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  • Writer's pictureMartin Kollmorgen


Updated: Apr 18, 2023

"Come with me if you want to live" - Kyle Reese, The Terminator (1984)

  • PERFORMANCE: Serenity Alternative Investments Fund I returned +1.69% in March, while REITs returned -2.47%.

  • BANKING CRISIS: What do the recent rumblings int he banking industry mean for REITs? Less commercial real estate lending. For well-capitalized REITs this is a POSITIVE.

  • OFFICE DISTRESS: The headlines are clear...the office is dying. Is shorting Office REITs the next big trade? Or am I baiting readers into a juicy "NOT SO FAST" moment?

  • RECESSION PROTECTION: Are there REITs that can withstand the next black swan event in the markets? Where is Serenity investing even though we anticipate a recession?

Did the banking crisis of March 2023 trigger flashbacks for anyone?

For a few days, the apocalyptic landscape of 2008-2009 seemed ready to re-emerge. Volatility spiked, uncertainty ramped, and the “B” word was on everyone’s lips (bailout). Not since 2008 had a large institution threatened the entire US financial system.

For those of us that invested through 2008, things looked frighteningly familiar. Could a banking crisis plunge the economy into a recession AGAIN?

Luckily the problems of this cycle are very different to those of 2008. Bank balance sheets are not stuffed full of subprime mortgages at 80 to 1 leverage. Correspondingly in REITs, there is not the 2008 looming wall of debt maturities that threatened to wipe out half the REIT universe.

Then again, the Fed is still raising interest rates and inflation remains stubbornly above +5%. The cost of capital for most firms continues to rise, and with bank lending standards now tightening rapidly, the relief valve for companies that need capital to survive is virtually non-existent. 2023 will certainly not be a repeat of 2008, but it may very well rhyme…

Fortunately, the REIT industry learned the lessons of 2008, and enters 2023 well capitalized, well diversified, and with a cadre of new property types. Many of these new property types have recession resistant cash flows. While commercial real estate will continue to face challenges over the next 12-18 months, the REIT universe sports a plethora of high-quality, recession resistant CRE portfolios with fortress balance sheets. These REITs are investable in the current environment.

Despite uncertainty, those of us with sharp pencils, a long-term time horizon, and nerves of steel continue to find opportunities. The worst may not be over for the economy, but our portfolio is prepared for this challenging market. In REIT land, we know which companies are equipped to survive in a high cost of capital world, and we know which are not. Come with us if you want to live.

PERFORMANCE: +1.69% in March vs REITs -2.47%

Serenity Alternative Investments Fund I returned +1.69% in March net of fees and expenses versus the MSCI US REIT Index which returned -2.47%. So far in 2023, Serenity Alternatives Fund I has returned +2.85% vs the REIT benchmark at +2.7%. On a trailing 3-year basis, Serenity Alts Fund I has returned +18.8% annually net of fees versus the REIT index at +12.2%.

The best performing position in the fund in March was once again Medical Properties Trust (MPW), a short position which fell -17.4% during the month. While problems continue to percolate at MPW, we have covered some of our short exposure with the name down -24% in 2023 versus REITs at +2.7%. MPW remains highly levered, with continued tenant troubles and eroding cash flow. For the time being we have booked gains but are primed to re-short the name if it moves higher.

The worst performing position for the fund this month was Hudson Pacific (HPP). HPP is an office REIT with a portfolio concentrated on the west coast. As Office REITs have become the go-to short for many generalist investors, HPP along with peers was hammered by the market in March, falling -26%. We initiated a small position in HPP around $9, with the rationale that the stock was extremely cheap. The past month has been a great reminder of a very basic investing lesson…when things get tough…cheap stocks get cheaper. Now trading at $6.50, HPP has gone from “cheap” to “distressed” from a pricing perspective.

This brings us to an extremely interesting point. Various Office REITs are now priced at near “fire sale” levels. Looking for distressed investments? Here they are, and the tickers are HPP, BDN, SLG, VNO, PDM, PGRE. Now for the fun part. Do you have the courage to pull the trigger on Office REITs trading at deep, deep discounts? Does that thought make your stomach turn over just a bit?

Buying deep value, “distressed” assets involves significant risk and is emotionally difficult. Nobody wants to touch Office assets with a 10-foot pole right now, but that is EXACTLY the type of environment in which some of the best investment decisions can be made! And just FYI, if you are waiting for distressed prices in Apartment REITs, or Warehouse REITs, so are 5 million other investors, which means they are not likely to appear. There is no one in line to buy Office, which is exactly why it’s cheap, and exactly why it MIGHT be a great opportunity.

