“Tomorrow does not exist. There is only now.” – James Clavell, Shōgun
PERFORMANCE: Serenity Alternative Investments Fund I returned +0.71% net of fees in January vs the REIT index at -4.14%.
TIME TO STRIKE: Why Serenity is buying REITs in early 2024.
THE SERENITY CODE: By popular demand…a written review of the Serenity process. A walk-through of how we are building the 2024 Serenity portfolio.
RISKS: What threatens our rosier outlook? Construction slowdowns often precipitate recession…
In investing there are times to be patient. There are times for preparation. There are times to leave the market to its own devices and let it drift in your direction.
And there are times to strike.
The defining characteristic of the fictional 17th century Samurai warlord Toranaga was timing. He never lost a battle, exhibiting seemingly limitless patience up until the crucial moment…and then striking with the precision of a master tactician.
After 24 months of patience, the REIT landscape has finally shifted in Serenity’s favor.
Interest rates have stabilized, growth has re-set along with investor expectations, and confidence is returning to the real estate capital markets.
These are the facts that investors need to embrace today. While they may change in the future, Serenity is focused on trading the market as it exists now, not the market we hope for tomorrow.
This month we deliver a much-requested written walk-through of the Serenity process. We will cover how we go from data to decision in REITs, and what that looks like in the current portfolio. We also outline some of the risks associated with our current outlook, and how we plan to mitigate them if they arise.
Battle lines have been drawn, and the time for silent maneuvering is over.
It is time to strike.
*If you have not read Shogun, do yourself a favor and order it from Amazon.
PERFORMANCE: +0.71% in January vs REITS -4.14%
Serenity Alternative Investments Fund I returned +0.71% in January net of fees and expenses versus the MSCI US REIT Index which returned -4.14%. On a trailing 3-year basis, Serenity Alts Fund I has returned +10.0% annually net of fees versus the REIT index at +5.5%. Over the past 5 years Serenity Alternatives Fund I has returned +13.0% annually net of fees and expenses, versus +4.2% for the REIT index.
Our more observant newsletter readers may have noticed that our December monthly newsletter was conspicuously absent this year. For this I must apologize. Between travel, our “2024 Outlook” webinar (click here to watch), and an otherwise extremely busy start to the year, our December newsletter was indefinitely tabled, and eventually morphed into the mid-quarter update you are currently reading.
The fund closed 2023 down -1.0% for the year, versus the REIT index at +13.7%. 2023 was the first year the fund has under-performed the REIT index since 2018. While I am not happy or satisfied with our 2023 results, most of our underperformance occurred in the last two months of the year as REITs rallied on the back of unexpected Fed dovishness. While it can be frustrating to miss REIT rallies, the whims of the interest rate market are impossible to predict, and occasionally the broader macro environment imposes its will on the portfolio whether we like it or not.
In the long-run, harnessing short term interest rate driven REIT rallies is not Serenity’s goal. We are investing to harness the cash compounding power of REITs over the full cycle, which usually spans years as opposed to months. We want to invest as REIT growth accelerates sustainably, which is much more predictable than 100 basis point moves in the 10-year treasury. Going forward, we are focused on getting the growth trajectory of the REIT market correct, and that picture is improving, which is why we are getting more bullish. This pillar of our philosophy has served us well over the last 5 years, and despite missing the Q4 REIT rally, the fund still leads the REIT index by a wide margin on a trailing 3-year and 5-year basis.
The best performing position in the fund in January was Medical Properties Trust (MPW), a short position which returned -37%. As Hemingway said… “How did you go bankrupt? Two ways. Gradually, then suddenly.” MPW has gradually, and now suddenly watched their largest tenant (which comprises over +20% of revenues) head towards bankruptcy, announcing in January that they are no longer paying MPW rent. It’s hard to overstate how rare it is for a REIT to have a 20% tenant go bankrupt. Even the now bankrupt B-mall REITs never had tenant struggles this acute. We have shorted MPW from $18 (it trades at $3.56) and see the probability of the equity going to $0 as now very high.
The worst performing position in the fund this month was Kilroy Realty (KRC), a long position that returned -10% in January. Kilroy fell along with other Office REITs in January but remains the highest ranked Office REIT in the Serenity model. With very little debt maturing, manageable lease expirations, and a new CEO that Serenity knows well (congrats to Angela!), Kilroy is one of the better equipped Office REITs to navigate the currently challenging office environment. Serenity continues to hedge much of the fund’s Office REIT exposure using the short book but has an eye towards a potentially improving office leasing market in 2024.
