“I HAVE THE POWER!!!" – He-Man
PERFORMANCE: Serenity Alternative Investments Fund I returned +6.08% net of fees in July vs the REIT index at +6.26%. In 2024, the fund has returned +9.75% vs +6.01% for REITs.
DISTRESSED CRE: REITs are actively scooping up distressed CRE assets, and higher REIT prices open the door for accelerated acquisition pipelines.
RED FLAGS: Is fading leisure demand in the Lodging REITs cause for concern?
TOWER DEFENSE: Why Cell-tower defense could be uniquely powerful in 2024.
For most of 2022 and 2023 REITs did not garner any positive attention.
With interest rates rising and growth slowing, the sector was wimpy and unassuming.
But in July of 2024 something abruptly changed.
Lightning flashed, magic sparked, and REITs powered up overnight.
Are REITs now the most powerful asset class in the universe?
While there remain some reasons for caution, key REIT attributes are coming into focus during the summer of 2024.
REITs have attractive valuations and stable cash flows, a perfect defensive combination.
Fundamental headwinds are fading and will turn into tailwinds in 2025 and 2026.
Investors are heavily underweight REITs, making the sector a beneficiary of sector rotation.
REITs are not a flashy asset class. They make investors rich slowly, over a long-time horizon, steadily compounding capital while rarely experiencing negative cash flow growth. On occasion, however, the sector flexes its proverbial muscle, reminding investors who the top dogs in CRE truly are.
REITs powered higher in July, and this story may be just beginning. Certain REITs are snapping up distressed real estate before it even hits the market. All REITs become more acquisitive when their stock prices increase, beginning a positive feedback loop of buying assets and increasing NAVs. And while increasing unemployment is a danger, REIT balance sheets are in incredible shape, ensuring a 2008 style correction is highly unlikely.
2022 and 2023 are behind us. In 2024 REITs have the power.
PERFORMANCE: +6.08% in July +9.75% YTD
Serenity Alternative Investments Fund I returned +6.08% in July net of fees and expenses versus the MSCI US REIT Index which returned +6.26%. Year to date Serenity Alts Fund I has returned +9.75% vs the REIT index at +6.01%. On a trailing 3-year basis, Serenity Alts Fund I has returned +4.8% annually net of fees versus the REIT index at +0.7%. Over the past 5 years Serenity Alternatives Fund I has returned +13.1% annually net of fees and expenses, versus +4.9% for the REIT index.
One of the most profitable positions in the fund in July was Newmark Group (NMRK), a long position which returned +27% for the month. Newmark is a commercial real estate services company whose business is highly correlated with transaction activity in the CRE market. 2023 was one of the worst years ever for CRE transaction volume, and NMRK and peers CBRE and JLL suffered accordingly. 2024, however, has seen a steady increase in activity as capital markets are more open, bid ask spreads have narrowed, and commercial real estate debt has increasingly come due. NMRK is ranked highly in the serenity CORE model, has accelerating fundamentals and a well-respected management team. A smaller position in the fund due to its volatility, we think NMRK has excellent potential over the next few years if the real estate capital markets continue to normalize.
The least profitable position for the fund in July was American Assets Trust (AAT), a short position which returned +18.5%. AAT falls into the diversified bucket of the REIT universe, owning a combination of Mixed-use, Office, and Retail assets. While AAT ranks in the bottom decile of our CORE model and has deteriorating earnings, in July the name posted positive returns. It’s not clear exactly why AAT was able to outperform the REIT index during the month and has since given back some of its June gains. AAT remains a poorly ranked name in our model, with uninspiring fundamentals. We remain short.
DISTRESS! Let the REITs do the work…
One of most discussed topics in commercial real estate continues to be CRE distress. Investors hear this term and instinctively lick their lips. Buying distressed assets is a well-known avenue for generating incredible returns. Unfortunately, it is also incredibly difficult. As I have written in the past, there is no distress in property types that most investors are currently targeting. Warehouse? No distress. Data Centers? No distress. Multi-family…some distress but also…a line around the block to buy distressed assets.
In Office assets distress abounds. Mostly because very few investors have appetite for Office.
Interesting how this works isn’t it?
