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Location, Location, Location

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Looking at Security Capital European Real Estate Fund’s track record, it’s easy to be impressed. According to Standard & Poor’s, SEUIX ranked 13th within the entire universe of 1,853 funds in the international equity category on a one-year total return basis. The fund was upgraded to five stars in December 2002, its turnover rate is a mere 33% versus an average 133% for its peers, and for the three-year period ended March 31, 2003, SEUIX had an average annualized return of 6.6%, compared to -18.1% for the FTSE World Index-ex U.S. What’s not to like? Though with assets of just under $13 million, one wonders why more people aren’t climbing aboard.

U.S. real estate has been one of the few sectors that has thrived during the bear market. European real estate, which performs similarly to its U.S. counterpart, has just as many, if not more, investment opportunities, and yet many Americans are still apprehensive about investing overseas.

“U.S.-based clients tend to invest only in U.S. securities whereas the Dutch and Canadians especially have very aggressively invested cross-border,” says Kenneth D. Statz, one of the three members of Security Capital Research & Management Inc.’s portfolio management committee. “My theory is that unless investors see a need to go outside their borders, they tend to stay home.” Currently, he says, the U.S. has an enormous market with such a variety of opportunities that the need for international diversification seems to be very low. But over time, Statz says he expects that to change.

As part of the management committee, Statz is one of three portfolio managers who make the final investment decisions for this fund. Statz, Kevin Bedell, and Anthony Manno review equities proposed by Security Capital’s analyst and VP Bernhard Krieg to determine which real estate securities from which countries will be included in the fund. “Some of the industry trends we see in the United States are followed in Europe and elsewhere around the world,” says Krieg. But “you get a little bit of a different twist in the sense that you have different currency exposure.”

Reviewing equities on a country-neutral and currency-neutral basis, SEUIX is a fund that invests in undervalued real estate securities with a strong management company. We recently spoke with Statz and Krieg about their European research tactics, and their emphasis on diversification.

Is doing research on European companies different than U.S. companies? Krieg: We probably rely a little bit less on face-to-face meetings than we do here in the United States. I do try to go back about twice a year to meet with companies and I also go to conferences, where I can meet with a number of people in a short period of time. Disclosure in Europe is a little sketchier; there is no similar body in Europe to the SEC. Their disclosure requirements are not quite as stringent as they are in the United States. You have to do a little bit more extrapolating of results there, [whereas] here where we have more minute-to-minute reporting every quarter. There, [companies] report mostly on a semi-annual basis.

Statz: There is an interesting interplay between the U.S. and European real estate stocks. The U.S. economy and the global economy are so integrated that many of the things we see developing in the U.S. seem to bubble to the surface within a few months and affect real estate companies around the globe, often the same way. We have a bit of an early warning system that seems to work pretty well in following European real estate companies.

What’s the same, and what’s different, about investing in European real estate compared with investing in the U.S.? For example, REITs in U.S. must pay out 90% of their taxable income each year to shareholders. Are there similar requirements in Europe? Krieg: There are number of countries that actually have a very similar structure in place. The Netherlands and Belgium have REIT-like structures in place, and the companies that are a part of our universe do have that payout requirement and are higher in yield than most other companies. France [will soon also] have a tax plan structure similar to the REITs that we have here.

Nearly 70% of your investments are in the U.K. and France, and only 3% in Germany? Why the disparity? How do you determine risk in these different countries? Krieg: The property sector in Europe is still not as well developed as it is here in the United States. Your investable universe of companies is not evenly distributed [among each country in Europe]. There is a well-established sector with a lot of depth in the United Kingdom and in France, while in countries like Germany, which has historically been more oriented toward open- and closed-end funds given the strong presence of banks there, whose [real estate] sector is not quite as developed yet. But I think that is [becoming] less of an issue these days with a common currency and a move toward an integrated economy. The country borders which have been a lot more important in past decades have definitely lost some of their dividing factor.