TIME TO STRIKE: Fading REIT headwinds and emerging green shoots
2022 and 2023 were two of the most difficult years in REITs since 2007/2008. Benchmark interest rates rose more than +4% over an incredibly short period… something markets have not seen since the inflation crisis of the early 1980s. At the same time growth moderated rapidly for many REIT property types following the monetary and fiscal excesses of 2021. Slowing growth and rising interest rates are not a good combo for REITs.
Against this backdrop, the early months of 2024 have seemed like a breath of fresh air. The Federal Reserve is openly discussing interest rate cuts, credit spreads have contracted, and growth may be finding a bottom for many REIT property types. Investor expectations have also been re-set much lower after 2 years of deteriorating REIT fundamentals. In Serenity’s eyes, this market looks much more like a baby bull than a sleeping bear.
As a visual illustration of why our confidence is increasing, we reference one of our favorite monthly charts. Below is displayed the year over year (YoY) asking rent growth for Apartments across the US according to ApartmentList.com. We pay close attention to this series because it closely mirrors Apartment REIT fundamentals, but as a monthly indicator it actually leads REIT results.
What jumps out from this chart is that Apartment rents seem to be stabilizing near +0% growth, despite continued supply pressure and a fragile economy. This data point is hard to ignore after 20+ months of rent growth deceleration (from +17.5% to -1.3%). Apartments are a highly cyclical sector within REITs and this chart suggests that fundamentals may be hitting trough levels for this cycle. In our framework, rent growth getting “less bad” is good. This is the pre-condition to rent growth accelerating, which is the best environment for owning Apartment REITs.
You can extrapolate this data point to other cyclical REIT sectors with varying degrees of confidence, but the key point here is that growth may be bottoming for REITs after falling for the better part of 8 quarters. That is a key change to the REIT narrative and has so far been supported by REIT commentary on Q4 earnings calls.
Add to this a significant improvement in the capital markets (BAA rates down to +5.8% from +6.8%), and the REIT market has come to life in early 2024 in a way not seen since 2021 or early 2022. Cost of capital is extremely important to commercial real estate owners/investors, and REITs now have a significant cost of capital edge versus private market peers. Investment grade publicly traded REITs are accessing capital in the 5%-6% range, while lower rated peers still pay closer to +8%. This bodes well for REITs ability to gain market share in a still elevated interest rates environment.
While headwinds still certainly exist (Apartment supply peaks this year), it no longer makes sense to short REITs as aggressively assuming growth will continue to slow. This alone has pushed Serenity’s net exposure higher, and if growth shows signs of truly accelerating, we will most likely put the pedal to the metal on the long side of cyclical REITs.
THE SERENITY CODE: Analyzing REIT data and assembling a portfolio
After pounding the pavement on the capital raising front in early 2024, Serenity has seen a large uptick in requests for a written strategy/process explanation. While we usually satisfy these requests on a one-off basis, I think it makes sense to step back during the early part of a new year and review how we assemble our REIT portfolio from start to finish. Buckle-up, as it’s about to get methodological.
Let’s start with a brief structural outline and our investment philosophy. Every decision we make in the portfolio should act in support of the key tenants outlined below.
Serenity Alternatives Fund I is a long/short REIT hedge fund focused on preserving and growing client capital by investing in the REIT market. We believe that deep commercial real estate knowledge and experience, coupled with disciplined and repeatable process execution can be used to generate attractive risk adjusted returns within REITs over the full real estate cycle. The fund seeks to assemble a concentrated, yet diversified REIT portfolio with an emphasis on owning REITs with a history of strong cash flow and NAV growth. Our portfolio construction process also emphasizes risk management and draw-down mitigation by consistently shorting REITs that have low quality portfolios, poor corporate governance, and high-risk balance sheets. The result is a balanced portfolio of high quality diversified commercial real estate companies with strong cash flow growth that is precisely risk-managed and assembled using a disciplined, repeatable process.
That is a mouthful, but each phrase in the above paragraph is carefully worded and carries meaning within the Serenity framework. The emphasis on capital preservation first, and growth second, for instance, is intentional. Our short book is used to mitigate drawdowns with the goal of generating stronger risk-adjusted returns for our clients than the REIT benchmark. That is a key difference between Serenity and most long-only REIT strategies.