This leaves investors that are looking to take advantage of CRE distress with a few options.
Comb through assets one by one, searching for one-off opportunities to pick up high-quality assets at distressed prices…or
Let the REITs, who have decades of experience and world class operating platforms, do it for you.
Below is a comment by Shankh Mitra, CEO of Welltower (WELL), the largest Senior Housing portfolio in the country.
“You can see Nikhil said we acquired 7,000 units to 82 different communities and we made 82 different deliberate decisions…I will tell you that we see a lot of motivated counterparties who have -- who want us to help them solve their debt problem, and we're happy to do so.”
Welltower is an excellent example of a REIT with a favorable cost of capital (stock price), that is hoovering up assets on the acquisitions market, propelling the company to near industry leading growth in 2024 and beyond.
Within Seniors Housing (SHOP for short, a sub-property type within healthcare commercial real estate), Welltower has significant scale advantages relative to one-off buyers of SHOP assets. They have a fully integrated operating platform, a national portfolio, and access to the public equity and debt markets that is nearly impossible to replicate.
Let’s look at a simple example to illustrate why this is powerful. Say for instance you have $3 million and would like to buy a Senior Housing property. You find a seller who has debt issues and is willing to sell an asset. Using your local or national banking relationship, you can borrow at +6.5% up to +70% LTV. Therefore your $3m in equity gives you $10m in purchasing power. Let’s also assume you need a cap rate +100bps higher than your debt cost to acquire the asset with confidence, therefore you are willing to buy the asset at a +7.5% cap rate, but it will likely take you 60-90 days to close, and the deal is contingent on your financing coming through.
Welltower, in the meantime, can raise debt OR equity at significantly cheaper rates (between +4% and +5%), can pay all cash (they have $3 billion in cash on their balance sheet), can close in 30 days, and likely has other assets in the same market. This means that they can beat most individual investors on price (pay for instance a +7.0% - 7.4% cap rate), time and certainty of closing (a big deal for distressed sellers), operating efficiency, and market knowledge.
That combination is hard to compete with.
For this reason, amongst many others, Welltower is a significant weight in the Serenity portfolio. Many investors don’t have the time, inclination, cost of capital, or knowledge to sift through individual Senior Housing assets looking for good deals. Welltower does, however, and Serenity clients will benefit.
This mental framework extends across the property spectrum as well.
Take the comments below from Angela Aman, CEO of Kilroy Realty (KRC), one of the top Office portfolios in the country.
“You haven't seen that kind of distress really hit the market yet… you might find us in a situation over the next couple of years where with construction loans coming due or something like that, there's some high-quality assets we could potentially look at from an acquisition standpoint, that would be sort of facilitated by something going on in the capital structure”
What Angela is saying here is that Kilroy is actively looking for distressed acquisition opportunities in Office, but not quite finding them. Kilroy is another example of a property sector expert that most investors could never compete with from a knowledge or cost of capital standpoint.
But we can own the stock and reap the benefits of Kilroy’s scale and expertise (we currently do NOT own KRC but it’s on our watchlist).
The bottom line here is this: the acquisitions expertise and buying power of the publicly traded REITs should not be taken lightly. In an environment in which capital is abundant (2020-2021), this advantage can be easily overlooked. In an environment in which capital is scarce, however (2024), REITs often become the only game in town. While many CRE owners continue to triage their existing portfolios and balance sheets, REITs are on the move, firing up an acquisitions pipeline that may be in its early innings.
RED FLAGS: Lodging REITs guide lower…
While Serenity is broadly optimistic regarding the outlook for REITs, some property specific red flags have emerged over the past month or so that are worth discussing.
Lodging REITs in particular had a rough earnings season in Q2. On average, Lodging REITs reduced RevPAR guidance by ~1.5% for 2024, with reductions happening across the board. Leisure demand was the unanimous culprit, as travelers have become increasingly price sensitive as 2024 has progressed.
This is concerning because Lodging is the most hyper-cyclical property type within REITs. The industry often acts as a leading indicator for other property types, as Lodging “leases” are marked to market basically every day. Said another way, changes in economic growth patterns tend to show up in Lodging portfolios first.
Per Jon Bortz of Pebblebrook (PEB).
