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  • Writer's pictureMartin Kollmorgen


"Tis but a scratch!" - Monty Python and the Holy Grail

  • PERFORMANCE: Animal spirits have returned! Re-capping a “risk-on” January.

  • HAVE FUNDAMENTALS BOTTOMED? A seasonal bounce is underway for housing demand, is a new trend emerging?

  • THE SWORD OF DAMOCLES: Could construction spending de-rail the soft-landing narrative?

  • FINDING THE GRAIL: A philosophical search for meaning & absolute returns.

The stock market has landed a solid blow to the bears in the early part of 2023.

The S&P 500 returned +6.3% in January, with the Nasdaq up +10.7% and REITs +10.6%.

Enthusiasm around slowing inflation, signs of life in housing, and a renewed sense of optimism (as seen in consumer confidence data) have re-invigorated risk assets.

Can the bears recover and fight back? Is the early 2023 rally just a flesh wound? Or has the bear case lost two arms and a leg?

While the economy is certainly showing signs of life, we would caution against sounding the all-clear and declaring victory. In fact, we may be able to reverse the Monty Python analogy here, as the economic outlook suffered far more significant injuries in 2022 than the bears have in 2023. With a key pillar of support clearly missing (a dovish Federal Reserve) can the economy miraculously heal itself in 2023?

We remain skeptical.

And a major sword-stroke remains on the 2023 horizon. As construction in the housing and commercial real estate markets abate, will the tight labor market be able to absorb a sudden influx of construction and related workers?

This is still a fair fight in our opinion, because there are significant challenges for the economy to overcome over the next 6-12 months and the Federal Reserve is still razing the countryside via interest rate hikes and quantitative tightening. The Bulls took the first round of 2023, but much more data is needed to confirm a new bull market.

In either case (Bull or Bear) we remain relentless in our search for the holy grail of investing…high return, low risk opportunities in the best commercial real estate portfolios in the world.

January twas but a scratch.

PERFORMANCE: -0.03% in January vs REITs +10.6%

Serenity Alternative Investments Fund I returned -0.03% in January net of fees and expenses versus the MSCI US REIT Index which returned +10.6%.

January saw the return of risk-on animal spirits in the REIT market and broader equities that we last glimpsed in April and August of 2022. Investors have become rapidly bullish as inflation has decelerated on the margin and the Fed has slowed rate hikes at successive Fed meetings. While fundamental data has continued to deteriorate, investor sentiment has improved rapidly, narrowing credit spreads and pushing valuation multiples for stocks rapidly higher.

This was a tough month for the fund, as were the four positive months for REITs in 2022. We still believe the Fed is pushing the economy towards recession, and bullish counter-trend market moves are incredibly difficult to time correctly (in our humble opinion).

That being said, the market is sending a message that should not be ignored. After a move like this, it is important to ask the question… did the outlook for REITs improve sustainably in January?

Let’s examine some data. Mortgage rates fell from +6.4%, to +6.0% during the month, which is certainly positive. Similarly, BAA rates fell from +5.9% to +5.4%. Also, positive. Seasonal trends turned up during the month (rental and homebuying activity typically accelerates in January) and consumer confidence ticked higher on the margin. All positives.

Sustainability, however, is the key question at hand. Single-family housing remains more expensive on a monthly mortgage payment basis than it has been since 1991, with median monthly payments still up more than +35% YoY. Notably, +82% of respondents think it is a bad time to buy a home according to Fannie Mae. While Hotel demand is healthy, there are signs that business travel demand is waning. Asking rent growth for Apartments has fallen from +14% to +2% in just over a quarter. Similarly asking rates for Self-Storage assets are close to -15% YoY. And +83% of REITs that have reported earnings so far in 2023 have guided to 2023 FFO that is BELOW consensus estimates.

If we simply zoom out on many data series, the trend over the last 6 months is firmly negative. Housing activity fell off a cliff in Q4. According to Camden Property Trust (CPT), demand for Apartments fell faster in 4Q than any time since 2008. Manufacturing is firmly in contraction territory, with “new orders” continuing to hit multi-year lows. And the yield curve continues to send an un-ambiguous signal…that a recession is on the way.

