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  • Martin Kollmorgen


Updated: Sep 8, 2022

“Accidents on big mountains happen when people’s ambitions cloud their good judgment.

climbing is about climbing with heart and with instinct, not ambition and pride.” – Bear Grylls

• REIT RECAP – What is driving the recent REIT rally and is it sustainable? • HIGHER FOR LONGER – Rent growth is a major driver of inflation. Can Apartment landlords keep raising rents with a hawkish fed? • GOT 10X HEDGES? – Serenity’s portfolio is long blue-chip REITs and hedged with bets that could 10x if the economy slips into recession. The July stock market rally has extended into August, leaving investing bears feeling cold and alone. It seems appropriate, then, to quote the Bear himself, the famous survival expert and British SAS veteran. Are bears investing with ambition and pride, or with intelligence and experience? And what about the bulls…is the bullish narrative built on reason and data, or hope and stubbornness? There are certainly reasons to be positive on the economy. Apartment and Self-Storage REITs just announced their best NOI growth quarters ever. The jobs market remains robust per the most recent BLS data. Even the Lodging REITs have struck a bullish tone and handily beat consensus estimates in Q2. And yet forward-looking economic indicators continue to deteriorate. The NAHB index just plunged at a pace not seen since 2006. Inflation remains above 8%, with many large inflation components showing no signs of slowing. Consumer confidence is below 2008 levels, and the CEO confidence index moves lower every month. Layoff announcements are increasing, and the Federal Reserve is still increasing interest rates. With the Fed explicitly trying to slow demand to combat inflation, can the party continue? This is the key point we keep coming back to when allocating Serenity’s capital. “Don’t fight the fed” was a bullish argument for stocks at almost every point over the last 14 years. It has now completely reversed. The Fed is bearish on economic demand, AND THEY ARE THE BIGGEST BEAR IN EXISTENCE. Have we sold all our longs and levered up our short book? No. The nice thing about being a hedge fund with a long-term time horizon is that we do not have to leverage our future betting in either direction. In the fund we are long high-quality strong balance sheet REITs in the Apartment, Self-Storage, Data Center, and Warehouse sectors. If the fed orchestrates a “soft-landing,” these names will have positive returns. We are actively hedged, however, using higher leverage, lower-quality names, which should under-perform if the economy continues to weaken. Additionally, we have begun accumulating out of the money options in certain REITs that have a high probability of becoming distressed situations. These “disaster insurance” bets are relatively small but have 10x upside if our economic prognostication is correct. So we arrive again at the question I have posed to investors in recent meetings. Who is protecting your capital if things continue to get worse? At Serenity, our clients can sleep well at night knowing we are actively mitigating downside risk. This insurance is not necessary if everything is going to be fine. But if its not…investors will need a bear in their portfolio. PERFORMANCE: -0.09% IN JULY, -10.6% YTD Serenity Alternative Investments Fund I returned -0.09% in July net of fees and expenses versus the MSCI US REIT Index which returned +9.0%. Year to date, the fund has returned -10.6% net of fees versus the REIT benchmark at -13.2%, the NASDAQ 100 at -20.3%, the S&P 500 at -12.6% and the Russell 2000 at -15.5%. On a trailing 3-year basis Serenity Alternatives Fund I has generated annualized returns of +18.5% net of fees and expenses. Over the same period, the REIT benchmark has returned +6.6% on an annualized basis. The fund’s Sharpe ratio over the past 3 years sits at 1.16, versus 0.34 for the REIT benchmark (remember higher is better, more return per unit of risk). The largest positive contribution to the fund’s return in July was Prologis (PLD), which returned +12.7%. Prologis is the premier global warehouse portfolio in the world. Simply put, no other entity can match Prologis in terms of size and scale when it comes to the warehouse real estate industry. While this was already the case coming into 2022, PLD further cemented their dominance by buying one of their largest competitors in Duke Realty (DRE). The combined entity will have a market cap around $125 billion, making PLD one of the largest REITs owning one of the pre-eminent commercial real estate portfolios on the planet. Prologis fits the Serenity portfolio in a variety of ways. From a long-term perspective, PLD sold-off significantly earlier this year, giving us the chance to add a high-quality, low-leverage, well run blue-chip REIT to our portfolio at an attractive basis. These types of portfolios we feel comfortable owning in almost any environment. Even if the economy falls into a deep recession, Prologis will be able to weather the storm, while smaller, higher levered competitors are more likely to struggle. We have hedged a portion of our Prologis long position with shorts in smaller, more expensive and more cyclical REITs, and are likely to add to PLD in any future REIT selloffs. The worst performing position in the fund in July was AirBnB (ABNB), a short position that returned +24.1% during the month. AirBnB is a small, short position in the fund and is a company most investors are familiar with. We shorted AirBnB based on the fact that sell-side expectations for sales and EBITDA growth over the next 3-5 years are astronomical. With inflation accelerating, gas prices breaching $5, and low-margin tech stocks increasingly under pressure, our view was that ABNB would have serious difficulty hitting sell-side targets. Unfortunately for us, our timing was poor, shorting ABNB into a +20% rally for the Nasdaq 100. We maintain that the sell-side will eventually have to bring down their estimates for ABNB. The companies valuation is also still well in excess of anything else in the lodging/vacation space. If the US consumer continues to show signs of weakness, it will certainly show up in ABNB’s portfolio. For now, we will maintain our small short position, and hope to improve our execution and timing on future short sales. REIT RECAP: JULY & AUGUST OFFER RELIEF… HAS THE MARKET BOTTOMED? July and August have seen an abrupt reversal in REIT trends that cemented themselves during the first six months of 2022. Property sectors and REIT factors that led the market lower have flipped and led the current rally higher. As can be seen in the chart below and to the right, Regional Mall REITs and Hotel C-Corps surged in July and August, after falling over -30% early in the year. Similarly, Homebuilders and Warehouse REITs have clawed back some of their losses as the market has reacted favorably to the perceived “fed pivot”. The question for REIT investors then, is does this rally make sense and is it sustainable? Let’s start with the bull case. Lodging and Hotel C-Corp earnings in Q2 were un-equivocally better than expected. This has been the case pretty much every quarter for the past year. The sell-side has consistently under-estimated the re-opening of the economy, and more recently the return of business travelers to lodging portfolios. Leisure travel has also been on fire, with the spring break season being one of the strongest ever per multiple Hotel REIT CEOs.

