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  From the Bottom Up UAM Heitman Real Estate Fund co-portfolio managers Tim Pire, Dean Sotter, and Randy Newsome (left to right) know a bargain when they see one. So, where do these practitioners of GARP (growth at a reasonable price) say they are finding the best values today? by Barry Vinocur |
Though the fund has undergone several name changes in recent years, it traces its roots back to March 1989, making it one of the longest-standing real estate funds. For the nine-month period ended September 30 of this year, UAM Heitman posted a negative 14.5% total return (to see how the fund stacks up vs its peers, see the table on page 56). The Wilshire Real Estate Securities Index, the fund's benchmark, returned a negative 15.2% over the same time span. More important, perhaps, is how the fund fares on a number of other measures, such as its Sharpe ratio. According to Morningstar, which ranks real estate funds by Sharpe ratio (see table on page 58), as of September 30, UAM Heitman had the second highest Sharpe ratio of the 18 real estate funds with a track record of at least 36 months. As of September 30, Sotter, Pire, and Newsome were managing just under $800 million in a mix of institutional separate accounts and the firm's mutual fund, which accounted for just under $650 million of that total.
The firm's approach is bottom-up, with a focus on growth-at-a-reasonable price, or GARP. Specific portfolio decisions are based on a proprietary scoring system that produces a relative growth and risk score for each company. The five key components of UAM Heitman's coring system are: (1) funds from operations growth rate; (2) cash available for distribution payout ratios; (3) interest rate sensitivity; (4) acquisition hurdle rate (yield required on new acquisitions to ensure no dilution of earnings); and (5) debt as a percentage of total market capitalization. Using the ranking system, Sotter, Pire, and Newsome determine the warranted share price for each security. Of the five variables, cash flow growth is the most critical.
Looking ahead, Sotter, Pire, and Newsome say they expect companies that have exhibited discipline, both in acquisitions and development, as well as those that have proven themselves stong operators, will trade at the highest multiples. Moreover, whereas in the past they were willing to pay up for management teams that had proven they were great acquirers, going forward, the trio says it expects their emphasis to be on the strongest operators/opportunistic buyers. "Someone such as Kimco's Milton Cooper is a great example of what we're talking about," Sotter emphasizes. "Do we think he'll mess up in an environment such as the one that we are in now? It's very, very unlikely," he adds.
Real estate funds come in a variety of flavors. Some invest only in REITs; others shun REITs altogether; others mix REITs and debt securities; and still others buy stocks that are only remotely real estate related. Which camp are you in?
Sotter: We stick primarily to what's in the Wilshire Real Estate Securities Index. That's equity REITs and non-REIT real estate operating companies. The only mortgage REIT we have owned, and that was a very, very small amount, was Crimii Mae.
We fill that asset allocation objective that people have to include income-producing real estate in their portfolios, albeit in the public market. So we don't invest in the real estate-related type companies or real estate service companies.
Describe your investment approach.
Sotter: We're value investors who use a growth-at-a-reasonable-price discipline.
How far out are you looking, three years, five years?
Sotter: At least three and preferably five years. But rather than a specific time frame, our focus is on determining what we believe is a sustainable growth rate.
Might you end up very heavily weighted in one sector because looking at it from a bottom-up perspective, office companies look so much more attractive than the companies in any other sector?
Newsome: It's more likely that our approach would result in our being underweighted in a sector. For example, hotels are 3% of our portfolio, while the last time I checked hotels represented about 15% of the Wilshire Real Estate Securities Index. In other words, we want diversification. But unlike some real estate funds, we don't start with the sector decision.
Being underweighted in hotels, these days, is a good thing.
Sotter: We have always been underweighted in hotels for a variety of reasons, not the least of which is that it's the only property type where you find rents that can change every day. It's the most economically sensitive sector. At the same time, we were concerned about some of the structural issues related to the hotel REITs.
What other quantitative measures do you focus on?
Newsome: Actually, for a while now, we have been concentrating on dividend yield. In fact, in October 1997, right around the time that the Morgan Stanley REIT Index peaked, we sat down and took a hard look at our portfolio, focusing on 1999 earnings expectations. When we looked at the expected total return from our portfolio, we found that about 80% of that expected return would come from growth. We decided that we had to strike a better balance between growth and current yield because we thought real estate markets were starting to mature.
What will distinguish the winners from the losers going forward? Is it going to be the sector? Is it going to be the balance sheet?
Pire: Keep going, you're almost done. Seriously though, we're in an environment in which there's a great deal of uncertainty. For instance, cap rates are backing up [prices are down]. Some managements may see that as a signal to rush right out and buy something. We think that's very dangerous thinking.