Demand has certainly bounced in January, both for single family and multi-family housing. Whether this is pent-up demand from 4Q, a typical seasonal acceleration, or represents a true “soft landing” is much less clear. We view a combination of the first two as the most likely explanation.

As we discussed on our 2023 outlook call, however, we could be wrong and demand may be here to stay. This could be the first time the yield curve has inverted this steeply without the economy entering recession. This time could be different. The Fed may nail the soft landing and the economy may seamlessly adjust to significantly higher interest rates. The next few months will reveal if this is the case. As usual we will wait, watch, and react accordingly.

ATTRIBUTION: EQIX leads the way

The largest positive contributor to the fund’s return in January was Equinix (EQIX), which returned +12.7% for the month. EQIX has been the largest position in the fund for about the last 6 months and remains one of our highest conviction longs. As a brief re-cap, EQIX owns the premier Data Center portfolio in the world, has historically grown its cash flow at more than +10%/year, has a fortress balance sheet, and could potentially see an acceleration in same-store growth over the next few years.

Higher debt costs for private Data Center peers are extremely beneficial to EQIX, as they suppress new development that competes with EQIX assets. EQIX is a poster child for the quality of REIT balance sheets, and how their superior ability to generate cash and raise attractively priced capital should give REITs a huge edge versus private peers in a higher interest rate environment. EQIX will not be immune to cyclical forces in the economy, but should fare better than many other REITs in a recession. We will look to add to our position on significant draw-downs.

The worst performing position in the fund in January was our short in Rexford Industrial (REXR). Rexford returned +14% during the month, moving higher with the broader REIT market. We have recently trimmed our short in Rexford, as fundamentals remain undeniably strong for their portfolio. We shorted REXR to hedge risk relative to some of our longs in the Warehouse sector, assuming it’s un-favorable style factors could generate some alpha on the short side. Said another way, REXR is a high valuation, high beta, smaller cap name in the warehouse sector. By shorting it, we reduced beta, valuation, and capitalization risk in our overall portfolio. Unfortunately, in January, high beta, small cap, high valuation REITs performed well, causing our hedge to work in reverse.

This, simply put, has been a mistake. While we have had success with similar “style factor” hedges in other property types, REXR may simply be too much of a juggernaut to short successfully. We have had great success owning REXR on the long-side in the past and should have had more respect for the name as a short-selling widow maker. Lesson learned.

REIT FUNDAMENTALS: Still slowing or finding a bottom?

Let’s return to our discussion of REIT fundamentals and lend a bit more data to the conversation. To summarize what we have already discussed: demand has picked up in January across cyclical REIT portfolios, prompting many investors to believe that “the bottom is in” for REIT fundamentals.

I would argue, however, that this may be far from the case. If we take a longer-term perspective and analyze quarterly same-store revenue data for the Apartment REITs, a clear trend emerges. That is, during quarters in which SS revenue growth is decelerating (moving lower quarter over quarter), Apartment REITs tend to have subdued forward looking 1-year returns. This can be seen in the red circles in the chart below. Decelerating fundamentals are typically not a good time to get long.

This changes when SS revenue growth either bottoms or goes negative. Bottoming or negative SS revenue typically tends to be the BEST time to buy Apartment REITs. There is only once instance, however, of SS revenue growth bottoming above +0%, and this occurred in late 2013, early 2014. This is the soft-landing scenario for Apartment REITs.

The Apartment companies, however, are not guiding to a bottoming in SS revenue growth. Based on our modeling and the companies guidance for 2023, we estimate that Mid America (MAA) will continue to see sequential declines in SS revenue growth for the next 4 quarters. This same trend holds for almost every Apartment REIT. Asking rents (which are driven by demand) would have to re-accelerate meaningfully in order to reverse this trend. As of this writing, most Apartment REITs are guiding to asking rent growth in 2023 of +2-3%, down from closer to +15% in 2022.

This is why we remain extremely cautious regarding buying cyclical REITs in early 2023. Traffic has certainly picked up in January (according to UDR, traffic increased from +0% in 4Q 2022 to +7-8% YoY in January/February*), but the long-term trend in YoY SS revenue growth remains lower. We continue to monitor this data closely and will happily buy cyclical REITs if demand trends prove more resilient than we anticipate.

