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  • Martin Kollmorgen


Updated: Sep 8, 2022

“I’ll tip my hat to the new constitution, take a bow for the new revolution.”

Won’t get fooled again, The Who

PERFORMANCE – Serenity Alternatives Fund I returned +8.2% in April net of fees and expenses versus the FTSE NAREIT REIT index at +8.1%. Year to date the fund has returned +22.7% versus the REIT index at +17.1%.

NEW BOSS SAME AS THE OLD BOSS? Investors are betting on an office apocalypse that echoes the retail apocalypse of 2016-2020.

A NEW CONSTITUTION: Will thematic investing dominate the next 5 years in the REIT market?

THE NEW REVOLUTION: Why the return of inflation could be the key development within the REIT market in this economic cycle.

The stock market has a long memory. Investors make mistakes, and the collective market intelligence is replete with investment theories that quickly or slowly turned sour, damaging investor bottom lines and inflicting emotional scars. Fool me once, shame on me, fool me twice, I won’t get fooled again. The widely discussed “retail apocalypse” of 2016-2020 fooled many investors. With Retail and Mall REITs consistently trading to juicy valuation levels relative to their history, many traditional investment frameworks deployed capital into what turned out to be value traps. As retail and mall landlords slowly saw rent growth deteriorate, turn negative, and then plummet during the pandemic of 2020, value-focused investors lost money, with many eventually throwing in the towel and capitulating completely. After years of this narrative dominating the industry, many REIT investors have sworn off retail altogether, while looking for the next impending secular “apocalypse.” At this point, valuations would suggest they have settled on Office REITs as the next property type set for secular decline. If Amazon killed the regional mall, then Zoom is set to kill the CBD office. Investors are committed to not being fooled again. But is this type of thematic investing that easy? How many investors made the rock-star “retail apocalypse” call in 2016? The answer is not many…so why are so many investors convinced that the next big “call” is such an obvious one? At Serenity, our quantitative REIT models are blissfully unaware of the prevailing REIT narrative. Built on cold, hard, historical data, they only care about triangulating REITs with a favorable combination of value, momentum, and quality characteristics. This generation of investing processes uses computing power to identify opportunities, not a weathervane to simply point the portfolio in one direction. Welcome to the new revolution; an investing framework free from emotional bias and baggage. Sounds pretty rock n roll to me.


Serenity Alternatives Fund I returned +8.2% in April net of fees and expenses versus the FTSE NAREIT REIT index at +8.1%. The fund has now returned +22.7% for the year, versus the REIT benchmark at +17.1%. Since our October 2020 newsletter titled “A Rare Opportunity: The 2021-2026 REIT Renaissance”, the fund has returned +47.9% net of fees. Since late 2018 the fund has returned 95.5%, or 33.3% on an annualized basis with a Sharpe ratio of +2.13. This month our returns since inception moved above 12% to 12.2% net of fees with less volatility and a lower net exposure than the benchmark. Performance was strong across the board in April, with Getty Realty (GTY) slightly edging out Switch (SWCH) for the largest contributor to the fund’s returns for the month. Both GTY and SWCH benefitted from falling 10-year yields in April, being two of the highest duration REITs in our portfolio. GTY is a net lease REIT that owns mostly convenience stores, gas stations, and car washes. GTY is the epitome of a steady, cash-flowing, business, collecting 98% of rents through the pandemic and continuing to slowly grow its dividend over the past year. While our portfolio will lean towards lower-duration property types over the next few years (see upcoming inflation discussion), diversification remains a priority, and we will continue to selectively take advantage of opportunities in higher-duration names. Months like April illustrate the importance of continuing to strike this balance.


There is no more applicable rock lyric to the state of Office REIT investing as “meet the new boss, same as the old boss” from The Who’s classic Won’t Get Fooled Again. REIT investors are treating Office REITs as if they are set to quickly traverse the well-worn path of the Retail REITs that stretched from 2016 until the pandemic of 2020. New theme, same as the old theme. For evidence of this outlook, we have to look no further than current Office REIT valuations relative to Retail REITs.

Excluding the Mall REITs, which are priced like the distressed assets they are, Retail REIT valuations are almost identical to those of Office REITs. Retail REITs even trade at a premium, based on EV/EBITDA and FFO multiple. Remember this is after 5-years of eroding NAV’s, falling FFO, and a global pandemic in which many retail REITs saw rent collection levels drop into the 80-90% range.

