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  • Writer's pictureMartin Kollmorgen

JULY 2023 in REITs: Maps, Zombies, and Buried Treasure

"Archeology is the search for fact, not truth…We do not follow maps to buried treasure, and “X” never, ever marks the spot.”

– Indiana Jones and the Last Crusade

  • PERFORMANCE: Serenity Alternative Investments Fund I returned –0.60% net of fees in July. Over the past 5 years the Fund has returned +11.4% annually versus +5.0% for the REIT index.

  • FOLLOW THE MAP: What is the value/momentum/quality model telling us this month?

  • ZOMBIE…ZOMBIE…ZOMBIE! Office REITs are rallying…is the move sustainable or is this a walk of the living-dead?

  • BURIED TREASURE: REIT juggernaut Extra Space Storage (EXR) might be an all-time bargain right now. How to stay EXTRA patient with a seemingly incredibly opportunity.

Since the commercial real estate market turned down in 2022 investors have begun to flock to the REIT market in search of buried treasure.

They have seen investors find that treasure in the past. American tower at $42 (now $186). Equinix at $78 (now $765), Extra Space Storage at $15 (now $129).

These are the ancient REIT artifacts that made long-term investors a fortune.

$10,000 invested in these REITs 15 years ago would be worth, $45,000, $114,000, and $137,000 today, respectively.

Buried treasure indeed abounds in times of REIT distress.

But is it as obvious as buying REITs that are “cheap?” The REIT market looked cheap for most of 2008, and then went down over -65%. The line between “cheap” and “value-trap” can be razor thin, as most investors eventually learn.

So how do we find the treasure buried in the REIT market? There is certainly no big X marking the spot. Instead, we need to use our wits, experience, and some sophisticated REIT stock selection technology to maximize our chances of success.

This is our day to day at Serenity. Using modern tools and decades of commercial real estate experience we scour the REIT market for compelling places to invest our capital. Over the last four years that has yielded net of fees returns of +32%, +18%, +45%, and -8.4%. With the strategy sharper than ever, and many REITs cheaper than they have been in years, the potential for finding hidden gems is increasing by the day.

This month we discuss where our trusty compass (the quant model) is currently directing the portfolio. With this context we can discuss the recent surge in Office REITs and assess its sustainability. We will conclude with a potential golden nugget in Extra Space Storage (EXR) and discuss our plan for extracting maximum value from this historical REIT juggernaut.

So sit back and relax as Serenity follows the trail of ancient clues towards ever elusive REIT market treasure.

PERFORMANCE: -0.60% in July vs REITs +2.86%

Serenity Alternative Investments Fund I returned -0.60% in July net of fees and expenses versus the MSCI US REIT Index which returned +2.86%. So far in 2023, Serenity Alternatives Fund I has returned -0.83% vs the REIT benchmark at +8.5%. On a trailing 3-year basis, Serenity Alts Fund I has returned +14.4% annually net of fees versus the REIT index at +8.5%. Over the past 5 years Serenity Alternatives Fund I has returned +11.4% annually net of fees and expenses, versus +5.0% for the REIT index.

The rally in risk assets continued in July, as the outlook for a “soft landing” has gone from low probability to overwhelming consensus in just a few short months. Inflation looks to be tamed, credit stress has not caused noteworthy blow-ups, and the potential end to the Fed’s tightening cycle has investors looking forward to a new bull-market. According to many, the Fed has nailed the landing… +500 basis points of interest rate hikes and no recession!

In the REIT market, however, on the ground fundamentals continue to tell a slightly different story.

Apartment rent growth on a YoY basis has now been negative for two straight months. Self-storage REITs continue to LOSE pricing power as demand remains moribund. Warehouse activity continues to normalize, and the debt markets remain challenging. Piedmont (PDM), an office REIT just priced a $400m bond deal at +9.25%.

