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2018 May Newsletter

Zach Liggett, CFA®
By: Zach Liggett, CFA®

Property Hunting

Commercial property investments are a material component of current FIM Group investment portfolios. Holding real estate via publicly traded shares, unlike direct ownership, enables us to assemble a diverse basket of literally thousands of properties around the world. We can adjust our real estate exposure, as opportunities arise to do so, in far less time and with much lower transaction costs than required by private real estate transactions. This liquidity can come in handy when pursuing a variety of portfolio objectives, including raising cash, controlling position size, or optimizing a tax situation. And then there’s the dreaded “3-T’s” often associated with being a landlord (tenants, toilets, and taxes). Owning property through listed stocks allows us to outsource those headaches to seasoned management teams, while we can just sit back, collect dividends, and watch our property companies appreciate. 

Okay, maybe it’s not all sunshine and rainbows. With property stocks, as with any stock, we are usually in a minority ownership position. This means we have little control over the strategic and tactical decisions made by the manage­ment teams of our holdings. If we’re not happy about a certain property purchase or the way a company chooses to finance its operations, we’ll have little recourse beyond selling the stock and moving on.

We must also contend with the daily “mark-to-market” of our property holdings. At any given time, the market value of our stocks will reflect the views, emotions, objectives, and incentives of a wide range of fellow traders and investors. Increasingly, the largest co-investors in some of our property stocks are market and sector index funds. The owners of these funds choose to buy or sell “the market” or “the property sector” with one trade rather than to do individual stock analysis. As these participants trade, the result can be far more volatility for stock prices relative to what’s happening with transaction prices in the underlying real estate. Herding behavior and the popularity of index investing can also lead to periods when individual property stocks with starkly different characteristics trade as if they were all just clones of one another.

Are rising interest rates bad for property stocks?

Over the last few years, one of the biggest factors driving property stock volatility is the great debate over how these stocks will do in a rising interest rate environment. This is understandable, as we are transitioning from the historically weird world of ZIRP (zero % interest rate policy) and QE (quantitative easing) and working our way back to a path of interest rate and monetary policy normalization. 

The higher interest rates = property stock pain thesis generally rests on the premise that:

1. All the way down the chain, most property owners, their tenants, and their tenants’ customers use debt in part to finance their spending and investment. As higher rates drive up debt servicing costs, profitability could get squeezed at each link in the chain. For property owners, this translates to the potential for higher financing expense on the debt they utilize and lower revenues should a profit squeeze at their tenants affect the ability to keep space leased.

2. Most investors assess the fundamental value of any asset, including property, by estimating the future cash flows that the asset will produce and dis­counting those future cash flows back to a “present value” (on the view that a dollar today is worth more than a dollar tomorrow). Higher interest rates used for this discounting exercise, assuming no change to the property’s expected future cash flows, results in a decline in the estimated value of the property.

3. As interest rates increase, investment options with more certain cash flow characteristics like CDs and government and corporate bonds will be better able to compete with dividend-paying property stocks. To entice investors to accept the added uncertainty that comes with property stocks, dividend yields will have to go higher (and prices lower).

Mitigating factors

While the thesis that rising rates could mess things up for property stock investors makes sense on the surface, there are mitigating factors that deserve close consideration. If the primary reason that interest rates are rising is that the economy is doing well, then maybe property stocks have much less to worry about. This is because the “top-line” effect of stronger revenues throughout the landlord-tenant-customer chain may well outweigh the higher interest expense burden at each level. With employment rates in most parts of the world the best they’ve been in years, corporate earnings breaking new records each quarter, and inflation remaining relatively subdued, consumers and businesses may have little problem dealing with additional interest expense in their monthly budgets. Throw a little tax reform sugar on top, and the case for continued momentum in the economy gets even better. Occupancy stays high and, as leases come up for renewal, landlords push through rent hikes that are more than enough to offset any incremental financing costs that come with higher rates.

As it turns out, history generally supports the view that higher interest rates, if higher because they reflect decent strength in the broader economy, are not really a problem for real estate stocks at all. Figure 1 shows how real estate investment trusts (REITs) did during the last FED rate hike cycle. As the Fed hiked rates over multiple years, REITs not only performed well in absolute terms, they also far outshone the overall stock market. Figure 2, which takes the clock back to 1992, indicates that REITs have also fared quite well during most periods of rising longer-term interest rates.


What about the stagflation scenario?

