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Investment Advisor

American Century Investment Management, Inc

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Fundamentally Driven REIT Exposure

Jun 21, 2019

American Century Real Estate Fund

  • AUM

    $965 million

  • Inception Date

    Sep 21, 1995

  • Portfolio Holdings


  • Portfolio Turnover


Q: What is the history and mission of the fund?

The American Century Real Estate Fund was established more than 20 years ago with the purpose to offer access to real estate investments through the public securities market. The fund has been delivering diversity, total return and income over that period. It appeals to investors or financial advisors, who want an allocation to real estate as part of a diversified portfolio. While the firm American Century is based in Kansas City, Missouri the real estate team is based in New York.

Q: Would you describe the unique characteristics that make REITs attractive?

The fund invests predominantly in publicly traded real estate companies or real estate investment trusts. REITs have the characteristics of commercial real estate, because they own commercial real estate properties, such as offices, industrial buildings, apartments, shopping centers, etc.

The core characteristics of commercial real estate are current income, stable earnings and growth due to the lease nature of the income stream. That means that relative to the stock market, REITs provide higher yields and lower, but more stable earnings growth rates. Typically, the properties owned by REITs have long-term leases with their tenants. That leads to steady and increasing rents, but not to high growth. REITs also provide diversification benefits versus stocks and bonds. While they have lower correlation to stocks and bonds, they are correlated to commercial real estate and offer a blend of growing income and some capital appreciation potential.

Q: What is your investment universe? Do you invest globally or in the U.S. only?

Although we have flexibility to invest internationally, this is a U.S. focused strategy and our investments are predominantly in the U.S. Our strategy is to invest in all the core commercial real estate types in the United States, including residential, retail, office, healthcare and industrial real estate.

The residential market is dominated by rental apartment buildings, while retail includes mainly regional malls and shopping centers. Office real estate encompasses both downtown and suburban office buildings. Healthcare real estate is predominantly senior housing and nursing homes. Industrial real estate means industrial warehouses. We also invest in specialty REITs that own self-storage properties, hotels, data centers or communication towers.

We can invest in companies outside of our benchmark, the MSCI U.S. REIT Index, but these investments must be in publicly traded real estate companies that benefit from commercial real estate trends. Such an investment could be a hotel management company like Marriott or a property brokerage firm like CBRE. All the companies we invest in must have their fortunes tied to commercial real estate fundamentals.

Q: What core beliefs drive your investment philosophy?

Our investment philosophy is driven by fundamental research. We focus on companies with strong property fundamentals that should result in above-average occupancy trends, rent growth and dividend per share growth. The fundamental tools that we use include earnings and earnings per share growth, net asset value (NAV) per share and dividend yield, because the real estate companies we invest in are income oriented.

We believe that the multiples of growth are important, because they are indicative of the ability of the companies to grow earnings through rent growth, property development and acquisition. We examine how steady and reliable the earnings growth is expected to be and how steady and reliable it has been in the past. So, we first rank the companies in our universe on a price-to-earnings/earnings-per-share growth basis. That measure leads to a bias towards REITs with above-average growth.

Second, we examine the stock price versus the NAV per share for each company. We consider the NAV per share to be a good value indicator, because many of the properties trade frequently in the real estate market. Third, we look at the safety of the dividend as measured by the dividend payout ratio. Over the last couple of years, many REITs exhibited dividend growth of 4% or 5%, so we look at the combination of the safety of the dividend and the ability of the REIT to increase that dividend in the coming years.

We also have quantitative screens for the portfolio. If the investment ideas come through the quantitative screening, then we apply our fundamental research process to these ideas as well.

Q: What are the key steps of your investment process?

We start with all the names in our benchmark and we apply the qualitative growth screen and the NAV screen. We rank the companies on a daily basis. Then we focus on and drill down the ones that look most appealing, which are the companies in the top third of our initial screening. Currently, the portfolio consists of 33 names, so it is relatively concentrated and with a high bar for entry. That’s how we screen out the names for the portfolio.

