A Downgrade for This Once-Excellent Real-Estate Fund

The following is our latest Fund Analyst Report for Third Avenue Real Estate Value Fund TAREX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

Third Avenue Real Estate Value is in transition. Co-lead manager Michael Winer is expected to retire in early 2018. Winer has been at the helm since the fund’s 1998 launch. Co-lead managers Jason Wolf and Ryan Dobratz have been key parts of the fund’s success for more than a decade, but there are parent-level concerns about Third Avenue. And this fund's team continues to have turnover among its analysts. This fund is downgraded to a Morningstar Analyst rating of Neutral from Silver.

The team uses a deep-value approach that seeks investments with a margin of safety. This process differs from others in the space in that the team frequently favors real estate operating companies over real estate investment trusts. It will also look to invest in restructuring situations, real-estate-related companies, and securities at different points in the capital structure that other funds ignore, often purchasing senior loan notes alongside equity.

The fund’s long-term performance is strong, but it can be out of step at times. Many of the team's themes take years to play out, subjecting the fund to bouts of underperformance and differentiating its returns from the benchmark's. But patient, long-term investors have been rewarded. Through the end of November 2017, the fund’s one-, three-, five-, and 10-year returns outpace both the peer group and benchmark. The fund has continued its winning ways of late. It has gained more than 19% for the year to date through November 2017, beating the FTSE EPRA/NAREIT Developed Index and the global real estate peer group by over 9% and 7%, respectively.

But parent concerns loom. Morningstar recently reaffirmed its Negative Parent rating on Third Avenue, which was initially downgraded in late 2015 following the liquidity crisis at Third Avenue Focused Credit TFCIX. The firm continues to have meaningful outflows and investment-team turnover. Outside of this fund, Third Avenue’s other offerings have experienced weak results.

Fees are also high here.

Process Pillar: Positive | Jonathan Wallace, CFA 12/13/2017 Like other Third Avenue offerings, this fund seeks companies that trade at a significant discount to management's estimate of net asset value. This team tends to favor real estate operating companies over real estate investment trusts because the REOCs aren't encumbered by dividend requirements and can reinvest their cash in property development. The managers expend great effort analyzing financial statements, visiting companies and their properties, and assessing management teams. The team has demonstrated skill in executing this unusual strategy. Expect no changes to this process, which earns the fund a Positive Process rating.

The skippers do not manage to a benchmark, instead focusing on long-term absolute returns. Many of their investments may take years to fully play out. With a flexible mandate and an opportunistic frame of mind, they will take advantage of restructuring situations, real estate related companies, and securities at different points in the capital structure that other funds frequently ignore, often purchasing senior loan notes alongside equity.

The fund originally focused on Western markets, but Wolf has helped steer the portfolio more globally since he joined the team in 2004. The fund's regional exposures are now close to category peers in most cases, except in Asia, where the managers have avoided Japan in favor of Hong Kong stocks.

The fund’s portfolio reflects management's patient, low-turnover approach that results in high active share. The fund’s universe consists of more than 500 names, but only about 200 overlap with the benchmark. The team narrows its universe to build a concentrated portfolio that generally consists of 30-40 holdings, with 35%-50% of the assets invested in the top 10 holdings. Additionally, the team keeps track of names that it has fully vetted and would like to own at lower prices. If it doesn’t see opportunity to buy at its desired price, the team lets cash drift up, looking to later deploy it when opportunity arises. To maintain diversification, the team limits positions to 5% weights at purchase and 7% at market.

A current theme in the portfolio is the expectation for a continued recovery in residential markets. The fund owns

The fund’s investment style gives it exposure to illiquid securities, but it has been able to meet redemptions by selling more liquid investments. The fund’s exposure to illiquid securities has been capped at 10% and has been drifting downward toward 5% recently.

Performance Pillar: Positive | Jonathan Wallace, CFA 12/13/2017 Investors patient enough to ride out this fund's periodic misalignments with the rest of the category can reap the rewards of the fund's distinctive, value-oriented approach. Its long-term record is consistently good and earns a Positive Performance rating.

