Ticker Symbols

EAREX (Class A) EIREX (Class I)

Investment Advisor

Eaton Vance Management

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Quality-Driven REIT Investing

Apr 4, 2019

Eaton Vance Real Estate Fund

  • AUM

    $50 million

  • Inception Date

    Apr 28, 2006

  • Portfolio Holdings

     

  • Portfolio Turnover

     

Q: Would you tell us about the history of the fund?

I have been investing in commercial real estate since 1990. Initially, I was a commercial mortgage lender. I was also a finance executive for a public real estate investment trust, or REIT, for two years in the mid-1990s. In 1999, I was given the opportunity by Northwestern Mutual Life Insurance Company to manage a REIT equity fund and was a portfolio manager of that fund for six years.

I joined Eaton Vance in early 2005 and I am the portfolio manager of the firm’s open-end real estate mutual fund launched in April 2006. The philosophy and the process are a continuation of what I had developed in the preceding six years, so I have been doing this for nearly 20 years with only minor adjustments.

Q: Why should investors consider investing in real estate?

I believe that every investor should have some exposure to commercial real estate for three reasons. The first reason is the dividend income. REITs provide a dividend yield, which exceeds the yield of the broad U.S. stock market, and that yield has the propensity to grow over time, except during the financial crisis, when dividends were cut across most sectors and industries. The dividend income coming out of REITs this year will be higher than it was last year and next year it will be higher than this year.

The second reason is the diversification benefits of being invested in commercial real estate. When it comes to constructing a portfolio with the best risk-adjusted returns, investors should seek to include uncorrelated assets in their portfolios. Since REITs are not highly correlated to stocks or bonds, they provide such benefits in terms of risk-adjusted return. The third reason for having exposure to REITs and real estate is the inflation hedge that these assets provide, because property values and rental rates grow over time.

I believe that the right way to get exposure to commercial real estate is through a REIT fund, because few individual investors can accumulate a directly-owned portfolio that provides adequate diversification in terms of property types and geographic markets. It is difficult for most investors to own a diversified portfolio of commercial real estate on a direct basis and, therefore, the stock market is the best way to do that.

Q: What are the fundamental beliefs that guide your investment philosophy?

Our investment philosophy has remained the same since we launched the fund in 2006. We believe that the stocks of high-quality companies outperform the stocks of low-quality companies over any long period of time. That’s the foundation of our investment philosophy. There are short periods of time when low-quality companies will outperform, but over periods of three to five years or longer, the propensity of high-quality stocks to outperform is exceptionally high.

Therefore, we aim to own a portfolio of real estate companies that exhibit capable management teams, high-quality assets with high barriers to entry, strong balance sheets and attractive valuations. For us, quality is exhibited in the management, the assets and the balance sheet.

To find high quality in terms of management, we look at governance and executive compensation, and whether our interests are aligned with those of the management. We evaluate if the compensation system rewards them for creating value for shareholders. When we see a disconnect between the drivers of executive compensation and those of total return, we view that as a negative factor and we would avoid the stock.

Capital allocation and balance sheet strength, which we believe are some of the most important drivers of long-term performance, also fall under management quality. Assessing a company’s current types of properties and markets may only represent the capital allocation decisions of prior management teams, whereas we closely examine the decisions of the current management team regarding future capital allocation in terms of assets to build or markets to enter or exit.

The balance sheet is another important aspect. We have found that over nearly all periods of time companies with strong balance sheets tend to outperform those with weak balance sheets. Therefore, we strongly prefer companies with low leverage, if everything else is equal. Overall, our philosophy is to focus on high quality in management, assets and balance sheet.

To clarify, investing in high-quality assets doesn’t necessarily mean investing in the best-looking buildings. It means having the ability to maintain and grow the cash flows over an economic cycle. It means owning companies who have the best tenants, the highest rental rates, the highest sales per square foot, etc. For example, in the last two to three years Class B quality apartments have actually demonstrated better rent growth than Class A apartments, because Class B has been less exposed to new supply than Class A.

Q: How have recent trends, such as online retail growth and manufacturing’s hollowing out, affected your investment decisions?

First, we believe that there are too many shopping malls and strip centers, so non-competitive retail real estate will simply be demolished or converted to another use. That being said, today the best-quality shopping malls and strip centers are near all-time highs based on their rental rates, occupancy rates and sales per square foot.

