- Martin Kollmorgen
A CINDERELLA STORY: DECEMBER 2021 NEWSLETTER
Updated: Sep 8, 2022
“HE GOT ALL OF THAT ONE!”
– Bill Murray as Carl Spackler in Caddyshack
• PERFORMANCE – Serenity Alternative Investments Fund I returned +8.83% in December net of fees and expenses. For the full year of 2021 the fund returned +48.8%. • 2022 OPPORTUNITIES – Three economic scenarios may create REIT opportunities in 2022.
o PEAKING INFLATION – As CPI readings decelerate a more dovish Fed could be a boon for duration sensitive REITs. o FED MISCALCULATION – What is now perceived as a Fed policy mistake roiled markets in 2018… could history repeat in 2022 creating fire-sale prices in the REIT market? o PANDEMIC DE-SENSITISATION– After multiple false-starts, the economy could finally fully re-open in 2022 which would be a boon for value-REITs.
• A DUO OF REIT IDEAS – Stocking stuffers from the Serenity crew.
What was 2021 like for your portfolio? Was it a year filled with calm nuanced data consumption and analysis? Or was it a year filled with panic and freakout? Did you bomb it down the fairway or shank it into the water?
2021 was replete with reasons to panic and sell stocks, buy bonds, or raise cash. Riots, Delta, Evergrande, Omicron, most of the major headlines in 2021 were screamingly negative. And yet throughout the year, the S&P 500 made 70 all-time highs, while REITs made 27 all-time highs.
How could an investor have possibly stayed bullish amidst this deluge of negative catalysts?
Data dependence. Apartment rents moved one direction in 2021…up. Self-storage rents similarly moved inexorably higher all year. Jobless claims went the opposite direction in 2021. Down. To 60-year lows. Hotel and Office occupancies moved slowly but recovered. Retail leasing exploded higher and is being followed by higher occupancy. Finding fundamentals in REITs that were not positive was basically impossible in 2021.
With that backdrop it should have been easy to be bullish. At Serenity we were steadfast in our orientation, and it allowed us to achieve the best year in our fund’s history…to the tune of +48.8%!
Entering 2022 we are grateful for an excellent 2021 and prepared for a less one-directional 2022. Fundamentals may not move as bullishly and broadly as they did in 2021, however, the REIT market is still flush with opportunity.
As usual this year end newsletter will be a bit more comprehensive than usual. We will detail what worked in 2021, what we are contemplating for 2022, and how we are positioned to take advantage of the current opportunity set.
Last year was the Cinderella story for REITs, from humble greenskeeper to investing master’s champion. This year we defend the crown. Onward!
PERFORMANCE: +8.83% IN DECEMBER, +48.8% IN 2021.
Serenity Alternative Investments Fund I returned +8.83% in December net of fees and expenses versus the FTSE NAREIT REIT index which returned +10.06%. The fund returned +48.8% for the year, versus the REIT benchmark at +41.9%. On a trailing 3-year basis Serenity Alternatives Fund I has generated annualized returns of +33.3% net of fees and expenses. Over the same time period, the REIT benchmark has returned +20.1% on an annualized basis. The fund’s Sharpe ratio over the past 3 years sits at 2.03, versus 1.11 for the REIT benchmark. Every $100,000 invested in the fund at the end of 2018 is now worth $237,000 a gain of $137,000 and a 137% return. Since inception, our fund has now returned +14.4% on an annualized basis, versus +11.9% for the REIT index. Our average net exposure still sits at just 79%, pushing our since-inception net of fees Sharpe ratio to 1.01 over a six-year period.
The best performing position in the fund during 2021 was Independence Realty Trust (IRT). IRT is an Apartment REIT specializing in renovating and owning non-core apartment assets across the sunbelt markets of the US. Along with one of the strongest rent growth profiles in the entire Apartment REIT sector, IRT also has an active re-development pipeline and a strong record of value creation within their core markets.
With some of the most impressive net asset value (NAV) growth in the Apartment REIT subsector, IRT has become a quant model darling as well as a favorite of our fundamental process over the last year. At its modest size (the company will have an enterprise value of about $7.5 billion after completing a recent merger), IRT is able to create meaningful value via re-development of existing assets and potential acquisitions.
As rent growth ramped in 2021, it became clear that IRT was an early leader with it’s sunbelt market focus. Coupled with its ability to create value in the re-development pipeline, as well as a valuation discount relative to larger more established peers, IRT became a medium sized position in the fund early in 2021. While part of the portfolio IRT has returned +84.2% with an average weight of 5%, adding +3.62% to the fund’s 2021 total return.
