An Interview with Third Avenue Management on Their Success with Residential Real Estate Holdings

An interview with our client Third Avenue Management, originally published in Citywire. In it, Third Avenue share insights on their success with homebuilders and other residential-related stocks driving performance.

Jason Wolf and Ryan Dobratz have managed the Third Avenue Real Estate Value fund (TAREX) for more than a decade, rarely have they enjoyed a better run than this year. Their flexible approach, allowing them to own non-REITs and residential-related stocks, while sidestepping the problems in office and retail REITs, has vaulted the fund to the top of Morningstar’s Global Real Estate category with a 13% return for the year through July.

Citywire spoke to Dobratz about the residential holdings driving this year’s performance, as well as timber, real estate services firms, and potential distressed opportunities.

Citywire: Homebuilders and other residential-related stocks have rocketed the fund to the top of its category recently. Make the case for Lennar, your top holding, and other related stocks.

Ryan Dobratz: The fund’s flexible mandate has always been distinct, but rarely as strategic as it is today given the divergence within real estate markets. Many traditional REIT benchmarks contain commercial real estate, [which is] facing secular headwinds and [is] encumbered with debt destined to refinance at higher rates.

By contrast, fundamentals for the US-residential markets have rarely been as compelling with record low levels of inventory and accelerating demand from the ‘millennial cohort.’ At the same time, the vast majority of industry participants are Real Estate Operating Companies that can retain their earnings and the balance sheets are in great shape. (Editor’s note: This is in contrast to REITs that have to pay out 90% of their net income as dividends, sometimes causing financial pressure.) Therefore, the fund is taking full advantage of its ability to invest in the residential sector, including businesses involved with single-family construction, repair-and- remodel spending, and niche rental platforms.

Lennar is a leading homebuilder utilizing its ‘net-cash’ balance sheet and significant scale to capture market share by delivering high-quality new homes at affordable price points, with its less-followed B shares trading at prices that imply only a slight premium to book value and roughly 7 times earnings.

CW: You own some timber companies that are also related to housing. Has sawmill consolidation hurt the them?

RD: The fund has been invested in some of the leading timber landowners for the better part of a decade—primarily by owning the common stock of Weyerhaeuser and Rayonier (which collectively own 14 million acres of timber lands in the US and New Zealand).

In both instances, the consolidation of sawmills that occurred after the financial crisis impacted these enterprises, particularly their holdings in the US South as the prices for Southern Yellow Pine logs have remained at depressed levels. Those who are well-versed in the space seem ‘to see the forest for trees’ though with two major shifts underway.

One, industry challenges were magnified following the financial crisis as a pine beetle epidemic led to accelerated harvesting in British Columbia. This ‘excess supply’ has now cleared and logging restrictions in the region have driven incremental capacity to the US South.

Two, there are several emerging opportunities to monetize timber lands through alternative uses such as generating carbon credit revenues for deferred harvest, leasing land for carbon storage or renewable generation, and converting land for residential or commercial use given migration patterns. Put together, these developments are likely to alter the supply-demand dynamics for professionally managed timber lands and private market values have already reset alongside these trends.

CW: You’re fond of real estate service firms too such as CBRE, Jones Lang LaSalle (JLL),
and Savills. What services do these businesses provide, and what’s the investment case for them?

RD: Real Estate Services firms have been an essential component of the commercial property markets for centuries, essentially acting as a toll booth on activity by advising property owners and occupiers on leasing, financing, and investment sales transactions. Notwithstanding, the traditional business model centered on cyclical leasing and sales activities now largely incorporates segments with significant recurring fee income (such as property management, and investment management) as well as counter-cyclical activities (including valuation and lender advisory services).

There are also a select set of real estate services firms that truly manage their business for the long-term and eschew financial leverage, including fund holdings CBRE and JLL (the two largest real estate services firms globally) and Savills (a global firm with a particularly strong franchise in Europe and Asia). When putting together these pieces, it seems likely that these enterprises will remain profitable given the more durable revenue streams despite pressure within the transaction segment.

Further, it is not a secret that certain industry participants are less creditworthy following recent consolidation. Therefore, it seems likely that the fund’s holdings will be able to utilize their super-strong balance sheets to lift out business and gain market share, as well as capitalize on other secular trends relating to outsourcing, sustainability, and flex office offerings with more limited competition. Should this materialize, each of these holdings could very well surpass previous levels of profitability when real estate capital markets stabilize.

CW: The fund has a history of buying what’s unloved or underappreciated, including distressed debt. Office and retail are the two problem children of real estate at the moment. Are there any opportunities there, either on the debt or equity side?

RD: When investing across the capital structure, the fund’s approach is to target an issuer’s fulcrum security at prices that would provide a double-digit yield-to-maturity (or better) while also creating a basis that may seem quite compelling should the issuer undertake a restructuring or reorganization.

Within this framework, the fund has certain positions that may be considered to be more opportunistic in nature including the bonds of Five Point Holdings (the largest land developer in coastal California) and the preferred equity of Fannie Mae and Freddie Mac with other opportunities relating to commercial real estate on the radar.

That said, the fund has been involved with a number of the large-scale retail restructurings in the past decade (such as General Growth and Centro Properties) and would expect to participate in the recapitalization of the office sector either through debt restructurings or capital infusions while acknowledging that this reset is likely to take time given longer-duration lease terms and generally well-laddered debt maturities for the listed sector.

In the meantime, the fund has exposure to some of the highest quality office and retail assets globally through its holdings in the common stock of Brookfield Corp. and CK Asset Holdings— both of which are well-financed enterprises trading at material discounts to the underlying value of their real asset portfolios, including hard-to-replicate commercial property portfolios that are benefiting from a flight to quality, in our view.

Disclosures:

Third Avenue Funds are offered by prospectus only. The prospectus contains important information, including investment objectives, risks, advisory fees and expenses. Please read the prospectus carefully before investing in the Funds. Investment return and principal value fluctuate so that an investor’s shares, when redeemed, may be worth more or less than the original cost. For updated information or a copy of our prospectus, please call 1-800-443-

1021 or go to our website at www.thirdave.com. For a full disclosure of principal investment risks, please refer to the Fund’s Prospectus.

Mutual fund investing involves risk, including loss of principal.

Past performance is no guarantee of future results. Mutual Fund returns include reinvestment of all distributions. Returns are annualized for periods longer than one year. The returns represent past performance and current performance may be lower or higher than performance quoted above. Investment return and principal value fluctuate so that an investor’s shares, when redeemed, may be worth more or less than the original cost. For the most recent month-end performance, please visit the Fund’s website
at
https://thirdave.com/pricing/, for the most recent standard performance please click here.

Please see top Ten Holdings here which accounts for approximately 55% of assets owned by the Fund as of 6/30/2023. Earnings growth is not a forecast of the Fund’s future performance. Holdings and dividends are subject to change and are not a recommendation to buy or sell any security.

Morningstar Rankings represent a fund’s total return percentile rank relative to all funds in the same Morningstar Category for the same time period. The highest (or most favorable) percentile rank is 1%, and the lowest (or least favorable) percentile rank is 100%. It is based on Morningstar total return, which includes both income and capital gains or losses and is not adjusted for sales charges or redemption fees. Past performance does not guarantee future results. Rankings shown for Institutional Share Class only: rankings for other share classes may differ.

As of 8/1/23, TAREX was ranked in the 3rd percentile out of 195 funds in the Global Real Estate category based on the prior 12 months trailing return.

©2023 Morningstar, Inc. All rights reserved.
Distributor of Third Avenue Funds: Foreside Fund Services, LLC. Interview by John Coumarianos.

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