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  • Writer's pictureMartin Kollmorgen

Enraged Bulls and Spartan Warriors: August 2023 in REITs

"SPARTANS...PREPARE FOR GLORY!”

– Leonidas, 300





  • PERFORMANCE: Serenity Alternative Investments Fund I returned +0.77% net of fees in August. Over the past 5 years the Fund has returned +11.6% annually versus +3.7% for the REIT index.

  • FRAGILE! Cracks in the economy continue to widen, and fragile REITs are beginning to break…

  • SPARTAN REIT WARRIORS: REITs with bulletproof balance sheets could be the best defense amidst continued CRE turmoil.

  • THE PHALANX: A long/short REIT portfolio for surviving the bear market and conquering the next bull market.

The investing world in late 2021 had something of a pristine beauty to it.


Companies were priced to perfection as the promise of world-changing technology made the future look bright and shiny.


Crypto currency was going to revolutionize finance. New SPAC’s were going to change industries ranging from healthcare to transportation. Old, tired Apartments were going to be made new by value-add enhancing capex and incredibly attractive financing.


The exterior of the economy was as glossy and polished as fine china in an antique cabinet.


Enter the Federal reserve. With the red flag of inflation flapping boldly, Jerome Powell charged into the market with the most aggressive interest rate hikes in a generation. The most fragile pieces of the new financial ecosystem (NFT’s, ponzi-coins, SPACs) shattered like so many teacups under the hooves of this newly enraged central banking bull. The business models “of the future” showed themselves to be all gloss and no substance, unable to survive in a world that is not flush with free money.


Fast forward to 2023 and the Fed bull continues to buck and stomp. Some unsustainable business models have survived but are showing significant cracks. Investors now face a difficult decision. Try and pick up the pieces of shattered business models in hopes that the bull calms itself? Or look to defensive investments that are less shiny…but more robust and even anti-fragile to the reality of higher for longer interest rates?


Just as the Spartans viewed battle as an opportunity for glory, for many REITs a challenged economy and elevated interest rates are a chance to show their true quality. The Serenity portfolio is focused on finding these battle-hardened warriors and arranging them into an impenetrable phalanx for surviving the current REIT bear market.


REITs that have recession-tested portfolios, iron-clad balance sheets, and management teams with steely discipline will see their market share expand as poorly capitalized competitors exit stage left. Acquisition and development spreads are likely to widen (making deals more accretive) as the REITs emerge as one of the only remaining capital sources in commercial real estate. In short, a higher interest rate market gives REITs a huge edge versus private competition, an edge that has not existed since the QE era began in late 2008.


And if, (heaven forbid) the Fed bull begins a stampede (recession) these companies will be VITAL to protecting a commercial real estate portfolio. If the bull retreats and economic headwinds ease, these companies will get back to doing what they do best…compounding cash flows. With well-run, high-quality REIT portfolios there are few long-term losing scenarios.


This is why we remain optimistic, despite continued challenges in the commercial real estate market. Come what may, our portfolio will be ready. Our Spartans are prepared for glory.


PERFORMANCE: +0.77% in August vs REITs -3.03%


Serenity Alternative Investments Fund I returned +0.77% in August net of fees and expenses versus the MSCI US REIT Index which returned -3.03%. So far in 2023, Serenity Alternatives Fund I has returned -0.07% vs the REIT benchmark at +5.19%. On a trailing 3-year basis, Serenity Alts Fund I has returned +14.5% annually net of fees versus the REIT index at +7.1%. Over the past 5 years Serenity Alternatives Fund I has returned +11.6% annually net of fees and expenses, versus +3.7% for the REIT index.


The threat of higher interest rates once again reared its ugly head in August, sending REITs down over -3% for the month while the 10-year treasury yield closed above +4%. With a massive fiscal deficit to finance, a steadfast federal reserve chairman in Jerome Powell, and unemployment still extremely low at +3.5%, the market seems to be coming around to a “higher for longer” reality.


In a bearish turn for REITs, Lodging and Hotel C-corps led the way lower in August, along with Regional Malls. These are some of the most cyclical sectors in the REIT universe, suggesting that risk appetite within REITs soured markedly over the last month.


Data Centers and Industrial (Warehouse) REITs saw the strongest performance in August, representing a flight to stable growth in industries with secular tailwinds. Serenity’s proprietary CORE multi-factor REIT model continues to like both property types, with large-cap REITs Prologis (PLD), and Equinix (EQIX) holding steady near the top of our REIT rankings into September.


