Dear Fellow Shareholders:
We are pleased to provide you with the Third Avenue Real Estate Value Fund’s (Fund) report for the quarter ended July 31. Quarterly Activity Macroeconomic events such as the Greek debt crisis, a continued rout in commodity prices, and significant declines in China’s stock markets led to global volatility during the quarter. As a result, we were able to further reduce the Fund’s cash position (approximately 14% at quarter end) by investing capital into bargain-priced securities in all three of its primary regions including: North America, Europe and Asia ex-Japan.
The bulk of the activity consisted of adding to existing holdings as the Fund’s core positions continue to offer the most attractive risk-adjusted return prospects in real estate and real estate related securities for long-term investors. Key additions during the quarter included increasing exposure to a select group of real estate businesses globally that seem capable of compounding capital by 10% or more per year over the next three to five years by undertaking development and redevelopment projects or by making opportunistic acquisitions. Additions included the common stocks of Westfield Corporation (WFD, Financial), Global Logistic (MCO, Financial), Forest City Enterprises (FCY, Financial), City Developments (C09, Financial) and Vornado Realty Trust (VNO, Financial). The Fund also increased its exposure to real estate related businesses that have strong ties to the U.S. and U.K. residential markets, where fundamentals continue to recover from multi-decade low levels but remain below where they need to be on a longterm basis (e.g., 1.5-1.6 million home starts annually in the U.S.).
Residential-related investments increased during the quarter included the common stocks of Weyerhaeuser (WY, Financial) and Rayonier (RYN, Financial), both of which are large timberland owners that trade at steep discounts to our estimates of net asset value (NAV) despite robust growth prospects. The Fund also increased its exposure to certain special situation investments by purchasing additional shares of Macerich (MAC, Financial), First Industrial (FR, Financial) and Wereldhave (WER, Financial). As is the case for the Fund’s other special situation investments, the common stocks for these companies trade at significant discounts to our estimates of their private market values.
The Fund also reduced a few positions during the quarter, reallocating the capital to other securities where the risk-adjusted return prospects seemed superior. Capital recycling activity during the quarter included selling the common stock of Starwood Waypoint (SWAY, Financial) and initiating a position in Kennedy-Wilson Holdings (KW, Financial); reducing CK Hutchison Holdings (CKH, Financial) in order to increase the Fund’s position in Cheung Kong Property Holdings (CHKGF); and eliminating Hang Lung Properties (HLPPY) and in turn buying Hang Lung Group (HNLGF).
The Fund also sold Quintain Estates & Development (QED). Starwood Waypoint is a U.S. REIT that owns a portfolio of single family homes for rent. At the time the position was initiated in 2013, the company was incredibly well financed (i.e., net cash) and run by a management team with a proven track record in both operations and capital allocation. Since that time there has been turnover in the executive ranks, large scale acquisition opportunities seem to have passed, and the balance sheet has become significantly encumbered.
With the original thesis no longer being intact (limited downside with upside optionality on improving profitability and potential acquisitions), the Fund exited its position at prices that were in-line with the original cost basis after factoring in dividends. Kennedy-Wilson Holdings (Kennedy-Wilson) is a U.S.-based real estate operating company that has been on Fund Management’s radar for a number of years. The company has evolved over time and, today, is an integrated global real estate investment and services company with a $2 billion portfolio of investments in a diversified mix of commercial and residential assets.
In addition, Kennedy-Wilson has rapidly expanded its funds management business with more than $18 billion of assets under management. The management team owns 19% of the company’s stock and has historically been savvy capital allocators, having made substantial investments in Japan during the 1990s, the United States following the financial crisis, and in Europe in recent years as a first mover in Ireland and Spain. The template has been the same in all markets: invest capital in out-of-favor regions or property types at substantial discounts to underlying value, actively manage the properties and add value during the holding period, and then ultimately realize profits over the long-term in order to recycle the capital elsewhere.
