Third Avenue Real Estate Value Fund commentary for the third quarter ended July 31, 2016.
Dear Fellow Shareholders:
We are pleased to provide you with the Third Avenue Real Estate Value Fund’s (the “Fund”) report for the quarter ended July 31, 2016.
Third Avenue Real Estate Value Fund – Portfolio Activity
The day after the United Kingdom (“U.K.”) held its referendum on whether or not to remain in the European Union (“EU”), the adage ‘Sell in May and go away’ seemed like prescient advice.With a majority of the U.K. voters unexpectedly electing to leave the EU, the reality of a ‘Brexit’ finally set in, leading to a great deal of uncertainty on how the process would play out and sharp declines in the prices of most U.K.equities as well as the British pound. In fact,prices for the common stocks of most U.K. property companies were trading at levels 25-35% lower than they had been (in U.S.Dollar terms) only days before. We have never been “market timers”. Instead,we invest when the securities of well-financed companies can be purchased at substantial discounts to conservative estimates of Net Asset Value (“NAV”). In this case, the Third Avenue Real Estate Value Fund emerged as an active buyer of U.K.property stocks in the days after the vote,accounting for the bulk of the portfolio changes during the period.
As we wrote about in the previous quarterly letter, the Third Avenue Real Estate Value Fund has been invested in the U.K. for more than a decade. At certain times the Fund has even had nearly 20%of its capital invested in the U.K.as it has been our long-held view that it is one of the premier property markets for long-term investors.This is especially the case for London where real estate investors enjoy strong property laws, favorable lease terms, strict zoning ordinances which limit new supply, steady occupier demand from both domestic and multi-national tenants,and a transparent and robust transaction market.The Fund’s exposure to the U.K.had been reduced materially in recent years, though,as certain companies were privatized (Songbird Estates, Quintain Estates & Development) or positions were either sold (Berkeley Group,Taylor Wimpey, Bellway) or reduced in size for valuation reasons (Hammerson, Segro, and Savills). As a result,approximately 7% of the Fund’s capital was invested in the U.K.earlier this year with the view that the U.K.exposure could go back to approximately 15% of the Fund’s capital should a vote for Brexit occur leading to even more substantial discounts to NAV.
With that plan in place, the Fund swiftly added to its U.K. exposure in the days after the referendum by investing more than $100 million in its existing holdings,boosting the U.K.exposure to more than 13% of the Fund’s capital in the process.The largest investment during the period was in the common stock of Land Securities’ now a top position in the Fund. As outlined in detail in the previous letter, Land Securities is a U.K.-based Real Estate Investment Trust (“REIT”) that owns a high quality portfolio of office and retail properties primarily concentrated in London with a particularly strong position in the Victoria sub-market in the West End of London. In addition, the Third Avenue Real Estate Value Fund increased its positions in the common stocks of Segro and Hammerson. Segro is a U.K.-based REIT that owns an irreplaceable portfolio of industrial properties in Europe with a market dominant position in the Royal Park and Heathrow markets which are key industrial hubs for London. Hammerson is also a U.K.REIT that owns some of the most valuable shopping malls in the U.K. (e.g.,Brent Cross in London,Bullring in Birmingham) as well as valuable centers in France and a strategic investment in Value Retail? the leading owner of premium outlet centers in Europe.Collectively, these three companies accounted for more than 11% of the Fund’s capital at quarter-end and share three key similarities.
First and foremost, Land Securities, Hammerson, and Segro are all very well-capitalized property companies. Not only do they own high quality property portfolios that generate very predictable cash flows,but they are also prudently financed with loan-to-value ratios of 40% or less without any significant near-term maturities or major capital commitments,given the modest development projects under way.Asa result, it seems likely that these companies are positioned to withstand any sort of downturn that the U.K.may face during this transition period and potentially take advantage of market dislocations.For instance,Land Securities has more than 2 billion GBP of excess capital,which could be used to provide liquidity for those with near-term capital needs (e.g.,U.K.open-ended property funds) and purchase well-located development sites to set itself up for the next phase of development projects.Similar opportunities exist for Hammerson and Segro. We expect these well-financed companies will not only make it through this period, but will likely emerge stronger and more valuable.
In addition to being well-financed issuers, the common stocks of Land Securities, Hammerson, and Segro are all trading at prices that represent material discounts to NAV. Undoubtedly the values for commercial and residential real estate will come under pressure as the multi-year process of the U.K. reworking its existing agreement with the EU ripples through the occupier market? especially the City and Canary Wharf sub-markets of London. However, it is our view that this period of uncertainty will have the biggest impact on those companies that have (i) large-scale speculative development pipelines under way where rental rates are likely to be cut to entice tenants, leading to lower returns for the projects, (ii) residential-led redevelopment projects where prices are already declining from highs reached in 2015 and unlikely to be as profitable as previously budgeted,and (iii) portfolios that are appraised at very low cap rates (i.e., initial yields) because of substantial rental rate growth assumptions which might moderate significantly in the near future. In the case of Land Securities, Hammerson, and Segro, more than 90% of the values of each company are comprised of diversified commercial real estate portfolios that are highly occupied and leased at below-market rents with an average lease term of more than 8 years.Asa result, it seems unlikely that the cash flows will change materially during the two year “Brexit” period should the U.K.parliament ultimately enact Article 50 of the Lisbon Treaty. In fact,when looking out more than a few months it is quite possible that highly-occupied properties could even become more valuable should cap rates fall further as income oriented investors target the durable cash flow streams provided by well-leased U.K.properties that are now generating yields at historically wide spreads to 10-year gilts (U.K. treasuries),which are now yielding less than 1.0%.
And finally, these companies own highly strategic and sought after portfolios that have taken multiple decades to assemble.To the extent the shares of Land Securities, Segro, and Hammerson continue to trade at meaningful discounts to NAV, we believe resource conversion is likely to materialize.Similar to the U.S., in the U.K. there is a very active market for mergers,acquisitions,privatizations, spin-offs, share repurchases, tender offers and other corporate activities that management teams and boards might employ to collapse the discounts which currently exist.What makes thisan especially interesting time as it relates to companies with high quality real estate portfolios, like these three businesses, is that not only are their stocks