The worst performing position in the fund in 2021 was predictably in the short book. Federal Realty Investment Trust (FRT) returned +38.2% while in the portfolio in 2021 with an average weight of -2.5%. Federal perennially trades at a premium to other strip center focused REITs due to its portfolio quality and very well-regarded management team. During the pandemic and subsequent lockdowns, however, FRT saw its portfolio fundamentals deteriorate materially, in many cases worse than that of other strip center REITs. For most companies, this would cause a deterioration in the valuation premium afforded to the company’s stock price. FRT, however, continued to trade at a significant premium to peers, suggesting a juicy short relative to other Strip Center REITs.
The market however, as it often does, had a more nuanced read. As the economy began to re-open, FRT’s portfolio snapped back to life, posting one of the quickest recoveries in the sector. With fundamentals back towards the top of the pack, FRT’s valuation premium is un-diminished, and once again seems justified based on the strength in fundamentals. While shorting FRT did not work as a trade, we think few management teams could pull off the turnaround experienced at FRT. This has been duly noted as we move forward.
The chart of our 10 most successful investments reinforces this conclusion, exhibiting a wide variety of property type diversity, and only accounting for about 50% of the fund’s dollar weighted returns since inception. Our process has been able to create value across REIT property types, market caps, and economic scenarios.
You may also notice that Simon Property Group (SPG) tops our list of successes. Considering SPG is one of the worst performing REITs over that past 5 years, the fact that we have generated 206% returns in the name is striking.
The glaring weakness in our track record comes in the Shopping Center REIT sector, mostly stemming from value style investments the fund made in 2018 which turned out to be “value-traps.” While we have made money in Office and Mall REITs historically, Shopping Centers have been a strategic weak spot. We hope in the future to reverse these negative returns by making better decisions within this property type.
2022 OPPORTUNITY PART 1: INFLATION PEAKING
Amazing what a difference a year makes in macro. Entering 2021 inflation was barely on the radar of most investors and macro-economists. The fed itself continually and famously referred to inflation as “transitory” throughout 2021, a piece of language it has recently “retired” with a CPI print of 6.8% for November. Views on the future aside, it’s become impossible to argue that inflation has not reared it’s ugly head. The upshot of this inflation surge is a Federal Reserve that has turned hawkish on the margin. The fed now plans on reducing its asset purchases to zero by March of 2022, and potentially raising interest rates at the same time. This is concerning for investors because tighter monetary policy often translates into multiple compression in the stock market. But how likely is it that inflation remains elevated in 2022? Data continues to accrue that suggest inflation may in fact be peaking in the near term, easing throughout 2022 from today’s levels above 6%. Energy prices have stabilized, supply bottlenecks are beginning to loosen, and government spending has moderated. And while you may not read it in the headlines, the economic consensus actually agrees with us. The chart below shows consensus inflation expectations per Bloomberg for 2022.
Could moderating inflation actually give the Fed cover to pause their hawkish rhetoric? The balance of factors influencing their decisions are impossible to predict, but we can say with confidence that in a vaccuum, lower inflation should lead to lower interest rates as the year progresses.
So what does this mean for REIT investors? The potential return of duration-sensetive REITs.
Duration sensitivity has not performed well since September of 2020. Bond-like free-standing Retail, Healthcare, and Data Center REITs have returned 32%, 34%, and 15% over this time period, while short duration Apartments, Self-Storage, and Hotel REITs have returned 78%, 98%, and 74%. Simply put, as inflation and growth accelerate, short duration REITs tend to perform well, and as inflation and growth retreat (and bond yields fall), longer-duration REITs tend to perform well.
This gives us an interesting setup in early 2022. With inflation potentially falling and growth potentially plateuing, duration could very easily come back into vogue for a portion of the year. And certain REITs within the “high duration” bucket have become extremely cheap.
Regular readers will recognize this as a new development within our macro view. In the fund we have been unapologetically bullish on both growth and inflation since late 2020, owning short duration REITs and shunning or even at times shorting longer duration names. While we are not completely flipping the script yet (the jury on growth in early 2022 is still out), we are decidedly more cautious on inflation linked names and much less bearish on more bond-like REITs. As always we will wait and watch for more data before increasing our high-duration bets, but we have added positions in some high dividend, very cheap high duration REITs at the beginning of this year.