During the quarter the Fund finally had an opportunity to purchase Kennedy-Wilson’s shares at a discount to our estimate of NAV. It seems likely that the company will continue to prove capable of increasing its NAV by 10% or more per year over the next two to three years as it further expands its asset management business and realizes profits (including promotes) from some of the well-timed investments it made over the past few years. With volatility in Chinese stock markets spilling over to the Hong Kong market, certain companies in Hong Kong have traded to historically low valuations. For instance, during the quarter the common stock of Hang Lung Group, a Hong Kong based holding company with a 53% ownership stake in Hung Lung Properties and other real estate investments, traded at prices that implied a value below the market value of its stake in Hang Lung Properties (without factoring any uplift for the Group’s additional ownership position in a 2.2 million square foot class-A office and residential space at the Grand Gateway complex in Shanghai).
Consequently, the Fund sold its stock in Hang Lung Properties and purchased Hang Lung Group, essentially trading one discounted security for an even more discounted security. Hang Lung Properties had been held in the Fund off and on for nearly 10 years. The Hong Kong-based real estate operating company historically concentrated on commercial properties and residential projects in Hong Kong. Hang Lung Chairman Ronnie Chan was a pioneer in China, developing retail led class-A mixed-use projects more than a decade ago. After enormous success in Shanghai, Hang Lung branched out to other cities in China, where it now has seven large-scale projects open with three more under development.
Once completed, the company’s properties in China will comprise more than 54 million square feet of space (approximately one-third of the size of Simon Property Group’s portfolio) and form one of the most productive and valuable portfolios in the region. The process of undertaking these large-scale developments is a challenging one, but the long-term value creation taking place as these projects open and stabilize should lead to outsized NAV growth and reward both Hang Lung Properties and Hang Lung Group shareholders. At this point in time, however, Group shareholders may benefit disproportionately given the larger discount and the outside chance that the company collapses the holding company structure. With the additions to Hang Lung Group and Cheung Kong Property during the quarter, the Fund’s exposure to Hong Kong based companies increased to 13% of net assets. Fund Management has been increasingly mindful of the impact global currency movements could have on the underlying value of the Fund’s Hong Kong holdings.
At the present time the Fund doesn’t have currency exposure relating to these investments, per se, as the Hong Kong dollar ($HKD) is pegged to the United States dollar ($USD). It is no longer inconceivable, though, that at some point over the next few years Hong Kong could elect to re-peg the $HKD to a basket of currencies or even the Chinese renminbi. Should such a scenario play out, there would no doubt be short-term market dislocations (potentially great buying opportunities for the Fund’s well-capitalized property companies), but the Fund’s investments could end up in a currency that is re-pegged at a rate that is lower than what exists today.
While the chances of this occurring still seem remote, the Fund purchased two-year put options on the $HKD for its entire notional exposure at a price that is approximately 3% below the current exchange rate. After purchasing the $HKD put option, the Fund has hedging instruments in place for its entire notional exposure in Europe, Australia, and Hong Kong. The common stock of Quintain Estates & Development (Quintain), a U.K.-based real estate operating company, was also eliminated during the quarter. Quintain Common had been owned in the Fund since 2004. Quintain controlled two valuable residential led mixed-use projects in London with sites in East London (Greenwich) and North London (Wembley). While the company had great development sites, those projects didn’t generate enough income to cover its interest costs during the downturn, which ultimately led Quintain to undertake a dilutive rights offering (which the Fund participated in) and bring in a new management team in 2009. Since that time, the company sold the Greenwich project for cash, significantly reduced debt levels, and refocused the company on Wembley with entitlements to build more than 7 million square feet of residential and commercial space in one of the most supply constrained markets globally. However, the public markets didn’t seem to be willing to give the company credit for its underlying holdings, leaving the stock at a large discount years after being repaired. In order to close this gap and realize value for shareholders, Quintain’s Board announced that it had agreed to sell the company to funds affiliated with Lone Star (a U.S.-based real estate and private equity group) for 131p per share or a 22.4% premium to the undisturbed price (107p per share) and a 7.4% premium to the company’s most recently published NAV (122p per share). Subsequent to the announcement, the Fund sold its shares. Having held Quintain Common for more than 10 years, realizing only a nominal gain on the investment was not the ideal outcome, but Fund Management supports the Board’s decision to crystalize value for shareholders by agreeing to sell for cash and at a premium to NAV.