Now the hard part here is sifting through the rubble to find that potential hidden gem, and not losing your hand while reaching into the cookie jar. Luckily at Serenity we have covered these names for over 10 years and have a model for every one of them. Right now, we are deploying capital opportunistically into one Office REIT (with 2 others on deck). We believe this stock offers a compelling risk/reward outlook. More to come on that in a minute…

BANKING CRISIS: How does the exodus from regional banks impact the REIT market?

Now that the dust has settled on last month’s bank panic there are a few things that seem clear. First, the government is not interested in wiping out bank depositors. This is a good thing. Personally, I am not interested in underwriting every financial institution I do business with. Second, the Fed seems to have no problem wiping out shareholders. I would also argue that this is also good thing. Companies that make bad risk management decisions should go bankrupt. Third, banks that do not offer competitive rates on cash deposits are seeing significant outflows. This is bad for bank earnings, and puts a lid on banks’ capacity to write new loans.

That last point is by far the most important here for REITs and commercial real estate in general. Less lending means a higher cost of capital for CRE, and eventually lower real estate values. We have detailed in previous newsletters why this occurs here and here. The Net Present Value (NPV) of a property goes down when your discount rate goes up. That is the very basic math that underlies all real estate investing.

The good news (from the perspective of Serenity) is that REITs rarely borrow from regional banks. As the largest, most diversified, most sophisticated operators in the commercial real estate industry, REITs have better options for borrowing. Many REITs are investment grade, unsecured borrowers, meaning they issue bonds into the investment grade bond market. These bonds tend to carry lower interest rates and have far fewer restrictions relative to bank borrowing.

Most REITs also have much lower debt leverage than the rest of the commercial real estate industry. While many private CRE investors will put +50-80% LTV debt on their portfolios, REITs tend to run closer to +35% LTV. This gives the REITs significantly more cushion in a challenging real estate market.

  • As a quick mathematical example here…assume you have $20m to buy an Apartment building. Using +80% LTV debt you buy a $100m building. If the value of that $100m property goes down by -20%, your equity is now worth $0! If you cannot cover your debt payments, the bank can foreclose on the property, and you now have no property and a loss of $20 million. By contrast, with a +35% LTV loan on the same $20m investment and -20% decline in value, you would still have $13m in equity, a loss of -30%. That is much better than -100%. Sound unrealistic? Many landlords bought Multi-family assets at +3.5% cap rates in late 2021. Those assets would trade close to +5% today, a drop in value of -30%. At +80% LTV they are significantly underwater. See a recent example here.

A secondary benefit of strong balance sheets is that many REITs currently have below market, in-place debt. In fact, the weighted average interest rate on outstanding debt for the REIT industry is +3.5%. That is barely above the current 10-year treasury yield. Said another way, REITs have effectively borrowed at a rate equal to what the US government borrows at today!

THIS IS A BIG DEAL. In-place debt, particularly at +3.5% is a HUGE asset with most companies borrowing at +6-8% in the current market. Again, the math is straightforward. Assume you have $20m to buy an Apartment building that costs $40m (+50% LTV loan). Assume you buy the building for a +5% NOI cap rate. If you can borrow at +6%, your annual cash flow from the building would be +$800,000. If you can borrow at +3.5%, your annual cash flow would be +$1,300,000, which is +63% higher. REIT cash flows are going to be significantly higher over the coming years than private peers that have to borrow at current rates.

For investors that value cash-flow, this is a significant point. Borrowing has gotten MUCH more expensive, and all else equal, you should be willing to pay more for a REIT portfolio with +3.5% in-place debt than a private portfolio that requires borrowing in the current market.

So, let’s circle back to the March banking crisis and regional banks that are currently lending in lower volumes and at higher interest rates. What is the big takeaway for REITs relative to broader commercial real estate?

REITs have best-in-industry balance sheets that are uniquely valuable in the current market.

I’m not sure I can say it more succinctly than that.

Balance sheets have barely mattered for the better part of 14 years. They matter now, and REITs have the best in the business.

OFFICE DISTRESS: Load up or press the shorts?

**WARNING: The following contains a semi-deep dive into two individual Office REITs and is replete with valuation and balance sheet statistics. Also, its long. Those allergic to going deep into the Office REIT weeds are advised to skip this section.

