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  • Martin Kollmorgen

POISED TO STRIKE: Serenity's 2023 Outlook

Updated: Jan 21

“When you see a rattlesnake poised to strike, you do not wait until he has struck to crush him” – Franklin D. Roosevelt

  • PERFORMANCE: Scared of REIT volatility? Roll with Serenity. -8.39% net of fees in 2022 vs -24.5% for the REIT benchmark.

  • REITS ARE NOT CHEAP: Follow the data…not the narratives.

  • THE 2023 PLAYBOOK: Winter is still coming…but this bear is not hibernating. We have a game-plan for positive returns in 2023.

Living in Colorado, I do encounter the occasional rattlesnake.


When this happens, there is not a lot of thinking involved. You back away, and calmly create as much distance between you and said snake as quickly as possible. It’s not complicated.


Here are some thoughts that do NOT go through your head.


“Maybe this rattlesnake isn’t THAT poisonous.”


“Well, since I can see the rattlesnake coming, it probably won’t bite me.”


“Relative to the value of private market rattlesnakes, this rattlesnake looks cheap.”


Investors, however, when faced with an obviously approaching rattlesnake (recession) and a still hawkish Federal Reserve, continue to equivocate as if the macro landscape is somehow unclear.


I am here to tell you to stop over-thinking it.


The Fed is still raising interest rates, the housing market is imploding faster than it did in 2008, consumer confidence is at 2008/2009 levels, and the labor market is still tight (which keeps the Fed hawkish). BAA bond yields (the best proxy for REIT debt) have increased by +250 basis points since early 2022, and REITs have fallen by -25% indicating commercial real estate cap rates have risen by +225 basis points (this is a long way of saying…based on bond yields REITs are NOT cheap).


Just within the last week, Bed Bath and Beyond announced it is likely to declare bankruptcy, Macy’s reported terrible holiday sales numbers, and the ISM Services index plummeted to 49.6 in December. The bulls who are anchoring on inflation peaking are ignoring the facts that 1) inflation peaking is old news and 2) it is no longer a good thing.


Just see the Apartment REITs. Inflation falling means rent growth is falling, which means NOI growth in 2023 could come-in WAY below the current estimates of +7-+8%. Deteriorating fundamentals are not a positive. This is the last leg of the stool getting kicked out from under Apartment REIT investors. And yet the prevailing rationale is that you should buy Apartment REITs because they are “cheap.”


The rattlesnake is coiled, and ready to strike. Loading up on equities on the verge of a recession is like sticking your leg right in the snake’s face.


Despite all of this, I have not looked forward to a year of investing as much as I look forward to 2023!


2022 was a warm-up to what could be an even more volatile 2023. Opportunities on the short side abound, and certain companies have begun to look interesting as longs. While fundamentals for many sectors peaked in 2022, they may bottom in 2023, setting up a much more attractive long-term buying opportunity.


For investors without the ability to short, this could be a brutal year. But for those of us with a go-anywhere framework, we can make active bets as opportunities arise. We can take out our machete and lop the snake’s head clean off, then continue on our merry way. We have the tools and the experience to be opportunistic, to hunt for the right targets, stalk them patiently, and then take them down.


Am I fired up over here? Heck yes I am. I can not remember a time when more investors were pushing a flimsier narrative on the bull side. Investors are desperate for a reason to buy risk assets, effectively fighting the fed, and assuming that we are headed right back to a world that resembles that of 2010-2021. Instead of respecting the snake…they are coming up with absurd reasons why it might not bite!


Consider this a call to action. If you do not have someone in your corner helping you actively manage the coming turmoil…you can do better. Serenity is ready, willing, and available to help. Otherwise, you are just “hoping” for a better 2023 than 2022. Don’t hope that rattlesnake doesn’t bite. Crush it.


PERFORMANCE: +1.06% in December, -8.39% in 2022


Serenity Alternative Investments Fund I returned +1.06% in December net of fees and expenses versus the MSCI US REIT Index which returned -5.14%. For 2022, the fund returned -8.4% net of fees versus the REIT benchmark at -24.5%, the NASDAQ 100 at -32.4%, and the S&P 500 at -18.1%.

On a trailing 3-year basis Serenity Alternative Investments Fund I has generated annualized returns of +16.2% net of fees and expenses. Over the same period, the REIT benchmark has returned +0.0% on an annualized basis. That is not a typo. Over the last 3 years our fund is up +57%, while REITs are +0%. The fund’s Sharpe ratio over the past 3 years sits at +1.11, versus +0.00 for the REIT benchmark (remember higher is better, more return per unit of risk).