In our little Ping-Pong game here, debating whether rising rates are bad for property stocks, let’s give the negative camp one more turn. Could there be reasons for interest rates to rise when the economy is not doing so hot? Sure, there can. Although relatively rare, there have been times in history when rising inflation took interest rates higher just as the economy was stagnating. Our most recent extreme example of this is the late 70s stagflation, which featured an oil shock, a jump in both consumer prices and interest rates, and higher unemployment. Could we see something like this today? That’s certainly not my base case. The disinflationary secular trends of aging developed world demographics and rapid technology-based disruption (think Amazon or the declining costs of alternative energy) are likely to act as a check on prices for many consumer goods and services. By contrast, when I see some of the recent actions our leaders are taking on the foreign policy front (trade tariffs on China, missile strikes in the Middle East), I can’t fully dismiss the chance of a self-inflicted stagflation period, either. 

Valuations reflect uncertainty discounts

Looking at property stock valuations today, it seems clear that many in the market are expressing the view that property stocks face a less rosy future. Look, for example, at the charts from Cohen and Steers (Figure 3). These charts take a global survey of property stock prices relative to net asset values (NAV, basically the estimated market value of a company’s real estate less any liabilities) and funds from operations (FFO, a key earnings metric). What they reveal is that property stock valuations in many parts of the world currently trade at the low end of five-year ranges. In other words, investors have voted with their feet (so to speak) and have already discounted some likelihood that property stocks may face material challenges ahead.

Shopping the sales

When stocks go on sale, you can bet that our team’s ears perk up! We’ve been adding selectively to our property stock basket as expected total returns improve. As uncertainty around interest rates is likely to be with us for some time, we believe a bottom-up, one-at-a-time stock picking approach will work better than just buying a property sector exchange-traded-fund. 

Figure 4 is a snapshot of our top-10 real estate-related stocks (as of April 17). As you can see, we are taking a diversified approach and hold a variety of property types, geographies, and corporate structures. From acute care hospitals in the U.S. and Germany to coworking spaces in Finland, solar farms in Japan, and almond orchards in Australia (see this newsletter’s Investment Team Spotlight), we own an extremely heterogenous basket of holdings. These investments include real estate investment trusts (REITs) designed to generate relatively high levels of recurring income and dividends for shareholders, as well as real estate operating companies and agricultural firms where a higher percent of cash flows are generally reinvested for growth.

Beyond simply providing space

Some of the general characteristics we look for in our property stock holdings are strong leasing teams, thought­fully structured balance sheets, and services that go beyond merely providing space. For example, several of our holdings, including Kennedy-Wilson and Ichigo, leverage their internal expertise to structure and manage third-party real estate funds on which they earn meaningful fees. Others, like Techno­polis, are aggressively rolling out services that include workspace design, on-site restaurants, reception, and cleaning, creating additional revenues and “stickier” tenants.

We also look for management teams who are willing to explore strategic actions that can catalyze change. New Senior Investment Group, for example, is an owner of senior living facilities. Its stock trades at a stubbornly high discount to NAV. In response, management there recently announced that it is undertaking a full strategic review. While this may ultimately result in a “stay the course” outcome, I would not be surprised to see this company merged with a larger player or taken private. Spirit Realty Capital, which owns thousands of single-tenant retail, services, and distribution facilities, is acting on its own strategic review conducted a year ago. The company will effectively split itself into two listed companies that appeal to two specific types of investor (those seeking modest returns from a high-quality, very diversified tenant base and a rock-solid balance sheet; and those willing to assume increased risk and higher expected returns with a more concentrated tenant base and higher debt balance sheet). By splitting, management expects that the two separately listed companies will command a significantly higher aggregate market value than the single company does today. 

Bottom-line, investor uncertainty around interest rates and future economic growth have improved the case for investing in real estate through property stocks. Taking the public investment approach, we can craft a cost-effective unique portfolio of diverse properties around the world while enjoying the liquidity advantage that such shares offer. And as a bonus, we can let others do the dirty work collecting any past-due rent, interpreting tax law changes, or dealing with the 3 a.m. calls when the toilets won’t flush.

Renée Egelski, CFP®
By: Renée Egelski, CFP®

Saving for College: A 529 or a Roth IRA?

First off, a Roth IRA is intended for retirement savings. If you are saving in other retirement accounts (such as a 401(k)), then it may make sense to earmark Roth IRA savings for college expenses. However, it is important to note that loans may be taken for college expenses. Loans may not be taken for retirement, however, so spend wisely. 