Office was at one point a pillar of the commercial real estate market. It was one of the “core” food groups, and still makes up a large percentage of many “Core” real estate funds. Investing in Office buildings has advantages for large institutional CRE investors that make it attractive. Namely, the assets tend to be large (so big investors can write big checks) and have very centralized operations (it doesn’t take much to run an office building or portfolio relative to a diversified Self-Storage portfolio or a Data Center). Office buildings also typically command 10-year leases, historically giving landlords a high amount of cash flow certainty. Put simply, in the days of vibrant urban CBD environments and few, if any, work from home options, Office was a compelling asset class for those looking to put dollars to work in commercial real estate.

Enter Covid-19 and the Zoom revolution.

Views on the work from home debate aside, the clear take-away for Office in 2023 is that utilization is likely permanently lower than it was before the pandemic. Kastle systems, which tracks occupancy stats for Office assets around the country puts current Office use at about 50% of its 2019 baseline. While this is a far cry from “dead,” office valuations may be permanently impaired by this new reality.

Fewer people are going into the office. I will in no way deny that.

HOWEVER…<oh lord he’s not going to pitch buying Office REITs is he?>

Should we short Office REITs based on this new paradigm <oh no he’s setting it up>? Are offices the new Malls <here it comes>? Or <GASP>, are Office REITs <gag> actually maybe…a bargain?

Did I whisper that softly enough via the smaller font? Before you light this newsletter on fire in disgust, let’s look at some cold hard data and see what we can discover.

Office REITs have been absolutely punished in 2023 down -19.9% YTD. The sector trades at a +12.7x EBITDA multiple using 2023 consensus EBITDA estimates, and a +9.5x cash flow (AFFO) multiple. The average EBITDA multiple for the REIT universe is +15.8x, and the average AFFO multiple is +15.1x, indicating that Office REITs trade at a -37% and -19% discount to the average REIT. Relative to private market values (NAV), the sector trades at an average -54% discount! As we mentioned earlier, commercial real estate investors looking for “distressed” assets…look no further.

What is driving these huge valuation discounts? For some insight let’s first examine one of the cheapest names in the entire property sector, Brandywine Realty Trust (BDN). Brandywine owns a portfolio of assets primarily in the central business district of Philadelphia. By most eye test standards, Brandywine has a high-quality portfolio. Shiny, well-located Office buildings in one of the largest urban markets in the US. But beneath the surface, problems at the corporate level have pushed BDN to its current valuation of +8.8x 2023 EBITDA and +5.7x 2023 AFFO (yes…BDN trades at a +17.5% cash flow yield).

Brandywines problems stem from a mismatch between sources and uses of capital as a company. Said another way, they have a lot of things they NEED to spend money on, and not a lot of money to spend. It sounds obvious to say, but the way companies go bankrupt is by running out of money. Companies that don’t need money…don’t go bankrupt. Large REITs like Brandywine can usually raise money when they need it (in the debt or equity markets). During a Fed tightening cycle and following a mini banking crisis, however, capital is currently hard to find and/or very expensive. Therefore, the market punishes companies that need capital, which BDN does.

From a sources of capital perspective Brandywine has the following: $28m in cash on the balance sheet, $511m available under their revolving credit facility, and $156m in cash flow per year (after capex). In terms of uses, Brandywine has $566m in remaining development spend, pays $131m in dividends each year, and has $750m of debt maturing in 2023 and 2024. Over the next two years, that equates to about $341m in cash generation, $511m in line availability ($850m in total sources), and $1.6b in total uses. That leaves BDN with a -$800m capital hole to fill before the end of 2024.

It doesn’t take a PHD in mathematics to know that a hole that large is problematic in the current market. Brandywine has a LOT of wood to chop over the next few years, and investors are betting that the company may have to raise equity or issue debt at a penalizing cost to stay afloat. The risk here is real, which is why BDN is not in the Serenity long book. The stock is incredibly cheap, but in our view faces an uphill battle and will likely have to cut its dividend (currently +18.25%).

Stepping back, a valuation discount for a name like Brandywine makes sense. Their cash flows over the next few years will be challenged by a combination of uncertain occupancy levels and rising interest expense. At the same time, with an +18% dividend yield (that is even attractive if they cut it to say +10%), the name has quite a bit of bad news already baked in. REITs almost never trade at cash flow yields above +10%, so BDN’s +17.5% is a huge historical outlier.

We don’t own Brandywine because we view its cash-flow stream as too risky headed into a recession. At some point, however, all BDN needs to do is survive, and coming out of the current business cycle it could be a huge winner.

On the other end of the Office spectrum is Highwoods Properties (HIW). Highwoods owns a portfolio of Office buildings across the sunbelt markets of the US (Raleigh, Nashville, Atlanta, Charlotte, etc). Their portfolio is 91% occupied (as of 12/31/22), with in place rents per square foot of $30.51.