One of the best performing positions in the fund this month was our short in Medical Properties Trust (MPW), down -28.1% in August. MPW reported Q2 results during the month, showing rapid deterioration at almost every level of the income statement. A tenant that was formerly +8% of the company’s revenue has stopped paying rent, and there are signs of financial distress at their largest tenant (+20% of revenue). Additionally, the company was forced to cut its dividend, a sure sign of distress for almost any REIT.


To add insult to injury, the management team continues to obfuscate, refusing to provide details regarding the true financial strength of their tenants. They also have incredibly aggressive accounting practices and pay themselves egregiously as the stock price tanks and investor capital vanishes. While we have viewed MPW as poorly run for quite a while, the situation is devolving into a grey space legally, with the SEC potentially getting involved (per management comments on their conference call). MPW is a great example of a fragile situation created by a risk-seeking management team that is currently coming unglued. More on this in the next section.


One of the worst performing positions in the fund in August was our short position in Global Net Least (GNL), up +6.5% for the month. GNL is a globally diversified portfolio of low-quality net lease assets with poor corporate governance. GNL has grown its cash flow per share at -6.16% annually over the past 5 years, with few prospects for improving on this metric going forward. With elevated leverage, a high cost of capital, and few avenues for earnings growth, GNL is exactly the type of REIT our model is designed to find on the short side. We can pair this name against any number of high-quality REITs with stronger balance sheets and better growth on the long side and sleep like a rock at night. Whether it was short covering or just Brownian motion (ie noise) that caused GNL to go up in August, we can live with the gyrations of the market shorting a name that is consuming investor cash instead of generating it. GNL, like many other highly levered names in REITs, remains quite…


FRAGILE! Why the carnage in the CRE market is not over…


As we continue to reiterate in these pages, a higher interest rate environment has significant consequences for commercial real estate. However, many REIT valuations suggest that investors don’t fully appreciate the impact that elevated interest rates will have on REIT cash flows and valuations over time.


MPW, which we have been short for over a year, is a prime example of this phenomenon (and more). MPW is the poster child of poor risk management and lazy decision making that occurred in commercial real estate during the QE era of cheap capital (2010-2021). As interest rates drifted lower for over 10 years, MPW consistently raised cheaper and cheaper capital, and invested it in private equity backed hospital real estate. Their investments had GAAP yields higher than their blended cost of capital and thus were “accretive,” allowing them to build a virtuous ten-year cycle of capital raises and hospital purchases climaxing in 2021 at an enterprise value of $25 billion.


We put “accretive” in quotes above; due to aggressive accounting and zero risk management, these investments in hindsight were massively value destructive.


Hospitals are notoriously one of the most difficult businesses in all of healthcare. With low operating margins and high amounts of revenue volatility, hospital operating companies often run into financial trouble. This is the primary reason NO OTHER HOSPITAL LANDLORDS EXIST. Almost every other healthcare REIT (of which there are many with very sharp management teams) actively passes on owning hospital real estate. It is difficult, risky, and the returns traditionally do not justify the risk.


MPW entered this space claiming to have built the expertise to prudently invest in hospital real estate. What has become apparent, however, is that the company simply took investor funds and made incredibly risky, speculative bets on poorly capitalized hospital operators. They then added significant leverage to these bets at the REIT level and paid themselves handsomely.


As the capital markets have become more challenged, reality has taken hold, and these poorly capitalized private equity zombie hospital operators are no longer paying rent. Despite MPW’s best efforts to obfuscate the truth, investors can plainly see that earnings and cash flows are down double digits YoY and identify a litany of misleading statements or outright non-truths espoused by management in multiple earnings calls. MPW now has no way to raise money, is burning cash, and has entered what, in CRE we call, the “doom loop.” The decisions of the management team over a ten-year period led them to this incredibly fragile financial situation. One in which the company may not survive without interest rates moving rapidly lower.


What’s the point of this diatribe against a company that is clearly getting punished by the market? In my view, MPW represents the worst of the excesses of the QE era that are now being unwound. The company believed its own hype, claiming to have re-invented the wheel, when all they were doing was taking excessive risk with shareholder capital. And they were rewarded handsomely for it (for a long time)! To someone who takes risk management extremely seriously…this makes my blood boil.


One of the main reasons I do what I do, is to allocate capital to REITs that take seriously the obligation to invest shareholder capital prudently. There are many REITs out there that do a lot of work, buy, build, and operate great real estate, and pay themselves reasonably. MPW is the exact opposite. They actively sought risk instead of managing it, and the result is shareholder value destruction.


