“Right full rudder, reverse starboard engine" – Captain Marko Ramius - The Hunt for Red October
PERFORMANCE: Serenity Alternative Investments Fund I returned -0.24% net of fees in November vs the REIT index at +10.4%.
PLOT A COURSE: Join us for Serenity's second annual yearly outlook call on January 17th!
CRAZY IVAN: Jerome Powell drastically changed his tone during the first two weeks of December. What does a newly dovish Federal Reserve mean for REITs?
FLOODING THE TUBES: Serenity is armed and waiting to pull the trigger on two specific REIT property types.
ONE PING ONLY: A key REIT bull market box has been checked. What else are we looking for to get more bullish?
Piloting a REIT portfolio through the most aggressive Federal Reserve tightening campaign in recent memory can feel a bit like navigating the depths of the ocean aboard a nuclear submarine.
Visibility is limited, the landscape is fraught with danger, and you are constantly trying to avoid torpedoes.
Maybe that last part is a bit dramatic, but you get the point. Commercial real estate investing has been exceptionally difficult and dangerous since early 2022.
But after winding our way through 18 months of increasing interest rates, the REIT market may be nearing the end of the bear market journey. Significant challenges to CRE still persist, but with some precise navigation a REIT portfolio is likely to see increasing opportunities as we move into 2024.
Precision, however, remains the key consideration. Loading up on cyclical REITs into a rapid consumer slowdown is a sure-fire way to scuttle a REIT ship. Similarly, embracing cyclical REIT risk into a slackening labor market and potentially widening credit spreads is a sure path to nuclear meltdown. While REITs have rallied off the October lows, a sustainable inflection higher in growth will be needed to turn this into a lasting REIT bull market.
To simplify the point above…things have begun to get “less bad,” which is positive. Fundamentals still need to bottom and accelerate higher, however, for the main thrust of the bull market to begin. This process will unfold over months and quarters and will require a deft hand to properly navigate. Hence the title of this month’s missive… “Navigating the bottom”.
In the end Serenity’s plan is simple, to continue to evolve with the data and fire on opportunities when they emerge. Recent Fed rhetoric sets the stage for more favorable investing conditions; but beware the torpedoes of a challenged consumer and still elevated interest rates. In 2024 we expect the opportunity set within REITs to broaden, but we are not yet ready to buy REITs across the board. Avoiding hostile economic developments remains a primary concern as the REIT market navigates a dangerously fragile economy.
PERFORMANCE: -0.24% in November vs REITs +10.4%
Serenity Alternative Investments Fund I returned -0.24% in November net of fees and expenses versus the MSCI US REIT Index which returned +10.4%. So far in 2023, Serenity Alternatives Fund I has returned -0.29% vs the REIT benchmark at +3.5%. On a trailing 3-year basis, Serenity Alts Fund I has returned +11.2% annually net of fees versus the REIT index at +4.9%. Over the past 5 years Serenity Alternatives Fund I has returned +13.7% annually net of fees and expenses, versus +3.6% for the REIT index.
The best performing position in the fund this month was Extra Space Storage (EXR), a long position which returned +25.7% in November. As we discussed in last month’s newsletter, Extra Space is one of the best portfolios in the REIT industry run by one of the most sophisticated management teams. Amidst poor fundamental performance in the self-storage industry, EXR recently traded to a valuation level not seen since 2009. After reporting a better than expected third quarter, and with interest rates falling significantly in November, EXR rallied sharply along with other self-storage names. We have an excellent basis in EXR and hope to own it for years to come.
The worst performing position in the fund this month was WP Carey (WPC), a short position which rallied +22% in November. WPC is a diversified REIT that has consistently fallen into the bottom of our multi-factor model lately as NAV/share has fallen over time, earnings have been stagnant, and the company has recently decided to spin out its struggling Office portfolio. To our chagrin, the recent Office spin transaction made WPC eligible for inclusion in the S&P 400, sending shares higher in November. The economics of the business have not changed, and the company has not moved any higher in our model rankings. It is likely to remain a short position in the fund with a myriad of Net Lease REITs available for investment with better track records of generating growth and trading at similar valuations.
PLOT A COURSE: Join us on 1/17 for a REIT outlook deep-dive!
With the turn of the new year approaching rapidly it’s time to mark your calendars for Serenity’s annual year end presentation. On January 17th, 2024, we will present the firm’s outlook for the overall REIT market as well as specific opportunities that we see and how and when we are investing in specific sectors and stocks to take advantage of those opportunities.
