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  • Writer's pictureMartin Kollmorgen

MAY 2023 - REITs: Data Centers to the Rescue?

"Accept the challenges so that you can feel the exhilaration of victory" - George S. Patton

  • PERFORMANCE: Serenity Alternative Investments Fund I returned -1.27% in May, while REITs returned -3.06%.

  • AI AND THE DATA-CENTER BOOM: Data Center REITs posted accelerating same-store growth in Q1. This was BEFORE the recent AI frenzy…

  • NAREIT CONFERENCE TAKE-AWAYS: Notes from the front-line of the industry flagship REIT conference in NYC.

  • REITS VS STOCKS: REITs are increasingly cheap on a relative basis when compared to the S&P 500 and Nasdaq 100.

This is a challenging REIT market.

Growth is slowing across almost every REIT property type.

Debt re-financing will pressure earnings for quarters or years to come.

Commercial real estate asset prices continue to fall.

And the Fed is committed to higher interest rates.

Making money in commercial real estate is not easy when financing is expensive and growth is low.

And yet with REITs there are almost always pockets of opportunity.

Data Center REITs, which under-performed peers from 2016-2020, may be staging an epic comeback.

As the physical storage space of the digital infrastructure that makes our modern digital age possible, the Data Center REITs offer CRE investors a coveted opportunity. A property type with secular growth tailwinds, a low correlation to traditional property sectors, and unique economies of scale that work in favor of the Data Center REITs global portfolios.

In the first quarter of 2023, Data Center REITs were the black sheep of the REIT industry, posting ACCELERATING same-store revenue growth. And this was BEFORE the AI mania that gripped the market in Q2.

With most commercial real estate portfolios facing a moderation in growth towards pre-pandemic levels, accelerating pricing power driven by less competition from private equity has brought Data Center REITs back into the spotlight.

Could Data Centers ride to the rescue of investor portfolios in the second half of 2023?

PERFORMANCE: -1.27% in May vs REITs -3.06%

Serenity Alternative Investments Fund I returned -1.27% in May net of fees and expenses versus the MSCI US REIT Index which returned -3.06%. So far in 2023, Serenity Alternatives Fund I has returned +0.52% vs the REIT benchmark at +0.4%. On a trailing 3-year basis, Serenity Alts Fund I has returned +16.5% annually net of fees versus the REIT index at +8.2%. Over the past 5 years Serenity Alternatives Fund I has returned +12.3% annually net of fees and expenses, versus +4.5% for the REIT index.

We are going to change it up a bit this month and examine the funds’ largest winners and losers for the year-to-date period. To put it bluntly, at Serenity we are not satisfied with benchmark level returns in our portfolio, and the last few months’ performance has been frustrating for our investing team. Let’s take a step back and examine what has worked and what has not so far in 2023.

The biggest winner in the Serenity portfolio so far this year has been Life-storage (LSI), returning +25%. Life-storage is being acquired by peer Extra-Space Storage (EXR), a deal which was announced on April 3rd, following a previous February bid from Public Storage (PSA).

LSI is an example of the Serenity process working as designed. As a quick recap of how our process works, we begin with our proprietary quantitative REIT ranking model, then perform in depth fundamental research on highly ranked names. We then conclude by determining how a company typically performs in the given macro landscape. Companies that check multiple boxes (well ranked in the quant model, attractive fundamentals, right macro environment) are likely to make it into our portfolio on the long side. The same holds for constructing our short book (only in reverse).

LSI was a highly ranked REIT within our quant model in early 2023. First box, check. As a company I have personally covered for over 10 years, the fundamental story of LSI was well known to the Serenity team. With a large value-add portfolio, attractive valuation relative to peers, and growth that was decelerating more slowly than other self-storage REITs, LSI scored about a 7/10 on fundamentals. So far so good. The final step was the macro screen. In a decelerating growth regime, our portfolio looks to avoid small cap, high beta, highly leveraged REITs, none of which describe LSI. So good on the macro side.

That’s 2.7 out of 3 boxes checked for those keeping score, thus, LSI made it into the Serenity long book early in 2023. As it happens, LSI’s peers seemed to agree with our assessment, starting a small bidding war for the company that will culminate in EXR buying the company for a significant premium to our cost basis in the stock. This is our process creating value in real time.

