Investment Results
Overview
What is the Cost of Capital?
Is Positive Spread Investing Possible?
What Level of Leverage is Sustainable?
What Does This Mean for the Real Estate Fund?
Investment Results
The Davis Real Estate Fund's Class A shares provided a total return on net asset value of 31.72% for the one year period ended December 31, 2009, while the Dow Jones Wilshire Real Estate Securities Index (DJWRESI) returned 29.20% and the NAREIT Equity® Index returned 27.99%.1
Total Returns
as of 12/31/09
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1
Year
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5
Years
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10
Years
|
Inception
(1/3/94)
|
Davis Real Estate Fund Class A Shares
without a sales charge
|
31.72%
|
-2.00%
|
8.83%
|
9.01%
|
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with a maximum 4.75% sales charge
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25.48%
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-2.95%
|
8.30%
|
8.68%
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Dow Jones Wilshire
Real Estate Securities® Index
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29.20%
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-0.23%
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10.47%
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9.22%
|
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NAREIT Equity® Index
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27.99%
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0.36%
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10.63%
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9.35%
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According to a Morningstar report on the Davis Real Estate Fund, "A rally in the stocks of real estate firms held by this fund has renewed credence in the fund's deep-value strategy. . . .The fund has managed to recoup losses for investors before, and its 10-year annualized returns are positive. . . . That's not saying that veteran managers Andrew Davis and Chandler Spears don't try to curb risk. They've had particular success doing so buying preferred and convertible securities, which are higher within a firm's capital structure. . . . Meanwhile, their research process is exhaustive and focuses on stress-testing the balance sheets while using models to microanalyze real estate valuation trends for the assets owned by holdings."2
Overview3
In February 2009, we were preparing for a conference call with a group of financial advisors. It was no ordinary environment in which we made preparations. The financial system that drives the global economy had seized and credit ceased to exist. Knowing there was little we could say at the time to fully explain the reasons for the credit crisis or answer the question of when it might end, we tried to assess the future of commercial real estate by analyzing and attempting to answer four basic questions in our conference call. Although 2009 began even worse than 2008 ended, it finished with a remarkable recovery in stock prices. Given how much we learned during the year, we revisit those questions now but freely admit there is still much we do not know.
What Is the Cost of Capital?
As the credit crisis intensified during the latter months of 2008, credit spreads swiftly widened to unprecedented levels. Even stalwart companies such as Simon Property Group (SPG) saw their debt priced at levels that implied default probabilities inconsistent with their fortress balance sheets. Equity prices responded in kind, dropping to unexplainable lows. By late March 2009, the situation became even more dismal as credit spreads widened further and equity in commercial real estate seemed worthless. At that point, any debate regarding the cost of capital was rendered moot. Capital was not available at any price, paralyzing public real estate companies.
In the waning months of 2008 and throughout much of 2009, the Federal Reserve, U.S. Treasury and other governmental authorities did everything in their power to restore the credit markets to normal. Among many other measures, near zero interest rates, myriad loan purchase programs and even guidance to bank examiners to abstain from adversely classifying overleveraged commercial real estate loans helped set the stage for a recovery in the capital markets. Still, it took a bold step by Alexandria Real Estate (ARE) to begin a wave of recapitalization that is nothing short of amazing.
In March, Alexandria Real Estate issued common stock at a time when investors believed capital was unavailable. While the stock did not behave well in the days immediately following the offering and performed even worse than the DJWRESI, the offering went a considerable distance in clarifying the demand for equity capital and its cost. Since that hesitant start in mid-March 2009, public commercial real estate companies have raised almost $20 billion of equity.
Simon Property Group made a similar brave move a few days later when it offered $650 million of unsecured bonds. While the 10.35% face interest rate was undoubtedly hard for the company to accept, Simon's offering was a necessary first step in repairing the credit markets. Since then, $10.87 billion in unsecured debt has been issued and, more important, each offering has been done on progressively better terms.
We believe that the commercial real estate industry owes Alexandria and Simon a debt of gratitude. They were among the few public real estate companies capable of attempting a capital offering due to their strong business models, and their moves made it possible for others to follow suit.
What was unknown in early 2009 is less so now, but we do not want to dismiss the long-term cost of the capital raised during the year. Equity issued at very low prices and high coupon debt will be a drag on earnings for years to come. We place a high priority on quantifying the impact of dilution when we consider investing our capital, but in this situation we were happy to see the industry recapitalize and deleverage. Had that not happened, many public real estate companies might not have survived.
Is Positive Spread Investing Possible?
