Independent Thinking^®

Q&A with Third Avenue Real Estate Value Fund

Editor’s note: Evercore Wealth Management supplements its core investment capabilities with carefully selected outside funds across the range of the firm’s asset classes.

Marty Whitman, a pioneer in value investing, founded Third Avenue in 1986; the firm launched the Third Avenue Real Estate Value Fund in 1998 to achieve long-term capital appreciation by investing in both real estate and real estate-related securities worldwide. Here we interview Co-lead Portfolio Manager Ryan Dobratz. Please note that this interview represents the views of Ryan Dobratz and not necessarily the views of Evercore Wealth Management.
 
Q: Third Avenue is best known as a value investor. How does that approach apply to your real estate funds?
A: Third Avenue has always emphasized creditworthiness and investments in the common stocks of well-capitalized companies. For real estate businesses, this means that they must have high-quality assets such as class-A office and retail portfolios, valuable and productive tracts of timberlands, or well-located land holdings with development potential. In addition, these businesses must be conservatively financed with modest levels of debt, as well as off-balance sheet liabilities such as contractual obligations.
 
We will invest in securities only when the shares can be purchased at a substantial discount to the company’s net asset value, or NAV. Our goal is to find companies where the NAV can increase by 10% or more per year.
 
Rarely does one find both good news and attractive prices. As a result, the Third Avenue Real Estate Value Fund typically buys companies, property types, and geographies that are out of favor, and holds on until conditions improve, which on average takes about five years. Since inception, the Third Avenue Real Estate Value Fund has earned an annualized return of about 11%, placing it among the top global real estate funds.
 
Q: Why should investors consider real estate now, in a rising interest rate environment?
A: If interest rates are going up for the right reasons, such as a rebound in economic activity and accelerated job growth, that’s actually quite positive for real estate. But dividend-seeking investors have pushed up many real estate securities, including real estate investment trusts, or REITs, to valuations that might not prove to be sustainable in a higher rate world. As long-term value investors, we have positioned the Third Avenue Real Estate Value Fund as an alternative that would not only seek to protect capital in a rising rate environment but to potentially benefit from it.
 
To accomplish this, we started reducing the fund’s exposure to yield-oriented real estate securities. Instead, we focused the fund’s capital in companies with securities trading at discounts to more durable property values and in property types with shorter-term leases, such as retail, industrial, and multi-family properties (as opposed to property types such as healthcare and net-lease, where cash flows are largely locked in for terms of 20 years or more).
 
The fund also increased its exposure to real estate-related businesses with strong ties to the U.S. residential markets (in particular, the construction of single-family homes), as well as commercial real estate companies with well-located development projects that could potentially capitalize on demand recovery and earn outsized returns. In addition, the fund initiated modest investments in U.S. banks and other real estate-related businesses with depressed earnings that would likely prosper in a higher-rate environment.
 
Since 2013, there have been three periods where the yield on the 10-year U.S. Treasury has increased by more than 0.50% over two or more months. During those periods, the fund has provided an average return of +1.4%, while the fund’s most relevant benchmark, the FTSE/EPRA NAREIT Developed Index, has generated an average loss of -8.0%. Using these three periods as a guide, we believe the fund is well-positioned if interest rates continue to increase further.
 
Q: What role do REITs play in the fund?
A: One of the key advantages of the Third Avenue Real Estate Value Fund is that it has a flexible mandate that allows it to not only invest in REITs but also in real estate operating companies, or REOCs, and real estate-related businesses such as home builders, timber companies, land development companies, and regional banks. We believe that our real estate universe is nearly three times larger than that of funds that closely follow the relevant benchmarks.
 
As a real estate strategy that seeks to maximize total returns while emphasizing capital appreciation, the fund has always been biased to investing more capital in REOCs than REITs for two primary reasons. One, unlike a REIT that is required to distribute 90% of its net income as dividends each year, a REOC is free to retain the cash flow generated in the business and reinvest in developments, redevelopments or opportunistic acquisitions. This approach tends to result in more attractive rates of growth over time and more tax-efficient capital appreciation. Two, having the ability to self-finance this expansion is a much more reliable business model in our view, as REITs are more dependent upon the somewhat fickle capital markets to finance their expansionary efforts. For these reasons, about two-thirds of the fund’s capital is now in REOCs and real estate-related businesses, including some of the top holdings like Cheung Kong Property in Hong Kong and Lennar Corp in the United States.
 
We are not opposed to investing in REITs, however, provided they are well-capitalized. At the present time, we just aren’t finding a ton of value in the more widely held U.S. REITs. However, there is one glaring opportunity in U.S. REITs today: timber. The fund currently has roughly 11% of its capital in these types of timber companies, most notably Weyerhaeuser and Rayonier. In our view, both of these businesses are incredibly well-capitalized and trade at large discounts to the private market value of their timberland holdings, but are poised to benefit as residential construction activity in the United States continues to approach more normalized levels (1.5 million homes built annually vs. 1.1 million currently). In such a scenario, both businesses have the potential to generate meaningfully higher cash flows and dividends by selling more logs at higher prices and closing the large discounts at which the shares currently trade relative to their NAVs.
 
Q: Geographic diversification seems to be a byproduct of the fund. Where are you finding the best opportunities now?
A: We have approximately half of the fund’s capital allocated overseas. These investments are primarily concentrated in the securities of well-capitalized property companies that own irreplaceable portfolios of assets in outstanding markets but are currently out of favor due to near-term headwinds, such as London and Hong Kong.
 
In the United Kingdom, property companies are dealing with the uncertainty of the Brexit impact on occupier markets, particularly financial services. We have taken advantage of the resulting dislocations in the public markets by boosting the fund’s exposure to Land Securities, Hammerson, Segro and similar companies that own office, malls, and industrial properties in and around London, which we view as one of the most attractive markets for long-term investors globally.
 
In Hong Kong, real estate businesses continue to trade at steep discounts to the private market, largely due to the lack of a takeover market and what investors believe are outdated corporate structures and capital allocation policies. We have established meaningful positions in blue-chip property companies such as Cheung Kong Property, Henderson Land, and Wheelock & Co. that control hard-to-replicate portfolios in Hong Kong (one of the most supply-constrained markets globally) at prices that are at 30%-60% discounts to conservative estimates of NAV.
 
Q: Third Avenue had a difficult time in the credit market. Please tell us what happened from your point of view and what impact it has had on the other funds.
A: In December 2015, Third Avenue made the decision to seek exemptive relief from the SEC and suspend redemptions in its credit fund to protect shareholders. Since then, the credit fund has made four liquidating distributions that account for approximately 40% of the total assets, and the adjusted NAV is above the NAV at the time the move was made. The Real Estate Value Fund did initially experience redemptions, but these materially tapered off in the following months. While significant redemptions can have serious implications for portfolios comprised of less-liquid securities, this was not the case for the fund. Fund management satisfied all redemptions from the fund’s existing cash resources and by selectively reducing holdings, largely on a pro-rata basis, to keep the portfolio positions and weightings intact. The portfolio managers in the Third Avenue Real Estate Value Fund have a significant portion of their personal wealth invested alongside shareholders and have increased their investment in the fund since the announcement.