- Martin Kollmorgen
SURVIVE THEN THRIVE: NAVIGATING A POST-FED REIT MARKET
“Survival can be summed up in three words – never give up.” – Bear Grylls
PERFORMANCE – Serenity Alternative Investments Fund I returned -1.23% in April net of fees and expenses and has returned -6.5% in 2022. The FTSE NAREIT All Equity REITs index returned -3.65% in April and has returned -8.7% for the year (through April 30th). • SURVIVING THE STORM – May has been tumultuous in the capital markets. Serenity is flush with cash and executing on our long-term process. • THRIVING AMIDST CHAOS – Rising debt costs have slammed the breaks on acquisitions for levered real estate buyers. The REITs are well capitalized and ready to pounce.
The teacup has been pushed off the table. The Federal Reserve has increased interest rates by 50 basis points, ended their purchases of treasury securities, and reiterated their commitment to “significantly reduce” their balance sheet. Since the rate hike on May 4th, the Nasdaq has returned -11.8%, the S&P 500 has returned -8.7%, and REITs have returned -9.3%. Year to date (as of May 18th), bonds have returned -9.7%, the Russell 2000 has returned -20.6%, the Nasdaq 100 has returned -26.7%, Netflix has returned -70.6%, and Bitcoin has returned -36.4%. Survival is now the name of the game. Just as spring follows winter and autumn follows summer, so do bear markets follow massive bull markets. All-time high multiples on all-time high earnings growth was not a sustainable setup for equities, and reality has set in. Cap rates for commercial real estate assets are set to increase along with interest rates, sending Net Asset Values lower. This reality has been reflected in REIT share price performance over the last few weeks. The probability of recession is also rising due to sticky inflation and shrinking asset prices. With the fed “put” meaningfully lower this time due to inflation, buying the dip on this recent correction could prove incredibly dangerous for investor portfolios. Said another way, the worst may be yet to come… Which is why we will survive now, and thrive later. The silver lining here is that with excellent balance sheets and inflationary protection via rent increases, REITs are much better equipped to deal with disruption than many other companies. When interest rates eventually stabilize, inflation begins to ebb, and a sense of calm returns to the capital markets…what will be on investors shopping list? Cash incinerating profitless tech companies? Or irreplaceable commercial real estate portfolios? The market is currently chaotic, but at Serenity, we were prepared. We continue to execute on our process, hedging macro-economic risks and looking for high quality real estate portfolios trading at distressed prices. Survive, then thrive.
PERFORMANCE: -1.23% IN APRIL, -6.5% YTD
Serenity Alternative Investments Fund I returned -1.23% in April net of fees and expenses versus the FTSE NAREIT REIT index which returned -3.65%. Year to date, the fund has returned -6.5% net of fees versus the benchmark at -8.7% (as of the end of April). As of this writing, the fund has returned -3.7% before fees in May, versus the REIT index at -9.7%. With an elevated cash balance, an active short book, and some timely stock picking, Serenity Fund I is once again over +700 bps ahead of the benchmark year to date. On a trailing 3-year basis Serenity Alternatives Fund I has generated annualized returns of +20.6% net of fees and expenses. Over the same time period, the MSCI US REIT index has returned +9.6% on an annualized basis. The fund’s Sharpe ratio over the past 3 years sits at 1.29, versus 0.49 for the REIT benchmark.
The largest positive contribution to the fund’s return in February was Host Hotels (HST) at +4.69%. We have written about Host on numerous occasions in previous newsletters, detailing the under-the-radar acceleration in business travel that has occurred in March and April. Just last month, we wrote a full page detailing the conservatism of consensus estimates in the name and how Host had the chance to beat and raise consistently over the next 4 quarters. | On May 4th, Host reported adjusted EBITDA of $306m, 42% above the consensus estimate of $215m. They guided to second quarter EBITDA of $392.5m versus consensus estimates of $314m (24% above). Year to date, Host has returned +11.2% versus the REIT index at -17.2% and remains one of the largest positions in our portfolio. Host is succeeding despite market headwinds from the fed, and still trades at a meaningful discount to Net Asset Value (NAV). Usually considered the riskiest and most cyclical of all the REIT sectors, Lodging is quietly leading the entire REIT universe in performance year to date. The worst performing position in the fund in March was Innovative Industrial (IIPR) -29.6%. IIPR has been one of the funds favorite REIT longs since 2019. With the economic environment changing, however, we reduced our position in the name significantly in the second half of 2021. IIPR is a small cap REIT dependent on acquisitions to grow. In late 2021 IIPR sported an extremely high valuation. These style factors all tend to be penalized during periods of slowing growth, which is why IIPR has underperformed in 2022. We still have a small position in the name and like the fundamental outlook, but until the macro environment improves, we are unlikely to add significant capital to the position. As with many REITs at the current juncture, we are happy to watch and wait, knowing that when the macro environment improves, there is a compelling fundamental story and a (now) attractive valuation waiting in the wings.