Even with some clarity on the cost of capital, positive spread investing may still be elusive. In the past commercial real estate companies relied on a combination of debt and equity to achieve a blended capital cost below the yield on new investments (or developments), hence the term "positive spread." As private real estate valuations began to increase over the three year period ending in 2007, it became more and more difficult to find investments that yielded a positive spread. To maintain required rates of return on equity, most real estate investors resorted to higher levels of debt and made property investments based on inflated rent growth and occupancy assumptions. In our models, positive spread investing had essentially vanished by the end of 2007. The trouble is that investors forgot higher prices mean higher risk and the credit crisis is in part penance for that lapse of memory.
With capital now available on acceptable terms and real estate pricing more than 40% below its peak, will we see the return of positive spread investing? Possibly. A few companies have been able to find investments that make sense. However, investment sales have plummeted and there is little activity for public real estate companies to evaluate. From 2005 through 2007, transaction volume averaged about $20 billion per month across all property sectors. In 2009, transaction volume ranged from $2.5 billion to $4.9 billion each month. The natural flow of property sales has been disrupted and we have yet to see any meaningful increase in distressed property sales.
Such a tepid flow of property sales is surprising. We would expect a credit crisis to increase the flow of commercial property sales, but forces are at work to forestall or even prevent the kind of fire sales we saw in the wake of the Resolution Trust Corporation debacle. The Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and others have implemented a series of measures that will give holders of commercial real estate loans time to wait for the recession to end and hopefully "earn" their way out of the problem. In addition, low interest rates are giving financial institutions the opportunity to rebuild capital cushions. Further, guidance to bank examiners is allowing banks to avoid adverse classification of loans with collateral valued below the loan balance. In some respects, this is a distressing development. Many public real estate companies are well capitalized and possess the tools necessary to take advantage of property that was purchased too expensively.
To be clear, we believe there will be opportunities for public real estate companies to invest their new capital and the industry as a whole will enter a period where positive spread investing is possible. At the same time, we believe the most ill-conceived real estate loans will fail, causing considerable pain for many regional and local banks. We differ with many industry pundits regarding the nature, quantity and timing of opportunities that make sense for public real estate companies. Institutional quality assets, meaning fortress assets with strong tenant bases located in great markets, will not trade at distressed prices. In fact, they will not likely trade at all and we would view acquisitions of such assets with a very skeptical eye. We would prefer that public real estate companies focus their efforts on such investments as broken development deals or buildings with large imminent lease expirations. Unfortunately, these situations may not be as abundant as some would hope and a huge flow of such opportunities is not likely in the near future.
What Level of Leverage is Sustainable?
Of all the questions we asked in early 2009, the question of appropriate leverage is the one for which we still have no satisfactory response. We began 2009 with stock prices telling us no amount of leverage was tolerable, so at that point there was certainty. However, the year ended with much higher equity prices and apparently acceptance that some level of debt is a necessary component of commercial real estate investing. We still see considerable volatility in stock prices whenever there is a credit scare, and that volatility is extreme for real estate companies with higher than average leverage. Equity investors are very focused on capital structure, as they should be, and that is the only clue we have so far regarding the optimum capital structure. In other words, leverage is still too high.
Complicating the resolution of the leverage issue is an evolving commercial real estate recession. Rents have been quick to reset and property fundamentals appear to be stabilizing, but the recovery will be slow at best. Some companies will continue to see material earnings decay as rents agreed to in the bubble years roll down to today's new reality. The combination of expensive refinancing (discussed above) with weakness in property fundamentals suggests that even if real estate companies continue to reduce debt levels, they may still appear overleveraged on an interest coverage basis (i.e., the number of times a company can pay its interest obligations out of preleverage cash flow).
We do not want to dismiss entirely what public real estate companies have accomplished so far. Using real estate investment trusts (REITs) as a proxy for all public real estate companies, levels of debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) have dropped to seven times from eight times since late 2008. Moreover, no one believes deleveraging is going to take place in the span of a single year or even several years. Efforts to right the ship have been commendable. However, the next three to five years may be a defining moment in the history of public commercial real estate companies. Will they be able to achieve an acceptable capital structure and at the same time take advantage of investment opportunities? We believe the answer is a resounding yes. A pessimist would probably say that real estate companies are destined to repeat their mistakes, but we are optimists and believe public companies will be the winners in the commercial real estate sector.
What Does This Mean for the Davis Real Estate Fund?4
In revisiting this question, it is worth considering what we did well during 2009 and, as is our custom, what we can learn from our mistakes. These observations will help explain steps we are taking now to construct a portfolio that reflects our underlying optimism, but is also mindful of the considerable risks that still confront the economy.
