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  • Writer's pictureMartin Kollmorgen


Updated: Nov 8, 2022

“Merciless is the law of nature, and rapidly and irresistibly we are drawn to our doom.” – Nikola Tesla

  • REITS -30% - TIME TO BUY? – What is the REIT market telling us about commercial real estate values, and is it time to buy?

  • BREAKING THE DOOM LOOP – What catalysts could rescue REITs from the bear market?

  • THE LIGHT – Significant selling in REITs has created distressed pricing in some high-quality portfolios.

The REIT market has gotten the message.

A Federal Reserve committed to fighting inflation is not the friend of commercial real estate values.

Higher interest rates mean higher cap rates.

They also mean slowing fundamentals…but on a lag.

Combine the two and you have a recipe for asset price disaster. Higher cap rates and lower cash flows mean sharply lower asset values.

This is the doom loop in action. The better the news…the higher rates go…which leads to lower cash flows, which translates to lower values.

What will arrest the negative momentum in REITs and the broader market? It could be a variety of things. Fundamentals (earnings) bottoming, Fed easing, the housing market bottoming, profitless tech companies going bankrupt to clear out the system. None of these are currently occurring. In fact, we are likely in the early innings of earnings deterioration and the bankruptcy cycle.

Are there bargains out there in REIT land? It certainly looks that way, but in a true bear market cheap stocks get cheaper…to a point that will eventually seem unbelievable. We are not there yet.

When we arrive at that point, however, there will be bargains in excellent long-term businesses that make investors nervous and emotional. Those willing to banish those emotions in favor of a sharp pencil will be massively rewarded.

During the last bear to bull market turnaround our fund returned +70% in less than 18 months. Our goal this time is to do even better.

But we are not there yet. We need to escape the doom loop first. For now, we are content to hurry up and wait. Our short book continues to perform, while we continue to prune our longs. This environment is tough, but our strategy was built for it. Sharp pencils abound at Serenity, and we are ready and patiently waiting to pounce when the time is right.

PERFORMANCE: +0.39% in September, -9.6% YTD

Serenity Alternative Investments Fund I returned +0.39% in September net of fees and expenses versus the MSCI US REIT Index which returned -12.1%. Year to date, the fund has returned -9.6% net of fees versus the REIT benchmark at -28.3%, the NASDAQ 100 at -32.4%, and the S&P 500 at -23.9%.

On a trailing 3-year basis Serenity Alternatives Fund I has generated annualized returns of +16.3% net of fees and expenses. Over the same period, the REIT benchmark has returned -2.0% on an annualized basis. The fund’s Sharpe ratio over the past 3 years sits at 1.02, versus -0.10 for the REIT benchmark (remember higher is better, more return per unit of risk).

To put this into context, Serenity clients have experienced +57.4% returns net of fees since September 2019, while REIT ETF investors have experienced -4.8% returns. In fact, the Nasdaq and S&P 500 have only returned +45% and +27% over this time period, putting Serenity Alternative Investments Fund I ahead of all three major indices over the last three years.

The largest positive contributor to the fund’s return in September was Medical Properties Trust (MPW), a short position that fell -16.8% during the month. MPW is a unique opportunity within the REIT space and is the largest short position in the fund.

MPW is a triple-net owner of hospital real estate across the US. Since the hospital business is operationally intense, MPW partners with hospital operating companies that operate or “run” these hospitals and pay MPW rent. This is a common structure in the healthcare real estate industry, as most healthcare RE landlords do not run the actual medical businesses that operate inside of their buildings.

While we could fill a short novel with the problems this company has, I’ll try and provide a short summary here. In essence, MPW has been supporting operations in many of their hospitals that lose money. Said another way, many of the hospitals MPW owns may not be able to support the level of rent they are currently paying to MPW. If this is indeed the case and MPW tenants need to cut their rent in order to survive (one of their tenants filed bankruptcy this week), MPW could be in deep trouble. The company has significant leverage, which means rent cuts have an outsized impact on the value of MPW’s equity. While supporting money losing businesses was never a good idea, in a low-rate environment it could be made to work (see RDFN, OPEN, PTON, UBER…any high-flying non-profitable tech company that soared in 2021). In the current environment, however, MPW’s model of subsidizing tenants so that they can continue paying rent does not work. Suffice it to say, we believe the value of MPW’s equity to be significantly lower than its current price, despite the stock falling over 50% YTD.

The worst performing position in the fund this month was once again Prologis (PLD), a long position that returned -17.8% for the month. Prologis illustrates the danger of falling in love with stock market stories. From a fundamental perspective, PLD has a bullet-proof narrative. Industrial rents are higher than ever, the company has embedded future earnings growth through positive mark-to-market on existing leases, a well leased development pipeline, a fantastic balance sheet, and a world-class management team.

