“If you look good, you feel good. If you feel good, you play good. If you play good, they pay good.” – Deion Sanders
PERFORMANCE: Serenity Alternative Investments Fund I returned +2.47% net of fees in June vs the REIT index at +2.88%. In 2024, the fund has returned +3.46% vs -0.24% for REITs.
CYCLICAL MOMENTUM: Apartment and Self-Storage REITs led the REIT index in June.
RECESSION INSURANCE: Could REITs catch a defensive bid?
DIGITAL INFRASTRUCTURE: How exposed is your portfolio to the data economy?
Deion Sanders was an eight-time pro-bowl cornerback in the NFL. He has two super bowls rings, a defensive player of the year award, and simultaneously spent nine seasons playing major league baseball. He is the only athlete to play in both a super bowl and a world series. He once hit a home run and scored a touchdown in the same week.
Now the head coach of the Colorado Buffaloes, Coach Prime is mentoring another remarkable athlete in Travis Hunter. One of the top-rated wide receivers in college football, Hunter also starts for the Buffs at cornerback. In the modern era, two-way players (offense and defense) are incredibly rare.
When putting together a team, elite athletes like Deion Sanders and Travis Hunter are not the type of players you leave on the sidelines.
REITs similarly, for the first time since 2020, offer an offense/defense combination that could be powerful in portfolios over the next few years.
Going into 2025 cyclical REITs will experience fading supply headwinds, extremely easy comps, and an advantageous cost of capital. In all likelihood these companies are set to return to mid-single digit earnings growth in 2025 from roughly 0 today.
Simultaneously, with the labor market slackening and unemployment moving higher, high duration REITs could become defensive portfolio stalwarts as interest rate pressures fade and the Fed contemplates rate cuts.
This dual threat points to a bright future for the REIT market in multiple possible economic scenarios. And this is before we consider the digital infrastructure REITs, which have secular tailwinds independent of the economic cycle.
With two years of headwinds beginning to fade and blow in the other direction, REITs could be a key player in championship portfolios over the next 3-5 years. Remember, REITs are the elite athletes of the commercial real estate industry. Bench them at your own peril.
PERFORMANCE: +2.43% in June vs REITs +2.88%
Serenity Alternative Investments Fund I returned +2.43% in June net of fees and expenses versus the MSCI US REIT Index which returned +2.88%. Year to date Serenity Alts Fund I has returned +3.46% vs the REIT index at -0.24%. On a trailing 3-year basis, Serenity Alts Fund I has returned +3.2% annually net of fees versus the REIT index at +0.2%. Over the past 5 years Serenity Alternatives Fund I has returned +11.9% annually net of fees and expenses, versus +3.9% for the REIT index.
One of the most profitable positions in the fund in June was Iron Mountain (IRM), a long position which returned +11.9% during the month. Iron Mountain is an interesting story within REITs, as their primary business is old school paper records storage. In today’s digital economy, this business is slowly shrinking, but is still very profitable. The other part of IRM’s business is Data Centers, which makes up about 10% of the company’s revenue, but is growing at a +30% yearly clip. Iron Mountain was ignored by REIT investors for many years due to its complexity and the conventional wisdom that paper storage would eventually go the way of the dinosaurs. Recently, however, the company’s growth has become too compelling to ignore, and IRM has completely re-rated higher from a valuation perspective. IRM has been a profitable position in the Serenity portfolio at various points over the last two years and we remain long the name.
The least profitable position for the fund in June was Park Hotels (PK), a long position which returned -3.97% during the month. The Lodging REITs have lost their mojo over the past few months as economic data has disappointed and updates from the Lodging companies have been uninspiring. Park in particular has detailed 2025 renovation expense headwinds for the company’s portfolio. These planned expenses have dampened investor sentiment since they were discussed at the NAREIT conference in early June. As of this writing we have sold our position in Park in favor of other names in the Lodging sector, as the company has fallen out of our CORE model top rankings. While we like PK’s outsized exposure to the NYC market, there are simply better growth stories out there in REITs that are more deserving of our capital at this juncture.
OFFENSE! Cyclical REITs starting to heat up…
The best performing property types in REITs in June were Apartments, Self-Storage, and Specialty REITs. As regular readers know, Apartments and Self-storage REITs are some of the most cyclical REIT property types, and Serenity has been growing more bullish on both for the better part of six months. In June, both property types led the REIT industry higher, indicating that other investors are coming around to the Serenity point of view.