REIT CEO’s have tried to espouse a positive tone and outlook for 2023 and 2024, however, the reality is that accelerating growth in the back-half of 2023 (that was widely anticipated) is not materializing. With real interest rates firmly in positive territory (which means interest rates are finally higher than inflation [and growth]), the question on our minds is…what is the next positive catalyst for the commercial real estate market? Rates remain high (and potentially moving higher), while growth is moving lower. This is the WORST of all worlds for commercial real estate.

While we remain open to the possibility of a soft landing, we need to see evidence of it in the data. Economic activity must improve for REIT earnings estimates to stabilize and move higher. Until that happens, we will remain cautious in the portfolio, focused on finding compelling pair trades and grinding out alpha in, what we view as, a very fragile market for risk assets.

READ THE MAP: What is the model telling us in August?

As a quick reminder, Serenity’s multi-factor REIT selection model weights 17 Value, Momentum, and Quality factors (extensively backtested) to rank each REIT in our universe daily. The model gives us an objective view of which REITs have the most potent combination of these characteristics. Said another way, it’s an algorithm designed to find the most favorable combination of cash flow growth, relative valuation, balance sheet, and management quality within REITs. The chart below shows the model’s top ranks as of 8/15.

There are a few things we can glean from this month’s model output. First, Industrial REITs account for 4 of the top 20 REITs in the model. With rent spreads remaining elevated, and same-store growth hovering around +10% for many Industrial REITs, there should be no surprise that these companies have strong momentum scores and some of the best growth outlooks in the industry. Plymouth (PLYM) and STAG (STAG) sport some of the most attractive valuations in the property sector, while Prologis (PLD) has one of the highest quality portfolios in the entire REIT industry. This indicates that momentum remains strong in the warehouse (industrial) property type, with the model giving us multiple ways to play the space.

Another noteworthy position in the model at #2 is Marriot (MAR). While not technically a REIT, Marriot is one of the best run real estate businesses on the planet. In their most recent quarter, the company reported accelerating fundamentals on the back of increased demand for international travel. While we have been hesitant to own Marriot in size (due to potential recessionary headwinds), the model has gotten this name 100% correct. This is the value of a multi-faceted process. Thanks to the model, we are up over +20% in MAR year to date.

The final names of note in the model this month are DHC and SVC. These are two of the lowest quality REITs in the entire universe, that have recently moved to the top of the model after large rallies driven primarily by short covering. These names screen well because they are extremely cheap, so any positive momentum (however fleeting) makes them jump to the top of the ranks. Again, these names illustrate the value of a multi-faceted process. Due to terrible management conflicts of interest at these companies and overall atrocious corporate governance, neither of them has made it into the portfolio this year. We are happy to miss out on dead-cat bounce rallies in low-quality REITs such as DHC and SVC, and our ability to exclude them from the portfolio illustrates the advantage of fusing deep REIT knowledge with our powerful REIT picking algorithm.

I’M NOT DEAD YET! Office REITs come roaring back…

Speaking of potential dead cat bounces…don’t look now but Office REITs are BACK. Up +13% in July and +28% from their May lows, the Office sub-sector has roared back from the May depths. Heavily shorted names SL Green (SLG), Vornado (VNO) and Hudson Pacific (HPP) are up +59%, +75%, and +45%, respectively over the last 3-months.

We discussed potential value in Office REITs here and would offer the recent Office price action as a good example of what happens when novice short sellers enter the REIT market. Short interest for SLG peaked in April/May, immediately before the stock went up +60% in 2 months. While Serenity did not have sizeable Long positions in Office, we also did not to press shorts into the distressed pricing that emerged in many of these REITs during April/May.

So what’s next? Is this the start of a new trend? Should we be <gasp> buying Office REITs with two hands?

Not so fast. While Office REITs are still heavily discounted relative to private market values, those values (NAV in the chart below) continue to fall. Negative NAV momentum is a BAD sign for any REIT and acts as a “stay away” signal within our framework.

The quant model is sending similar signals. Of the lowest 10 ranked names in our universe, 7 of them are Office REITs.