Other winners in the Serenity portfolio in 2023 look similar. IRM, EQIX, and GLPI have all been excellent performers that screen well in the Serenity multi-factor model, have strong underlying fundamentals, and work well in a growth decelerating macro-environment.

On the other side of the book, Crown Castle (CCI), an owner of cell towers, has been the largest detractor from Serenity’s returns year to date in 2023, returning -16.5% while in the Serenity portfolio. We have written about CCI on numerous occasions extolling the virtues of a counter-cyclical portfolio with strong free-cash flow trading at a very attractive valuation relative to history. On the surface, CCI still has a great story, and is a long position that should generate attractive total returns over a 3-5 year time horizon.

The mistake we have made with CCI this year arose from a slight departure from our core process. This is where most of our investing “mistakes” happen. Allow me to explain.

While CCI has an attractive valuation story, a strong long-term outlook, and favorable macro characteristics (large cap, fortress balance sheet, counter-cyclical cash flows), the company has not been able to crack the top ranks of our multi-factor model at any time in 2023. Additionally, while sporting very predictable organic growth historically, in Q1 of 2023, CCI posted the lowest organic growth in 8 years, a clear deceleration from 2022. Taking an objective hindsight view, CCI has never checked more than 1.5 of the 3 key boxes in the Serenity process. Poorly ranked in our quant model, only about a 5/10 on the fundamentals score, but a strong macro profile. That’s 1.5 out of 3, which is enough to merit a weight on the long side but not make the company a top position in the fund.

With CCI we made the classic mistake of becoming a bit too enamored with a story, while not verifying that the hard data supported our decision as determined by our quant model and the direction of fundamentals. The company’s weight in our portfolio was too high and has been adjusted lower in recent weeks. We are still confident in CCI as a long-term investment, but until it ranks more highly in the model or fundamentals re-accelerate, it will remain an average weight in our long book, as opposed to a top weight.

DATA CENTER DIVERGENCE: A Pre-AI Same-Store Inflection

While CCI has languished due to growth headwinds along with much of the REIT industry, a once popular and still polarizing property type has quietly bucked the growth slowing trend in recent quarters. With private equity capital moving rapidly to the sidelines in 2022, Data Center REITs have begun to show signs of pricing power that has been mostly absent in the industry for the better part of 8 years.

The chart below from CBRE shows very clearly how rents have trended over the last 10 years for Data Centers. Lower from 2014 to 2021, then sharply higher in 2022.

To add a bit of context, private equity investment in the Data Center industry ramped up right around the 2015-2016 time frame. Private competitors to the publicly traded Data Center companies took advantage of a simple concept; they could accept lower pricing versus public REITs to win Data Center mandates. This gave them lower yields, but by adding higher leverage still allowed them to deliver double digit levered returns for their investors. Said another way, investors learned how lucrative Data Center development was, and money flooded into the space, lowering returns and eroding pricing power.

Fast forward to 2022, and the fastest Fed hiking campaign in recorded history has re-ordered the decks in terms of capital availability for the industry. Private equity capital has rapidly dried up, slowing development as continued demand has absorbed available supply. This leaves the Data Center REITs as one of the last remaining options for both available space and available capital in a still rapidly growing property sector. How do we know this? Let’s examine the same-store portfolios for the two largest remaining Data Center REITs over the past few years.

There is an outlier observation in each of these charts and it occurs concurrently in both. That is Q1 2023. Both Equinix (EQIX) and Digital Realty (DLR) saw growth in same-store revenue and NOI spike in the first quarter of this year. This follows (in the case of Digital) years of negative SS NOI growth.

Was Q1 just a fluky quarter? The rent data from CBRE does not suggest it was. In my opinion this looks more like a near term return to pricing power that could be quarters or years long. And keep in mind, these results were achieved BEFORE the AI mania that gripped markets in Q2.

Many investors (myself included) are skeptical regarding AI’s ability to revolutionize the modern world. One undeniable ramification of the technology, however, is continued (or elevated) spend in technology infrastructure. All those Nvidia GPU’s need power and cooling, and the most economical way to provide both is in a Data Center. With both DLR and EQIX suddenly back in pole position within the industry (especially with regards to latency sensitive requirements for EQIX), the Data Center REITs may find themselves in the rare position of ACCELERATING growth into a recession.

From the perspective of Serenity, this adds to our conviction in top portfolio weight Equinix (EQIX), and has us taking a long hard look at value-play DLR. If these companies continue to capture renewed pricing power, our investors could be set to benefit meaningfully over the next few years.

