The Winter of REIT Discontent: October 2023
Updated: Nov 14
“Now is the winter of our discontent…made glorious summer by this son of York – Shakespeare's Richard III
PERFORMANCE: Serenity Alternative Investments Fund I returned -0.43% net of fees in October vs the REIT index at -4.37%. Over the past 3 months REITs are down -13.6% while Serenity Fund I is up +0.8%.
WINTER IS HERE: Q3 Earnings for REITs have been full of tricks, with few treats.
THE GROWTH-REAPER COMES FOR WAREHOUSE: One of the last bastions of cash flow growth (Warehouse REITs) showed cracks in Q3. Where do REIT investors hide now?
SUMMER ON THE HORIZON: The first glimmers of fundamental stabilization may be selectively appearing. Serenity has eyes on potential bargains…
Now is the winter of REIT discontent.
As third quarter earnings roll in, the economic picture being painted is not pretty.
Cyclical REITs in the Apartment and Self-Storage industries continue to see falling rents as consumer finances deteriorate. Office leasing, an indicator of corporate confidence, slowed again in Q3, with decision makers hamstrung by economic uncertainty. Even the growth juggernaut of the past 10 years, Warehouse REITs, saw rent growth slow and leasing stall in Q3.
And as if to add insult to injury, interest rates have moved meaningfully higher since June, with BAA rates (a good proxy for REIT debt capital) hitting +6.8% in October. Over the past 3 months, REITs have fallen by -13.6%.
Winter is certainly here for the REIT market.
And yet, as growth normalizes and investor expectations are re-set lower, the foundation of the next REIT bull market is steadily being laid.
For some glimmers of summer, look no further than the cell-tower REITs. After an incredibly painful 18 months in which all three large tower REITs (AMT, CCI, SBAC) have fallen more than -30%, the third quarter of 2023 saw some stabilization in fundamentals. Growth may bottom out in early 2024 for CCI and may have already hit its low point for AMT and SBAC.
Similarly in the Data Center space demand has remained robust, with strong pricing power reported by both EQIX and DLR. While a leasing slow-down is possible, a supply-starved Data Center market has driven same store NOI growth steadily higher in recent quarters, and AI tailwinds are just beginning.
Lastly, a plummeting pipeline of new multi-family construction should set the table for an epic bull-market in multi-family REITs from 2025-2026. While this reality is still on the horizon, pain in the near term can translate into future success for the best capitalized commercial real estate landlords (ie…the publicly traded REITs).
That is to say, the challenging market of today is grinding towards the REIT bull market of tomorrow. And we are much closer to this outcome in late 2023 than we were at any point in 2022 or earlier this year.
Caution is still warranted, but the time to sharpen REIT pencils is now. If this REIT bear market culminates in panic, investors will want a wish-list ready of high-quality REITs that could get fire-sale cheap. As you can probably guess, at Serenity our list is long, and our pencil is sharp.
Now is the winter of REIT discontent. But we are preparing for summer…
PERFORMANCE: -0.43% in October vs REITs -4.37%
Serenity Alternative Investments Fund I returned -0.43% in October net of fees and expenses versus the MSCI US REIT Index which returned -4.37%. So far in 2023, Serenity Alternatives Fund I has returned -0.05% vs the REIT benchmark at -6.23%. On a trailing 3-year basis, Serenity Alts Fund I has returned +16.7% annually net of fees versus the REIT index at +5.1%. Over the past 5 years Serenity Alternatives Fund I has returned +14.2% annually net of fees and expenses, versus +2.5% for the REIT index.
The best performing position in the fund this month was Global Net Lease (GNL), a short position which fell -13.9% in October. GNL has consistently ranked poorly in our model, as poor corporate governance, a low-quality portfolio, and high amounts of leverage have caused the company’s NAV to drift lower over the years. These characteristics have not been rewarded in the current market and GNL was punished by investors in October. We have closed our GNL short for the time being but will gladly short the company again at higher prices.
The worst performing position in the fund this month was Extra Space Storage (EXR), which fell -14.8% during the month. As we will detail in the upcoming section, Self-Storage fundamentals have been nothing short of a disaster in 2023. With an elevated amount of floating rate debt relative to peers, EXR has traded to a relative valuation discount, which is nearly unprecedented for a company with one of the best management teams in all of REITs. While our position in EXR is hedged via short positions in other self-storage REITs, in October the company underperformed its peers and negatively impacted the portfolio.