At the risk of sounding like a broken record, let’s briefly revisit the bull case for cyclical REITs that is currently emerging.
The key to the cyclical REIT story as it will play out from 2025-2027 is supply. New supply is the great leveler in commercial real estate, because it puts pressure on rental rates. As a brief example, think about what would happen if you owned an Apartment complex, and someone built an identical Apartment complex across the street. The best way for them to fill up their building would be to offer lower rents than you were charging, and therefore absorb any new tenants that came into the market. If demand was weak enough, this may even force you to lower your rates just to keep people in your building. Until the competing Apartment building was full, this “new supply” would significantly pressure the amount of rent you would be able to collect.
In 2024, there is more supply being delivered in Apartments than any year since 1974. This is one reason we were very BEARISH on Apartment REITs for most of 2022 and 2023, we simply saw this massive supply wave coming, and knew what it was likely going to do to rent growth. As of this writing, YoY asking rent growth in the Apartments has compressed to nearly 0%. All due to supply.
Now let’s look forward. The nice thing about Apartment supply is that we have very effective leading indicators. To build an Apartment building, you need to get a permit, and then when you start your building, it must be filed with your local municipality. Which allows us the luxury of the chart to the right.
What we see here is that multi-family (Apartment) permits and starts have moved drastically lower over the past year, with few signs of stabilization. Similarly, but on more of a lag is multi-family units under construction, which peaked more recently but is now falling.
Just as high amounts of supply is a headwind to Apartment rents, low amounts of supply is a tailwind. While we are not quite there yet (there are still a lot of Apartments being delivered), the path of permits and starts is clear, and leads to a much lower supply world in 2025, 2026, and 2027. This is very bullish for the Apartment REITs, as a 2022, 2023, 2024 headwind will soon turn into a 2025, 2026, 2027 tailwind.
A similar story is unfolding for Self-Storage REITs, Warehouse (Industrial) REITs, and even Office REITs. Supply is currently elevated, but leading indicators point to an unequivocally more bullish outlook over the next 3-5 years.
This is the key reason we have gotten more constructive on Apartment and Self-storage REITs, and in June the market agreed.
Now, there will certainly be bumps in the road along this journey. There is reason to believe the back half of 2024 may be more challenging than recent months from a rent growth perspective. Similarly, continued increases in unemployment could begin to erode the demand for multi-family assets, and a recession would certainly challenge Apartment revenues.
The long-term picture, however, clearly shows a more favorable environment for cyclical REITs from 2025-2027. The Serenity portfolio has increased exposure to these REITs and is a likely buyer on dips for the remainder of 2024.
DEFENSE: REITs as a recession hedge
On the defensive side of the ball, REITs were something of a disappointment for many investors in 2022. While tech stocks and the S&P 500 sold off, many investors hoped that REITs would act as a bastion of capital preservation within their portfolios. This was not the case, as REITs fell almost -25% (Serenity Alts Fund I closed down only -8.4% in 2022).
But investors should not make the mistake of conflating a single bad data point with a broader trend or rule. REITs were not effective defensive exposures in 2022 for a variety of reasons. First of all, growth peaked and began to slow meaningfully in 2022, after the most rapid growth acceleration in REIT history in 2021. Simultaneously, the Federal Reserve embarked on one of the most aggressive tightening campaigns in US economic history, increasing interest rates meaningfully through the year.
Slowing growth and increasing capital costs are not good for REITs (or any asset class really), which is why 2022 was such a brutal year for everything in the investing world.
If we set 2022 aside, however, longer term history would suggest that REITs are key components of defensive portfolios amidst more normal growth slowdowns. This is due to the low volatility of their cash flows, as well as their bond-like qualities. In fact, high duration REITs tend to be extremely valuable portfolio tools during most growth slowing regimes.
Let’s examine two quick examples.
For the first, we can rewind the tape to 2008, which was the peak of the great financial crisis. Over the two-year period from 2008 to 2009 REITs returned -20%, which was in-line with the S&P 500. High duration REITs, however, returned +6%, significantly mitigating portfolio losses for those overweight this exposure during a harrowing time in the capital markets.
2019 tells a similar story. Amidst the most recent instance of Federal Reserve rate cuts (August 2019), high duration REITs not only insulated portfolios, they LED most asset classes in performance. This intuitively makes sense, as bond like assets will benefit from lower interest rates.
The moral of the story here is that REITs still have a significant defensive component, as high duration sectors make up a sizable portion of the REIT market. Free standing retail, Healthcare, Cell Towers, Homebuilders, and Data Centers all respond positively to lower bond yields.
