Q&A: Not Your Usual Real Estate Trusts (extended)

Michael Winer discusses his fund's unique angle

Portfolio manager Michael Winer's Third Avenue Real Estate Value Fund is an odd bird. It's the only mutual fund to invest primarily in real estate operating companies (REOCs) instead of real estate investment trusts (REITs), which every other real estate fund buys. The differences in their financial structures give REOCs an edge, Winer says.

So far, his bet has paid off: As of May 31, his $322 million fund has the best three-year annualized return -- 17.85% -- among 115 real estate funds. BusinessWeek Personal Finance editor Lewis Braham recently caught up with the 46-year-old Winer in his New York office to discuss his strategy.

Q: How is your fund different from other real estate funds?

A: Primarily, it's our focus. Our investment objective is long-term capital appreciation, whereas most real estate funds are seeking the dividend yield that REITs throw off. REITs usually make up only 10% to 20% of my portfolio.

Q: Why do you prefer REOCs over REITs?

A: Since real estate is a capital-intensive business, access to capital or the ability to retain capital is precious. REOCs are structured like any other operating company, so they can retain all of their cash flow.

REITs have a special tax status, which requires them to pay out 90% of their taxable income as dividends. That gives REITs attractive yields, but it also makes it difficult for them to invest in their businesses. Thus, they have to access the capital markets, especially the equity markets, in order to grow.

Q: That must especially hurt REITs during a weak real estate market.

A: Right. They're not always able to access capital, and the best time to be investing in real estate is not when the markets are hot and REIT stocks are high. The best time to be investing is when things are looking a little bleak and there are more opportunities. REOCs are able to be more opportunistic at those times, because of their ability to retain cash.

Q: After a three-year rally in real estate stocks, both REITs and REOCs, how hard has it been for you lately to find good values?

A: I am still finding values, but they're not as good as they were three years ago. Back in 1998 and 1999, we could find stocks trading at a 25% to 30% discount to their underlying real estate value. Today, my portfolio is trading at a 10% or 15% discount.

The REIT market, by contrast, is trading in a range between a 5% discount and a 5% premium. That isn't cheap, but it's still much better than in 1997, when REITs were trading at 30% premiums and were grossly overpriced.

Q: How dependent on a U.S. economic recovery are real estate stocks?

A: When the economy enters a recession, the effects aren't felt by commercial landlords immediately. There's a lag to the downturn because tenants of retail, office, and industrial real estate tend to have long-term leases, 3 years to 10 years. Provided the tenants don't go bankrupt, they're still going to pay rent, whether they are as profitable as they were before or not.

That said, as leases expire, there will be vacancies as companies decide not to renew their leases. So there are currently higher vacancy rates in every property sector, and rents have fallen, but those are temporary effects. People should invest in real estate for the long term.

Q: I've heard that the housing market is an endangered sector right now. Do you see any evidence of a pricing bubble there?

A: We did have a substantial portion of the fund's assets invested in homebuilder stocks until about a year ago. We probably exited too soon, but at that time, I thought homebuilder stock prices were at a level that couldn't be sustained. We were entering a recession, yet the companies were selling more homes than they had before the slowdown.

A lot of that growth stemmed from the interest-rate cuts last year. Mortgage rates are now at or near historic lows, so it is relatively inexpensive to buy a home. But if we see some spikes in those rates, I think the run will be over.

Q: Two REOCs, LNR Property and Forest City Enterprises, account for nearly 20% of your portfolio. What do you like about them?

A: Forest City is, in my opinion, the best REOC out there. It has been in business for over 60 years, has a terrific balance sheet, excellent management, and if you look at the return on its stock over the past 10 years, it has beaten every single REIT.

Q: What kind of real estate does Forest City specialize in?

A: Retail, office, residential, multifamily, hotels: It really is a very diversified real estate development company. About 60% of the properties are in the Northeast, with a high concentration in the New York metropolitan area.

The company has worked on some very creative projects that other companies don't have the financial wherewithal or patience to do. It worked on the redevelopment projects in Times Square, building and leasing the Hilton Times Square, the Loews multiplex cinemas, and Madame Tussaud's Wax Museum.

Q: And LNR Property?

A: LNR is a real estate operator and developer, as well as a mortgage lender and servicer. The company cut its teeth in the distressed real estate business of the early 1990s, and has tremendous expertise in working out troubled mortgages. Today, its portfolio is a mixture of commercial mortgage-backed securities and actual real estate -- apartments, hotels, and offices.

Q: What regions of the U.S. real estate market are you focusing on now?

A: Regions are secondary to me. I don't look at a region and say, 'This is hot market, so I should find a company that's in it.'

We're looking at companies first, and if we like the company's management and the way it is financed and its properties in general, we'll take into consideration where it's located, but that's not going to be a prime mover. It turns out, though, that about 40% of our portfolio is concentrated in the Northeast.

Q: The Northeast has one of the tightest real estate markets.

A: Yes. Its office and retail real estate markets have low vacancy rates. I especially like New York metropolitan real estate. I live here, I know it well, and I'm very comfortable that this market -- despite the events of September 11 -- is the financial capital of the world, and it should continue to be, over the long-term, an important place to live and work.

Q: What about California and the downturn in the tech market? Do you think that has had some pretty damaging impact?

A: It certainly affected the Bay Area. And we're not heavily invested there. There wasn't a lot of real estate development in the area. Prices just got pushed up to ridiculous levels during the tech bubble. But they're probably back to where they should be after the crash.

Q: Are there any sectors of the real estate market that seem vulnerable to higher vacancy rates?

A: We have always shied away from hotels because of their short leases: The tenants move out every day. It's a very tough, competitive sector, which is highly sensitive to fluctuations in the economy. The guy next door builds a hotel, and all of a sudden your 75% average vacancy goes down to 65%, and your average daily room rate goes from $100 to $80.

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