Tax benefits and use of funds

Roth IRAs and 529 plans have similar tax treatment. Both are funded with after-tax dollars, contributions accumulate tax-deferred, and qualified distributions are tax-free. But in order for a 529 plan distribution to be tax-free, the funds must be used for college or K-12 education expenses. By contrast, a qualified Roth distribution can be used for anything – retirement, college, travel, home remodeling, and so on.

In order for a distribution from a Roth IRA to be tax-free (i.e., a qualified distribution), a five-year holding period must be met and one of the following must be satisfied: The distribution must be made (1) after age 59½, (2) due to a qualifying disability, (3) to pay certain first-time homebuyer expenses, or (4) by your beneficiary after your death.

For purposes of this discussion, it’s the first condition that matters: whether you will be 59½ or older when your child is in college. If the answer is yes (and you’ve met the five-year holding requirement), then your distribution will be qualified and you can use your Roth dollars to pay for college with no tax implications or penalties. If your child ends up getting a grant or scholarship, or if overall college costs are less than you expected, you can put those Roth dollars toward something else.

But what if you’ll be younger than 59½ when your child is in college? Can you still use Roth dollars? You can, but your distribution will not be qualified. This means that the earnings portion of your distribution (but not the contributions portion) will be subject to income tax. (Note: Just because the earnings portion is subject to income tax, however, doesn’t mean you’ll necessarily have to pay it. Nonqualified distributions from a Roth IRA draw out contributions first and then earnings, so you could theoretically withdraw up to the amount of your contributions and not owe income tax.)

Also, if you use Roth dollars to pay for college, the 10% early withdrawal penalty that normally applies to distributions before age 59½ is waived. So, the bottom line is, if you’ll be younger than 59½ when your child is in college and if you use Roth dollars to pay college expenses, you might owe income tax (on the earnings portion of the distribution), but you won’t owe a penalty.

If 529 plan funds are used for any other purpose besides the beneficiary’s qualified education expenses, the earnings portion of the distribution is subject to income tax and a 10% federal tax penalty. 

Financial aid treatment

At college time, retirement assets aren’t counted by the federal or college aid formulas. So, Roth IRA balances will not affect financial aid in any way. (Note: Although the aid formulas don’t ask for retirement plan balances, they typically do ask how much you contributed to your retirement accounts in the past year, and colleges may expect you to apply some of those funds to college.)

By contrast, 529 plans do count as an asset under both federal and college aid formulas. (Note: Only parent-owned 529 accounts count as an asset. Grandparent-owned 529 accounts do not, but withdrawals from these accounts are counted as student income.)

Investment choices

With a Roth IRA, your investment choices are virtually unlimited – you can hold mutual funds, individual stocks and bonds, and REITS, to name a few.

With a 529 plan, you are limited to the investment options offered by the plan, which are typically a range of static and age-based mutual fund portfolios that vary in their level of risk. If you’re unhappy with the market performance of the options you’ve chosen, under federal law you can change the invest­ment options for your existing contri­butions only twice per calendar year (though you can generally change the investment options on your future contributions at any time).

Eligibility and contribution amounts

Unfortunately, not everyone is eligible to contribute to a Roth IRA. For example, your income must be below a certain threshold to make the maximum annual contribution of $5,500 (or $6,500 for individuals age 50 and older).

By contrast, anyone can contribute to a 529 plan; there are no restrictions based on income. Another significant advantage is that lifetime contribution limits are high, typically $300,000 and up. And 529 plan rules allow for large lump-sum, tax-free gifts if certain conditions are met: $75,000 for single filers and $150,000 for married joint filers in 2018, which is equal to five years’ worth of the $15,000 annual gift tax exclusion. 

Note that a Roth IRA may be opened in the name of the child and funded if the child has their own earned income.

Source: Broadridge Investor Communication Solutions, Inc.

FIM Group Staff
By: FIM Group Staff

Investment Team Spotlight: Select Harvests

Summary Snapshot
Ticker: SHV AU / SHVTF
Share Price (AUD) / Market Capitalization (AUD) (04-19-2018): $6.40 | $610.4M
Website: selectharvests.com.au

Company Description (In Their Words): “Select Harvests is Australia’s largest vertically integrated nut and health food company with core capabilities across: Horticulture, Orchard Management, Processing, Sales and Marketing. These capabilities enable us to benefit throughout the value chain. 

“We are one of Australia’s largest almond growers and the country’s leading manufacturer, processor and marketer of nut products, health snacks and muesli to the Australian retail and industrial markets, in addition to exporting almonds globally.”