With unemployment creeping upwards (now +4.1% from +3.4% in 2023), a continued slowdown in economic growth would likely bring the shine back to high duration defensive REITs. This occurred frequently between 2010 and 2020, and REIT performance over the past 7 days shows evidence of a potential new trend in this direction.
SPECIAL TEAMS: Digital Infrastructure is a key piece of the REIT market
The cherry on top of the proverbial REIT narrative cake in 2024 continues to be the digital infrastructure portion of the REIT market. While both cyclical and high duration REITs have potential positive catalysts on the horizon, the bull case for digital infrastructure REITs continues to build and is much more insulated from ebbs and flows in the general economy.
What may surprise some investors is that digital infrastructure (Data Centers and Cell Tower REITs) are a significant portion of the overall REIT market. Of the $1.8 trillion market cap Serenity universe, Data Centers and Cell Towers account for almost $300 billion, or +16%.
And this is after the acquisitions of Coresite (COR), CyrusOne (CONE), and QTS (QTS), all of which were taken private by large pools of capital within the last few years.
Suffice it to say, investors are keen to add digital infrastructure to their portfolios. So keen, in fact, they are buying entire publicly traded companies to get their exposure.
And it should be no mystery as to why. Let’s look at the performance of two gold standard digital infrastructure REITs, Equinix (EQIX) and American Tower (AMT). Over the past 15 years, each of these companies has posted benchmark incinerating returns. Since 2009, EQIX has returned +18.15% annually, American Tower has returned +14.4% annually, and REITs have returned +10.8% annually.
If you were to have invested $100,000 in EQIX in 2009, it would be worth well over $1,000,000 today.
This is all due to the irreplaceable nature of these portfolios.
Equnix was literally there during the early days of the internet, housing some of the first key internet connections in Northern Virginia (now the center of the global data center universe). Their portfolio spans the globe, and they control key connection points in almost every major internet market. Think of a commercial real estate portfolio that owns the best assets in London, New York, Tokyo, and Beijing. Equnix is the Data Center equivalent, effectively building up a portfolio of high-quality digital infrastructure over more than a 30-year history. In Data Centers, a better portfolio does not exist, and investors trying to buy digital infrastructure exposure in the private market simply cannot replicate the quality and diversity of the EQIX portfolio.
American Tower is similar. The company controls a portfolio of cell-towers that simply cannot be replicated. A public company since 1998, AMT owns 224,000 towers, has a fortress balance sheet, and continues to benefit from the expansion of mobile data usage, as more data requires more equipment be placed on American Towers…towers. With three tenants on a single tower, the returns on invested cost to AMT reach as high as +24%. There is only one other industry in REITs known to hit such high yields (did you guess Data Centers?).
Both of these portfolios serve as critical pathways in the modern digital economy. American Tower streams data straight to your cell phone, and Equinix sits at the connection point between the web browser you are using and the server hosting this newsletter. Add in the huge amounts of data consumption and transmission required by AI applications, and the long-term demand picture for both EQIX and AMT is incredibly robust.
The bottom line? Digital infrastructure REITs are the elite athletes of their asset class. While some investors may prefer private equity exposure to these industries, the public equities should NOT be ignored. They simply have a large quality advantage, long operational history, and balance sheets that in a higher for longer environment could prove incredibly valuable.
This is why we refer to them as the cherry on the REIT cake. During the pandemic, when most real estate was empty due to shelter in place orders, these companies actually benefitted. The secular forces behind more data creation and use will not reverse any time soon, and EQIX and AMT will continue to benefit. Serenity is long both companies.
BUILDING A CHAMPIONSHIP TEAM
My enthusiasm for REITs in 2024 continues to grow as the opportunity set within the industry seems to broaden out by the day. Short ideas are increasingly difficult to find, and data continues to support our long exposures as we move through 2024.
As a portfolio manager I sleep well at night knowing that our clients are invested alongside the elite athletes of the commercial real estate market. Not all my predictions will come true, and as always, the market will at some point zig right when I expect it to zag.
But the path to success for both cyclical and defensive REITs has identifiable catalysts, and at Serenity we have no problem being long both defensive AND cyclical companies. If the outlook for either improves or deteriorates, we can adjust our exposure accordingly, knowing that in almost any scenario SOMETHING in our portfolio will be working.
That is the definition of a well-constructed REIT portfolio. A book that can make money even when you get things wrong (which is inevitable).
Look good, play good,
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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