We use a daily valuation model. The fundamental inputs don’t change every day, but the stock price does. The earnings estimates and the changes to the NAV per share could change monthly or quarterly, but we update the stock price on a daily basis.

Once we rank the stocks in our universe, we focus on the top 30 or 40 names. If stocks that we own have fallen out of the top 35 or stocks that we don’t own that have moved up to the top 35, we would do additional work on these names to decide whether to make changes to the portfolio. Through the additional research we determine if it is time to sell a name that we own or to add a new name to the portfolio.

The research starts with a meeting or a call with the management of the company to get an update on their outlook for the business. It also includes a property tour of some of the important assets, as well as discussions with the analysts who cover the company.

The next step is updating the earnings model to make it as accurate as possible and to see what trends the company may be benefiting from. Such trends may be changes or acceleration in employment in the region, where the company operates, or an expanding tenant group.

For example, in the industrial property sector, companies have been benefiting from the rise of e-commerce. As Amazon, Target and Wayfair continue to expand their online offerings, there is greater demand for distribution centers with strong logistics capabilities. Certain REITs benefit from developing logistic warehouse facilities that appeal to the high-growth e-commerce companies.

Our investment process includes analysis of how well positioned the companies are to benefit from that trend. Today it is much more than just Amazon, because traditional players like Home Depot, Walmart and Target have dramatically increased their spending on e-commerce and, respectively, the demand for logistic facilities.

Q: How important are macroeconomic trends in your strategy?

While we focus on individual companies, we acknowledge that some companies are affected more by macro trends, both positive and negative. We have invested in data center REITs, which have been a beneficiary of the move towards online transactions. There’s a huge demand for data centers—a macro trend that affects every company in the space. The next level of research is analyzing the companies in the data center space to see which ones will benefit the most.

Conversely, on the retail side, the growth of e-commerce has had a negative impact on the market share of traditional retailers. Many tenants of regional malls or shopping centers have seen their business negatively affected by e-commerce. We have seen an uptake in bankruptcies from Toys "R" Us, Charlotte Russe, Sears, etc. Our strategy is to underweight retail and to look for the names that are least exposed to the troubled retailers.

Multi-story warehouses also reflect the demand for greater capacity from e-commerce companies. We see the trend of logistics development in tracking the products in the warehouse and shipping to consumers. Lately, the large e-commerce players want the warehouses to be closer to consumers to cut the shipping costs. However, the closer the warehouse is to the customer, the more expensive the land is. As a result, the new warehouses are taller to store more products and to justify the cost of the land. We see that as an ongoing trend.

Q: Do changes in interest rates play a major role in your universe?

We monitor the capital markets, but we don’t predict changes in interest rates. However, we factor in the cost of capital and its impact on a REIT’s business strategy. We prefer REITs with strong balance sheets and high levels of financial flexibility. We look for certain levels of debt/ assets and debt maturity. The uncapped sources of capital on the balance sheet are important for REITs as they allow them to grow their businesses, even if interest rates go up.

The higher interest rates would impact all the REITs by increasing the cost of capital, but they would have a smaller impact on REITs with predominantly fixed-rate financing, strong balance sheets and lower leverage. So, for us it is important to know how the companies are capitalized.

Q: Would you give some examples that illustrate your research process?

Through the end of the first quarter, the fund had an overweight position in Prologis Inc, an industrial REIT. We wanted to overweight the industrial property sector because of the strong property fundamentals. The demand for modern industrial facilities is greater than the supply in most U.S. markets as large users like Amazon, Target and Home Depot have grown quickly. The decision to overweight the industrial space was based on that macro theme.

Within the industrial space, we chose to have an overweight in Prologis REIT for several fundamental, company-specific reasons. First, Prologis has a track record of successful property development. That’s important due to the growing demand for new facilities, with new standards for the height of the entrance because of the size of the trucks. New facilities are built with a greater component of logistics capability at the property level. Prologis has one of the best development teams in the space and can meet the needs of the modern tenants.

Second, Prologis has a strong leasing team, so the company can proactively seek tenants, who are undergoing expansion, and to get contracts for development of new industrial properties. Third, Prologis has a successful track record of opening industrial warehouses on budget and on time, which enhances its relationship with the clients.