Over the full cycle we are confident in EXR’s portfolio and management team. We firmly believe the relative value discount the company currently trades at will revert to a premium over time, and at a +6.5% implied cap rate, the company is currently cheaper than it has been at any point SINCE 2009! EXR is a premier quality REIT trading at a significant discount to its historical valuation, and we very much look forward to letting this position off the leash (closing our hedges) when storage fundamentals improve. Until that is the case, however, the position will remain hedged, and we will bide our time.
**Quick Note: EXR reported 3Q earnings the day after we wrote this paragraph. They beat expectations and guided to a potential bottoming in storage fundamentals late this year or early next. The stock was up +10.5% on the day, indicating investor optimism that the bottom for storage may arrive more rapidly than we had anticipated. More on this possibility later in the newsletter…
WINTER IS HERE: A Q3 earnings season to forget…
October saw a wave of bad news for REITs that sent the industry down -4.37% for the month and brings the industries 3-month trailing returns to -13.6%. Self-Storage and Industrial (Warehouse) REITs led the industry lower, with Q3 reports that fell well short of investor expectations.
Self-Storage as a property sector continues to struggle with a moribund housing market. Asking rents for storage space are now down -18% year over year. While investors and self-storage operators had hoped asking rents would find their footing in the last few months of 2023, the opposite has in-fact happened, as rates have fallen FASTER in September/October than they had so far in 2023.
Per CUBE’s 3Q earnings call.
“Our expectation several months ago was that we would be able to start to narrow that gap year-over-year. And the 16.9% gap in the third quarter would start to narrow throughout the fourth quarter. And in fact, as we sit here today, it's actually gapped out a little bit more.” – Tim Martin, CUBE CFO
These sentiments were echoed in the multi-family space, with Camden Property Trust (CPT) making the following comments.
“We had planned for a more normal fourth quarter but that didn't happen. As a result, we have revised our fourth-quarter full-year guidance to reflect weaker new lease growth, lower occupancy, and higher bad debts than we expected even in the summer.” - Ric Campo, CPT CEO
There is no soft-landing occurring in the cyclical REIT sectors.
At Serenity we are on the record as being extremely cautious (and often short) cyclical REITs in 2023. This is why. Rate growth, and by extension cash flows have continued to deteriorate for the past year in these names. Many REITs in these sectors sport attractive valuations and a positive long-term story, but timing here matters. As we discussed in last month’s newsletter, when growth decelerates, cheap stocks get cheaper.
And while it is too early to buy most of these names (in our view), we can still make money the hard way in these property sectors, by picking the right stocks and hedging them with highly correlated peers.
In Apartments, for example, we are newly long Equity Residential (EQR) and short Nexpoint Residential (NXRT). EQR has a high-income tenant base, a high quality portfolio, and an extremely strong balance sheet. Meanwhile NXRT remains over-levered, with worse portfolio demographics than EQR, and yet trades at a premium valuation. We are confident EQR will have better cash-flow preservation and growth in the near term and can profit from this fundamental insight.
THE GROWTH-REAPER COMETH. Warehouse growth slips, warehouse stocks slide…
In case we needed more proof that REITs are firmly mired in a bear market; this quarter the golden child of commercial real estate saw cracks appear in its growth narrative for the first time since the pandemic.
Lower re-leasing spreads, longer lease-up times, and flagging occupancies all hit the radar of investor concerns during the Q3 earnings season for Industrial (Warehouse) REITs.
It started with Prologis (PLD), making the following comments on their Q3 earnings call, one of the first of the season.
“Demand is definitely softer. It's closer to normal, maybe even a little bit below normal at this instance. There is a lot of latent demand that large companies having large requirements are continuing to talk to us about build-to-suits, but they're reluctant to pull the trigger”
This refrain was consistent across property types in Q3. That is…US companies seem incredibly hesitant to make any type of significant real estate decisions in the current market. Leasing is the lifeblood of the commercial real estate market, and when it comes to a halt, fundamentals for REITs and their private peers deteriorate.
This deterioration manifested itself in re-leasing spreads for multiple warehouse REITs during the third quarter. First Industrial (FR), saw signed lease mark to market (the difference between expiring rents and new rents) decrease from +74% in Q2 to +39% in Q3. Rexford saw spreads fall from +75% to +51%. As a leading indicator of future organic growth, investors took these slowdowns as a deterioration in fundamentals, with both REITs falling more than -11% during the month.
