"Keep calm and GET FIRED UP" - Ted Lasso
PERFORMANCE: Serenity Alternative Investments Fund I returned -1.01% in April, while REITs returned +0.82%.
GET FIRED UP: REIT valuations have re-set, laying the foundation for the next REIT bull market. Now all we need are accelerating fundamentals…
KEEP CALM: Fundamentals remain under pressure and will fall further if the economy goes into recession. Risk management remains paramount.
ONCE IN A DECARDE OPPORTUNITY: REITs returned +29% per year for five years following the great financial crisis. Could a similar bull market begin in 2023 or 2024?
Can you keep two thoughts in your head at the same time?
Can you keep calm and get fired up?
Can REITs be both cheap, but also NOT a bargain?
Investing is not a binary discipline. Most professional investors attempt to get things right about +60% of the time. That means most decisions involve probabilities, and the best investors are flexible mentally and nimble with their capital. What seems obvious one day can be flipped on its head the next, and a company you love could be one bad earnings report away from entering the proverbial doghouse.
This is why REITs can be both incredibly cheap and NOT a buy… AT THE SAME TIME.
The simple fact is that buying equities into a recession is a bad idea. And the conference board series of leading indicators just hit -8%, with their coincident index below +2%. This combination has historically predicted recessions with 100% accuracy. Maybe this time it’s different…but how much capital do you want to wager on that?
Now, should we bet the farm on a 2008 style collapse for the US economy? No. Again, a well-balanced portfolio assigns different probabilities to different outcomes. The economic picture is almost always going to play out in a way that we are not anticipating. The key is to be flexible enough to adapt, and not lose too much money if the economy zigs when you anticipate a zag.
REITs are cheap, there are no two ways about it. Historically this leads to very attractive forward returns. That should get investors fired up.
But we also need to keep calm. Fundamentals continue to deteriorate for many cyclical REITs and the capital markets get less friendly by the day. In a recession, cheap gets cheaper, so stick with Serenity and stay patient. When fundamentals bottom, we will be ready. Keep calm and GET FIRED UP.
PERFORMANCE: -1.01% in April vs REITs +0.82%
Serenity Alternative Investments Fund I returned -1.01% in April net of fees and expenses versus the MSCI US REIT Index which returned +0.82%. So far in 2023, Serenity Alternatives Fund I has returned +1.81% vs the REIT benchmark at +3.6%. On a trailing 3-year basis, Serenity Alts Fund I has returned +17.0% annually net of fees versus the REIT index at +9.4%.
Over the past 5 years Serenity Alternatives Fund I has returned +13.4% annually net of fees and expenses, versus +5.9% for the REIT index. That is more than +7% alpha PER YEAR over a 5-year stretch. As the Serenity process has matured and improved, so have our results. We think we can do even better over the next 5, the reasons for which we will detail in the newsletters next section.
The best performing position in the fund in April was Life Storage (LSI), a short position which fell -4% during the month. Life Storage is being acquired by competitor (and Serenity long position) EXR, and our short position in the name is a hedge against our EXR long. If the deal goes through, Serenity will still be long EXR with newly added scale synergies (which are uniquely important in Self-Storage). If the deal breaks, Serenity is likely to benefit as LSI falls. While not our most exciting position, in April this hedge performed well.
The worst performing position for the fund this month was Crown Castle (CCI) which returned -8%. We have written and spoken about Crown Castle quite a bit in recent months, as the company has become one of the largest positions in the fund. CCI is a US focused cell-tower REIT with a history of +8% dividend growth and a fortress balance sheet. From a cash flow perspective, CCI has one of the most recession resistant portfolios in all of REITs. For this reason, it typically behaves as a defensive exposure, falling less than other REITs when the REIT market sells off.
