne, they’ve got a couple of things going from and one of which is we really truly believe that there are some resource-conversion opportunities with these businesses, meaning, a takeover or some type of transaction that can revalue the business to where we think something happens within the next 12 to 18 months.

But the other side of it is, is that in order to get into a cyclical business like the hotel business, where you have daily leases, we require them to be very well-financed, and both Hyatt and Millennium & Copthorne fit that bill.

Charlson: In terms of the concerns about the rising-rate environment, what is sort of your time frame over which you see that becoming a concern, and what are some other ways you are thinking about positioning the portfolio to benefit from that?

Wolf: We are thinking about it over the next three to five years, and the prospect of higher interest rates, when you put a probability on that, appears to be very high. Thinking through that and the headwinds that would be faced by general real estate securities, we have been trying to position the portfolio both to protect it by avoiding dividend-sensitive-type securities, shortening the cash flow duration, having implementing some hedging on some of the most interest-rate-sensitive parts of our portfolio, as well as how do you benefit from that. That's, I guess, the real avenue for us. I think you really have to be in businesses that are going to be economically sensitive.

So sort of like the hotel businesses that you mentioned, the residential businesses that you mentioned, both in the U.S. and the U.K. And along with that, you’ve got to own businesses, particularly REOCs that can retain capital that are involved in the development and redevelopment of real estate assets.

Development has been at all-time lows for a long time since at least postcrisis, and a recovery in the development side of these businesses, some of the land banks that the companies that we own are extremely valuable because they don't have to go and buy the inventory. They’ve got it. It's entitled, and they just need to start the development. That can create a lot of long-term value for these businesses.

Then on the flip side, you have the cash balance, right? So as interest rates start to creep up, you'll have market dislocations every now and then and you've got to be able to redeploy and buy opportunistically, and maybe that's where we are today.

Charlson: One final question. You mentioned hedging, and over the years you have opportunistically taken the opportunity to do some hedging in your portfolio if the cost of the hedging was cheap enough. You have done some over the past year or so; that's helped out recently. Talk a little bit about that?

Wolf: As I mentioned about the fear of rising interest rates and the impact on some of the positions within our portfolio, we looked back historically and tried to figure out where we could sort of dampen volatility within the fund by instituting some hedging.

There are two areas that we were highly insensitive to. One was our largest position in Forest City Enterprises. While it has a higher-than-typical debt levels, it's mostly nonrecourse mortgage debt, but we felt like we could adequately protect the market volatility through doing some caller transactions, selling calls and buying put options, so that we would be able to take advantage of a market dislocation due to fears, unwarranted fears on the fundamentals of the business, but on the securities price so we could take advantage of that.

And then in Hong Kong, a market that is highly sensitive to interest rates, we decided to buy plain-vanilla index puts on the Hang Seng Property Index, where we would offset some of the downturn, or the market dislocation that could be expected in interest rates, and that's occurred here in 2013 in a pretty dramatic way very recently.

Charlson: Great. Thanks so much, Jason.

Wolf: Thanks, Josh.