The largest positive contributor to the fund’s return in 2022 was our short in Medical Properties Trust (MPW), which returned +49% for the year. MPW is a poster child for the type of REITs we like to short, particularly in a higher interest rate environment. Over the past 10 years, MPW has done two things in volume, raised capital and bought hospitals. The short opportunity, however, is defined by the one thing MPW has NOT done at all, which is manage risk.


In an environment in which interest rates are steadily moving lower, with the “Fed Put” available at the slightest sign of financial distress, the MPW model works. Raise money, put it to work. The risk of tenants experiencing financial distress is fairly low. In the current environment, however, MPW finds itself with a tenant that makes up 30% of its rent roll that is potentially financially distressed. It’s third largest tenant, at 11% of rent, has coverage ratios below 1.0 (meaning it doesn’t earn enough money to cover its rent payments to MPW). The company has regularly lent money to these tenants…so that they can continue paying MPW rent (yes, you read that correctly…it’s as absurd as it sounds).


MPW remains a short and has the rare potential to be an actual $0 due to elevated leverage and multiple tenant issues. Shout out to Rob Simone of Hedgeye for his incredible work uncovering the “questionable” (that’s being kind) behavior at MPW. If anyone is looking for a crash course in how to incinerate investor capital, MPW is a good case study.


The worst performing position in the fund in 2022 was Innovative Industrial Properties (IIPR). IIPR fell -58.9% in 2022, going from badly over-valued, to now quite cheap. A small, long position in the fund going into 2022, we simply overstayed our welcome in IIPR. From a long-term perspective, we have traded the name quite well, generating a +211% total return in the name from 2019 to 2021. After trimming our position throughout 2021, we were not quick enough to recognize the triangulation of style factors that put IIPR in the doghouse in 2022. This is why banishing your emotions as an investor is so important. Humans are instinctively loathe to sell names in which they have had success, even when the writing on the wall is compelling. In the future, we will be less hesitant to jettison high-risk former winners when the macro picture shifts against them.


REITS ARE CHEAP? Don’t believe the hype.


If you peruse our website, you will notice that the term “quant” gets thrown around quite a bit. My degree is in Quantitative Economics. I started my career at a company called Quantitative Services Group. My favorite dinosaur is Quantisauras Rex. I made that last one up, but you get the point.


One of the tenets of quantitative investing is data dependence. Quantitative models are un-emotional and driven by cold hard facts as opposed to narrative. As an investor, this can be hugely beneficial, as our human baggage often causes us to make investing mistakes.


Which is why at Serenity we stress data dependence, and consistently try to put investing narratives to the test. Does the data support the investing “theme” of the day? In early 2023, that theme (in REITs) seems to be that “REITs are cheap”. But does the data support this bold assertion?


To begin let’s explore some basic math. Real Estate is not rocket science, and can be valued very simply using two components, Net Operating Income (NOI) and a Cap Rate (multiple). This goes for individual buildings, portfolios of commercial real estate assets, and REITs (which are just big diversified CRE portfolios). If you know the NOI, you can input a cap rate to determine the asset value. Subtract any liabilities (such as debt) and you get a Net Asset Value (NAV). Derive an accurate NAV, and you have a good estimate of the value of the given commercial real estate asset or REIT.


REIT stock prices tend to track their underlying NAVs over time, so these values are important. We will come back to this idea momentarily, but for now let’s ask a simple question. With REITs down -24.5% in 2022, what does this imply for REIT asset values? In other words, what is the market telling us about commercial real estate prices?


The chart above is from our year end presentation (which we are presenting next week…ping me for details). It is a simple sensitivity chart for asset values using combinations of NOI and Cap Rates. It reflects how asset values change as cap rates increase and NOI increases or decreases.


Since 2022 is in the books, we have a good idea of where REIT NOI’s finished the year (~+8%), and where REIT cap rates started the year (+5.00%). We also know that REITs ended the year at -24.5%. These data points allow us to triangulate how much REIT “implied” cap rates changed in 2022. The answer…they increased from about +5.00%, to +7.25%, a change of +225 basis points.


We have done this exercise in previous newsletters, but it bears repeating with this final set of data. The question then becomes…does a +225 basis point increase in cap rates make sense?


YES! BAA bond yields (the best proxy for REIT debt) started 2022 at +3.5% and ended the year at +5.8%. That is a +230 basis point increase… almost exactly in line with the implied cap rate move for REITs. Similarly, the 10-year yield rose from about +1.75% to +3.8% in 2022, a greater than 200bp increase in a fixed income product that is MUCH LESS RISKY than commercial real estate equity.