We would also like to announce a one quarter fee-discount window for allocations of more than $3m. Our conviction that 2024 will see increased opportunities in REIT’s has motivated us to encourage investors to join us in what might be the best opportunity set we have seen since 2020. For additional details please reach out to me directly at MdKollmorgen@Serenityalts.com.
CRAZY IVAN: Jerome Powell shows the market some dove…
Through mid-December REITs have rallied by about +19% off their late October lows, embracing the market’s newfound belief that interest rate cuts are just over the horizon. In what I would describe as a “surprising” turn, Jerome Powell did little to squash investor expectations in early December, sending the market into a duration buying frenzy at the prospect of new Federal reserve dovishness.
The move is reminiscent of a maneuver referenced in our titular classic “The Hunt for Red October.” In the movie, a sonar tech of the USS Dallas describes a cold war era Russian sub tactic known as the “Crazy Ivan”, in which Russian sub captains would sometimes turn randomly to see if any enemy subs were behind them.
As a portfolio manager, it is difficult to prepare for such sudden market moves. They are, however, a reality of investing and the proper response is to take in the new information presented and update your outlook accordingly.
So how have recent market developments and Fed commentary changed our views? There are a few key takeaways that I think are important and NEW.
Absent a re-acceleration in growth or inflation, interest rates likely peaked near-term in late October. This should on the margin ease pressure on CRE financing, and potentially open the transaction market back up.
Mortgage rates similarly may have hit their near-term cycle high. This should again, on the margin, increase demand for housing (particularly for existing homes), which is positive for certain REIT property types.
The risk of further interest rate increases from the Fed now seems remote. This could reduce market uncertainty, leading to more decisiveness from business owners.
While these conclusions may seem vague in their implications, they have direct impacts on our thinking at the REIT property sector level.
Lower or stable interest rates are most beneficial to Free Standing, Healthcare, and Infrastructure (Cell Tower) REITs. Serenity is more inclined to add to these property types on the long side than we were six weeks ago.
The housing market directly impacts the demand for self-storage. Stronger existing home sales could help fundamentals in this sector find a bottom. We were already warming up to self-storage, and now we are flooding the torpedo tubes. More on that in the next section.
A key decision CEO’s have been punting on for the better part of 12 months has to do with the need for office space. Reduced uncertainty could be very bullish for one of the most beaten-down sectors of the CRE market going forward…
As referenced in the newsletters opening, we are not ready to go fully bullish on all REIT property sectors after Jerome Powell’s dovish December turn. Apartment construction remains elevated, the consumer is still facing significant headwinds, and there are few signs of accelerating fundamentals in most REITs. Remember, short-term interest rates are still an order of magnitude higher than they were 18 months ago, and companies with high leverage levels still face significant earnings risk from re-financings that come due in 2024.
But on the margin, stress has eased for companies across the REIT universe. Capital activity surged in November as management teams took advantage of a newly opened debt market. Well capitalized REITs now have a green light to assume a more offensive position, potentially gobbling up market share as highly levered competitors continue to struggle. This is a positive as investors can now turn their focus to fundamentals, searching for pockets of momentum that could spur long-term bull markets.
FLOODING THE TUBES: Getting closer on Towers/Self-Storage
We stress fundamentals at Serenity because in our view, all long-term, sustainable REIT bull markets are accompanied by accelerating fundamentals which drive earnings growth and NAV creation. The chart below tells this story at the highest level, illustrating how NAV growth was the bedrock for the REIT bull market that stretched from 2009 - 2022.
This phenomenon can also be illustrated at the individual property sector level, by plotting the YoY change in same-store revenue (an excellent proxy for the direction of fundamentals) against forward 1-year returns.
When examining the Self-storage REITs, forward returns are much higher when YoY revenue growth is low and accelerating, and much lower when it is high and decelerating. This is the point we have been emphasizing with the cyclical REITs since the beginning of 2022. That is, we are not interested in loading up on the long side until fundamentals begin moving in the right direction.
In December of 2023, we are much closer to a positive fundamental inflection for Self-storage REITs than we have been at any time since 2020. While YoY asking rents are still badly negative from a year over year perspective (around -15% as of our last channel checks), there are reasons for optimism heading into 2024.
Our first optimistic data point comes from Extra Space Storage (EXR), which we referenced in last months newsletter. As a quick recap, the company (which is one of the best managed in the entire REIT universe) reported on their Q3 earnings call that rents may be bottoming in December of 2023. This would be the first step in stabilizing fundamentals and would remove a key headwind the Self-storage REITs have faced for almost 8 quarters now (falling asking rates).
