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  An Anchor to Windward Michael Hoeh’s steady hand and an investment strategy with a twist make Dreyfus Real Estate a fund worth keeping your eye on. by Barry Vinocur |
One reason for the fund’s success this year is that portfolio manager Michael Hoeh trimmed his exposure to equity REITs early in the year. As Hoeh explained during a recent interview, he and his colleagues became concerned by what they saw as a growing supply-demand imbalance as companies rushed to do follow-on equity offerings early in 1998. At the same time, Hoeh says fixed income real estate securities, such as commercial mortgage-backed securities (CMBS), looked very attractive, so they increased their exposure to them.
A balanced asset allocation fund for real estate investors, Hoeh says his fund’s exposure to equity REITs has varied from 15% early this year to as high as 48% this past summer. When we spoke with him, the fund had approximately 30% of its roughly $14 million in net assets invested in equity REITs (see table on page 28). How much is invested in equity REITs vs. fixed income real estate securities depends on economic analysis and, Hoeh explained, their take on real estate fundamentals.
Despite the disappointing performance of equity REITs this year, Hoeh says the combination of declining interest rates and strong real estate fundamentals bodes well for the stocks over the next 12 to 18 months. The companies that should benefit most from the REIT rebound, he says, are the ones with financial flexibility and management teams that have proven that they can add value for their shareholders.
Of roughly 50 real estate funds, yours was the only one in the black as of mid-September. What do you know that everyone else doesn’t?
There are advantages to being a “small” fund. The fund also benefits from being able to draw upon the full resources of Dreyfus. As the fund’s portfolio manager, I can tap into all of Dreyfus’ analyst capabilities. We probably have more people on a per dollar basis to draw upon than any other small fund in the sector. Finally, our strategy has been a major plus.
Tell us about that strategy.
The fund is a balanced fund for real estate investors. What often gets ignored is that a lot of areas in real estate increasingly have been securitized over the last four or five years. Most of the attention has been focused on equity REITs, but the commercial mortgage market and the residential credit market, as well as real estate mezzanine debt, have also been securitized. In the past, individual investors really didn’t have a way to invest in those areas. Our fund invests in all of them. It’s not just a REIT fund.
Are you buying mortgage REITs, then?
No. If we thought there was value in buying them, we could. But those companies have other characteristics that make them something we don’t want to own. We do own some of the same types of securities as some of the mortgage REITs. In some instances, we find ourselves bidding against those companies.
Does buying those securities raise any liquidity concerns?
Most of our mortgage related investments not only are investment grade, but also public securities. That market is $400 billion and growing. The commercial mortgage market alone has gone from zero to the size of almost any other corporate bond market over the past five years. So, there’s really a very high degree of liquidity in these securities.
The CMBS market is experiencing a pretty rough period right now.
There are a couple of things going on in the CMBS market. One issue relates to widening spreads in the CMBS market. That’s a concern for those issuing the securities, the conduits. That’s separate from the concern about underwriting standards. We obviously look at almost every single CMBS deal, so we are constantly talking with all of the conduits, and we are monitoring underwriting standards very closely to make sure those standards aren’t being sacrificed.
The CMBS market has grown quite dramatically over the past several years, but it is still very much in the early stages of its development. Two years ago, no one considered CMBS to be a mainstream asset class. Today, it’s increasingly being viewed as one. A lot of investors who wouldn’t have looked at the CMBS market a couple of years ago are coming into the market. At the same time, roughly 60% of all residential loans are securitized. However, only about 20% of commercial loans are securitized, so there’s tremendous growth potential.
Over the past two years or so, there’s also been a standardization of the structure of the loans that are being securitized. The industry still talks about the terms of each deal, but increasingly, deal after deal looks the same. If you look at the last 10 deals that have been done by the major conduits, they look very much the same. They have all included at least 300 loans, they are diversified geographically, as well as by property type. They were all rated triple A to triple B-minus. They all have the same cash flow structure. They all have the same lock outs on the loans. They are becoming more and more homogeneous. That’s a sure sign that the CMBS market will become very much like the residential mortgage market, which is a very well developed market.
What determines your fund’s asset allocation?
It’s based strictly on our economic analysis and our fundamental analysis of real estate markets. We have several economists on staff who help us. Once I have all of the information in hand, I sit down with our senior REIT analysts and determine how much to allocate to equity and how much to allocate to fixed income. It’s the same basic process that’s used by all of Dreyfus’ balanced asset allocation funds.
What’s been the range of that allocation?
The allocation to REITs has been between 15% and 48%. It was 15% during the first quarter of this year. When we looked at the market in January and February, we became concerned about supply-demand issues on the equity side and the fixed income market looked attractive. So, we started making allocation changes.
When you say a big reason why you have outperformed your peers is your strategy, I assume you’re referring to your ownership of fixed income securities?
That’s a big component of our outperformance. Rates have dropped this year while real estate fundamentals have remained strong, so those securities have outperformed equity REITs, which is interesting. If I told you interest rates were going to fall and real estate fundamentals would remain strong, you would have expected equity REITs to perform much better than they have.
You would think so. But that hasn’t happened. Why?