The back-up in cap rates is telling investors something. The question, of course, is what.
Sotter: One of the reasons that cap rates started backing up in the first place was the concern over new supply. Now that concern is being replaced by concern about what will happen to demand. If we see, for instance, enormous layoffs in the financial services sector, that can only heighten investors' concerns about the demand side of the equation. That concern also will impact retail because if there's concern about a weaker economy that will affect consumer confidence.
What about the supply issue?
Pire: We never were all that concerned about oversupply. It was something that we kept an eye on, for sure. But even in cities such as Dallas, we never worried that things would get back to where they were in the 1980s. Our big concern for sometime has been the economy. We kept asking: How much longer could the momentum in our economy continue? Then, all of a sudden you start having, one-by-one, the Asian economy starting to break down, and Russia, and it's spreading to Latin America, and so forth. All of a sudden there's potential impact on demand, significant impact. And not only that, but you also had concern about corporate earnings.
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Pire: Wages are rising at an annual rate of about 6%. Without pricing power, there really isn't much corporate America can do. We sat down with David Kostin from Goldman Sachs recently, and he said that at one of his firm's Monday morning meetings they ran through the various sectors of the economy and they concluded that there were only two sectors that have any pricing power in the United States. Those are the U.S. airlines and landlords. So, again, if you have wage inflation, and there's no pricing power, it's only a matter of time before corporate earnings get whacked pretty hard. When that happens, corporations—particularly the service industries—will have to reassess their employment needs and, in turn, their space needs.
Most of the "office guys" I have spoken with recently argue that if demand falls off they may not get the rent increases they have projected, but even if rents just roll to what market rents are today that's pretty good. Is that a reasonable way to look at it?
Sotter: Probably not. The reason is that when the economy shuts down, it shuts down. If you look at 1990-91, you couldn't give space away. Now in 1990-91 there was a lot of excess supply and that's not the case today. But keep in mind that even if in-place rents are significantly lower than market rents today, you almost never see all of the rents go to today's market. The reason is that by the time all of the space in any given office—that typically has a 7- to 10-year lease—hits expiration, you're going to be at a very different point in the market. In certain markets there may be some oversupply, for instance. Office is a very lumpy category.
What about the debate over next year's earnings? Are you concerned that some analysts' estimates may still be too rosy?
Sotter: We're concerned. Think about the office example, again. Say demand doesn't fall; assume it remains flat. If there's some supply coming on-line, and you're entering a recession, it's a tough spot to be in. It was like the double whammy in 1990-91, too much supply and a recession.
Pire: If there's a silver lining in all of this, it's that markets are in far better shape today than they were back in 1990-91. So for some of the REITs, we have guarded optimism with regard to how their portfolios will perform. At the same time, given what's happened in the equity and debt markets this year, particularly in the CMBS market recently, supply will be constrained. In other words, next year may not be as bright as we might have thought last year or even earlier this year, but it isn't quite as negative a picture as some people are suggesting.
What sort of earnings growth do you expect next year? Recently, I have seen a number of analysts reduce their numbers from 11% to 13% to just over 10%.
Sotter: We're in the process of reviewing our numbers. The first half of next year should be okay because companies raised a good deal of capital early this year, and that should carry the year-over-year growth numbers into 1999. The second half of 1999 is a little harder to predict. We think the 11% to 13% number is going to be high. What we're willing to pay for in our GARP model is 8% to 10% growth. That's still higher than the long-term growth rate that we'd expect from these stocks.
What do you tell your investors and clients they should expect from real estate, in terms of total returns?
Newsome: Investors—institutions and individuals—continue to demand a reasonably high premium from real estate. Forget betas; forget standard deviations. We're talking about people who feel they were economically hurt as a result of investing in the asset class. That's one of the reasons why you're seeing people who want relatively high returns on real estate. What matters is total return. And today, the market seems to be saying it wants a total return that's in the 12% to 15% range.
Is 15% realistic?
Sotter: Through June 30 of this year, the Wilshire index, historically, had delivered roughly 14% annually. We're not telling people to expect that in the next five years, however. The dividend yield on our portfolio today is about 61¼2%. With modest leverage, we think companies can deliver growth of roughly 51¼2%, so that gets you to a 12% total return. You might get a bit more than that, but 12% seems conservative. You know, in this business, investors get paid quite well for waiting.
There's been some discussion recently about how safe dividends would be if there's a recession. What's your view? Have you stress-tested dividends?
Sotter: We have. One way we stress test dividends is to look at a company's variable rate debt exposure. We're also looking closely at debt maturities. But for the most part, we think dividends are pretty secure.