For example, if you go to Aventura Mall in Miami, Florida on a Saturday or Sunday afternoon, you may have to drive around for five or ten minutes just to find a parking spot. And when you walk around in the mall, you see many people with shopping bags. Aventura, which is one of the best malls in the country, is doing better than ever before.

Regarding manufacturing being hollowed out, REITs and commercial real estate investors generally do not own factories. These manufacturing facilities tend to be operated by the owners. General Motors does not lease its massive factories; it owns that real estate.

Industrial real estate, on the other hand, is owned by REITs and commercial real estate investors – these tend to be warehouse properties, not manufacturing facilities. Currently the demand for warehouse properties is quite strong, because warehouses are largely full of consumer goods like apparel, electronics, auto parts or boxes of cereal. As e-commerce continues to grow, more consumer products find their way to the end user through a warehouse instead of through a retail store. So the shift of manufacturing from the U.S. to other areas, which has been going on for several decades, has not really affected the investment in commercial real estate in any meaningful way. That’s true for the industrial REITs and also true for the institutional owners, who own industrial property on a direct basis.

But there is an interesting trend in the U.S. that we haven’t seen for probably 100 years. Prior to the early 1900s, it was not uncommon to see multi-story manufacturing and storage buildings, but in more recent decades nearly all manufacturing and storage facilities are single-story buildings. Japan started building multi-story warehouses about 10 to 15 years ago, because the land was expensive. Now, for the first time in nearly 100 years, we see the construction of multi-story warehouse buildings in the U.S. There’s one under construction in Seattle and another one that will be breaking ground soon in San Francisco. This development is driven by the strong demand for warehouse space close to the consumer. The rental rates justify multi-story construction, which is always more expensive than single-story construction.

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

One of the differentiators of a real estate fund from a broad stock market fund is the manageable universe. There are only about 120 companies that are eligible for a traditional real estate fund. While a diversified manager may need to use screens to surface new ideas, the approach to a sector fund with a small universe is different. I have actually known many of the companies in my sector for over 20 years. The number of new companies is small, so screening for new idea generation isn’t as relevant for this fund as it would be for a diversified fund.

Our process also differs in comparison to other real estate funds because of our long-term, strategic orientation. Many fund managers focus on short-term factors, such as missing or beating quarterly or annual earnings expectations or the slight changes in occupancy rates. We have a different approach for two reasons. First, that’s not the best way to think about intrinsic value, which is our focus. Second, that’s a very crowded trade.

So, we prefer to focus on periods of two to three or even five years. We evaluate who is making good decisions and what properties will generate better cash flow growth over time, because these are better indicators of intrinsic value. With most of the fund managers having a different approach, it is easier for us to get an edge by doing something that fewer people are doing.

High quality, low turnover and long-term strategic orientation are fundamental parts of the process. Our annual turnover rate has been about 30%, which implies that we own our investments for three years on average.

We also meet with management teams to identify high-quality companies, but our field research is another differentiator. For example, the research team of a Wall Street firm may organize two or three-day bus tours, where 20 or 30 investors work with six or eight REITs, which are active in a certain marketplace. Each company handpicks their best one or two assets to show to these 30 people on a bus and everybody learns the same thing at the same time. In such settings, it’s difficult to develop an informational advantage.

We don’t think that’s the best way to learn what’s going on in the field. Instead, we pick a city and we generate a list of every property owned by every REIT in that market. Then we decide what properties we want to visit. Generally, we set up meetings with the regional management of these companies and talk with them about the developments in their business. I believe that this approach gives us differentiated and more representative information than our peers receive on bus tours.

Q: What is the influence of macroeconomic developments in your process?

We do not believe that it’s possible to accurately predict interest rates or the timing of the next recession. Also, there is no better predictor of long-term interest rates than the forward-yield curve on a weighted basis. So, we don’t make significant investment decisions based on the idea that interest rates will move a certain way.

However, we do take a distinct contrarian approach. When the market is pricing REITs in a way that reflects a strong belief that rates are going to do one thing, we tend to make a bet on the other side. For example, when the 10-year Treasury rate was at 1.4%, REITs were priced as if the market was confident that the long-term interest rates were going to stay that low or even lower. But the forward-yield curve was making a different prediction, so we made some changes in the portfolio.