The second reason for optimism is the recent pullback in mortgage rates from all-time highs. It has become very clear over the past 18 months that self-storage activity is highly correlated with housing market activity. As existing home sales have ground to a halt, there has been less need for self-storage space as moving activity has dropped precipitously. Lower demand has led to the aforementioned asking rate declines of -15% YoY.
A return of housing activity due to falling mortgage rates could easily put a floor under Self-Storage REIT fundamentals and set the stage for a potential new bull market in the property sector. In a more normal economic environment, we would expect earnings growth of 5-10%, well more than current 2024 estimates of +0.1%
The story in the Cell-Tower (Infrastructure) REITs is similar. Growth is likely to find a bottom in early 2024, and in the last cycle Cell Tower REITs had industry leading AFFO growth. Currently trading at a below-average valuation level (+15x AFFO for CCI), investors can get an attractive return from things simply returning to normal for these companies. As perennial cash compounders, Serenity is also preparing to pull the trigger on the Cell Tower REITs now that interest rate headwinds are abating.
Now, a final point to note here is that the portfolio is not heavily overweight in either of these sectors YET. Our multi-factor model remains un-impressed with both property types, with 0 Self-storage or Cell-tower REITs cracking the top quintile of the REIT universe. As the model uses historical data as its guide, it does not trade on anticipated turns in fundamentals the way a human might. This is not a bug, it’s a necessary aspect of our REIT selection process, and the real power of the process comes when these names move into the top quartile and our forward-looking fundamental research points in the same direction.
When that occurs, we will load up the boat and shout the praises of Self-Storage and Cell-
tower REITs from the rooftops. In the meantime, we are flooding the torpedo tubes and preparing to fire.
ONE PING ONLY: Checking in on our REIT bull checklist…
Setting the stage for increased long exposure to Self-storage and Cell-tower REITs begs an obvious follow-up question that I am sure we will get from investors over the next few months. That is…what else are you looking for to get more bullish in REITs?
After the dovish Powell pivot in December here are the key REIT bull market boxes that have been checked, and those that remain unchecked.
Fed stops raising rates – Check.
REIT NOI/Earnings growth stops decelerating – Potentially in progress for Self-storage/Cell Towers.
Interest rates make lower highs – Not 100% certain but appears likely.
Monthly Storage/Apartment rents bottom – potentially in progress, need 1-2 months more data.
Fed cuts rates – not there yet.
Credit spreads peak – potentially occurred in October, but too early to sound the all-clear.
REIT NOI/Earnings growth accelerates – No signs of this yet.
Obviously, this list is not exhaustive, but it serves as a good short-hand visual of our thoughts on the CRE cycle and how REITs will progress going forward. As we have repeated ad nauseum in these pages, our focus is on monitoring the direction of fundamentals and how they drive NAV creation and earnings momentum. As fundamentals improve, our net exposure will increase.
SCANNING THE HORIZON
To summarize our thoughts - after an impressive 6-week rally in REITs; conditions for the sector are clearly improving, but challenges remain, and certain REIT property types are more likely primed for success going forward than others. The full impact of interest rate increases will continue to challenge the economy, and REITs need economic growth to sustainably grow earnings and NAVs over time.
Again, as fundamentals improve, our risk appetite will increase, and our net exposure will move up towards more typical levels. This is a process, however, not a light switch, and it will happen gradually as we collect more data, and the REIT landscape becomes clearer.
While it’s been a challenging two years at Serenity and within REITs, we remain committed to the grind, and see rosier days ahead. Our process is sharper than ever, and 2024 looks much sunnier than 2023 did.
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
DISCLAIMER: This document is being furnished by Serenity Alternative Investment Management, LLC (“Manager”), the investment manager of the private investment fund, Serenity Alternative Investments Fund I, LP (the “Fund”), solely for use in connection with consideration of an investment in the Fund by prospective investors. The statements herein are based on information available on the date hereof and are intended only as a summary. The Manager has been in operation since 2016 and the Fund commenced operations on January 14th. The information provided by the Manager is available only to those investors qualifying to invest in the Fund. By accepting this document and/or attachments, you agree that you or the entity that you represent meet all investor qualifications in the jurisdiction(s) where you are subject to the statutory regulations related to the investment in the type of fund described in this document. This document may not be reproduced or distributed to anyone other than the identified recipient’s professional advisers without the prior written consent of the Manager. The recipient, by accepting delivery of this document agrees to return it and all related documents to the Manager if the recipient does not subscribe for an interest in the Fund. All information contained herein is confidential. This document is subject to revision at any time and the Manager is not obligated to inform you of any changes made. No statement herein supersedes any statement to the contrary in the Fund’s confidential offering documents.
