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How One Hedge Fund Manager is Navigating REIT Volatility

Harbor Group International’s David Rosenberg sees an investment opportunity thanks to a disconnect that’s developed between REIT equity prices and underlying net asset values.

Publicly-traded REITs have been caught up in Wall Street’s wild ride over the past several months. Following a stellar performance in 2021 when the FTSE Nareit All REITs Index generated total returns of 41.3 percent, the sector has struggled with year-to-date returns that have fallen nearly 30 percent.

Yet some investors continue to see buying opportunities. While REITs have been swept up in the broader stock market sell-off, the fundamentals driving commercial real estate itself have remained strong. This has resulting in many REIT stocks trading below net asset values (NAV).

WMRE recently talked with David Rosenberg, managing director and senior portfolio manager at Harbor Group International (HGI) Capital Management to hear about the firm’s listed real estate strategy and his views of challenges and opportunities in the current market. Rosenberg oversees the Harbor Group International Real Estate Securities Fund, a hedge fund with roughly $500 million in assets under management. HGI is a leading global real estate investment and management firm with $19 billion in AUM.

This interview has been edited for style, length and clarity.

WMRE: From a high-level view, what’s your current investment strategy for HGI’s Real Estate Securities Fund?

David-Rosenberg.jpgDavid Rosenberg: Our investment strategy is to identify and invest in publicly traded real estate, whether it is a REIT or a company that generates a majority of income from real estate. Essentially, we’re looking for one of two things. We’re looking for deep value where we see companies trading well below the values of the real estate they own, or in companies where we feel that the macro thematic trends impacting real estate are very supportive of the property type and the company.

Harbor Group International overall has nearly $20 billion in assets under management, and it has hundreds of people on the ground and real-time information across geographies and across property types. Over the past 30-plus years, we have developed on-the-ground, real-time information, and that intelligence gives the company a competitive edge to invest in real estate markets. When you take all of that information and overlay it into the public markets, including the volatile market that has existed this year, you can identify opportunities where there is tremendous value and discounts relative to private real estate value.

WMRE: Is your primary focus REITs?

David Rosenberg: REITs are a very strong focus at roughly two-thirds of our universe, while one-third is other real estate companies that are not REITs. Those companies may include real estate services companies, lodging brands such as Marriott and Hilton, and home builders as another example.

WMRE: Has your investing strategy shifted at all given the volatility in the market, or do you see more value opportunities out there if you can time it right?

David Rosenberg: The answer is yes and yes. Let me start with how our strategy has shifted in light of all of the various factors impacting markets, including the pandemic, inflation and interest rates. The types of companies that we target include various types of properties—commercial real estate, residential, hotels and healthcare-related assets such as hospitals and nursing homes. Just thinking about those alone, when you look at the types of leases on those assets, it is really across the gamut in lease terms.

Hotels have the shortest lease term possible. You sign the agreement for one night and pay the rate. When there are changing factors in the economy and fundamentals, hotels can change their rate quickly, raising it $20 or dropping it $20. Hotels are very sensitive to any shifting trends. On the flip side are REITs that will own an asset and lease it to an operator for 20 or 30 years sometimes, which is the case with a hospital or nursing home. It is very bond-like with a fixed income stream. Then you have other property types in the middle, such as retail, office and residential.

Our strategy or outlook in the type of investments we look for has shifted somewhat as we see rates rising and we see inflation in the environment. We generally have been staying away from properties that have very long-term leases, because in a rising rate environment and a high-inflation environment, bond-like investments tend to under-perform because, while the cash flow stream might be nice, predictable and stable, it is not growing.

WMRE: What categories do you like among those property types that have shorter lease terms—hotels, multifamily, self storage?

David Rosenberg: We came into 2022 positive on lodging for the reasons we just discussed. We felt valuations were attractive. We saw tremendous potential in the broader lodging market for leisure, as well as many businesses increasing their travel budgets. They had a lot of recovery coming out of the pandemic and it’s a very good asset to own in an inflationary environment.

As we went through the year, Russia invades Ukraine and above expectation inflation numbers are causing the Fed to act more aggressively in tightening monetary policy. When you put all of that together, it seems to threaten the growth trajectory of the economy. Earlier in the year, lodging performed well. But anticipating the potential slowdown in 2023 or possibly even a recession, you probably don’t want to be in hotels where they may be forced to reduce nightly rates. So, we have over the course of this year reduced our holdings in lodging.

Our strongest exposures we have today in the portfolio are in those areas with short- to medium-term leases. That would include self-storage, which is approximately 90 days to six-month leases, residential—be it apartments, single-family rentals or manufactured homes—with an average lease term of one year. One other area is senior housing, which is part of the healthcare universe, but it is more assisted living and independent living closer to residential where the lease term is one year. Similar to lodging, it hasn’t really recovered much post-pandemic.

WMRE: How do you navigate the volatile market?