These trades were based not on a prediction about interest rates, but on a belief the market was too confident that it knew what was going to happen. In such situations, we believe that the best opportunity to outperform is to be contrarian.

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

Last summer I spent a couple of days in Pittsburgh, Pennsylvania, meeting with companies and doing property tours. I arranged a tour of an A quality mall, considered to be the best in area and owned by Simon Property Group. When I was touring the mall with the general manager, she told me that she had held this position since 2000. When she got the job, she was handed a waiting list of tenants, who wanted to be in the mall, but couldn’t because of the space constraints. In her 18 years as general manager, there was never a time when this list disappeared, including during the technology bust, the great financial crisis or the recent years of growing online competition.

Every single day the mall has been practically full and she has had a waiting list of tenants. I think that insight allowed us to have a better understanding of the prospects for this particular mall and for similar “A” malls.

Q: How do you analyze a REIT? What is the structure of your research team?

We are a big firm with a lot of resources that I can rely on, but in the REIT universe, I do most of the stock analysis. There is an analyst on our U.S. Small Cap team, who covers some of the smaller-cap REITs. The analyst shares with me the information he gathers and the conclusions he reaches, but I still do most of the heavy lifting.

We also have a private real estate investment group, which owns and manages between $3 billion and $4 billion of commercial properties in the U.S. I talk to the people there on a regular basis to get their insights into fundamentals, capital markets and asset pricing. These frequent meetings have served as a tremendous resource.

At Eaton Vance, we have our oars in the water across the entire stock and bond market, so if I am thinking about the retail business, for example, I can talk to the retail analyst and gain insight on any retailer. Technology is important for property as well, so I can talk to our tech analyst to see what Google, Twitter or Facebook are saying about hiring, for example. We have plenty of resources that provide useful, well-rounded information for making better decisions.

Q: What are the key elements of your portfolio construction process?

We believe that the right number of names to own in the fund is about 50 companies. That range gives us exposure to a wide variety of property types and geographic markets and limits the portfolio risk from any single investment doing poorly. In terms of position sizes, we limit our active weights to about 300 basis points, which is the weight in the index plus or minus 3%.

There are stocks in the benchmark with weightings of only 15 or 20 basis points or companies like Simon Properties, which account for more than 8% of the benchmark. So, the absolute position size varies, but capping the active weight helps to manage the risk.

In terms of property types, we tend to cap our sector overweights at 400 basis points, but we rarely let the sector exposure get that high. For example, we currently like the apartment sector. It is about 22.5% of the benchmark and about 25.5% of the fund, which is an overweight of about 300 basis points.

The fund has consistently had a standard deviation that is lower than that of peers. I think that feature reflects both the high-quality orientation and the risk management in terms of portfolio construction. Our benchmark is the Dow Jones U.S. Select Real Estate Securities Index.

Q: What is the benefit of an actively managed fund in comparison with a traditional ETF in the real estate space?

By definition, an index fund must own everything in proportion to its representation in the universe. Therefore, it will include stocks with high leverage and with low-quality properties, which underperform in the long term. That factor makes it harder for ETFs to outperform a well-managed, active fund in our space.

Since inception, this fund has generated returns that have exceeded the returns of the REIT ETFs, notwithstanding the fact that the fees may be slightly higher. I believe that is due to our approach for generating long-term outperformance through high-quality properties and strong balance sheets.

Q: How do you define and manage risk?

For me risk means the permanent loss of capital. If I own a stock of a company that is well managed and makes good decisions, the stock may go down over a short period of time, but if my analysis is correct, that temporary loss will be recovered over the long term. For example, during the financial crisis, the companies that entered the recession with too much leverage were forced to recapitalize their balance sheets at a disadvantageous time. Many of these stocks are still below the peak they achieved prior to the recession, even if the property values are higher.

We believe that our way of managing the fund carries a lower risk of permanent loss of capital than our peers and our benchmark.

 

Annual Return 2018 2017 2016 2015 2014 2013 2012 2011 2010
EAREX -4.61 3.93 4.94 6.40 31.20 0.41 15.54 9.15 -
EIREX -4.43 4.23 5.12 6.73 31.40 0.76 15.81 9.50 28.13