The fund's annualized return of over 11% since its September 1998 inception through November 2017 outpaces both the FTSE EPRA/NAREIT Developed Index by over 100 basis points and the global real estate category average by over 200 basis points. It has beat the the benchmark and peer group average over the one-, three-, five-, and 10-year periods and ranks in the top quintile in each of those periods. The fund's Sharpe and Sortino ratios--measures of its risk-adjusted return--also outpace the benchmark and peer group. The fund focused on the U.S. market during its early years but outpaces the domestic index as well.

The fund has experienced several droughts in performance. It has trailed its benchmark at various times as some out-of index picks struggled. Still, the fund did an admirable job in preserving value during the 2007-09 financial crisis. The fund’s drawdown of almost 68% was significant, but it was smaller than the 72% and 71% losses experienced by the benchmark and peer group, respectively.

People Pillar: Neutral | Jonathan Wallace, CFA 12/13/2017 This fund has operated as a five-person team with co-lead managers Michael Winer, Jason Wolf, and Ryan Dobratz leading the charge. They are supported by two analysts, with the most recent joining the firm earlier in 2017. Winer, who has been on the fund since its inception, is expected to retire in early 2018. It is also expected that Third Avenue will hire another analyst to support Wolf and Dobratz. Wolfe and Dobratz have been involved in succession planning and have served as key players on this strategy for years. They are seasoned and capable managers, but the loss of Winer is material. There has also been continued analyst turnover on the real estate team. The fund is downgraded to a Neutral People rating.

Wolf served as a senior analyst on the fund for more than six years before being named comanager in September 2010 and becoming co-lead in 2013. Wolf played an instrumental role in expanding the fund's investment into Asia and other foreign markets. Also in 2013, Dobratz, who previously served as a senior analyst and as a team member since 2006, joined the manager roster. The firm promoted him to co-lead two years later.

Winer, Wolf, and Dobratz have significant skin in the game, as all three have more than $1 million invested in this strategy. This is especially impressive given that this fund typically would not serve as a core holding in an investor’s portfolio.

Parent Pillar: Negative | Jonathan Wallace, CFA 12/13/2017 Problems continue to persist at Third Avenue. In September 2017, the firm saw more shakeup with the loss of three portfolio managers, two of whom left the firm, while the third remains as an analyst. The firm also continues to experience turnover in the analyst ranks, and outflows persist, in part prompting the proposed merger of Third Avenue International Value into flagship Third Avenue Value. Meanwhile, the firm continues to face SEC scrutiny as it liquidates Third Avenue Focused Credit.

More positively, the firm seems to have settled its management committee after the departures of CEO David Barse in 2015 and other senior leaders between 2015 and 2017. It now includes just three tenured portfolio managers on the management committee: Jason Wolf, Matt Fine, and Ryan Dobratz. Meanwhile, two portfolio managers, Michael Fineman and Victor Cunningham, have rejoined the embattled firm. The firm also hired Mark Aaron, who worked at AMG affiliate TimesSquare to serve as chief risk officer and chief operating officer. AMG continues to keep a majority share of the company.

As always, Third Avenue boasts solid manager investment in its funds. Still, the remaining work to be done on the unwinding of Third Avenue Focused Credit, considerable disruption in the investment and operational teams, and concern over outflows continue to support its Negative Parent rating.

Price Pillar: Negative | Jonathan Wallace, CFA 12/13/2017 The fund's expenses continue to increase. It has two share classes, and almost 90% of the assets are in the lower-priced Institutional shares, priced at 1.13%, up from last year's price of 1.10%. The fund's Investor shares are priced at 1.38%, up from last year's 1.35%. The pricing for both share classes lands among the more expensive in the category, which earns this fund a Negative Price rating. Outflows could weigh on the fund's economies of scale and cause expenses to rise further. This would certainly detract from the appeal. On a positive note, Third Avenue has capped fees at 1.15% and 1.40% for the Institutional and Investor share classes, respectively.