Investment Thesis: Almonds. We thought about leaving this investment snapshot at that, just… “Almonds”. However, the story is more dynamic than that. Healthier foods (i.e. natural plant-based snacks) are comprising a larger portion of the average consumers diet, almond prices are competitive versus other tree nuts (e.g. cashew, pinenut, pistachio, and walnut all seeing higher prices than almond over the last two years), and while California may produce 80% of the worlds almonds, Australia has got something interesting going on down under.

With 18,500 acres of almond orchards across three Australian states (New South Wales, South Australia, and Victoria) and reaching out to the edge of The Outback, Select Harvests is in the position to expand production from roughly 15,000 metric tonnes (MT) today to over 20,000MT in the next five years. This footprint also affords Select Harvests with some geographic diversity which should in turn help with weather, disease, and insects.

What intrigues us about the agricultural side to this story is that a capital outlay today (with some love along the way) can grow and produce more tomorrow. Put another way, when a tire manufacturer builds a new production line - water, fertilizer, care and maintenance aren’t enough to boost production 30%+ a few years out. 

Almond trees have an average lifespan of roughly 25 years which in our estimation matches up well with Select Harvests’ orchard profile. Select Harvests appears well positioned for many years to come with 80% of their trees in a mature phase (meaning they are generating cash).

By now you’ve likely got a question tingling between your ears, “Australia? Almonds? What about water?” Fair enough, and here is where it gets exciting as the water situation for Select Harvests is, in no uncertain terms, strong. With orchards securing their water foremost from the Murray River (Australia’s longest at 2,508km or 1,558 miles) and the Murray-Darling Basin, Select Harvests has a distinct advantage over their California peers.

Water and geographic diversity aren’t the only aspects that stick out; as Australia is in the Southern Hemisphere as growing season doesn’t match up with California. This can translate to a supply and demand dynamic whereby Australian almonds receive a premium due to the Indian festive season; India is a large importer of almonds, estimated at 95,000MT in 2017. Another example, should Australia stay out of the U.S.-China trade spat, there might be a near-term boost as Chinese tariffs on California almonds (and other nuts) would skew prices dramatically.

This favorable footprint has not gone unnoticed and big money (e.g. pension funds) have moved into the space, which is an opportunity. As counterintuitive as that may seem, we need to circle back to one key aspect of this story – agriculture. 

Mother nature can be brutal, so when big money comes in willing to take on the agricultural risk, looking for entities to partner up with for the horticulture, processing, etc. there is opportunity. Near-term, these entities have a direct need for talent, expertise, and the tools/facilities of the trade. Longer-term, they will at some point be looking to exit, which could provide for an attractive set of orchards coming up for sale – hopefully at the same time and leading to competitive pricing.

We’ve owned Select Harvests in your portfolios twice over the last few years, most recently building up a position after visiting its orchards and processing facilities in early 2017. We have a high level of confidence in management and the board and wanted to point out that in all our interactions Environmental, Social, and Governance have been topics at the top of the agenda. 

Select Harvests doesn’t take business risk lightly and is actively working to stay on a solid footing. Throughout the employ­ment stack it is aligning compensation with companywide goals from safety to efficiency.

Currently there are two important projects nearing completion: an additional processing and packaging facility and a biomass boiler. While running behind schedule both are coming fully online this year and will add economic value to the Select Harvest story. 

The “Hull to Energy” project is particularly interesting as you probably remember headlines about high energy prices and electricity woes in South Australia. Select Harvests plans to put all those almond hulls/shells to good use, i.e. powering the new processing plant. This new processing plant has capacity beyond their orchard production and Select Harvests is in a good position to consolidate the needs of the industry. Interestingly, they’ve got what might be the largest earthworm farm in Australia as the processing waste/water from the facility ultimately helps to produce fertilizer for the orchards. 

Select Harvests has strong brands in the value-added segment (e.g. bagged nuts, muesli, etc.) where they processed more than 10,000MT in 2017. By our math, investors have been giving a null to negative value for this part of the business. Turnaround in this segment will add some robustness to their business model. 

Select Harvests should be able to increase production and exact efficiencies on top of what is already a cost advantage over their California counterparts; this is in addition to a strong secular tailwind for almonds. 

Ultimately, agriculture is at its core, so we’ve employed a more rigorous model, one where we attempt to better define what base, bullish, and bearish scenarios might look like. We then require sufficient upside from a, probability adjusted, blend of these three scenarios. 

We see great opportunity and value in Select Harvests but as always will stay engaged with management, on top of its project development, and aware of requisite global trends. 

Sources: Company, Bloomberg http://selectharvests.com.au/s... http://selectharvests.com.au/a... http://selectharvests.com.au


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