And there is more pain to come for the non-risk sensitive management teams in the REIT market.


Nexpoint Residential (NXRT) is another example. Now to be clear, NXRT has a much better management team than MPW, with no track record of egregious capital misallocation or investor gaslighting. NXRT even has a very strong track record of adding value converting B- and C quality Apartments to B or A- quality Apartments. Nevertheless, NXRT has run their company with high amounts of leverage, and they are now paying the price. Despite early guidance for +10% same-store NOI growth in 2023, the company has guided to +0% earnings growth.


Think about that. The company is growing their net operating income by +10% organically, but none of it is accruing to investors. 100% of their growth is being offset by higher interest expense as they re-finance their considerable debt. And NXRT trades at a similar multiple as much larger, better capitalized REIT peers: MAA and CPT.


This is why I firmly believe the opportunity set for active management in REITs remains robust. In a capital markets environment in which risk management is rewarded over risk seeking, Serenity should stand out. Prudently managed REITs with high quality portfolios and modest amounts of leverage will deliver superior cash flow growth for years to come if interest rates remain elevated. Serenity’s process is designed specifically to take advantage of this mathematical fact.


Again, we are optimistic on the opportunity set while remaining cautious on the overall REIT market. The days of buying everything and actively seeking risk are over (at least temporarily). The age of the risk-manager is upon us, and Serenity is here for it.


SPARTAN REIT WARRIORS: Who thrives amidst higher interest rates?


With that risk-management rant behind us, let’s look forward to the good news that originates out the other side of the adversity in the current CRE market. There are a LOT of well-run REITs out there worthy of absorbing investor capital.


This is the fun part.


Let’s start with the 800-pound gorilla of the warehouse industry, Prologis (PLD). PLD owns the largest warehouse portfolio in the world, with 1.2 billion square feet of space spread over 4 continents. The company has growth it’s cash flow per share at +13.57% annually over the past 10 years, +13.38% over the past 5 years, and +13.83% over the past 3 years. I had to double check those numbers because they are so consistent.


Prologis currently ranks 15/126 REITs in our CORE model rankings and is a good illustration of how a good REIT management team can use a variety of methods for creating shareholder value. Over the past 5 years, PLD’s NAV has increased by +15% per year, making it a top-tier value-creator in REITs. It has accomplished this in a few major ways.


  1. Organic growth – PLD’s same-store NOI growth has increased from around +4% in 2019 to +10% today. Demand for warehouse space is so high that PLD expects to raise rents on expiring leases by +80% next year, all but locking in another high single-digit SS NOI growth year.

  2. Development – On a global basis, Prologis has over +$6.5 billion worth of warehouses under development in 2023, which will yield +6.2%, and would likely sell for +4.9% cap rates in the open market. That translates to an estimated $1.5 billion in value creation this year from development alone.

  3. Acquisitions – Prologis recently acquired its largest US competitor and fellow REIT Duke Realty (DRE). Adding Duke’s portfolio to the Prologis platform was undoubtedly synergistic, as the scale of PLD’s offering gives it significant advantages when leasing existing and new space.

This is how a REIT creates +10-15% cash flow growth consistently and delivers it directly to shareholders. And we haven’t even mentioned PLD’s asset management business, the fees from which effectively offset the company’s G&A. PLD is a locked-in value creator in REITs with an A-rating from Standard & Poor’s, a fortress balance sheet and in general a phenomenally run business.


Will interest rates impact PLD’s business? Mildly. With 9.7 years of term remaining on debt maturities on average, and only +30% debt to asset value, the annual hit to PLD’s earnings is negligible compared to higher levered peers. Would a recession impact PLD? Once again yes, but with a current mark-to-market on leases of +80%, PLD has locked-in growth even in the event of a recession.


A similar juggernaut from another industry is Marriot International (MAR). While Marriot is not a REIT, it is widely accepted as one of the best business models in the hotel industry. MAR has a slightly lower but still impressive +11.7% 10-year historical CAGR in cash flow per share. With a consistent top rank in the CORE REIT model in 2023, MAR is one of Serenity’s best performing positions for the year.


Marriot primarily grows through adding “flags”, ie adding hotel management contracts to it’s system. The more hotels Marriot manages, the more cash flow to investors. The company also benefits from RevPAR increases, but its results are much less volatile than the Hotel REITs, which live and die based on the direction of RevPAR growth.


