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Quality-Driven REIT Investing
Eaton Vance Real Estate Fund
Interview with: J. Scott Craig

Author: Ticker Magazine
Last Update: Apr 04, 12:00 PM EDT
Investing in real estate offers three key advantages Ė non-correlated asset, inflation hedge and dividend yield. For three decades, Scott Craig, portfolio manager of the Eaton Vance Real Estate Fund, has been investing in commercial real estate with a focus on higher-quality companies with capable management teams and attractive valuations.

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

A: 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 firmís 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?

A: 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?

A: 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. Thatís 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 companyís 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 doesnít 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 manufacturingís hollowing out, affected your investment decisions?

A: 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 Ė 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. Thatís 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 havenít 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. Thereís 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?

A: 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 isnít 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, thatís not the best way to think about intrinsic value, which is our focus. Second, thatís 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.

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