Similarly in Shopping Center and Mall REITs, leasing has remained strong, and these companies have continued to gain occupancy. While pricing power remains elusive for Mall owners, these stocks got extremely cheap towards the end of June and were likely due for a bounce regardless of fundamentals. So the rationalization of this rapid move higher for Lodging and Mall REITs is that the companies got very cheap during the first half of the year, without deteriorating fundamentals. Said another way, the market very likely got ahead of itself in discounting disaster for these companies. So where do we go from here? While Mall REITs and Lodging REITs still look relatively cheap versus peers, what are the chances that fundamentals continue to improve? That is a much more difficult question, with comparable periods getting more difficult, seasonal tailwinds fading, and economic activity slowing across a wide variety of metrics.

The forward economic outlook continues to give us caution with regard to these cheap but very volatile property types. The composition of the recent rally also gives us pause, as we question the “quality” of this recent bounce. Below we detail the top performing REITs since 6/30/2022, and one thing that stands out is the utter LACK of high-quality real estate portfolios on the list. Two formerly bankrupt B-Mall companies, the former Sears real estate portfolio that is badly over-levered and heavily shorted, the two worst Hotel REITs from a corporate governance perspective, two money-losing real estate “disruptors”, and an apartment development portfolio (the riskiest practice in commercial real estate).

Simply put, if you were long this portfolio over the last month and a half, you need your head examined. It is the absolute bottom of the barrel from a “quality” perspective in REITS and is more reminiscent of a compelling short book than that of a long book. Any analyst proposing this portfolio to a serious REIT portfolio manager would be quickly looking for a new job. Which begs the question…how much of the recent rally was real buying versus pure short covering? This is important because short covering is not a durable foundation for future returns. Once it’s over, there needs to be follow through, either via improving fundamentals, or an improving cost of capital. With BBB spreads (REIT cost of capital) pegged up near 2% (+87 bps YoY), and the fundamental outlook uncertain at best, we continue to find this rally hard to buy into. HIGHER FOR LONGER: THE FEDERAL RESERVE VS APARTMENT REITS Another reason for our skepticism has to do with recent results for Apartment and Self-Storage REITs. The second quarter of 2022 was the best quarter in many of these companies’ histories. For a company like Equity Residential, which has been around since 1993, that is a significant achievement. But wait a minute…why on earth would “best results ever” translate into bearish skepticism? For the exact reason that we said “buy Apartment and Storage REITs” in late 2020 and early 2021. That reason is that the best time to buy these companies is when their results look TERRIBLE. While this may be counter-intuitive, this is just how the market works. Bull markets are born out of negativity and bad news, not elation and celebration. Warren Buffet said it best with his “be fearful when others are greedy, and greedy when others are fearful.” Don’t believe me? Examine the chart below. Forward 1-year returns for the Self-Storage REITs are significantly higher than average when same-store revenue growth is NEGATIVE. Additionally, the only time these companies have negative forward returns is when same-store revenue growth is decelerating, as it did from 2006-2008, and 2016-2018. Well, guess what the self-storage companies have guided to for the remainder of 2022…that’s right…decelerating same-store revenue growth.