The information contained herein does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made by means of delivery of an approved confidential offering memorandum and only in those jurisdictions where permitted by law. Prospective investors should inform themselves and take appropriate advice as to any applicable legal requirements and any applicable taxation and exchange control regulations in the countries and/or states of their citizenship, residence or domicile which might be relevant to the subscription, purchase, holding, exchange, redemption or disposal of any investments. The information contained herein does not take into account the particular investment objectives or financial circumstances of any specific person who may receive it. Before making an investment, prospective investors are advised to thoroughly and carefully review the offering memorandum with their financial, legal and tax advisers to determine whether an investment such as this is suitable for them.
There is no guarantee that the investment objectives of the Fund will be achieved. There is no secondary market for interests and none is expected to develop. You should not make an investment unless you have a long term holding objective and are prepared to lose all or a substantial portion of your investment. An investment in the Fund is speculative and involves a high degree of risk. Opportunities for withdrawal and transferability of interests are restricted. As a result, investors may not have access to capital except according to the terms of withdrawal specified within the confidential offering memorandum and other related documents. The fees and expenses that will be charged by the Fund and/or its Manager may be higher than the fees and expenses of other investment alternatives and may offset profits.
With respect to the present document and/or its attachments, the Manager makes no warranty or representation, whether express or implied, and assumes no legal liability for the accuracy, completeness or usefulness of any information disclosed. Certain information is based on data provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed and should not be relied upon as such. Performance information and/or results, unless otherwise indicated, are un-audited and their appearance in this document reflects the estimated returns net of all expenses and fees. Investment return and the principal value of an investment will fluctuate and may be quite volatile. In addition to exposure to adverse market conditions, investments may also be exposed to changes in regulations, change in providers of capital and other service providers.
The Manager does not accept any responsibility or liability whatsoever caused by any action taken in reliance upon this document and/or its attachments. The private investment fund described herein has not been registered under the Investment Company Act of 1940, as amended, and the interests therein have not been registered under the Securities Act of 1933, as amended (the “1933 Act”), or in any state or foreign securities laws. These interests will be offered and sold only to “Accredited Investors” as such term is defined under federal securities laws. The Manager assumes that by acceptance of this document and/or attachments that the recipient understands the risks involved – including the loss of some or all of any investment that the recipient or the entity that he/she represents. An investment in the Fund is not suitable for all investors.
This material is for informational purposes only. Any opinions expressed herein represent current opinions only and while the information contained herein is from sources believed reliable there is no representation that it is accurate or complete and it should not be relied upon as such. The Manager accepts no liability for loss arising from the use of this material. Federal and state securities laws, however, impose liabilities under certain circumstances on persons who act in good faith and nothing herein shall in any way constitute a waiver or limitation of any rights that a client may have under federal or state securities laws.
The performance representations contained herein are not representations that such performance will continue in the future or that any investment scenario or performance will even be similar to such description. Any investment described herein is an example only and is not a representation that the same or even similar investment scenarios will arise in the future or that investments made will be profitable. No representation is being made that any investment will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between prior performance results and actual Fund results.
References to the past performance of other private investment funds or the Manager are for informational purposes only. Other investments may not be selected to represent an appropriate benchmark. The Fund’s strategy is not designed to mimic these investments and an individual may not be able to invest directly in each of the indices or funds shown. The Fund’s holdings may vary significantly from these referenced investments. The historical performance data listed is for informational purposes only and should not be construed as an indicator of future performance of the Fund or any other fund managed by the Manager. The performance listed herein is unaudited, net of all fees. YTD returns for all indices are calculated using closing prices as of Jan 14th, the first day of the funds operation. Data is subject to revision.
Certain information contained in this material constitutes forward-looking statements, which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “target,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Such statements are not guarantees of future performance or activities. Due to various risks and uncertainties, actual events or results or the actual performance of the Fund described herein may differ materially from those reflected or contemplated in such forward-looking statements.
Our investment program involves substantial risk, including the loss of principal, and no assurance can be given that our investment objectives will be achieved. Among other things, certain investment techniques as described herein can, in certain circumstances, maximize the adverse impact to which the Fund’s investment portfolio may be subject. The Fund may use varying degrees of leverage and the use of leverage can lead to large losses as well as large gains. Investment guidelines and objectives may vary depending on market conditions.