Let’s do the same sources and uses analysis for HIW that we did for BDN. As of the end of 2022 HIW has $26m in cash on the balance sheet, $316m available under their revolving credit facility, and $254m in cash flow per year (after capex). In terms of uses, Highwoods has $358 in remaining development spend, pays $215m in dividends each year, and has $0 of debt maturing in 2023 and 2024. Over the next two years, that equates to about $535m in cash generation, $316m in line availability ($851m in total sources), and $788m in total uses. That leaves HIW with a +$62m capital surplus by the end of 2024.

The difference between the two companies is stark. Over the next two years, Brandywine must come up with $800m in additional capital, while Highwoods needs effectively $0. So HIW must not be that cheap right?

On a cash flow basis, Highwoods trades at +9.2x AFFO, and on an EBITDA basis trades at a +10.5x multiple. That is a -38% discount to the REIT average on an AFFO basis and a -33% discount on an EBITDA basis. The company’s cash flow yield is +10.7% and its dividend yield is currently +8.3%.

Relative to consensus NAV, Highwoods trades at a -47% discount. On a per square foot basis, the company trades for $185/ft. That is cheaper than most warehouse portfolios in the current market. Also, the company has recently sold assets into the private market at $509/sf.

HIW has no balance sheet issues but still trades at a deep valuation discount to other REITs and private market transactions. They must have tenant issues then, right?

Over the next 3 years, 33% of Highwoods portfolio rent is up for renewal, equating to 8.3m square feet of space. Over the past 5-quarters, Highwoods has leased on average 836,697 sf of space (3.3msf per year). Based on these historical statistics, in a normal environment Highwoods would not break a sweat back-filling upcoming expirations. Even over the past two quarters, HIW has leased almost 2 million square feet of space, a pace that would EASILY backfill their 2.7 million square feet per year expiring from 2023-2025. There must be something in their tenant roster then to explain the valuation. Do they have a large tenant that is about to go bankrupt?

Highwoods top 5 tenants are Bank of America, Asurion, the Federal Government, Bridgestone Americas, and Metropolitan Life Insurance. Every one of them makes up less than +4% of HIW’s revenue. Hmmm…not sure Bank of America or the Federal Government are big bankruptcy risks. Could these tenants decide to downsize their space over the next 2-3 years? Certainly. But are many of them going to completely vacate their space in favor of remote work? I would say unlikely.

Let’s recap. No issues with sources and uses of capital. No tenant issues. No large expirations that look problematic. No debt to refinance over the next two years…as Seinfeld might say, “what’s the deal with Highwoods?”

The deal is that investors are frontloading the “death of the office” trade. They are baking in years of declining fundamentals and deteriorating cash flow into Office REIT valuations. It took the Mall REITs the better part of five years of fundamental deterioration and a full-blown pandemic to reach valuation levels that Office REITs have already achieved in 2023.

Now the consensus here may be correct. Cash flow is VERY likely to deteriorate going forward. The problem is that a huge amount of cash flow degradation is already baked into valuations. Even if +100% of Highwoods expiring leases choose not to renew over the next three years, investors would receive cash flow yields of +10%, +9%, and +8%. While many investments in the current market require growth to achieve returns that are higher than the 2-year treasury yield, Highwoods is likely to yield 2x short term bonds even assuming draconian occupancy declines.

And Highwoods does not have a leverage problem. On Serenity’s numbers, the company has a debt to asset value ratio of just +37%. Over the next two years, HIW has 0 debt expiring. None, nada, zilch. The companies weighted average in-place interest rate is +4.09%, which again should be viewed as an ASSET in this market.

To make a long story short, there is little to suggest that Highwoods is even mildly financially challenged, let alone “distressed”. And yet the company trades at roughly half its estimated private market value. Does the Office industry face challenges ahead? Certainly. Are there Office REITs that have significant capital needs that will be difficult to address over the coming years? Yes (see BDN above).

But Highwoods is a good example of what happens when over-zealous investors paint an entire sector with a broad brush. Their balance sheet is excellent, their portfolio is in the fastest growing markets in the US, their tenant concentration is very low, and they have an extremely well-respected management team (one that navigated the 2008-2009 recession). Investors can currently earn an annual +10% cash yield in a name that has an almost 0 probability of blowing up.