The most interesting metric here, however, is implied cap rate. “Cap Rates” are a common commercial real-estate valuation metric that indicates valuation for a given property or portfolio. Lower cap-rates equate to higher values, so a 5.0% cap rate asset is valued at a higher multiple than a 7.5% cap rate asset. Office REITs trading at an implied 7.5% cap rate indicates that REIT investors believe that Office REIT portfolios would trade for 7.5% cap rates in the private market.

There is little evidence, however, that private market values have fallen this far for office properties. Kilroy Realty (KRC) recently sold a high-quality office asset for a 4.25% cap rate, and Highwoods (HIW) recently bought a portfolio of office assets in secondary markets for a 6.5% cap rate. At 7.5% on an implied basis, investors are assuming that office values have to fall close to 25% in order for REIT valuations to be correct at current levels (assuming private market office values are ~6% cap rates).

This certainly could occur. As companies assess their space needs post-pandemic, it’s possible that office landlords struggle to retain occupancy and cap rates move higher. However, this is already clearly reflected in the share prices of Office REITs. Said another way, Office REIT investors are assuming this is going to happen with certainty.

What if in fact office demand only falls 10-15%, and the jobs market in the US recovers rapidly? Say 20-30% more rapidly than following the previous recession. Would office cap rates rise in that scenario? That answer is much less clear, but a favorable outcome is NOT being discussed by investors at this juncture.

Will certain Office REIT portfolios struggle over the next 3-5 years? Certainly. But with valuations currently baking in a retail-apocalypse type scenario for the space, the bar is not high for Office REITs to deliver better than expected results. We continue to carry exposure to multiple Office REITs which we believe represent deep value opportunities and have the chance to grow their earnings and cash flow as the economy recovers. With job growth accelerating along with capex plans, we believe office bears are going to have to swim against the current of an incredibly strong economic recovery.


Part of our skepticism around the “death of the office” narrative is philosophical, so allow us to wax poetic for a moment if you will. If we rewind the clock to 2010, when a certain bright-eyed and bushy-tailed REIT analyst was hired onto a team managing over $7B in US REIT assets, there were certain orthodoxies in the REIT world. A few things investors took for granted back then. 1) Warehouse rents never grow. Warehouse is a commodity product, and as soon as rents start to grow development picks up and squashes the potential for rent growth. So never bank on warehouse rent growth, it never happens. 2) Mall REITs are “special”. For some reason Malls consistently outperform. NOI growth is always strong, rent spreads are consistently high, and occupancies stay in the 90’s almost no matter what. Bet against them at your own risk, Mall REITs almost never under-perform. 3) Self-Storage is a 7% cap rate asset class. While Self-Storage has experienced periods of rapid NOI growth, it is also a commodity property type, and will never sustain the 2.5%-3.0% full-cycle NOI growth necessary to trade in line with Apartment REITs. Storage REITs < Apartment REITs. Reading those bullet points 11 years later is laughable. Warehouse rents have grown massively over the last 5 years, malls have been the worst-performing property type in the REIT universe, and the Self-Storage REITs trade closer to 5% cap rates than 7% cap rates. These heuristic rules, however, were completely consensus opinions in 2010 and were based on real data and experience. If you would have pitched the idea to go long Warehouse and Self-Storage REITs while shorting Malls, you would have been laughed at or fired. It’s important to remember these moments because many investors still fall into the trap of “thematic” investing (Office is dead). They take the state of the world as they know it and extrapolate that world into the future. If the world changes, their narratives tend to break down, and few investors are mentally flexible enough to immediately move on and adapt to their new reality. When we designed Serenity, it was important for our process to understand but also escape the echo chamber of REIT orthodoxy. Building a quantitative model rooted in data and long-established investing principles was of paramount importance. Our model has no conception of what the hot gossip topic is in REIT circles. It is un-emotional, precise, yet flexible. It changes as data changes, both in REIT fundamentals and REIT share prices. It can ride the wave of warehouse rent growth without ever acknowledging the existence of Amazon, or similarly punt on the retail sector as NAV momentum falls into the model’s lower quintiles. The existential question then is “how would you design a REIT selection process?” Would you use a computer or a weathervane? We’ve made our choice.


One of the dangers of thematic investing is that changes in economic paradigms tend to blow “themes” to smithereens. One macro trend which has driven a huge amount of capital deployment and spawned innumerate investing themes over the last 10 years is the often-discussed trope of “lower for longer.”

