Andrew Davis and Chandler Spears, co-portfolio managers of the Davis Real Estate Fund, say the key to successfully investing in real estate securities is to treat REITs like any other equity. According to Davis and Spears, the only difference between REIT stocks and other equity stocks is that REITs offer space—be it shopping malls or apartments. Their strategy has worked for the fund as it earned Lipper Leader awards in preservation and tax efficiency.
The fund—including predominantly REITs (approximately 85 percent), plus a few real estate operating companies (REOCs), select international investments and cash—uses several key investment criteria in ascertaining its portfolio holdings.
Spears |
According to Davis, the duo's "owner-earnings methodology" is the core of the fund's investment criteria. The owner-earnings equation is the future free cash flow available for management to either pay out as dividends to shareholders or reinvest in the business.
"It's the concept of how the business generates cash for an investor—the idea of how much money we can extract from these businesses each year," Davis says.
Spears says the team also takes into consideration how a company manages its investments through various cycles, as well as a management team's motivations.
"One way you can evaluate management is whether they have a material stake (in the form of equity ownership) in their business," Spears says. "That says something about their motivations as operators in the business."
If a company is only a "one-trick pony"—as in management can only acquire properties, but is unable to sell, develop, etc.—Davis adds that it's most likely not a worthy investment.
Of the REITs in their portfolio, all have passed the "one-trick pony" test. However, there are two companies in particular that Spears and Davis say are ideal examples of what they look for in a real estate investment.
Spears says that CenterPoint Properties Trust (NYSE: CPT) is the poster child for how a real estate business should be run. According to Davis, only a handful of REIT management teams could manage any type of company, regardless of industry, and CenterPoint is one of them.
"CenterPoint seems to really get the concept of managing an entire real estate cycle," Davis says. "They know when to buy, build and sell at different points in the cycle."
Forest City Enterprises, Inc. (NYSE: FCE.A), a real estate operating company, is the other business the duo highlighted.
| Top 5 Sectors: |
| Sector |
% of Portfolio |
| Office |
22.0% |
| Industrial |
15.2% |
| Shopping Centers |
13.7% |
| Diversified |
13.1% |
| Multifamily |
9.4% |
"Forest City is a great company in terms of being an expert at what they do," Davis says. "They are the premier developers in the country."
Spears adds, "They also have an ability to recycle capital from assets and steepen the growth of cash flow over time. This is different than selling assets to cover the dividend."
According to Davis and Spears, the art of recycling has never been a widely accepted practice in real estate. Davis likens the recycling process to a garden, an analogy he received from his father. A key concept of gardening is that once any good crop or plant has reached its peak, it must be cut back to yield a greater return the following season.
| 5 Largest Holdings: |
| Company |
% of Portfolio |
| CenterPoint Properties Trust |
6.6% |
| SL Green Realty Corp. |
4.1% |
| Forest City Enterprises, Inc. |
4.0% |
| ProLogis |
3.8% |
| Vornado Realty Trust |
3.6% |
"Real estate represents the seedlings that grow into crops, mature, and then flower. Once they flower, you should cut them back," Davis says. "Essentially, it is the best thing you can do [which allows for a fuller flower to grow in its place]."
Spears agrees and adds that investors need to embrace the notion that real estate can have an element of turnover in the business and both Forest City and CenterPoint are good examples of that.
Regardless of the individual merits of a company, Davis and Spears stress that owning publicly traded real estate companies should be a long-term proposition. And while some firms think one year is considered long term, both Davis and Spears emphasize that they do not. The pair typically holds onto any given stock for four or five years to maximize returns.
"It's so easy to look at REITs doing incredibly well. Inevitably at some point they have to go down," Davis says. "You [as an investor] need to walk to the mirror and ask yourself, ‘can I hold onto a real estate investment for five years?' If you can't, don't buy now."