At +13% debt/asset value, MAR has some of the lowest direct interest rate exposure of any company in Serenity’s investible universe and is a cash generation machine. The company also prolifically buys back its own stock, which contrary to some financial tourist headlines is a very shareholder-friendly use of capital.


Like PLD, MAR will not make it through a recession untouched. RevPAR will fall, and unit growth will likely slow, compressing the company’s multiple. Hotel REITs, however, will be far more impacted with their higher direct exposure to swings in RevPAR and higher leverage levels. This makes MAR the relatively “safe” bet amidst the Lodging industry in the event of a recession.


THE PHALANX: Assembling the long/short portfolio.

My hope for our readers this month is that a pattern is beginning to emerge as to Serenity’s investing style and current portfolio construction. We are long high-quality, well-run REITs with fortress balance sheets that have histories of cash flow growth and well-built machines for producing growth in the future. On the flipside, we are short REITs with large debt loads and fragile corporate structures that will be a continuous drag on earnings and cash flows going forward. In an uncertain macro-environment, we lean towards companies that have navigated challenging markets, and that we know are working diligently every day to deliver value to shareholders.


Now a few notes on portfolio construction. As our economic outlook has changed (we expect a challenging REIT environment over the short and medium term), our portfolio has taken less and less Beta (REIT market) risk. This served the portfolio and investors well last year as our fund fell -8.5% as we trimmed market exposure, while the market fell -25%.


With low exposure levels, the portfolio is more dependent on creating pure alpha, meaning we are +100% dependent on our ability to go long REITs that outperform our shorts. This lowers the risk profile of the portfolio meaningfully, so we thought this month it would be informative to discuss what the portfolio construction process looks like at these lower exposure levels.


As always, we start with the top and bottom 20% of REITs as ranked by our proprietary CORE REIT model. We then analyze each name individually using our REIT stock picking hat (fundamental analysis), which can move names up, down, or completely out of the portfolio based on our almost 15 years of professional REIT investing experience.


Once we have a high conviction list of Longs and Shorts based on our quant + fundamental work, our risk management procedures kick in. For our top 5 ranked REITs, we choose the lowest ranked name in the same property sector and use it as a hedge to neutralize our property sector exposure to that individual name. When done for all 5 of our top ranked REITs, this creates 5 sector neutral pair trades that give us a beta-neutral REIT portfolio. We then do the same for the bottom 5 ranked names (pair them against top ranked names within the property sector), yielding a high conviction list of 10 long/short pairs that is perfectly sector neutral.


Next, we add the highest ranked next 10 REITs and lowest ranked 10 REITs, removing any names that would take our property sector exposure above +10% or below -10%. Said another way, we add 10 more longs and 10 more shorts without loading up on any single property sector long or short.


The result is 20 high conviction longs, 20 high conviction shorts, minimal property sector level risk within the portfolio, and virtually no REIT market beta.


This process is something we have extensively backtested and spent quite a bit of time developing as we run the portfolio with less market risk and gear our efforts more towards pure alpha generation. From a Quant modeling perspective, the historical (backtested**) results are very encouraging. See the "Sector Managed" column in the table below.


“Marty”, you might say, “this sounds like the perfect recipe for a market-neutral Serenity REIT strategy.” That is a very astute observation, my intelligent and good-looking friend.


This is, in fact, the bedrock for a new product that Serenity is currently seeking partners for. The backtest looks great, the core process is identical to what we have been doing in the fund for 7 years, and we are actively using the new process in our flagship fund until the opportunity set in REITs improves.


So, for those of you looking for the low risk, market neutral version of the Serenity process, here it is. Please reach out if you would like more details.


FIGHT IN THE SHADE


Make no mistake, this is a tough REIT market. With elevated interest rates and slowing growth across a myriad of REIT property types, generating returns in REITs in 2023 has been tremendously difficult.


When the going gets tough, however, the tough... fire up their backtesting platform, drink too much coffee and scratch and claw for ways to improve their REIT selection and portfolio management processes. That has been my day to day over the past few months, and I’m happy to say our process is now tighter than ever. Add in a now solidified framework for building and maintaining a market neutral portfolio, and the future looks rosy for the Serenity strategy.


As storm clouds linger over the economy, we are content to fight in the shade for now, looking to uncover profitable REIT pairs as we wait patiently for an opportunity to add more risk. We are much closer now to the end of the bear market than we were a year ago, but patience is still key. When fundamentals improve, we will be ready, spear sharpened, prepared to charge like a battle mad spartan warrior.


We are…preparing for glory,


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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