2022 OPPORTUNITY PART 2: A FED INDUCED FIRE-SALE
While our base case for 2022 is that inflation moderates and the Fed is able to pump the brakes on balance sheet reduction, there remains the possibility that the Fed remains aggressive, and we see a repeat of 2018 in 2022. As a quick economic recap, in 2018 the federal reserve raised interest rates throughout the year, leading to a 20% stock market crash from October to December. With the capital markets roiling though the holidays, Fed Chair Powell was forced to pivot his policy stance in January of 2019, effectively pausing rate hikes indefinitely. In wall-street economic circles, the Fed’s policy path in 2018 is now viewed as a “policy mistake”. The Fed “over-tightened”, causing a significant correction in equities and credit. The ramifications for investors were a period of intense stock market pain, but also one that created excellent opportunities. As a portfolio manager I remember the beating inflicted on the REIT market all too well (REITs fell 8% in December of 2018), but also the fire-sale prices that were available for a short period of time in the aftermath. Why is this significant? Because every few years REITs go on sale for one reason or another. Remember the recession of 2011? How about the recession of 2015/2016? The recession of 2018? Remember that one? The answers to those questions should be no, no, and no, and yet REITs still traded at huge discounts to the value of their underlying portfolios in each of those years. In each instance, headline volatility in other parts of the market caused selling in the REIT space, with little change in fundamentals to support the bearish narrative. These opportunities can create excellent buying opportunities for high quality REIT portfolios that are unlikely to be economically impacted by the headlines.
The chart above tells the story. Almost every time REITs trade to a significant discount to their NAV, the following 12-month returns for the sector are elevated. This simply reflects the fact that REITs by and large have contracts with their tenants that are not subject to rapid changes… REIT cash flows are much less volatile than REIT stock prices. For the astute investor, this creates opportunities. I don’t bring this up to make some kind of big “call” on the REIT market right now. REITs are currently fairly priced and trade at a slight premium to NAV. But in the event that the Fed stays aggressive and things in the capital markets go south, we will be ready to pounce, with a playbook refined over multiple episodes of REIT distress. We are not rooting for distress, but we are prepared for it, and investors better believe we will be sounding the horn when the time comes to draw a new red circle on the chart above.
2022 OPPORTUNITY PART 3: VALUE AND RE-OPENING 2.0
Embracing the possibility of both an economic re-opening and a large market correction in the same year may sound crazy, but the game of investing requires creativity. One of the skills of a successful portfolio manager is the ability hold a myriad of possible scenarios in their head without going completely insane. As data regarding the Omicron variant of the coronavirus continues to accumulate, it appears more and more likely that the economy will fully re-open at some point in 2022. In spite of the extremely rapid spread of the new variant, the data indicates that people’s behavior has not changed significantly. Travel remains elevated per TSA data, RevPAR has not meaningfully slowed in the Lodging space, and Hotel and Office REITs are leading the REIT sector in performance so far in 2022. All of these developments point to re-opening momentum in spite of surging COVID cases across the world. This does not mean an immediate, massive change in demand for affected property types, but it does suggest that bad news is getting incrementally less impactful in the highly COVID sensitive REIT property types. Now why is this important to REITs? Primarily because Office and Lodging REITs remain extremely cheap relative to their NAV’s, historical multiples, and to peers. Also, in an interesting turn, after almost a year of accelerating growth and inflation, even free-standing retail REITs have fallen into the value bucket, a place they have not been in almost 5 years. While valuation is rarely a catalyst for stock price moves, it does give you an idea of how significant future moves can be. With Warehouse REITs trading at 31.6x 2022 cash flow, and Lodging REITs trading at 15.7x that same metric, good news is likely to have a much larger impact in the Lodging REITs than in those sectors in which a huge amount of good news is already priced in. Will this valuation gap completely close if the economy re-opens? Unlikely, but in an age of elevated valuation multiples, incremental investor interest during another re-opening is likely to be turned to those companies that have NOT benefitted as much from Fed largess. With cap rates in the low 3’s and even the high 2’s for Warehouse REITs, even a goldilocks scenario for these companies might not be good enough in 2022.
The addition of high-duration Free Standing Retail to the value bucket is interesting as well. A scenario in which interest rates fall, duration sensitivity outperforms, and value REITs continue to surge could move these names meaningfully higher.
STOCKING STUFFER #1: A POTENTIAL REPEAT? Time to cue the record player. Wait, this one is broken? Well apologies for sounding like a broken record, but our first best idea for 2022 is a well-covered (in these pages) former and current favorite in Independence Realty Trust (IRT). As a quick re-cap, IRT owns primarily A- and B quality apartment assets in the sunbelt markets of the US. There are a few long-term tailwinds that we think make IRT attractive. They are 1) favorable demographics for sunbelt apartment markets, 2) cap rate compression in lower quality apartment assets, and 3) attractive re-development yields and an active re-development pipeline.
Let’s start with IRT’s portfolio. The chart to the right illustrates IRT’s footprint. Atlanta, Dallas, Denver, and Raleigh/Durham are some of the fastest growing markets in the US from a population and economic growth perspective. From a rent growth perspective, they rank 8, 24, 23, and 10th out of 52 MSA’s. Atlanta in particular has been impressive, with 24% YoY rent growth as of November 2020 per Apartment List. With attractive population and economic growth characteristics, we believe many of these markets will experience elevated rent growth for multiple years to come.