And that is assuming 0% returns from any kind of valuation mean reversion. If HIW trades to a normalized multiple over the next 3 years (say to 15x – in line with the current REIT average), that would be an extra +50% return. A current return north of +8% with a margin of safety and potential for a +50% re-rating in a more favorable capital markets environment? Short HIW at your own peril…

To wrap up, Office is interesting because it is a lightning rod for controversy. Investors that like to live on the edge can get some real juice in names like Brandywine or Hudson Pacific (on either the long or short side). And while the “death of the office” generates a lot of clicks, shorting Office REITs at these valuations is incredibly expensive. In fact, we would argue there is a compelling case to be made on the long side in select Office names.

The beauty of running an opportunistic REIT strategy is that we can wait and watch, zeroing in on opportunities like Highwoods in which we believe there is a significant margin of safety and potential long-term upside. Our view remains that the economy is headed into a recession, which is no time to be a hero from a risk-taking standpoint. If high quality Office portfolios get significantly cheaper, we get the chance to incrementally buy higher yields.

Patience and preparation is our current mantra. When it’s time to take a big swing at Office distress we will be ready…

RECESSION PROTECTION – Cash compounders, War chests

Now for some less controversial ideas. At the risk of sounding like a broken record, at Serenity we continue to pound the table on REITs that have cash flows that are well insulated from recessionary risks. Even amidst uncertainty, there is an opportunity to deploy capital into high-quality REIT portfolios that are historically epic cash compounders and trade at attractive valuations. These companies can add value to a portfolio even if fully hedged using a REIT index or lower credit quality REIT as a short. Said another way, we believe the likes of EQIX and CCI are likely to significantly outperform the REIT benchmark over the next 1-2 years.

Let’s reiterate some of our favorite ideas.

1) Cash compounders with attractive valuations (EQIX, CCI).

We won’t spill too much ink here as we have discussed both EQIX and CCI in previous newsletters. The short version is this. +4.5% & +5.9% cash flow yields, +10.1% & +6.3% historical cash flow growth. Our expected annualized return for these names is +11.8% and +12.7%. CCI has almost 0 recession related cash flow risk, and EQIX has one of the best balance sheets in all of REITs. Don’t over think these two, they are the largest current weights in the Serenity portfolio.

2) Cheap, low cyclicality businesses (IRM, GLPI).

While not the growth powerhouses that EQIX and CCI are historically, IRM and GLPI offer highly certain cash flow streams at higher going-in cash flow yields relative to their high growth peers. IRM has successfully re-shaped its business (adding data centers while selling low-margin services) and generates a ton of cash flow, while GLPI proved in 2020 that even when casinos are empty, the companies will still pay the rent. These two companies may not be sexy, but at +4.7% and +5.7% dividend yields that have steady growth, these companies should hold up extremely well in the event of a recession.

3) War-chest balance sheets (O, PSA).

We discussed earlier in the newsletter why balance sheets are important in the current environment, but we left out one key point that is worth mentioning here. Well capitalized REITs are the best positioned entities in the market to take advantage of any distress that crops up in commercial real estate. While buying “distress” again sounds awesome, it is in reality very difficult. REITs, however, have a strong track record of using their balance sheet strength to flex on the CRE market in times of uncertainty.

Think of a hypothetical example. Say a distressed Self-Storage portfolio comes to market for $500 million. There is literally nobody who can outbid Public Storage for such a portfolio. They can pay all cash, they can run the portfolio more efficiently than anyone, and they most likely have a pre-existing history with the portfolio’s owners (PSA has been in the self-storage business for a LONG time).

Think of the possibility of a high-quality REIT portfolio not only surviving but growing through a recession. That is the opportunity in names like O and PSA.

CUT THROUGH THE NOISE: Using proven tools to embrace uncertainty.

With a REIT investing career now in its 13th year, I have had the good fortune to sit in rooms and attend panels populated by the best real estate investors in the business. One comment I absorbed years ago that stands out came from Sam Zell, the OG of distressed commercial real estate investing. When asked about how young CRE investors should try and make their mark on the world, Zell said something to the following effect (pardon my paraphrasing).

“If you look at the annual Forbes 40 list, and take out anyone that inherited money, everyone left on that list has one thing in common. At some point in their career, when everyone else was going right, they went left.”

Instead of hoping for a soft landing, Serenity is actively investing in high quality REITs with recession resistant characteristics. Instead of being permanently long cyclical property types, we are shorting REITs with high leverage and problematic capital needs. Instead of following the herd, we are opportunistically buying distressed Office REITs while generalists blindly short them.

This is the way we like it, leaning against the wind, snapping up opportunities that others are happy to ignore.

Uncertainty? Consider it Terminated.

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

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