*Keep in mind we are currently comping the Omicron wave of the coronavirus in early 2022. That means January comps across a myriad of economic data series may be artificially easy.

THE SWORD OF DAMOCLES – Why the housing slowdown has yet to show its teeth

If it is not already clear, we monitor trends in the housing market extremely closely at Serenity. Housing is a leading indicator for the economy, and by many estimates has a direct impact on up to +15% of GDP. Housing also clearly shares a huge amount of common ground with the publicly traded REITs. Some own and rent houses (Single-Family Rental REITs), some own and rent Apartments (Multi-Family REITs), and all REITs are interest rate sensitive, just as housing is.

The housing market also produces an incredible amount of data, some of which is available on a weekly basis. This makes the housing cycle straightforward to track if you use the proper data and contextualize it in the correct way. After a risk-on January, a huge move in home-builder stocks, and an uptick in housing sentiment, we think it is prudent to examine some key data series in the housing market as we move through 2023.

The first is the MBA mortgage purchase applications index, which is released weekly and tracks the number of people applying for mortgages each week. There may be no better indicator of housing demand than weekly purchase apps. So, what does this data tell us about recent trends?

Not much that is positive. The MBA mortgage purchase apps index has plunged by about -35% over the past year, falling to levels last seen during the 2010-2014 period following the great financial crisis. In the past month, this index has bounced off its October low, but as the chart makes clear, the evidence that the housing market is in a new bull market is…scant. We would look for a sustained trend of greater than 200 on this index to gain confidence that the housing market is returning to health.

Couple this with a statistic we mentioned earlier. According to Fannie Mae’s Home Purchase Sentiment Index, +82% of respondents see this is a “bad time to buy” a home. That is up from the mid 30% range in 2019. In other words, real sustainable demand in housing DOES NOT CURRENTLY EXIST. Affordability must correct meaningfully for demand to return to the housing market. This will keep transaction activity low for the foreseeable future, which is not positive for the economy.

Now for the proverbial sword of Damocles…housing construction. While housing unaffordability (is this a word?) is a bummer for those looking to buy a new house…housing transactions do not have huge impacts on GDP. Housing construction, however, is the true transmission mechanism between housing and the overall economy. Building houses and Apartment buildings generates a myriad of downstream impacts, between spending on construction materials, employment of construction workers, permitting fees for local municipalities…etc.

While housing demand and activity plummeted in the second half of 2022, housing units under construction have to this point remained elevated, only falling slightly in the last 2 months of 2022. This is set to change in 2023. As can be seen in the chart to the right, building permits and starts lead units under construction, and both of these series are headed rapidly lower. This means as houses and multi-family assets are finished in 2023, there is nothing behind them in the pipeline.

Current economic activity being generated in housing construction is about to fall rapidly, and the knock-on effects for the economy will not be positive. This is why economists discuss the “long and variable lags” of monetary policy. Interest rates go up, construction activity grinds to a halt, and eventually this lull in activity effects the broader economy… but on a LAG. There is no clearer chart of these impacts than that of housing permits, starts, and units under construction. This is why we are of the belief that the real economic impact of interest rate hikes has yet to be felt.

Is the market resilient enough to absorb a huge drop in the demand for construction materials and labor? Time will indeed tell. In our view, however, this may be the sword that eventually slays the soft-landing narrative. There is no soft landing in housing, that is becoming increasingly clear.

ILLUMINATION: Why I can’t get bullish.

At a hedge fund conference in Miami this month I found myself consistently repeating a short phrase. This was not pre-written, but in various conversations it kept bursting forth. It went something like this.

“When we called for a new REIT bull market in late 2020 (see the newsletter we published here), the call was fairly straightforward. Fundamentals for REITs were depressed but improving, and the Federal Reserve was aggressively dovish. In 2023 we have the exact opposite setup. Fundamentals for REITs are elevated and falling, and the Federal Reserve is aggressively hawkish.”

To be honest, our view may be just that simple. Once those two things change, we will get more bullish. Until then however, our view is that risks to the downside are elevated, and potential returns on the long side are capped. Good investors seek the holy grail…asymmetric risk return profiles. Right now we have the opposite.

None shall pass,

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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