Now how does this work in practice? Let’s discuss the process…
The Serenity process utilizes two distinct investing methods for building our long/short REIT portfolio. When combined properly, the complimentary nature of the two methods ensures our portfolio is concentrated in REITs with a favorable combination of Value, Momentum, and Quality characteristics, and the process is executed in a disciplined, and repeatable fashion.
Top down, multi-factor modeling is the first step in our process. Serenity has extensively back tested over 80 individual REIT data points going back over 20 years, using the results to build our proprietary “CORE” multi-factor REIT model. The model is built from 18 factors (fundamental REIT data points) across the Value, Momentum, and Quality factor groups. The result is a diversified multi-factor REIT ranking tool that emphasizes cash flow and NAV growth, relative valuation, and management team and portfolio quality. The model can be updated daily, and acts as a starting point for the next phase in our process…deep dive fundamental REIT research.
Frequent readers of our newsletters are likely familiar with our proprietary “CORE” multi-factor REIT model. This is Serenity’s secret sauce, and I can say with confidence that nobody else in the REIT industry employs a model that looks like ours. It is the compass that un-emotionally points towards the true north of value, momentum, and quality REITs.
After updating the Serenity “CORE” model, our team examines the top and bottom 30 ranked REITs. Again, the top ranked names represent REITs with the most favorable combination of Value, Momentum, and Quality characteristics at any given point in time. These companies are then analyzed using fundamental analysis tools employed by some of the largest institutional investors in the REIT industry. NAV (Net Asset Value) modeling at the individual REIT level, earnings trends analysis, balance sheet decomposition and stress testing, management team due diligence…a wide variety of tools are used to vet this list of REITs. Again, our criteria for REITs on the long side are sustainable cash flow growth, NAV creation (either through strong organic or external growth), attractive valuation (using a variety of measures), and management team and physical portfolio quality. Rigorous income statement, balance sheet, and cash flow analysis are essential for uncovering REITs with true cash-compounding potential.
An ideal long candidate will have a high model rank, accelerating same-store revenue and NOI growth, strong earnings trends, accretive acquisition or development opportunities, a management team with a strong track record of capital allocation (both on the CRE investing and balance sheet management side), a strong balance sheet, and a discounted valuation relative to property type specific peers and the broader REIT universe.
If a REIT is highly ranked in the model, shows strong fundamentals, and passes quality checks in corporate governance and balance sheet strength, it is likely to be included in the Serenity portfolio on the long side. The same process is then employed for REITs on the short side, emphasizing the opposite criteria: low quality portfolios, earnings deterioration, cash burn, etc.
Sensing a pattern? In each phase of our process, we are looking for Value, Momentum, and Quality REITs. Companies that grow their cash flows, trade at reasonable valuations, and have high quality portfolios and management teams.
Serenity targets a long portfolio of 20-30 REITs, spread across 8-12 distinct commercial real estate property types (think apartments, cell towers, data centers, medical office, hotels, warehouses, net lease retail as distinct property type examples). On the short side we target 10-15 REITs with a similar level of diversification. Over the full cycle, the fund is long biased, targeting +130% gross long exposure, and +30% gross short exposure, for a net of +100% (on average). The fund can go as low as -10% on a net exposure basis or as high as +125% (again net).
At the individual position level, Serenity has a max allocation of +15% to any individual security, and a max property sector exposure of +40% (on a net basis). On average long positions will be between +2-7% of the portfolio, with most short positions at -2-2.5%. Serenity rarely has positions larger than +10%.
Portfolio management rules are boring but important. The proper level of diversification is a key to ensuring the fund is insulated from shocks that may occur at the individual company or property sector level.
Historically our process has allowed the fund to generate positive returns for investors across a wide variety of REIT property types, including (but not limited to) Apartments, Data Centers, Self-Storage, Office, Regional Malls, Healthcare, and Industrial (Warehouse). Over +80% of our historical returns come from REITs with a market cap greater than $3 billion, and the fund is historically profitable in both the long and short book.
On a trailing 5-year basis, the fund has returned +13.0% net of fees, versus +4.2% for the REIT index. Since inception, the fund has returned +8.3% net of fees versus +5.1% for the REIT index.
Now for the final question, how does Serenity think of net exposure at the property type level, as well as at the portfolio level? Said another way…how do we know when to hedge and when not to?