During 2009 we were successful on a number of fronts, but none was more important than improving our investment process to avoid costly mistakes we made in 2008. We enhanced our geographic information systems (GIS) model to allow better evaluation of property cycles. We also expanded our capital adequacy model to evaluate the pricing of all publicly traded securities, not just common stock, and as a result now take a finely detailed approach to evaluating mortgages. The result of these efforts is visible in a number of investments that performed quite well in 2009.
For example, the Fund benefited tremendously from our investments in the convertible and preferred securities of some of our favorite companies. These include ProLogis (PLD), SL Green Realty (SLG), Alexandria Real Estate, and Digital Realty Trust, Inc. (DLR). All of these investments have a superior position in the company's capital stack and provide a very high yield on cost. As the year progressed and uncertainty about the availability of capital eased, the prices of these securities increased dramatically. In some instances prices more than doubled.
We were also successful with a few deep value plays, notably CBL & Associates Properties, Inc. (CBL) and SL Green. CBL Properties is best characterized as a company whose debt was misunderstood at the time of our investment. Investors focused on CBL's high absolute debt level without fully understanding the nature of that debt. After considerable research, we determined that CBL's mortgage debt, which represents most of its debt, had low loan-to-value ratios. Further, financial institutions that had done business with CBL for years held most of the debt. We believed the probability of refinancing was very high. When CBL began to announce the refinancing of its mortgage debt, the stock responded nicely.
New York City property manager SL Green, on the other hand, entered the year trading at a discount to replacement cost too significant to ignore. Despite the formidable headwinds facing the New York City office market, it still costs about $750 per square foot to construct office buildings there. At the time of our original investment SL Green's common share price implied a value of half that amount. Investors soon realized the headlines proclaiming the demise of New York City office demand were greatly exaggerated. Not only did SL Green do a commendable job in shoring up its balance sheet, but the company also had one of its best leasing years ever in 2009. The stock was one of the best performing property stocks during 2009 and we participated in most of that increase. If we are guilty of any mistake with this stock, it was selling our position in the common stock too soon. We still maintain our position in SL Green's preferred stock.
Improved performance during 2009 was quite welcome, but there were investments that performed poorly. Lingering concern about the value of land and vacancies at new developments weighed on the common stock of Cousins Properties (CUZ) and to some extent Alexandria Real Estate, a company that represents our largest single investment. Cogdell Spencer (CSA), an owner and developer of medical office buildings, experienced a very tough year as the municipal bond market failed to recover in any meaningful way, and that continues to cloud the future of the company's fee development business. Cogdell's subsidiary, Marshall Erdman, develops projects for a fee instead of investing its own capital. All are companies in which we maintain some degree of conviction, but with the exception of Alexandria, increased risk required a commensurate reduction in the size of our position.
As we think about the future of public real estate companies, we wrestle with a new question: Is commercial real estate destined to be a slow growth industry? While lower levels of acceptable leverage alone would be enough to suggest that might be the case, a looming mountain of maturing debt and a dysfunctional job market would seem to make slower growth a virtual certainty. That may be the future some companies face, but not all. Recognizing this, the Fund's investments fall into three categories. Longtime investors will recognize the first category: companies with a defensible franchise value (i.e., companies that do something better than anyone else). Currently that means focusing on companies that specialize in property sectors where demand has been less affected by the recession. This first category of investments, which represents about 30% of assets under management, is concentrated in just a few names and includes Alexandria Real Estate, Corporate Office Properties Trust (OFC), American Campus Communities (ACC), and Digital Realty. All are exceptionally well capitalized and specialize in industries where demand for real estate space is growing.
The common characteristic of our second category, roughly 40% of assets under management, is liquidity. This category consists of holdings in a variety of companies operating in areas where demand for space may be muted or even declining, but that have massive liquidity. These companies are positioned to take advantage of distressed property sales and include Simon Property Group, Douglas Emmett (DEI), Boston Properties (BXP), and Vornado Realty Trust (VNO), among others. We believe opportunities for attractive acquisitions will emerge at some point. If any of these companies are able to capitalize on those opportunities, earnings growth may accelerate.
The balance of the Portfolio includes a group of high yield securities (preferred stock and convertible securities) in addition to the few deep value investments in common stock still remaining in the Fund. Like the second category, this one contains many individual positions and our objective is to earn a high current return while we wait for our deep value positions to realize their worth.
To borrow from Yogi Berra, the credit crisis and recession won't be over till they're over, and the road to recovery will be long and strewn with potholes. We remain mindful of the lessons we have learned and recognize there are considerable risks still confronting the economy as a whole and commercial real estate in particular.
As tumultuous a period as this has been for us, we recognize that it has been every bit as challenging for you, our valued shareholders. Your continued confidence that we will do the right thing inspires us to focus every day on getting better than we were the day before. As investors in the Fund along with you, we appreciate your continued support and thank you for your trust as we move ahead. ■
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