NAREIT: Walking the halls of the industry’s largest conference…

In early June of each year the REIT industry converges on New York City for one of the largest commercial real estate conferences in the country (that you have probably never heard of). The majority of the REIT industry can be found walking the halls of the New York Hilton Midtown for a span of 3-4 days. This means REIT management teams, REIT investors of all shapes and sizes, REIT research analysts, and REIT investment bankers all mixing it up, exchanging industry scuttlebutt, having a few cocktails, and sometimes sowing the seeds for industry shaping events that will happen down the road.

I’ve attended REIT week now every year since 2010, and it remains one of my favorite work-related events of the year. There is no better place to gather information from every corner of the REIT universe in such a concentrated amount of time.

Below are my high-level impressions from this year’s conference, with some eventual bloviation (I can’t help myself).

  1. The recession is NOT upon us…yet. The vast majority of REIT management teams describe the 2023 growth slow-down as a return to pre-pandemic norms, as opposed to the path towards recession.

  2. Office companies are surprisingly upbeat. Based on the headlines you would expect doom and gloom from Office REIT CEO’s. Cousins (CUZ) in particular struck a decidedly positive tone.

  3. REIT investors are frustrated, and much less optimistic than management teams. Lack of compelling opportunities could lead to narrow, exaggerated moves in individual REITs.

  4. The industry is changing. Younger, more aggressive REIT management teams are actively taking mind share, and often market share from older, more conservative REITs.

Let’s do a simple agree/disagree breakdown of these four points with Serenity’s rationale for each.

  1. Agree for now, disagree over the next 6 months. While the recessionary conditions that necessitate job cuts, rent reductions, and overall pessimism from REIT management teams are not here YET, leading indicators continue to suggest that they are on the way. As we’ve written in the past…don’t sit on the tracks arguing that you will be safe because the train has not arrived yet. Jobless claims have recently inflected higher, and the New York Federal Reserve puts the chances of a recession at 70.85%.

  2. Agree on a relative basis. While I’m not optimistic on cash flow growth over the next 5 years for the Office REITs, sentiment seems too bearish to me. Office REITs tend to own premium Office assets, leasing is still occurring (so cash flows are not falling off a cliff), and sales for high-quality assets are still progressing (see HIW’s recent sale at $345/foot while the stock trades at $198/foot). Select names here could be an absolute bargain within the next 12 months.

  3. Disagree. As a long/short hedge fund opportunities in my opinion remain robust. Is it easier to make $$ when the entire REIT universe goes up? Sure. But I like having opportunities on the bear (short) side as well…

  4. Agree. This is more of a personal observation but it is backed by some objective facts. On my first night at the conference I had dinner with one of the largest Healthcare REITs. The overwhelming take-away for me was that they are commitment to adding value as a management team (one of the youngest in the industry), as opposed to simply collecting a paycheck. Their messaging and execution are clearly being rewarded by the market and should serve as a template for REIT boards everywhere.

To summarize, REIT management teams remain optimistic, which is the case pretty much 95% of the time, so not much incremental information there. Investors are much more pessimistic, but the vast majority of them cannot short REITs. Serenity has an active short book, so we remain bullish on the opportunity set. And lastly, the gulf between management teams that add value over time and those that destroy it seems to be widening. At Serenity we have the tools to distinguish the former from the latter. Ping us for a more in-depth discussion of how we are taking advantage of this divergence.

REITS VS STOCKS – Speaking of widening divergences…

MEET THE CHALLENGE – This market is not for everybody!

We designed Serenity from day one to have a go anywhere process within REITs, which stands in stark contrast to most REIT investment firms. Our ability to short REITs opens a significant set of opportunities in both the short and long term.

Short term, we can hedge cyclical risks from the portfolio as economic data continues to decelerate and the odds of recession increase.

Long term we can pair REITs that destroy value on the short side against REITs that add value on the long side. These trades can create huge alpha for investors over time, and the opportunity set here is only growing with the emergence of young, aggressive REIT management C-Suites.

Lastly, we can concentrate the portfolio in emerging opportunities that may be bucking industry trends (Data Centers), while waiting patiently for blue-chip cash compounders to return to form (Cell Towers).

While the market remains challenging, we remain optimistic. Our optimism is founded on process, and our process is built on years of research and execution.

Serenity continues to prepare for victory…

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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