Anyone claiming that REITs are cheap is essentially arguing that commercial real estate cap rates should not increase as much as the bond market would suggest. This would imply that commercial real estate equity values are less risky than the bonds that are senior to them in the capital stack.


For any finance newbies out there, that last statement MAKES NO SENSE. In the words of Mugatu… “I feel like I’m taking crazy pills.” Equity is not senior to debt in the capital stack and is inherently riskier. It goes to $0 first. There should be little ambiguity on the overall valuation question here. The fixed income market is giving you the answer. REIT values have fallen almost EXACTLY as much as the changes in their cost of capital would suggest, indicating that they are fairly valued, as opposed to cheap.


So where is this “REITs are cheap” narrative coming from? The chart below gives us an indication.


Relative to consensus NAV estimates, a data series we follow closely, REITs appear “cheap”. The problem is that this ignores the direction of this series and the fact that it LAGS REIT PRICES consistently. Said another way…REITs are cheap relative to consensus NAV estimates that are still too high…and falling. They do not yet reflect changes in CRE pricing that would be in-line with current bond yields. This comparison puts REITs up against a moving target…and that target is moving lower, but on a lag.


Take the example of 2008. Throughout the year of 2008, REITs traded at a -10-30% discount to consensus NAV estimates. Were REITs cheap then? They went on to fall by over -60%, so no, they were not cheap. Consensus NAV estimates were falling and then plunged in late 2008/early 2009 (and this was with a dovish Fed... the Fed slashed interest rates from +4% to +0% throughout 2008).


The moral of the story here is that private market commercial real estate pricing has not yet caught up with the bond market. REITs are the LEADING INDICATOR in commercial real estate, so until BAA yield spreads stabilize (they tend to spike during recessions), REITs are more accurately priced than consensus NAV estimates. Could REITs eventually become cheap versus bonds? Absolutely. During a recession we would expect this. But for right now, relative to the bond market, REITs are priced just about to perfection. Now let’s explore one last slightly hyperbolic analogy.


Arguing that you should buy REITs because they are cheap here is like tying yourself to railroad tracks and arguing that there is not a train coming because you are still alive. It’s backwards. If you are tied to railroad tracks (we do not recommend), it is much more important what happens 5, 10, 30 minutes from now. With REITs, consensus NAV estimates today are much less important than what they WILL be in 3-6 months. The chart above indicates the direction they are moving. Lower.


Does this all sound a bit dramatic? Yes. But the number of incoming calls and requests we are fielding asking after this topic is concerning. We are trying to save people money by presenting the facts in an unbiased fashion. We would love it if REITs were truly cheap. Serenity would buy them hand over fist like we did in late 2020. We are in a much different world, however, and until the Fed is truly dovish and we get to the other end of the coming bankruptcy cycle, we will remain cautious.


2023 PLAYBOOK – Winter is coming…lets go skiing!


Now the fact that we remain bearish on the economy does not mean we cannot have a bit of fun. A bear market does not mean a lack of opportunities. We look forward to 2023 because in our view, there are clearer opportunities to make $$. Here are the main themes we have expressed in our portfolio that we think will be profitable in 2023.

  1. Short High-Risk, Low Return – Yes this sounds obvious, but in 2020 and 2021, high valuation, high leverage, low ROIC REITs and RE companies were some of the best performing names. Just look at the charts of OPEN, RDFN, SAFE, FPI, etc. These companies all have business models dependent on borrowing (or raising equity capital) at low rates and deploying capital at slightly higher rates. Borrowing at 3.1% and lending at 3.2% is exciting when the 10-year yield is at 1.5%. Not so much with the 2-year above 4%. Some companies simply do not have a way to grow in a higher interest rate environment. With low yields (low cap rates and low dividend yields), there becomes a natural arbitrage between these companies and peers with higher yields and embedded organic growth (a type of carry trade). Let’s look at a slightly off-the run example. Take Farmland Partners (FPI). FPI owns (surprise) a portfolio of farmland. Because the government provides extremely attractive financing terms for farmers, farms are a low cap-rate asset class. FPI borrows in the mid-high 3% range and acquires farmland in the low-mid 4% cap rate range. That is a fine business, with somewhat tight margins. FPI also trades at a 4.1% implied cap rate and has a dividend yield of 1.8%. A current investor receives a 4.1% NOI yield, very little in the way of growth, and a 1.8% dividend yield. Compare this with a company like First Industrial (FR). FR has a slightly higher cost of debt but develops warehouses to a +7.4% yield and buys warehouses in the high +4%-mid +5% cap rate range. FR has grown its same-store portfolio by +10% over the last 9 months, and trades at almost a +6% cap rate with a +2.3% dividend yield. Being long FR and short FPI is the REIT version of a carry trade. FR has a higher current yield, better growth, and can actually present a compelling total return profile in a world of higher interest rates. FPI may be a fine business, but it has a lower yield than a 2-year treasury bond and not much more in the way of growth. Again, this trade doesn’t really work in a world of super low interest rates, but that is no longer the world we live in. Our short book is filled with REITs and RE companies like FPI. Many have business models that simply do not work as well in a higher rates environment. Some are even worse and should not exist at all. While few of these companies are likely to go to zero, we do not need most of them to. We just need them to have meaningfully lower total returns than…

