In early 2008, Michael Winer felt like a kid with empty pockets in a candy shop. After a downturn in real estate stocks in 2007 and early 2008, Winer, who manages the $2.3 billion Third Avenue Real Estate Value fund, was itching to buy shares of what he considered great real estate companies at discounts he had not seen for nearly a decade. But in the midst of daily headlines about declining home prices and suffering real estate markets, the fund, like other real estate offerings, had seen net redemptions by the end of 2007. The frustrated manager recalls "pounding the table, saying this is the time to buy" at a time when there was little cash to go shopping.
Eventually, investors saw the sector as over-punished and, like Winer, found the compelling valuations hard to ignore. Since March, real estate investment trusts, or REITs, have performed better than the broader markets. After suffering a 27% decline between January 2007 and February 2008, the FTSE NAREIT All REIT Index began climbing and was up 6.46% during the first five months of the year, a period when the broad market averages sank into negative territory.
Winer says that while large discounts to net asset value are not as across-the-board as they were at the beginning of the year, he still sees plenty of value, particularly in certain overseas real estate companies with strong portfolios and pummeled stock prices. If the real estate market has been punished, he says, the stocks of solid publicly traded real estate companies have been punished even more.
Pessimism may continue in the housing market; however, Winer's fund is focused not on housing but on commercial real estate companies with long-term leases, strong management, solid cash flow and properties located in attractive markets with high barriers to entry. "There will be pockets of weakness in commercial real estate, but some companies will need to go through two or three real estate cycles before they have to start worrying about vacancies," Winer says. "Notwithstanding the evidence that commercial property values have declined, and may decline even farther, the public market for stocks of high-quality real estate companies has overreacted to the global credit crisis."
The fund's global exposure is one reason that its performance often diverges from that of its competitors. Its foreign holdings, which make up nearly half of the portfolio, worked in its favor during the sector's downturn in 2007, when surging stocks from Japan and Hong Kong balanced out lagging returns from U.S. holdings. Last year, the fund's Hong Kong holdings leaped 60% to 80% as U.S. REITs suffered double-digit declines. But with the recent upturn in large, popular U.S. REIT stocks, the fund has lagged many of its more traditional peers so far this year. "We often zig when the rest of the REIT market zags, and we tend to outperform in bear markets," observes Winer, who has shifted some of the profits from the Hong Kong holdings into U.K. and Japanese stocks with more compelling valuations.
A certified public accountant and former real estate developer, Winer was investing in overseas real estate stocks long before the practice became popular. With a small asset base and plenty of stock bargains to choose from in the U.S., Third Avenue Real Estate Value fund stayed domestic for a few years after it opened its doors in September 1998. It expanded its reach about five years ago as U.S. real estate stocks became pricey and its asset base swelled.
To access the kind of valuations he wanted, the manager called on the international equities team at New York-based Third Avenue Investors to help him mine less discovered real estate companies based abroad. Today, the fund has ample exposure to real estate companies based in the U.K., Hong Kong, Japan, Canada and Singapore.
Winer says that foreign real estate companies tend to be well financed and more conservative in their business practices than their U.S. counterparts. And despite their far-flung properties, there is plenty of information available about them to determine whether their stocks represent a good value. In the U.K. and Hong Kong, for example, real estate companies must get properties appraised twice a year, a mandate that helps Winer arrive at an estimate of their real estate portfolios. Japanese reporting is somewhat less transparent, although the firms in Japan own some of the highest-quality office properties in the world and enjoy favorable financing rates of less than 2%.
Regardless of location, one of the key questions Winer asks when he makes a purchase is whether the public value of a company's stock is less than the private market value of its real estate, and if so, by how much. Even though many of the companies in his portfolio have attractive real estate collections and strong fundamentals, their stocks often sell at a substantial discount to the value of their holdings.
He cites British Land Common as an example of a stock that has been oversold because of fear and uncertainty, despite very strong underlying property and corporate fundamentals. The firm has a high-quality portfolio of office buildings outside of London, with average lease terms of 14 years; properties that are 99% leased; low-cost, fixed-rate financing; and cash flow that covers interest charges by 180%. Even though property valuations have declined, the company's stock has dropped at an even greater rate and, according to Winer's estimate, was recently selling at a 45% discount to net asset value. Other stocks of U.K. real estate companies are selling at discounts ranging from 35% to 50%, he says.
Many of the stocks in the portfolio are priced at what Winer considers significant discounts to any reasonable valuations. "I'm not sure if I'm getting in at the lowest stock prices, but I do know that there are some compelling values out there for some great companies, and I'm willing to wait things out until stock prices catch up," he says. With his top ten holdings accounting for 55% of assets and a focused portfolio of 38 stocks, he is also willing to invest decisively in companies he likes and hang on to them, often for several years. Two analysts assist him in his evaluations.
In addition to its foreign leanings, the fund's emphasis on real estate operating companies, alongside REITs, sets it apart from its competitors. Like REITs, REOCs are traded on major stock exchanges. But REITs are required to pay 90% of their cash flows in dividends, while REOCs have no such restriction and can plow the money back into their businesses. About 60% of the fund's assets are in REOCs, with the rest in REITs, home-builder stocks and cash. With less emphasis on dividends, the fund has a growthier, more tax-friendly flavor than a more traditional pure REIT fund that has generous payouts, and it may be better suited for taxable accounts than many of its peers.
Winer likes the structure because companies that reinvest cash flows in the business rather than pay dividends can expand without relying on hefty doses of outside capital, which is particularly important in an environment of tight credit. While the recent global credit crunch has had a minimal impact on interest rates, it has made a dramatic dent in the ability of real estate companies to obtain financing. The lending slowdown in commercial property transactions has forced many borrowers to seek financing from "portfolio lenders" such as insurance companies and pension funds, which tend to have more conservative underwriting standards.
Because of their strong financial positions, the well-capitalized real estate companies the fund invests in are able to use their financial muscle to pick up properties at distressed prices even in an environment of tight credit, Winer says. Forest City Enterprises, the fund's largest holding at nearly 11% of assets, recently acquired 2,500 residential lots in San Antonio for about 25% of what the seller had paid three years ago. A holding since the fund's inception, Forest City has a strong foothold in markets with high barriers to entry such as New York, Boston and Washington, D.C.
Winer recently increased the fund's position in another longtime holding, St. Joe Company. St. Joe started out as a paper producer back in the 1930s, and acquired huge tracts of forestland in the Florida Panhandle. Ten years ago, new management sold off noncore assets, including the company's paper mill and railroad unit, to focus on maximizing the value of its land. Today, it owns nearly 800,000 debt-free acres. Although Florida's real estate market has taken a severe hit, Winer says the company has a stronghold in the region's land market and is well-positioned to take advantage of opportunities that arise over the next 50 years.
More recent portfolio positions include Cousins Properties, which the fund acquired at a substantial discount to Winer's conservative estimate of net asset value. The Atlanta-based REIT develops and owns commercial and residential properties, mainly in the Southeastern U.S., and has a 45-year track record of acquiring and developing real estate. Its portfolio includes office, retail and industrial properties, as well as a large pipeline of retail, industrial, office and residential properties.