Having said all that…I have a confession to make. My contrarian instincts as an investor are pushing me to be more bullish on Office. If Office REIT NAV’s can stabilize…the value gap between NAV and current prices is still VERY wide. Meaning there is still a LOT of potential upside, and most investors are either short, or have very little capital allocated to the sector. Low levels of ownership by REIT dedicated funds, coupled with high short interest, makes for the volatile cocktail that has sent certain Office REITs rapidly higher. Continued positive news from the sector would likely continue to do so.

As always, however, we remain data dependent, and will stick with our process, which currently says stay away. We are monitoring the situation closely.

AN EXTRA JUICY DEAL: EXR looks like a bargain…but watch the fundamentals…

As the 2022/2023 bear market in REITs evolves and matures, more and more opportunities are presenting themselves to buy high quality REITs at extremely attractive prices. Cell tower REITs have traded to values not seen since 2012-2013. Similarly Net Lease REITs are plumbing cycle valuation lows as interest rates continue to move higher. And now, after a semi-brutal earnings report, REIT juggernaut Extra-Space Storage (EXR) has traded to a cash-flow multiple that it has not touched since 2011!

Why is this significant? Because EXR is one of the best performing REITs EVER. From 2010-2020, the company returned +1,167% (+29% annually), handily trouncing the REIT index, the S&P 500, and the Nasdaq 100. EXR is a best-in-class Self-Storage REIT, with historical cash flow growth of +15%/year from 2013-2023. At a 15x multiple, EXR looks like your average REIT, despite a track record of growth that is 3x better.

For value-investors with a long time horizon, this is a DEAL. While EXR can certainly get cheaper, at 15x 2024 estimated cash-flow, there is a significant margin of safety baked into the name at current levels. So what’s the catch?

Stop me if you’ve heard this before, but to get more bullish on EXR, we need to see fundamentals bottom out and begin to normalize. I feel like a broken record, but this remains our position on many REITs that look “cheap” on first glance. With the housing market setting new lows for activity levels in July/August, there is little to suggest that fundamentals are on the cusp of turning higher for EXR. Self-storage activity is highly correlated with housing market activity, and until people are moving actively again, the self-storage market is likely to remain slow.

EXR reported as much on their most recent earnings conference call. Asking rents in storage continue to fall, which work their way through Storage REIT earnings on a lag. While the company is doing everything they can to manage much lower demand, there are only so many levers they can pull until the housing market begins to recover. For this reason, EXR’s fundamentals remain mired in the dirt, and absent a large exogenous shock, there is little on the horizon to turn the story around.

Our model agrees with this assessment, ranking EXR 59/129 REITs, near the middle of the pack.

The value investor in us is again itching to buy EXR at such an attractive price, but nothing in our process suggests that the time is right. When this changes, however, we will load up the boat. We look forward to that day, as between mid-2020 and the end of 2022 EXR returned +142%. Patience, again dear readers, remains key.

THEY'RE DIGGING IN THE WRONG PLACE! Why avoiding value-traps is extremely important.

Investors are not a patient bunch, and it only takes a quick glance at LinkedIn or Seeking Alpha to see how many people WANT to be bullish on REITs. “REITs are CHEAP” headlines abound, with more and more missives penned about the opportunity to “Buy with fear in the streets.” Just yesterday the WSJ ran an article about the massive amount of distressed capital that has been raised to buy commercial real estate.

While we would love to get on board with the prevailing market narrative, I still believe it misses 50% of the equation. Growth is still slowing. Values are still falling. Interest rates are still rising. Headwinds for many REITs are not abating and in some cases are getting worse.

Lucky for us, our fund has a short book, and can generate returns in almost any economic environment. While our last few months have been lackluster, we’ve tightened the screws on our process a bit and expect to do much better through the remainder of the year.

Every day gets us closer to the next REIT bull market, but we are not there yet.

Stay patient friends,

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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