  2. Long counter-cyclicals - During a recession, the best tool in an investor’s toolkit is the short book. Since I do not have the risk appetite to go massively net short, at Serenity we hedge our short book with longs. Owning anything on the long side can be challenging in a bear market, but the idea is to own REITs that go down less than peers. Profound, I know. Our best bet in this regard is to own REITs that have counter-cyclical demand drivers. While it is nearly impossible to fully avoid any type of cyclical demand risk, some REITs are simply more defensive in nature than others. Our favorite bet in this vein currently is Equinix (EQIX). To put it simply, EQIX is one of the best REITs in existence. Over the past 10 years, EQIX has grown its AFFO/share (cash flow per share) by +10.1% per year and returned +14.9% on an annualized basis. It owns the most network dense, irreplaceable Data Center portfolio on the planet, and outperformed REITs significantly from 2007-2010. EQIX trades at a +5.8% implied cap rate, with the potential for +10% earnings growth over the next 3-5 years. That gives it a solid total return profile on its own. Now add in the fact that data demand continues to increase, the data center market is historically tight, and most other REIT property types have deteriorating fundamentals, and EQIX stands out even further. We feel great owning REITs like EQIX and shorting REITs with higher leverage, lower growth, lower quality portfolios, and much worse total return profiles. While fundamentals re-set for many cyclical REITs, EQIX will continue generating excellent cash flow and re-investing it at high ROICs.

  3. Prepare to Get Greedy – The third part of our 2023 plan is a bit more forward looking. It stems from examining the history of cyclical REITs, which makes one thing clear. When fundamentals peak and start to decline, forward-looking returns are typically low (or negative). This was the story of cyclicals in 2022. For Self-Storage REITs, Apartment REITs, and even Warehouse REITs, fundamentals peaked and began to move lower. This is part of the reason these property types on average fell by about -20% in 2022. It is also the reason we continue to short these property types…because growth is decelerating rapidly. In 2023, however, we may eventually be presented with the inverse opportunity. Rapidly decelerating fundamentals are about to meet a wave of supply and extremely difficult comps particularly in Q2 and Q3 of 2023. Same store growth has a strong chance of going negative for many cyclical REITs at some point this year. While this doesn’t sound like a positive… the best time to buy these companies is when they have low or negative same-store growth. While most investors remained stubbornly positive on Apartments and Storage in 2022, we shorted the sectors successfully. Our hope is that in 2023 as investors get increasingly negative on cyclicals, it presents us an opportunity to buy them extremely cheaply. And this goes for the broader REIT sector as well. While many investors remain optimistic in the face of rapidly deteriorating economic conditions, a recession is likely to bludgeon the optimism out of even the most stubborn bulls. We are already sharpening the pencil on deep value names in the Office and Lodging sectors for this eventuality. While these sectors will be challenged in a recession, they already represent deep value opportunities, which are only likely to get juicier (for those that will survive). When the economy truly bottoms (likely 6 months after the Fed starts CUTTING rates), there will be the potential for huge returns in some of these beat-down property types. That is…for investors with the courage and staying power to lean into this true “distress.”

THIRSTY FOR MORE? Join our 2023 outlook call!


After an excellent 4-year run (+19.7% net returns since 2019), Serenity is poised for continued success in 2023. Despite our bearish outlook for the economy, we see 2023 as a more opportunity rich environment than 2022 and are investing accordingly. As a quick reminder, we will be hosting our first annual Serenity Summit on Jan 17th at 11am EST. This is simply a 1-hour call in which we will discuss the lessons of 2022 and provide a more in-depth review of our plans for 2023. We hope you can join us.


Don’t get bitten,


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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