We point this out because Warehouse REITs have been the last bastion of elevated and consistent growth in a REIT market that has seen growth meaningfully decelerate over the past 6 quarters. Warehouse REITs trade at a meaningful valuation premium relative to the rest of the REIT industry and are heavily owned by both REIT hedge funds and long only funds. While Serenity was net long Warehouse REITs early in October, we have since hedged most of those positions based on Q3 data. The fundamental moderation in this property sector may only be beginning, and while growth remains amongst the best in the industry, Warehouse REIT valuations are elevated, suggesting strong growth is already priced into the names.
Long story short…the growth slowing grim reaper has now come for almost every REIT property type, and REIT investors are going to have to get more creative in their search for potential long ideas.
SUMMER ON THE HORIZON: Glimmers of bullishness beginning?
Which brings us to the mental gymnastics part of the newsletter. While news from Q3 REIT earnings reports was incredibly bearish…our outlook is <gasp> improving.
This probably seems counterintuitive. Serenity has been THE BEAR on REITs for the better part of the last 1.5 years. I even named my fantasy football team “Da Bear” last year, which unfortunately also delivered me a bear market in fantasy points. Now with news coming in worse than expected and our thesis being vindicated, should we not be more bearish than ever?
Not so fast. After 6 quarters of slowing growth for most REITs, we are now actually closer to the end of the growth-slowing story than the beginning. Our thesis is playing out as we expected (growth slowing), and now it’s time to look ahead towards the next season of the story, which is growth bottoming, and potentially the best part of the CRE cycle to buy REITs.
The chart of self-storage revenue growth below tells this story clearly.
Self-Storage YoY revenue growth has fallen from +17.1% in Q1 of 2022 to the recently printed +2.0% in Q3 of 2023. Again, we have been bearish of cyclical REITs because stocks typically do not perform well when growth falls by +15% over the course of 1.5 years. But today, with growth hitting +2%, the risk of further deceleration has dropped dramatically. Apart from a recession (still a possibility), Self-Storage revenue growth almost never goes negative, meaning we NEED a recession for things to get worse from a fundamental perspective. While again, a recession is certainly a possibility, the stage is also set for a potential re-acceleration in storage revenue growth late in 2024.
And it does not take a rocket scientist to understand that forward returns for cyclical REITs are MUCH higher than average at positive growth inflections. The chart above illustrates clearly how elevated forward-looking returns are when revenue growth goes negative and then bottoms. In fact, in quarters in which SS revenue growth is negative for self-storage REITS, forward 1-year returns average +46%!
This is why we stress the rate of change of growth so heavily in our fundamental research. The very BEST opportunities in REITs occur when growth accelerates, particularly when it switches from deceleration to acceleration.
As we alluded to earlier in the newsletter, this bottoming in growth may be closer than we think for certain REITs. EXR, one of the best management teams in all of REITs, does not expect much more downside in self-storage rents over the next few months. That’s not an all-clear, as CUBE has sent the exact opposite message, but when EXR speaks, we listen. This may be the first glimmers of a growth bottom in Storage that manifests itself over the next two quarters.
The very important point here is that the growth bottoming process is beginning in a few REIT property types, which is a significant departure from the past 18 months. After 1.5 years of negative growth momentum, a true growth turnaround could generate explosive returns…
DON’T FOLLOW THE HERD
I want to end this newsletter with a warning to investors of all stripes. As we endure one of the most challenging commercial real estate markets in 50 years, the great temptation when faced with uncertainty, is to do nothing. Just wait it out and make decisions when things improve.
That attitude…will not create wealth. The fact that you are reading this newsletter proves that you are intelligent and ambitious enough not to settle for mediocre market-level returns and all the concomitant volatility.
In a period in which most investors have headed to the sidelines, the largest rewards of the next bull market will be reaped by those that invest actively despite uncertainty. This is the time to explore opportunities that everyone else is abandoning. Self-storage REITs, tower REITs, Mall REITs…these property types all trade at cycle low multiples due to current below-trend growth and a fleeing investor base. The mob will wait until revenue growth goes back to +4-5% to get back in, at which point self-storage REITs will already be up +30-40%. Serenity’s investors will already be on the beach with a cocktail in their hand.
So choose your path wisely: either follow the herd into the depths of the bear market, or lean against the crowd with an original thinking Colorado based REIT hedge fund.
Summer is coming…
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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