Another example would be Alexandria Real Estate, an office REIT that specializes in life science or biotech tenants. The strategy of the company is to focus on areas with biotech clusters, such as Greater San Francisco, Cambridge, Massachusetts, the Baltimore Washington Corridor and parts of San Diego. In these areas are the headquarters of many biotech and venture capital firms, as well as many research complexes associated with universities.

As a result, there is above-average growth in demand in the markets where Alexandria Real Estate operates. Due to the growth in demand, the company has been less affected by the WeWork type of tenant and by the trend of people working from home. It benefits from the increase in capital raised for biotech or life science research, when the tenants use that money to expand their research facilities. Overall, Alexandria is well positioned in a highly specialized niche that has positive demand/supply dynamics and above-average growth characteristics.

Q: What is your portfolio construction process?

We manage a concentrated portfolio that currently consists of 33 names. When building the portfolio, we aim to meaningfully overweight the stocks to generate alpha from our research efforts. We typically overweight our positions between 100 and 300 basis points versus the benchmark. For example, if a REIT has 300 basis point weight in the index, we would have at least 500 basis points or 5% of the portfolio in that name, so it would represent an overweight of at least 200 basis points. If the investment idea works out, we have the potential to generate above-average alpha.

We have the flexibility to own non-benchmark names and to have zero exposure to sectors, where our view is negative. We have a few underweight positions but, typically, we aim to invest in names that we are willing to overweight. We do diversify property sectors and although we have negative views on retail, we still own several names with a major underweight. Overall, while there is property and geographic diversity in the portfolio, our emphasis is on building a relatively concentrated portfolio with meaningful overweight in the names.

We limit our exposure to individual positions to 400 basis points over the benchmark. In terms of subsectors, we can be plus or minus 400 or 500 basis points versus the benchmark.

Q: What is your sell discipline?

There are two primary drivers for our sell decisions. If the ranking of an investment in the daily valuation model drops from 25 to 50 due to price appreciation that would be a clear signal to reevaluate the position to see if it still offers attractive total return characteristics.

Another reason to sell would be a change in the fundamentals at the property level. For instance, we recently reduced the number of names we owned in the industrial sector. We maintained the subsector weight, but we eliminated one of the names, because we felt that the other names had better total return characteristics and were better positioned to take advantage of the growth. So, we eliminated that position based on the company fundamentals as compared to other companies with the same asset type.

Q: How do you define and manage risk?

We use several quantitative screens to measure some of the risks in the portfolio. We are aware that being overweight or underweight versus the benchmark will affect the strategy’s tracking error, its active share and the information ratio. We are also aware of the amount of non-index investments we have and the tracking error of the portfolio versus the benchmark. When we make company-specific investment decisions and take a large overweight or underweight, we are certainly aware of the impact on the performance if our thesis doesn’t play out.

We mitigate the fundamental company risk by constantly reevaluating the investment thesis and by being in contact with the company. We track the performance of the fund daily and we are aware when an investment idea doesn’t develop according to the original thesis. In such cases we reevaluate our position and examine why the results differ from our expectations.

Q: What lessons did you learn from the financial crisis of 2008-2009?

The financial crisis certainly highlighted the importance of the strong balance sheets. The companies with overextended balance sheets prior had to raise equity at a substantial discount to net asset value in order to restrengthen their balance sheets. But we believe that companies get rewarded for having a strong balance sheet in both good and bad times.

Q: What other factors are important in your strategy?

Environmental, Social, Governance, or ESG, is also important in our investment world and we see more REITs that dedicate resources to updating their ESG profile. The SEC filings and the property statements contain a lot of information about a company’s commitment to ESG. So, we follow and incorporate ESG in the research of the individual companies we invest in.

While many real estate companies don’t manufacture anything and do not generate pollution, the tenants in newly developed properties have a commitment to ESG and prefer green buildings or LEED-certified buildings. We see demand from the tenant base for environmentally smart buildings, so there is a premium on these types of properties.

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