In September, however, none of that mattered. What did matter was that PLD has a high valuation and is massively over-owned by REIT investors. As interest rates moved up, PLD shares were dumped on the market, inflicting pain on all those overweight the name (most of the REIT investing industry). This is why investing in the stock market is so incredibly difficult. Prior to September you would be hard pressed to find a PLD bear amongst professional investors, and yet it significantly under-performed during the month. This is not irrationality in action…it reflects the reality that investors were simply TOO bullish on PLD. While we recognized this in our analysis, we did not appreciate it enough to take our exposure down further than we have. It has been noted going forward, and our conviction shorting more expensive warehouse companies as a hedge against our PLD long has increased.

REITs -30%...Time to buy?

The REIT market has taken a beating lately, as interest rates have increased and expectations for future rate hikes have moved significantly higher. Year to date, the REIT market is down almost -30%, and trades at an equal weighted -27% discount to NAV (private market real estate value). Almost any time between 2010 and 2020 in which REITs sold off like this it was an excellent buying opportunity. So is it now?

In order to answer this question it’s instructive to examine what exactly the REIT market is pricing in. Commercial real estate values are a basic function of three things; income, cap rate, and leverage. You divide an asset (or portfolio’s) income by its cap rate (the same as multiplying by the multiple), then subtract the value of the debt to get to “Net Asset Value”. This simple framework can be used to determine the value of a CRE asset or the value of a REIT portfolio.

So what if we take the performance of REITs, and work backwards to find out how much cap rates would have to rise (or incomes would have to fall) in order for asset values to reflect current REIT stock prices? Said another way…how much cap rate expansion is the REIT market pricing in?

The chart below illustrates how much asset values fall (or rise) as cap rates increase or incomes fall. The base case in this scenario is a REIT trading at a 5% cap rate, with income (NOI) of 100 and leverage of 30%. This is a good proxy for the state of the REIT market on Dec. 31st, 2021. Every cell in the table represents the increase or decrease in value mathematically attributed to the cap rate/income combination from the axis relative to the base case. For example, if we assume cap rates at 6%, and income at 98 (so cap rates 100 bps higher and income 2% lower than Dec. 2021) then we would expect asset values to fall -18.6% (blue box).

This table shows how significant the impact of rising interest rates can be for REITs. A 100 basis point increase in cap rates from 5% to 6% causes a -16.9% decline in Net Asset Value.

Now let’s examine what REITs are pricing in. At -28% YTD, most of the scenarios in the orange box are in play here. These are all permutations of cap rates rising between 1.75% and 2.25%, with income rising or falling by 2%. Does this make any sense?

As of this writing, the 10-year treasury yield has increased +2.36% YTD, AA bond yields have increased +2.53% YTD, and BAA bond yields have increased +2.82%. Does a +200 basis point increase in cap rates seem that crazy in the context of these moves in bond yields? No…in fact it looks rather mild considering REITs are collectively rated close to BAA and have a high correlation with BAA bond yield spreads.

In fact, if we assume NOI has grown by +6% since last year (a safe assumption), REITs are implying a +2.5% move in cap rates, which would be about in-line with the move in AA rated bond yields (red box).

What does this analysis tell us? Many prognosticators have presented the disconnect between REITs and their real estate values (remember REITs trade at a -27% discount to consensus NAV) as a buying opportunity. They argue that REITs are cheap because of this historically wide discount.

This is a complete misread of the data. The un-willingness of sell-side analysts to lower their NAV estimates (yet) does NOT mean REITs are cheap. It simply means that NAV estimates have not moved in tandem with changes in bond yields. And I hate to be the bearer of bad news, but bond yields are like economic gravity for real estate. Cap rates WILL reflect bond yields over time.

The chart below further illustrates this fact. Notice that in between 2006 and 2008 NAV estimates did not start to fall meaningfully until REITs were down -30% from their peak (early 2008). Sound familiar? REITs closed September at -28% YTD. We would argue that consensus NAV’s will fall significantly from here, potentially completely closing the NAV discount gap, without REIT prices moving anywhere. Or pessimistically (realistically TBH), REIT NAV’s could fall -25-30%, and REITs could trade at the same discount. Meaning REITs still have 25-30% FURTHER TO FALL.

This is a long and somewhat depressing way of saying be careful when assuming you are buying a REIT that is “cheap” relative to NAV. In bear markets cheap - gets cheaper, and we have not yet seen the earnings decline portion of this bear market play out. That is where the real NAV cuts will happen, most likely within the next six months.

Woof. It’s not good when realism sounds like pessimism.

Doom loops. Beware, prepare, break out.

Pessimism, believe it or not, does not come naturally to me. I hate having a bearish outlook. It’s much more fun to be bullish, and much more lucrative (see our 2021 performance).