2022 and 2023 have bucked this trend, however, as CCI has fallen by -42% since December of 2021 versus -24% for the REIT index. This is despite a pristine balance sheet (+21% debt/asset value), and a still attractive cost of debt capital (CCI priced a 10-year bond at +5.1% in early May 2023). As growth has slowed from +5.7% to +4.3% (trailing 4-Q average of organic growth), investors have become incrementally bearish on the CCI and the other tower REITs. While the company expects a re-acceleration in organic growth in the second half of 2023, investors seem skeptical, as CCI now trades at a +15.1x forward AFFO (cash flow) multiple, the lowest valuation the company has sported since 2014.
We continue to own CCI because of the defensive nature of the company’s cash flows. As economic data deteriorates, we believe investors are likely to pay a premium for counter-cyclical REITs such as CCI. This is already happening with the large cap tech names in the Nasdaq 100 index. Microsoft and Apple are trading near all-time highs despite growth slowdowns, and those growth slowdowns are much more pronounced than CCIs. As the cycle begins to bite, we would expect a similar flight to quality to benefit the cell tower REITs, and we can collect a growing +5.4% dividend yield in the meantime.
GET FIRED UP: A 5-year outlook worth salivating over…
With a new baby in the house this month I think it’s appropriate to take a break from our recession soliloquizing and step back to ponder the bigger picture. Regular readers will be familiar with our overall level of bearishness (see here and here), but on an extended time horizon at Serenity we are VERY bullish on REITs. Here are a few of the reasons.
The revival of one of our favorite charts makes it clear that expected returns for REITs on a go-forward basis are historically elevated when REITs are this cheap. In a more normal environment, (the economy not headed into recession) REIT returns increase to +42% on average on a forward 1-year basis when REITs trade at discounts to NAV greater than -15% (this number is +29% when you include the 2008 recession). While our outlook that a recession is coming keeps us cautious, we are consistently on the lookout for positive data that would trigger a re-valuation higher in the REIT market. At valuations this attractive, positive data in REITs is likely to have an outsized positive impact. Unfortunately, there is not much positive data being reported. Overall, though, lower valuations are one of the first pre-requisites we need for a REIT bull market to begin.
Our next chart makes us even MORE bullish using a forward 5-year time horizon. This chart illustrates how strong REIT returns can be, historically, coming out of recessions. On average, following every recession since 1972, REITs return +16.9% annually FOR 5 YEARS. That is an incredible stretch of performance, and usually entails a few years of +30% returns. If the US economy does experience a recession (which we think is likely), it sets the stage for an extended REIT bull market the likes of which we have not seen since 2010-2015 (REITs were +119.8%, or +17% annually over that period).
Again, this is the Serenity team holding two seemingly conflicting thoughts at the same time. We are expecting a recession, which is likely to send REIT prices lower. But we are also long-term bullish. REITs by and large are well diversified, high-quality commercial real estate portfolios. Most of them are not going anywhere, regardless of a recession. Capital market turbulence is likely to give the patient and vigilant investor excellent entry points into many of these companies.
This is why we are fired up. A recession is likely to be painful, and the next 6-12 months could be extremely difficult. Challenging times, however, pass by like anything else, and on the other side there is very likely a REIT rainbow. If we can navigate the coming volatility prudently, REIT valuations have already laid the foundation for a sustainable future REIT bull market.
KEEP CALM: REIT fundamentals have NOT bottomed!
A valuation re-set is the first box to check on our list of REIT bull-market ingredients. Check. The charts above make it clear how powerful lower valuations are for long-term investors. Simply put, if you buy REITs cheap, historically you do very well.
So what’s the next item on the checklist? Fundamentals. We want to see them accelerating. That means occupancies headed higher, accelerating rent growth, and accelerating same-store revenue growth. So how are we doing?
Self-Storage and Apartment REITs tend to have the cleanest same store (SS) trends in the REIT universe and give us a clear view of REIT fundamental cycles. Self-storage REITs tend to lead Apartments slightly (due to somewhat shorter average lease duration), so we can start there. The chart below shows same-store revenue growth for the publicly traded self-storage REITS going back to 2006.