“The Fed continues to keep its foot on the brake, and it's clearly showing up in weakening employment growth, increasing unemployment, slowing consumer spending, increasingly restrictive interest rates, and a more cost-conscious consumer.
As a result, we're a little more cautious about RevPAR growth for the second half of this year, particularly ADR growth. As Ray indicated, business travel continues to recover, both group and transient. Leisure demand remains healthy and we certainly saw substantial increases in our portfolio, but leisure demand across the industry remained generally flat.”
Similar sentiments were echoed on other Lodging REIT earnings calls, sending the property sector down -0.5% for the month (with REITs +6.3%).
Apartment REITs also voiced some words of caution in Q2, with recent positive trends leveling off in June in various Apartment portfolios. While some of this may be seasonal (Apartment rents tend to peak in the summer), this is the first time in about 6 months that trends did not uniformly move in a positive direction. Add to this the uptick in unemployment reported in early July (+4.3% from +4.1%), and the outlook for cyclical REITs has darkened slightly over the past month.
Regular readers will be familiar with the fact that Serenity is bullish on cyclical REITs looking out over the next 3-5 years. Simply put, supply pressures begin to ebb meaningfully in 2025, which should act as a significant tailwind for cyclical REIT fundamentals (see chart below). Recent data points, however, could point to a delay in the arrival of a true cyclical REIT bull market. If unemployment continues to rise, and consumers tighten the purse strings further, Apartment and Lodging REITs are certain to feel the effects.
For these reasons Serenity has lightened our cyclical exposure in the portfolio and shifted into safer REITs within these property types. Reducing beta in this type of environment seems prudent, as we continue to monitor the evolution of cyclical REIT demand and watch the data like a hawk.
TOWER DEFENSE: AMT is powering up…
In the non-cyclical portion of the REIT universe, things continue to improve, and investor appetite is showing signs of returning.
American Tower (AMT) is one of the funds favorite defensive positions, and has quietly begun to outperform the REIT index over the past 3 months (+29% vs +14% for REITs since April 30th).
We continue to write about American Tower because of its long history as a cash-flow compounding real estate company and its central role within the nervous system of the digital economy. Growth in mobile data usage translates directly into rent growth for AMT over long periods of time and has led to one of the most attractive total return profiles in the REIT industry. Over the past 15 years, AMT has delivered +15.6% annual returns, versus +10.3% for the REIT index.
To put it bluntly, American Tower is part of a borderline oligopoly in the cell-tower industry. AMT, CCI, and SBAC own a large portion of the US cell-tower market, and cell carriers must go through them in order to service their customers. This means the more mobile data that flows through your cell phone, the more rent AMT is eventually able to charge AT&T, Verizon, etc to deliver that data.
AMT also owns a high-quality data center portfolio that was formerly a publicly traded REIT (CoreSite). While AMT’s core business has slowed over the past few years, CoreSite has begun to pick up the slack, with revenue growth hitting +12.6% in Q2 on the back of +8.5% MRR growth and +3.6% growth in leased megawatts. This DC exposure is an excellent way for AMT to deploy the hordes of cash the company generates on an annual basis (+$1.6 billion AFTER dividends in 2023).
Bottom Line: AMT has incredibly steady growth, a recession resistant business, and a world class balance sheet. The company generates a huge amount of cash flow and re-invests it accretively, allowing it to compound NAV growth rapidly over time. Investors are beginning to wake up in 2024 after AMT’s valuation hit nearly 10-year lows in 2023. Serenity remains long AMT.
BY THE POWER OF GREYSKULL!
All REIT investors eventually come to terms with the fact that REITs will never be a sexy asset class. REITs don’t build world-changing products, they don’t grow earning at +30% per year for years on end, and they will never be large components of the S&P 500.
They do, however, deliver extremely steady growth born from some of the best physical assets on the planet. REITs are not get-rich-quick tickets, but they are long-term wealth creators. And in certain circumstances, REITs are exactly what the doctor ordered.
July was exactly one of those months. When the market craves true cash flow certainty, REITs suddenly start to look like He-Man. Do not ignore the get rich slowly strategy, sometimes it’s the most powerful force in the universe.
REITS HAVE THE POWER!
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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