Some REITs have been undisciplined when it came to the capital markets. We saw managements chasing property prices ever higher with what was clearly an inflated currency. They were doing uneconomic deals. Then we saw some companies issue stock at prices that didn’t make sense. One thing that really upset me was the sale of stock to unit investment trusts at prices that were dilutive. Those deals were detrimental to existing shareholders. The market didn’t like any of those things. So, that’s a big reason why the REIT market is down so much this year.
Fundamentals still matter?
At some point, the value of the cash flow and the value of the real estate are going to dominate. Unfortunately, in the short run, some of the supply issues will continue to plague the market. If performance lags, investors are going to pull money out of retail stock funds. If they own the stocks directly, they’ll sell them. I frequently look at the YAHOO Web pages to gauge investor sentiment. It’s a great way to see what investors think of some of these companies. For the most part, those comments are negative, which leads me to believe that investors will continue pulling money out of this sector. It may take a while longer before this supply demand imbalance gets settled. In the meantime, at these prices, there are some stocks that offer very good value.
What catches your eye?
On the equity side, ours is very much a value approach. We especially like companies with low debt. Companies whose financial flexibility will allow them selectively to pursue external growth opportunities. That’s one thing that’s going to determine who really outperforms going forward. The companies that we have stayed away from are the ones that have tapped out their credit lines or that have so much secured mortgage debt that they are risking credit downgrades—companies that the only way that they can grow is internally.
Have the stocks bottomed?
That’s a tough call. One that’s usually only made with the benefit of hindsight. But I’m starting to feel that if it’s not a bottom, we have to be close. Whatever valuation method you use to look at REITs today—whether it’s vs. utilities, the S&P 500, 10-year Treasurys—they look very attractive. Then you look at interest rates which continue to decline, and real estate fundamentals which still look very strong. That’s all good for REIT accounts. I also think there’s a sense that these stocks have overreacted.
One concern seems to be that if REITs were to rebound, companies are so equity starved they would rush to issue stock. As soon as those deals are announced, the theory holds, the rally would be cut short. Portfolio managers, especially non-dedicated REIT fund managers, say they don’t want to get caught in stocks that are relatively illiquid when that happens. Are those concerns valid?
They are. That’s one reason why, as I said earlier, we’re focusing on REITs that have financial flexibility. We think those companies will be less inclined to rush to raise equity because they have other avenues open to them. They may be feeling the pain of a lower stock price, but they aren’t going to be under the same pressure as companies without those alternatives.
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We focus on the company’s total debt picture. We take everything into account, including credit lines, secured mortgage financings, and any joint ventures the company might have. We look at the same ratios as the rating agencies, including coverage ratios and debt-to-total equity. We also frequently rely on the rating agencies. Even if I think a company might be a bit too highly levered, if the company has an investment grade rating, that company has the ability to come back to the market.
Do you see many red flags?
There are very few red flags and very few alarming situations. Most of the companies are very conservatively financed. There are, however, a lot of companies whose principal business strategy has been external growth. Those companies are going to be impacted most by the current market situation. In some instances, those are the larger companies.
A number of sell-side analysts maintain that next year’s numbers are “in the bag.” Do you agree with that view?
1999 may be a little bit of a problem. A lot of Street analysts still have very high expectations. External growth opportunities are very limited, and internal growth numbers may be a bit on the high side because occupancies are reaching a plateau and companies may not be able to continue to raise rents as much as had been expected. I think some analysts have recognized that and they have started to dial back their estimates for next year.
You said earlier that being a small fund is a plus.
It’s very easy for me to take a 5% position in a company. It’s a relatively insignificant position from the company’s point of view, but it’s a nice percentage of my fund. At a position of that size I have perfect liquidity or pretty close to prefect liquidity. Where our size hurts us is on the fixed income side. Those securities tend to trade in lot sizes of $10 million. So anything smaller than $10 million is an odd size. As the portfolio gets larger, it would be just the opposite.
There’s been a lot of discussion about fund size, especially in the small-cap arena. Will your fund close if it hits, say, $1 billion?
I don’t think Dreyfus would allow it to get that large. One of our small-cap value funds grew rather quickly and it was capped at $500 million. So the cap on the fund would probably be in that range.
What about turnover?
I haven’t seen the numbers, but I’d suspect it’s around 300%.
Why such high turnover?
Because we see opportunities, and because, as I mentioned, our size provides us the liquidity to take advantage of situations that arise when stocks get hurt by large institutional sellers. Again, this is with regard to our equity holdings. On the fixed income side, we are occasionally able to take advantage of arbitrage opportunities.
How many people, in addition to yourself, work on the fund?
There are four people on the fixed income side and three on the equity side. One of the nice things is that there are other people I can call upon. If we are looking at a retail REIT that has a lot of exposure to Dayton Hudson, we can turn to a retail analyst who knows Dayton Hudson and its competitors.
What other funds do you run besides the real estate fund?
The mortgage fund.
Yours is a no-load fund. It has a back-end load of 1%, however. I assume that’s to discourage “switching”?
That’s right. The 1% back-end load gets paid back to the fund. It’s only in effect for the first six months.