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  • Writer's pictureMartin Kollmorgen


Updated: Nov 11, 2022

“The world is changed. I feel it in the water. I feel it in the earth. I smell it in the air.” – Lord of the Rings: The Fellowship of the Ring

  • THE GREAT CAP RATE RESET – How does a “higher for longer” economy impact REITs?

  • PUBLIC VS PRIVATE – In the aftermath of 2008, how did commercial real estate pricing evolve in the private and public markets? What should we expect for REITs from 2023-2025?

  • TURN OF THE TIDES? – Could pricing power be returning to Data Center REITs? Why accelerating same-store metrics could be a game changer…

The easy money era of 2008-2021 profoundly impacted the US real estate market.

Steadily falling interest rates (since the early 80’s), and successive bouts of quantitative easing (2010-2021) made acquiring commercial real estate assets of all stripes quick, easy, and profitable.

Asset quality, risk assessment, proximity to population centers…these underwriting criteria slowly fell by the wayside as capital proliferated and investors searched for yield at any price. Many assets that started the decade at 8-10% cap rates ended the decade at 4-5% cap rates.

Active management and disciplined capital allocation took a back seat to financial engineering and leveraged buying.

Then in 2021 something happened that nobody expected. Inflation…long dormant and thought to have passed into legend, emerged from the shadows.

With the return of inflation and the emergence of a newly hawkish Federal Reserve, the tools of active management in commercial real estate are suddenly more important than ever. Inflation and higher interest rates have demolished passive portfolios in 2022, and their destruction continues to spread. Gone are the days of buying low quality assets, levering them up, and heading to the golf course. In this new world, it will be difficult to survive, let alone thrive without the tools to actively defend investor capital.

While the world slowly awakens to this new economic paradigm, some of us are already active. Serenity is among the select few CRE investment firms that has weapons in our arsenal to combat the spreading capital markets gloom. We are defending client capital with our short book, scouring the REIT landscape for distressed opportunities, and preparing for sunnier economic days, when we can more aggressively deploy capital on the long side.

In a word, we remain active yet patient. Trends we are monitoring include strength in group travel amongst the Lodging REITs, pricing power potentially returning to the Data Centers, and distressed pricing emerging in Office names. It may not be time to get aggressively long, but as economic shadows lengthen, compelling long-term opportunities will become more and more prevalent.

The world is changed. You can feel it in the REIT market. You can see it in the stock market. You can smell it in the bond market. Are you prepared?

PERFORMANCE: -1.24% in October, -10.7% YTD

Serenity Alternative Investments Fund I returned -1.24% in October net of fees and expenses versus the MSCI US REIT Index which returned +4.87%. Year to date, the fund has returned -10.7% net of fees versus the REIT benchmark at -24.8%, the NASDAQ 100 at -29.6%, and the S&P 500 at -17.7%.

On a trailing 3-year basis Serenity Alternatives Fund I has generated annualized returns of +15.1% net of fees and expenses. Over the same period, the REIT benchmark has returned -0.9% on an annualized basis. The fund’s Sharpe ratio over the past 3 years sits at 1.03, versus -0.04 for the REIT benchmark (remember higher is better, more return per unit of risk).

The largest positive contributor to the fund’s return in October was Host Hotels (HST), a long position that returned +18.8% during the month. Host and its Lodging REIT peers have proven remarkably resilient in 2022, with the sector only falling -1.75% YTD versus REITs at -24.8%. As the year has progressed, business and group travel have continued to recover steadily, allowing many Lodging names to surpass 2019 RevPAR levels much earlier than anticipated.

With fundamentals moving the right direction and valuations that are historically low, Loding REITs have responded positively to continued strength in the economy. We remain cautious on the sector, however, as Lodging is historically highly cyclical, and leverage remains a concern for some Lodging REITs. Host has a fortress balance sheet and an excellent management team, and we can confidently hold this blue-chip portfolio while hedging our exposure with more highly levered, lower quality Lodging names.

Speaking of…the worst performing position in the fund this month was Service Property Trust (SVC), a short position that returned +60.1% for the month. SVC is a highly levered Lodging REIT with extremely poor corporate governance and a management team with a history of value destruction. Going into the month, SVC looked to be on the brink of financial distress, with leverage in excess of 70% and a credit facility that was completely tapped out. The company, however, was able to sell enough assets over the last few months to extend the maturity of their credit facility, pay down some of the balance, and re-instate a dividend. These positive developments caused a sharp rally in the shares off the late September lows.