I’ve kept the chart above clear to allow the reader to draw their own conclusions. It shouldn’t take a red arrow to see the direction of the trend in year over year same-store revenue growth. It is clearly moderating rapidly. Over the past few quarters, revenue growth has fallen from +17.1% to +13.6% to +10.7% to +8.0% in the most recent quarter. With a long-term average of +5%, we have not even reverted to the mean yet with regards to SS revenue growth.
And there are no signs of this growth leveling off until (potentially) the 4th quarter of 2023. On their 1Q earnings call Extra Space Storage CEO Joe Margolis said the following.
“And we went from minus 11% in February all the way to minus 3% in March, and we did see that there was some weakness at that level and the systems brought things back and we're recovering”
In the quote above Margolis refers to pricing power in the EXR portfolio. Said another way, self-storage asking rents were -11% year over year in February, they tried to increase them to -3% YoY in March, and demand dried up, so they lowered them again. Not a ringing endorsement of a sound economy or fundamentals that are set to bottom imminently.
The story is similar for Apartment REITs. Using ApartmentList.com’s data, we track national Apartment asking rents monthly. The chart to the right shows how rent growth for multi-family assets has tracked over the past few years.
The story is similar to that of storage. Year over year rent growth peaked at +17.7% in November of 2021, and has since fallen to +1.5%. Is the next move a re-acceleration to +5% rent growth? That would be an abrupt reversal that has no real historical precedent. Again, maybe this time it’s different…but that is a dangerous phrase…particularly with a Federal Reserve that is still increasing interest rates!
This is why we continue to stress patience. The best time to buy Apartment and Self-storage REITs is when same-store growth is close to 0 or negative (see chart below). We are not there yet. Oh and did I mention 2023 will see the largest number of Apartment units delivered since the 1970s? Patience, patience, patience. Keep calm and keep the pencil sharp. There will be a day to load up on these names, and you better believe Serenity will be there ready to back up the truck.
THE ONCE A DECADE OPPORTUNITY – A recession with bulletproof balance sheets?
As a portfolio manager with nearly 100% of my net worth invested in his own fund, I find myself contemplating two distinct scenarios for the next 6-12 months. The first is the miraculous, and nearly unprecedented “soft landing.” This entails a reversal higher in economic growth, moderating inflation, and a complacent Fed. This would begin a leg higher in consumer and corporate spending, pushing GDP growth back to +3-5% from the current +1-2%.
This would be great for REITs. Rent growth would stabilize, credit spreads would contract, and REITs would likely do extremely well considering they trade at a LARGE discount to private real estate values AND to the broader stock market (REIT Earnings multiple = +13.6x vs +30.3x for the NASDAQ and +20.0x for the S&P 500).
In this scenario, there are huge opportunities to generate compelling returns on the long side, and Serenity has a quiver of ideas we are prepared to let loose. We can put this plan into action IMMEDIATELY if data improves.
The second scenario, while painful in the near term, has an even more favorable forward 5-year outlook. That is a US recession. We think this is the most likely scenario (for reasons well-articulated in the following video which is exceptionally well done – Shout out EPB Research).
A recession is likely to send REIT prices lower in the near term. Leasing would slow, occupancies would fall, some REIT tenants would go bankrupt, and a REIT or two could even go to $0 (looking at you MPW).
By and large, however, REITs would survive, and most likely exit the recession in better shape than they did in 2009. Remember from the bottom in 2009, REITs returned +29% annually for 5 years. That is a once in a decade style opportunity set. And in 2023 REIT balance sheets are FAR superior to REIT balance sheets in 2008/2009.
In either scenario, Serenity is poised to strike, waiting patiently for fundamentals to bottom so that we can get more bullish. It might happen tomorrow, it might happen in 6 or 12 months. The question for other REIT investors is… are you prepared for all these scenarios? Do you have a plan for navigating and profiting from a potential recession? Are you ready to deploy capital in cyclical REITs when fundamentals bottom?
Serenity is. We are calm. We are fired up.
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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