The bulls will say “but growth is still good,” and that is completely correct. The problem is that the market prices these companies on the margin, meaning it only cares about better or worse, and the companies are telling investors, that things are NOT going to get better from here. It is also important to consider the inflationary consequences of recent results from these companies. Rent growth for Apartment and Self-Storage REITs leads CPI growth, and correlates highly with owners’ equivalent rent, which makes up about a third of the CPI. The longer rent growth for these companies remains elevated, the longer inflation remains persistently high. While this may be a boon for these companies…it is bad for the US consumer, and more importantly…it keeps the Federal Reserve hawkish. With the Fed committed to fighting inflation, they are effectively committed to fighting Apartment and Self-Storage rent growth. This sounds strange, but it is true. The Fed must bring down demand to curb inflation, and the only way to do that is by continuing to raise rates and eventually push up unemployment. The same forces that will curb inflation will curb fundamentals for these companies. Again, this is why being long Apartment and Storage REITs is tantamount to “fighting the fed”. For our money (and our clients money) we are hedging the Serenity portfolio aggressively against this risk by shorting REITs that we believe are the most exposed to decelerating rent growth. 10X HEDGES: HOW SERENITY PLANS TO MAKE A MINT IN THE WORST-CASE SCENARIO. Let me be direct regarding my views on the economic environment. I do not want the economy to fall into recession. Recessions are painful for many, ruinous to some, and have a plethora of negative consequences. That being said, as a large investor in my own fund, and a fiduciary to my clients, I can not sit idly by as the data continues to flash recessionary warning signs. Particularly with the most hawkish Fed of the last 50 years. The market, however, continues to price in some version of a soft-landing for the economy. One of the most compelling pieces of evidence for this is in options pricing (volatility is extremely cheap). Particularly that of many REITs that could enter a period of distress if financial conditions continue to tighten. By and large REITs are in much better financial condition than they were going into the great financial crisis of 2008-2009. Well capitalized, large cap REITs will survive a recession and potentially thrive with their ability to capitalize on distressed asset pricing. There are pockets, however, in the REIT space that have the potential to completely blow up if the economy gets meaningfully worse. We have recently accumulated a small portfolio of out of the money put options in names that we believe fit the “potential disaster” criteria. These are extremely cheap options with a low probability (in a normal market) of expiring in the money. We believe, however, that the probability is much higher than the market is assigning that some of these companies experience significant erosion in the value of their equity within the next 6-12 months. Said another way, these options could 10x in value if we are right about the economy. These small bets are the potential rocket-fuel in the Serenity portfolio. The fund is well positioned to weather an economic storm, with longs in low-levered blue-chip REIT portfolios and a short book consisting of higher-leverage, lower quality REIT portfolios. But throw on our high-return, low probability 10x disaster hedges, and our portfolio can not only survive a recession, but is likely to thrive. Again, we hope the Fed can engineer a “soft landing”. This would show up in the data as ISM surveys bottoming, housing finding a floor, inflation rolling over significantly, and continued durability in the labor market. None of those things are currently occurring, however, which is why we remain cautious and positioned for continued economic weakness. THE LONELY BEAR: THE ONLY REAL ESTATE FUND THAT CAN PROTECT YOUR CAPITAL In most instances, you should avoid bears. Stock market bears and the actual animals can both be dangerous in different ways. Luckily, bears mostly avoid humans, and tend to be solitary creatures. Commercial real estate bears in particular are exceedingly rare. But occasionally the CRE bears emerge from hibernation and wreak havoc on investor portfolios. It is during those rare seasons when cap rates increase while cash flows decrease. The dreaded “R” word that has been sleeping peacefully since 2008. If the fed nails the landing and beats inflation without harming the economy, most real estate portfolios will be just fine. The bears will continue to sleep, and investors can stay on the bull-market path. But what if for the first time in 14 years the Fed lets the bears wake up? What if layoffs increase, and over-levered non-profitable businesses start to fail? In that scenario, you need a bear in your portfolio. I know just the fund for the job. Bear Down, Martin D Kollmorgen, CFA CEO and Chief Investment Officer Serenity Alternative Investments Office: (630) 730-5745 **All charts generated using data from Bloomberg LP, S&P Global, and Serenity Alternative Investments DISCLAIMER: This document is being furnished by Serenity Alternative Investment Management, LLC (“Manager”), the investment manager of the private investment fund, Serenity Alternative Investments Fund I, LP (the “Fund”), solely for use in connection with consideration of an investment in the Fund by prospective investors. The statements herein are based on information available on the date hereof and are intended only as a summary. The Manager has been in operation since 2016 and the Fund commenced operations on January 14th. The information provided by the Manager is available only to those investors qualifying to invest in the Fund. 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