Cap rate compression for non-core assets is another phenomenon that should benefit IRT over the short and medium term. With many assets in IRT’s markets trading in the 3.25-3.75% range, IRT’s value in the public markets looks attractive. As of this writing, IRT trades at an implied cap rate of 4.4%, almost 100bps wide of the potential private market value of their portfolio. This can be seen in IRT’s AFFO multiple relative to peers as well, with IRT trading at 25.9x 2022 AFFO, versus the Apartment REIT weighted average of 28.7x. Simply put, IRT is inexpensive relative to peers, and it is growing faster. The final fundamental data point that makes IRT attractive is its active and growing pipeline of re-development assets. IRT hopes to ramp their pipeline of re-developed units to 4,000 per year over the next few years. With incremental yields on their historical re-dev deals in excess of 17%, we believe IRT can add about 1.8% per year to their NAV simply through re-development. Add this to our estimated 5.6% annualized SS NOI growth and lever it at 35%, and the path to double digit “organic” growth for IRT over the next 3 years is fairly straightforward. Any incremental acquisitions or developments the company undertakes on top of this organic base would only add to growth going forward (assuming the deals are accretive). IRT remains one of the largest positions in our portfolio, and we are likely to be buyers on pullbacks.
STOCKING STUFFERS # 2: A SLEEPING GIANT?
Idea #2 comes from the value bucket in a value sector of the current REIT universe. Host Hotels (HST) is a large-cap blue-chip Hotel REIT, that predictably has been profoundly impacted by the pandemic. In Q2 of 2020, Host’s revenue fell 93% from a year earlier, and has slowly climbed back towards 2019 levels ever since. In Q3 of 2021, revenue was still over 30% below that of Q3 2019. As for many Lodging companies, the recovery has been uneven for Host, consistently delayed by the newest COVID variant. Trends were moving quickly in the right direction in July before the Delta variant took hold, and then again in December prior to Omicrons rapid spread. This can be seen in a volatile stock price and a slowly contracting multiple (earnings estimates have moved higher but the stock price has not). The chart below shows the historical forward AFFO (cash flow) multiple for HST going back to 2008.
Between 2011 and 2020 HST traded at a multiple between 10x and 20x AFFO very consistently. As of this writing, HST was trading at 11.1x 2023 estimated AFFO. Consensus assumes HST reports $1.60 in AFFO in 2023, 10% below their reported 2019 AFFO of $1.75. Said another way, Host is trading at the low end of its historical valuation range using a 2023 estimate that is still below 2019 levels. While there is very little in the way of recovery assumed for Host and other Lodging REITs currently, the company has quietly continued to recycle capital accretively through the pandemic, slowly creating NAV as they have historically. While Hosts’ stock price has not yet recovered to 2019 levels, the companies NAV is near all-time highs, and set to move even higher in a more consistently re-open world. NAV is important in the lodging space because in the private market there has been a dearth of distressed sales, despite fundamentals that have been depressed for 18 months. In other words, those looking to buy hotels on the cheap have been disappointed, as a wall of capital has bid most hotels back to 2019 valuation levels. This stands in stark contrast to the publicly traded Hotel REITs, which trade on average at a 13% discount to NAV. Host represents a true value opportunity in the REIT space that is poised to outperform upon a more permanent re-opening of the economy. At a low historical valuation on conservative consensus estimates for 2022 and 2023, those looking for “distressed opportunities” in the REIT market need look no further for a high-quality, well run, Lodging portfolio.
HE’S GOT ABOUT 195 YARDS LEFT; IT LOOKS LIKE HE’S GOT ABOUT AN 8 IRON…
2021 was a tumultuous year by any standards, but it did not have to be a distressing one for investor portfolios. REIT fundamentals saw broad and rapid recovery and our fund was able to capture their subsequent outperformance. As the low-hanging fruit has been picked, 2022 will require more skill and precision. For seasoned investors with a battle tested process, this presents new opportunities, and the chance to deliver even more value to investors. Time to put away the driver and pull out the trusty 8-iron. With three-year annualized returns of 33.3%, Serenity is ready and waiting for the next challenge. Over six years we have generated returns across property sectors, market caps, and through bull and bear markets. 2021 was the culmination of years of development and diligent execution, but as always, we feel that we have just begun. “The crowd is just on its feet here, tears in his eyes I guess as he lines up this last shot. Cinderella story, out of nowhere…” “It’s a mirac…ITS IN THE HOLE!”
Martin D Kollmorgen, CFA CEO and Chief Investment Officer Serenity Alternative Investments Office: (630) 730-5745 MdKollmorgen@SerenityAlts.com
**All charts generated using data from Bloomberg LP, S&P Global, and Serenity Alternative Investments
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