That being said, at Serenity we are committed to dispassionately reading the economic tea leaves, and they currently do not paint a pretty picture. As mentioned above, the bond market is signaling that real estate values have significant markdowns ahead of them, and the REIT market agrees.

But again, the devils advocate would argue that…this is all priced in. Buy REITs because the bad news has been digested! Inflation has peaked and rates probably won’t go much higher, right?

Not so fast. First of all, there is never any way to know with certainty what is “priced in.” Secondly, there are markers that traditionally signal the end or peak of a bear market. We can call them “Bottom criteria.” None of these criteria are currently being met. Let’s discuss a few.

  1. The Fed Put! Every…again… every bear market in stocks since 2008 (and including 2008) has been met with a forcible response from the Federal Reserve. The Fed has consistently cut rates to 0, embarked on QE1, QE2, operation twist, or operation “increase the money supply by 20% because of COVID.” The market traditionally bottoms AFTER fed intervention. In the case of 2008…it was more than six months after the fed cut to 0 before stocks bottomed. The fed is still raising rates, potentially by 75 basis points at their next meeting. Bottom criteria = Not met.

  2. Earnings bottoming. Another sign of a bear market turning point is when earnings growth starts to go from badly negative to less-badly negative (those are technical terms). Earnings growth is still positive, and for many REITs hit all-time highs in Q2. With estimates starting to move lower, and companies just beginning to guide more conservatively, there is a LONG way to go before REIT earnings even go negative, nonetheless bottom. We are only at the beginning of the earnings portion of this recession. Bottom criteria = Not met.

  3. The bankruptcy cycle. While recent bear markets have not been deep enough to generate true bankruptcy cycles (except in some areas of retail and restaurants), these were a staple of bear markets prior to the institution of the Fed put. With the Fed put gone (or at least severely delayed), I would expect the first true bankruptcy cycle since 2008 to begin towards the end of this year. As profitless, cash-incinerating companies start to fail, the capital re-formation that will occur will act as fertilizer for the next bull market. Again, we are not there yet. Bottom criteria = Not met.

Optimism! The long-term variety. A new recurring newsletter segment!

In case it needs reiteration, we remain bearish on the economy, commercial real estate prices, and REITs broadly. Until we see some of the markers of a bear market bottom, we will remain cautious, actively shorting REITs that have the potential for significant NAV deterioration or potential bankruptcy.

That, however, is enough bearishness for one newsletter. As always there is still hope! The Fed could theoretically pivot tomorrow, jolting bond yields lower and re-infusing life into asset prices. If they do, we will gladly re-consider our bearish stance.

More realistically, as we have written about in recent newsletters, the current bear market is likely to create opportunities to buy high quality businesses at distressed prices. Bill Ackman, for all his flaws bought GGP amidst the carnage of the 08/09 financial crisis, turning $60 million into $1.6 BILLION. No that is not a typo. He turned $60 million into over $1 billion buying a portfolio of malls that was priced as if it were going bankrupt.

Now I can’t say for sure there will be another GGP out there this time around, but you had better believe that there are 3-4 REITs and RE companies on our valuation sheet that are circled as potential candidates. We continue to pay close attention to these potential 2-5 baggers, licking our lips at the possibility of buying them at truly distressed valuations.

Additionally, there are larger, less risky REITs that are beginning to look like real bargains. While these portfolios are unlikely to trade at true “fire-sale” valuations, they can still generate 50-100% returns in the next bull-market. Some examples are in the table below. These are REITs with strong balance sheets and very strong cash-flow yields. XYZ and 123 trade at very low valuations but have high quality portfolios and low leverage, while ABC has a history of 10% yearly cash flow growth. Again, these companies will not be 5x or 10x returns coming out of the next bull market, but they have attractive cash yields now, and could be available at even more attractive prices in the next 6 months.

THE LONELY BEAR: Bullish narratives are increasingly stinky

The unfortunate truth of the equities and real estate markets is that the vast majority of institutional investors can only do one thing. Buy stocks or real estate. They can only make money when asset prices increase, they have no incentive to get you out of the market at the top (it would reduce their fees), and they must promote an ever-positive perma-bull view of the world.

These voices can be extremely dangerous in a true bear market. REIT investors touting REITs as “cheap” relative to NAV are ignoring obvious signals in the bond market and the basic physics of real estate finance.

At Serenity, we take capital protection extremely seriously because we invest alongside our clients. This is our money as well, and we will protect it at all costs. We look forward to the day when we can jump back into the market with two feet, hammering the ask on distressed potential 5 baggers. That day, however, is still in the future. In the meantime, we will continue to monitor the economic data, looking for signs that we are breaking out of the doom loop.

Beware the bulls,

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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