Statz: As we go about our management, we look first at our index of real estate companies as our menu set, and we try to figure out [the best investments] on a country-neutral and a currency-neutral basis. Since we don’t make currency bets, we try to be somewhat neutral toward having the portfolio distributed by currency; then we make bottom-up investments with a high degree of conviction within those currencies. Sometimes that helps to better explain our exposure as opposed to saying “We don’t like Germany,” or some other country.

Once a security is proposed to your committee, what are you approval criteria? Statz: [We look] at the due diligence [of the security], and the cash-flow dynamics of the company, including what the current cash flow is versus the long-term value. Everything we do in real estate securities resides in two worlds. One is the very large private world of commercial real estate, and the other is the smaller world of publicly traded securities of those commercial real estate companies. Our job, in Europe or not, is to know what is happening in the real estate market and then put a public market overlay on it. [We evaluate] how inexpensively or how dearly priced these securities are from our perspective. [Then] we have to see a coherent real estate platform, we have to understand the management companies, then we [get] our own sense of what the value of the company is and we check it’s trading price in the public market. It is fairly straightforward; if we see undervaluation, we will own the security.

Where are you allocated across real estate sectors? Are you invested in hotels, shopping malls, housing developments? Statz: We invest where we see opportunity, with a huge footnote. We are always trying to create a diversified commercial real estate investment. And by diversification that includes geographic diversification and currency diversification, but property type diversification is also important. We would not be fulfilling our mandate for our clients if for some reason we had [just] a big office market portfolio: it could be a very strongly performing portfolio, but it wouldn’t be very well diversified. First we figure out which companies are attractive on a risk/reward basis, but then we set the weights of those companies to achieve broad diversification so we have a strong representation in office, in multi-family, and in retail. But we do vary the weights. For example, we had been focusing on tilting the portfolio toward retail, now we are starting a slow tilt back toward the cyclical office side because we think that as the global economy improves we can get more traction in that area. But the key word I am stressing is tilt. We want to tilt toward one property type or another based on where the economy is going, but we don’t want a seriously out-of-balance portfolio skewed toward one property type.

You currently have around 30 holdings in the fund. Is that always the case? Krieg: That is fairly typical. We try to take a concentrated approach and maintain a diversified portfolio.

Statz: One of the issues we have is that even though we have a lot of companies, there are only a few very large companies that are a big part of the CitiGroup Global Property index. We only own 25 to 30 names by nature, and owning some of these companies is going to result in a fairly significant overweight versus the index because there are so many tiny companies. The bottom line that we are trying to get into the portfolio is a sense of a very diversified cash-flow stream. We want to latch on to lots of leases, lots of different locations, and give our clients a very diversified cash-flow stream to support their valuations. [While] it is important to us how many companies we own, it’s more important to know the nature of their leases and how secure those leases are, and how cyclical is their volatility. We are very cautious in not only the mix of companies and the mix of regions, but also what kind of leases we have. There are a lot of decisions we have to make in sculpting a cash-flow stream to support our valuations and we will vary that depending on how aggressive or defensive we want to be.

Do you hedge your currency risk at all? Krieg: No, and part of it is practicality. We found that the cost of hedging was fairly substantial. This is a very appropriate product for our clients to achieve geographic diversification but also to achieve currency diversification as part of their overall portfolio strategy. Hedging that currency risk was relatively costly and was not required or mandated by our clients.

Statz: The best thing we can do is give our investors a sense of the currency risk we are taking. But clients vary on this point: Some will do it on their own and some don’t want you do it. We found it more efficient not to hedge.

Who is your ideal investor, and who is your actual average investor? Do you make a lot of sales through the advisor channel? Statz: Ideally, our investors firmly want to be investors for the three- to five-year timeframe, they value diversification and return, they appreciate a disciplined investment process, they [understand] why we are taking the risks we are for the rewards we expect to achieve, and they have a healthy respect for research. We don’t make a lot of sales though advisor channels. Most advisor channels are discovering U.S.-based publicly traded real estate securities, and really haven’t spent time studying the European side of it. [If we do] it tends to be very fast money [in and out of the fund].