David Rosenberg: We run a hedge strategy. So from day one our strategy is long/short, which enables us to take advantage of opportunities that we see, but at the same time hedge the portfolio in a volatile market. Ultimately, that allows us to reduce our exposure to the market to navigate some very volatile periods until things settle down. Having access to real-time information that can set the stage for how we look one month ahead, six months ahead and 12 months ahead, all of that in a very liquid environment allows us to navigate.

We are not looking to shift our strategy or shift our outlook on a daily, weekly or even monthly basis. We believe the general demographic views and supply/demand fundamentals across the country don’t change overnight, and they don’t even change month-to-month. What we see on the ground in terms of where there’s new construction, where demand is going, the general employment market, all of those set our medium to long-term views.

The trading that I mentioned is really massaging those views, maybe reducing exposure if we believe the market is going to be volatile for a while because of super-high inflation numbers or some other factor. Ultimately, the liquidity enables us to keep our views in place but shift them in a way to avoid some of the volatility in the market or to even double down on some of those views where we see some meaningful opportunity.

We’re generally fundamental investors. We set our real estate view looking forward six to 12 to 18 months or even longer. Our views generally match the views of what Harbor Group International is seeing on the direct real estate side, because while we’re investing in public markets, we’re real estate investors and looking for the right fundamental trends impacting the industry.

WMRE: Do you have any examples of that strategy?

David Rosenberg: We have been large investors in the residential markets coming out of COVID. So, we have not shifted our broader view on strong rental residential markets—apartments, mobile homes and single-family rentals. They are large pieces of our portfolio, and we are very favorable on those sectors because of the supply-demand fundamentals, as well as general demographics such as population growth and where population is moving, particularly students and those that are moving up in their careers.

WMRE: You said you take short positions. What are you shorting these days?

David Rosenberg: I can give you some general themes. We have been short some healthcare names that fit into some of the themes I mentioned before with long-term leases, particularly with weaker credit tenants. The concern with rates rising is that any bond-like real estate investment is likely to underperform. In this particular subsector of healthcare we’re also shorting weak credit. We’re shorting those real estate companies that bought assets and leased it to tenants that are struggling. They don’t have the best operating platform and have been hurt by COVID because their costs have been rising; they haven’t been able to attract the right staff; and, ultimately, they have not been profitable.

Another area we have been shorting is some lodging names. Earlier in the year, we were very bullish on lodging coming out of the pandemic and the ability to benefit in the recovery alongside inflation. But as we get closer to a period where we feel the economy may go into a slowdown or a recession, we have begun to short some lodging stocks that we feel have more sensitivity to being hurt in the recession.

WMRE: What do you see as the biggest risks facing the listed real estate marketplace, and how are you navigating those risks?

David Rosenberg: Most of the risks we have discussed throughout this conversation. Fundamentals in some areas of real estate are a risk. Those areas that have seen meaningful growth post-COVID due to stimulus are a risk because of the fact that growth may slow down and valuations in those sectors may have gone too high.

Globalization is very important and there are many economies outside of the U.S. that are seeing challenges and potential slowdown in growth that may come before the U.S. So, if someone has exposure to global markets and currency issues, that’s a risk and a concern. Clearly, lodging is at risk for a global slowdown, and the number two area would be the industrial space.

Industrial is a phenomenal business. So, it is not a negative view on the sector as much as where it sits today. That business has been on fire for years, even prior to COVID. Rents were rising double digits for multiple years and valuations also were rising double digits for multiple years. Historically, cap rates have been somewhere around 5, 6 or 7 percent.

Because of the tremendous growth that investors expected and achieved, those cap rates came down to levels below 3 percent. If we do see a slowdown in the overall economy, we’re going to see those rents come down. With interest rates and financing costs rising meaningfully, it is not very realistic for an investor to be able to accept a return of 3 percent when their financing costs might be 5 percent.

Although fundamentals are still very strong on the ground, industrial REITs have corrected. Some of them are down 20 to 30 percent and some are beginning to reflect attractive valuations in the public markets. But when you ask about general risk in the real estate market today, high valuation and low cap rates—like in the industrial space—in a period of time when rates are much higher today than they were at the beginning of the year, that poses a risk and those are areas where we are generally staying away from.

WMRE: Is there anything else that you would like to add?

David Rosenberg: The only thing I would add is that when you’re a long-term investor you look at fundamentals and quality of real estate and quality of management teams operating this real estate. When you’re satisfied with all of those, it ultimately comes down to valuation. What is the value embedded in these stocks? Despite all of these concerns that I mentioned that are real, the public markets are already reflecting a lot of that concern. On average, the U.S. market today trades approximately 25 percent below fair value and there are some sectors that trade 40 to 50 percent below fair value.

While the overall environment is a little bit cloudy or heavy with some of the concerns that we’ve discussed, we believe that valuations in several areas are compelling. Therefore, we have become more positive overall in the public sector because we have the opportunity looking forward to buy high-quality real estate, well-located real estate and high-quality management teams at compelling valuations. These valuations are not available on Main Street today, because Main Street real estate pricing we would say is fair. Wall Street valuations are compelling.

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