Serenity’s net exposure decisions are made primarily at the individual company level. We want to own REITs (and other RE companies) when fundamentals are improving or accelerating. This can mean accelerating same-store revenue or NOI, improving earnings growth, accretive capital activity such as growing dividends or share buy-backs, or an improving opportunity for external growth.
REITs that grow their NAV/share over time are shown to have outsized positive returns over the full cycle, therefore NAV/share growth is the key criteria for the Serenity long book. When growth is low and accelerating, Serenity is likely to have unhedged bets on the long side. When growth is high and decelerating, Serenity is likely to hedge bets actively at the individual REIT and by extension the REIT property type level.
When growth prospects improve, our net exposure increases. When they get worse, our net exposure decreases. The formula is that simple. Predicting the direction of growth is the hard part but is possible in REITs due to the high quality of their disclosures and the large amount of REIT data that is available. Serenity was able to successfully hedge the portfolio as growth topped, then slowed in 2022. In 2024, we are making the opposite bet, expanding our net exposure as growth potentially bottoms and accelerates.
RISKS: Inflation and Recession are both REIT foes...
With growth potentially bottoming for REITs in 2024, what risks exist that could throw a wrench into our early bull market call?
The two wild cards right now are inflation and recession.
While inflation has fallen (particularly over the back half of 2023), history has a clear message for those that declare victory over it prematurely…be careful. It is no secret that inflation was thought to have been tamed in the early 70’s during the Arthur Burns era, only to roar back more strongly than before, surging to +12.3% in 1974 after troughing at +2.7% in 1972. Obviously, we don’t anticipate such a rapid re-acceleration (Apartment rents lead inflation and are currently at +0% per the chart above), but even a small uptick over 6 months could be a real danger. Say inflation pushes back towards +3.5% in 2024. This would likely keep the Fed hawkish and keep capital costs high for commercial real estate.
An inflationary environment is bad for REIT costs of capital but can be good for REIT organic growth. An uptick in inflation would likely see an uptick in growth for Apartments and other cyclical REITs. For this reason, inflation is not 100% a bad thing for REITs, but would certainly create interest rate headwinds. The real danger is more likely in wild card #2…the dreaded “R” word.
While most mainstream economists have capitulated on the possibility of a recession, it’s worth contemplating a few key points. First, most recessions are presaged with the illusion of a soft landing. Pundits were calling for one as late as September of 2008, literally weeks before the wheels fell off the economy during the GFC.
Second, and much more importantly, the labor market traditionally hinges on highly cyclical jobs in manufacturing, mining, and construction.
I underline construction because this is where the macro rubber meets the REIT road. Multi-family construction is a HUGE driver of jobs and a key swing factor for the labor market. Up to this point, there has been no weakness in construction employment, because multi-family construction is still hitting all-time highs. While I expected this data series to peak in 2023, I underestimated the size of the current multi-family pipeline, and the time it would take to begin to roll over. This buoyed the construction jobs market in 2023 while most economists expected it to falter.
Fast forward to 2024, however, and the pipeline of multi-family construction projects is shrinking RAPIDLY. In my view, the largest risk to the broader economy (and by extension the REIT market) in 2024 is that construction employment goes negative as these buildings are delivered…because there are no new projects behind them. This is only partially conjecture…we do know the trajectory of multi-family starts over the past year and it is not pretty. What we do not know is how well construction jobs will be absorbed by other parts of the economy as multi-family construction peaks and begins to decline.
For this reason, we continue to watch the macro data like a hawk, as the growth trajectory for cyclical REITs will largely depend on the labor market remaining strong. Any noticeable deterioration in the jobs data will likely cause us to downgrade our growth outlook and reduce our long bets in cyclical REITs.
Ima ga sonotokida (Now is the time!)
Making decisions based on data can be extremely difficult. As human beings, we have all kinds of emotional baggage that prevent us from being perfectly rational. My ego, for instance, does not want to admit that I missed a significant REIT rally in Q4 of 2023. It wants to double down on the REIT bear market call, arguing that a recession is certainly still on the way.
This, however, would be an example of living in a tomorrow that may not exist.
In investing, there is only now, and right now the data is improving.
As the year progresses, our outlook will undoubtedly change, and the complexities of the REIT market take different property types in different directions. For the time being, however, our net exposure is rising in anticipation of better growth prospects for REITs going forward.
Invest like there is no tomorrow,
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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