SURVIVING THE STORM. SHORT BOOK TO THE RESCUE…
As a long/short REIT hedge fund portfolio manager I frequently get the question “why short REITs?” The answer is relatively simple… because REITs don’t always go up. Shorting is incredibly difficult, and there is a large graveyard of investors that have tried shorting stocks and failed. This is why we get the question. Why attempt something that many investors do not do well? Because in environments like the current one, it is incredibly valuable. Let’s quickly re-wind to 2020, the last time we were meaningfully bearish on the macro environment. Even prior to the outbreak of COVID, the employment market was starting to roll-over, the yield curve had recently inverted, and REIT fundamentals were not inspiring. We wrote at the time that the system was fragile, and ripe for a catalyst to disrupt the capital markets. Then the Coronavirus arrived. Between Jan 1st of 2020 and March 31st, REITs returned -23.4%, the S&P 500 returned -19.6%, and the Nasdaq 100 returned -10.3%. Over the same period, Serenity Alternative Fund I returned -3.9% net of fees and expenses. By the end of the following month, Serenity was almost back to even for the year, with REITs still down over 16%.
Of this -3.9% return, the fund’s long holdings contributed -14.0%, while the short book reutrned +9.0% (with the remaining differntial being our cash allocation). This was with gross long exposure of +87% on average, indicating that as a fully invested long-only fund, Serenity would have theoretically returned -16.0%. As a long/short fund, we returned -3.9%. This level of investor protection can easily get swept under the rug when examining a time-series of returns, but it is extremely valuable to investors when they entrust you with their hard earned capital. That is why in our founding documents, the purpose of our firm is outlined as capital protection and growth. Notice which comes first. Capital protection via a short book also gives us the ability to wait and watch for high probability bets on the long side. Waiting can be extremely painful, but in order to capture outsized returns it is necessary. By the last quarter of 2020, we were confident enough to deploy capital into extremely cheap “value” style REITs heading into the end of the year. That call led us to a +15% return in November of 2020, and we closed that year +17.9% net of fees and expenses versus -5.1% for the FTSE NAREIT index. Why do we short stocks? Because it saves our investors money. As we progress through 2022, our short book has already added a significant amount of value, and is likely to do so throughout the rest of the year.
THRIVING AMIDST CHAOS: REIT BALANCE SHEET DOMINATION…
We stress the importance of the short book because it will likely remain our most important tool over the near to intermediate term. With large cracks beginning to appear in the US economic picture, rates already an order of magnitude higher than they were six months ago, and much more difficult comps approaching for many REITs, the picture for the industry is not rosy. We can easily envision a world in which consensus NAV’s for the REIT space have to fall 10-20% from here, which would likely take down REIT prices to a similar extent. If this turns out to be the case, our short book is going to shine. Our shorts can thrive amidst the chaos. Simlarly, many REITs will be able to differentiate themsevles versus peers simply by surviving and having patience with their capital. This is already occuring in the acquisitions market, as evidenced by comments make by Shankh Mitra of Welltower (WELL) on their Q1 earnings conference call. It is imporant to remember that most REITs have low levels of leverage relative to private real estate buyers. This means that they are much less dependent on the debt markets to fund acquisitions. Per Shankh: “And given what happened in the marketplace in the last 30 days… <the> financing market totally blew up as I said, leverage is down, cost of leverage is significantly up and IO completely vanished. If you think through that that really put a levered IRR model upside down…I’ve seen more deals dropping from contract in the last 30 days than I’ve ever seen in my career… I’m starting to see the margins of sort of those low-double digit, unlevered deals starting to pop up again.” Increasing interest rates have already made it impossible for levered real estate buyers to pay prices that made sense only 2-3 months ago. This makes the landscape competetive for the REITs, and presumably will allow them to capture more of the acquistions market. Less leverage also makes their portfolios much more resilient in the face of rising cap rates. Remember, rising cap rates = lower real estate values = lower equity values. Highly levered companies with rising cap rates = WAY lower equity values. We can short high leverage REITs as a hedge against rising cap rates, effectively hedging much of the interest rate risk out of our portfolio. The short book, once again to the rescue.
NEVER GIVE UP
Experiencing losses in the capital markets is painful. For many investors, this year has been uniquely difficult as no asset class has been safe from falling prices. A stout investment process, however, does not quit in the face of pain. There are always decisions to be made, and therefore the opportunity always exists to make good decisions on the margin. At the current juncture, opportunities may be more prevalent on the short side. It follows, then that long opportunities currently require extreme patience. At Serenity we have an elevated cash balance, we are sharpening the pencil on short ideas, and getting fired up to wait on our long ideas. We will survive the current environment so that we can thrive in the next. Never give up,
Martin D Kollmorgen, CFA CEO and Chief Investment Officer Serenity Alternative Investments Office: (630) 730-5745 MdKollmorgen@SerenityAlts.com
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