The chart above makes it blazingly obvious why “lower for longer” has made it into the investing lexicon. For the last 40 years, interest rates have moved steadily lower, pushing down investors’ cost of capital and exerting a huge influence on capital allocation decisions.

Net Lease REITs, Healthcare REITs, and other high duration property sectors have benefitted hugely from ever lower interest rates. Lower quality real estate portfolios with higher leverage have escaped their traditional fate of distress or bankruptcy due to an accommodative fed and an abundance of capital. Investors have paid ever increasing premiums for sales and earnings growth as earnings growth has become scarcer. And through this entire period, new philosophies and behaviors have been codified into investors mindsets.

But what happens if the next 40 years are not the same as the last 40? Or what if the next five are markedly different than the last five? What if the boogeyman actually rears its ugly head?

The boogeyman in this case would be inflation. That long dead economic phenomenon, which is unequivocally bad for bonds, has a mixed effect on real estate, and would certainly be harmful to investors that have leaned heavily into the lower for longer playbook over the last 5-10 years.

Inflation has been mostly absent for decades for a variety of reasons, but there are signs that this may be set to change. The charts below show new developments in data sets that are key inflation drivers and are worth noting.

The chart above shows unit labor costs going back to the 1950’s. Unit labor costs are a key inflation driver and have begun to move higher at a more rapid rate than at any time since the late 1960s. It’s no coincidence that the last time this series moved sustainably higher; inflation was much higher. With unit labor costs barely budging during the recession, minimum wage laws gaining popularity, and inequality a key concern for millennials, it’s hard to imagine a world in which unit labor costs do not continue to rise.

The second chart of note shows the growth in the M2 Money stock, a proxy for the growth in the money supply. As Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon.” In the wake of the great financial crisis (2009-2010) many economists were worried about inflation due to the rapid expansion of the feds balance sheet and the money supply. The growth in M2 of 10% during that period looks like chump change in comparison to what the Federal Reserve and US Treasury have unleashed during the pandemic induced recession of 2020. While inflation did not materialize in the wake of the GFC, with a policy response that is literally 3 orders of magnitude larger during the current crisis, it would stand to reason that it is more likely to occur in this new economic cycle.

The final chart of note displays the population pig moving through the python that is known as the millennial generation. While the aging of the baby boomers gets quite a bit of play in the general media, I find the emergence of millennials to get much less attention, unless it is someone complaining about how poor our work ethic is. Wow writing that paragraph was exhausting I think I’ll take the rest of the day off. Joking… Love us or hate us, there are 82.2 million millennials, the majority of which are currently 29 or 30 years old. As an elder member of this generation, I am experiencing firsthand what this could mean for the economy as we start to reach our peak spending years. Think about this scenario. I graduated from college in 2008, into the worst financial crisis and job market in 100 years. I am now 35, have a wife, first house, and first child on the way. My early earning years came amongst the slowest economic recovery in recorded US history, and after 10+ years of work, my friends and I are ready to spend some of the hard-earned money we have. There are 82 million of us, and we haven’t even started buying second houses, boats, or taking our kids to the mall yet. Imagine what might happen when 82 million millennials have 82 million children under the age of 10. We might need to re-think closing all these malls. The point of this entire inflation discussion is to think radically about how the world could change over the next 5,10 or even 20 years. While it’s impossible to predict what WILL happen, we can prepare for what CAN happen. If unit labor costs keep rising and millennials start spending the stimulus dollars that have been injected into the system, inflation could be much higher than expected over the next five years. In this scenario investment managers without an inflation accelerating playbook could find themselves in a world of hurt. If we know anything from history, it’s that the new cycle we are in is likely to look vastly different from the one we just exited. Having a process that can navigate changing economic conditions is extremely important.


One thematic observation that few can argue with is that the world looks much different today than it did only 12 months ago. We have traversed a global pandemic, uncorked an unprecedented amount of fiscal and monetary stimulus, and we are on the verge of a major generational transition that will have wide-ranging effects. While the lessons of 2016-2020 should not be forgotten, that era is gone, and the playbook that has been effective for five years may not work well over the next five. At Serenity, our process is built to adapt with the capital markets. Rooted in a coldly rational quantitative REIT model, we will continue to allocate capital to real estate companies that can grow their cash flows, trade at discounts to peers, and have high-quality portfolios and balance sheets. These companies will shape the investing narrative going forward, allowing us to look to the road ahead instead of in the rearview mirror. This is my generation, baby,

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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