The good news here is that we had shorted SVC much higher (at $7.66/share). Our mistake in this situation was not taking profits when the company traded to $5.19 at the end of September (a 32% unrealized gain). At a current price of $7.47, our short is still profitable, albeit much less so than a month ago. The lesson here is that we should be more diligent in covering shorts in low quality names when they are well in the money. These borderline distressed scenarios have a tendency to move violently higher on good news, even if the moves are only short lived. This has been duly noted and will be more closely monitored going forward.

THE GREAT RESET – Higher cap rates set the stage for a new era…

What a difference 10 months makes.

Earlier in 2022, sunbelt Apartment REIT NexPoint Residential (NXRT) made the following comments on their 4Q 2021 earnings call (which took place in Feb. 2022).

The acquisition market certainly has its challenges with the material supply-demand imbalance driving cap rates down to 3.5% and below

That means Apartment cap rates across the country were +3.5% as recently as Q1 of this year.

Fast forward to today, and NXRT has increased its estimated market cap rates (in its own disclosure) from +3.75% at the midpoint to +4.5%, lowering their estimated NAV from $98.30 to $76.75 (a -22% revision). The stock currently trades at $44.78, or an implied cap rate of +5.4%, indicating that the stock market is pricing an additional +1.0% revision higher in NXRT’s cap rate. We believe the correct cap rate for the NXRT portfolio could be closer to 6.0%, which translates to a NAV of $41.12.

Oh boy, that’s a lot of real estate jibber jabber. What does it mean in layman’s terms?

The stock market is indicating that cap rates have moved up about +2.0%, while NXRT (in their disclosure and comments) are indicating that cap rates have only moved up +1.0%. For the sake of context, BAA bond yields (the average REIT is rated BAA) have increased from +3.3% in January to +6.3% today (+3.0%). Remember, cap rates move the opposite direction of asset values, so cap rates up = asset values down.

If you believe that the stock market leads the private market, then it may only be a matter of time before NXRT and the broader private market adjust their Apartment cap rates closer to the +5 - 5.5% implied by REIT prices. Remember, BAA bond yields are above +6.0%, and recently briefly moved above +6.5%.

The overarching point here is that the commercial real estate world has changed. While some investors remain skeptical that CRE prices are set to fall by -20-30% relative to early 2022 values, the bond market and REIT market are sending an unambiguous message that this is the most likely outcome. Not convinced?

Let’s walk through the following thought experiment. With the 2-year US Government Treasury Bill yielding +4.65%, which is a more enticing investment option? A 50+% levered sunbelt Apartment REIT with an implied cap rate of +5.5% or a guaranteed +4.65% yield?

Now consider the fact that the economy is likely headed for recession. Does the extra +0.9% yield on the Apartment portfolio compensate an investor for the additional risk of holding a cyclical investment into a recession?

To be clear, I am not suggesting the answer is to buy the treasury bond. Over the next two years, it’s entirely possible that the total return on an investment in NXRT will be higher than the +4.65% annualized return of the 2-year note. But the decision is far from a layup.

And this is assuming the 2-year yield does not increase to +5.5% over the next 6 months. In that scenario, assuming NXRT moves sideways, there would be effectively 0 risk premium for owning a B+ sunbelt Apartment portfolio relative to a 2-year treasury note. Investors can be crazy…but I find it hard to believe they would stomach that type of relative risk/reward.

Again, I take no joy in sounding like the doom and gloom guy in commercial real estate. The simple fact is, however, that presenting these data in their raw form does not lead to the conclusion that REITs are cheap…even REITs that are down -45% YTD.

The outcome of higher interest rates for commercial real estate assets is higher cap rates and lower values. That is a simple mathematical fact. Commercial real estate prices are falling, and they will continue to do so until interest rates stabilize, and the market is able to clear.

The good news here is that higher cap rates and higher interest rates are synonymous with higher returns. The simple fact that you can earn 4.6% effectively risk-free over 2 years should seem incredibly attractive relative to investors’ experience of the last 10 years. If this level moves even higher, there will be incredibly high-quality REIT portfolios for sale at 7% cap rates. With long-term growth rates between 3-5%, it’s fairly easy to imagine +10% un-levered returns for blue-chip REIT portfolios. That is an exciting proposition for a capital allocator.

Unfortunately to get to the double-digit unlevered return promised land we may need to pass through the valley of REIT despair as cap rates move higher in the short to intermediate term. With a well-hedged portfolio and an active plan for capital preservation, however, Serenity is poised and ready to make that journey.

PUBLIC VS PRIVATE – How to position for a recession/recovery

Which brings us to the age-old question that everyone is asking (albeit prematurely in my opinion); how do we make the most money when the market eventually bottoms?

This is the pavlovian reflex built into investors’ subconscious over the last 10 years by easy monetary policy. That does not mean, however, that it is not a topic worth exploring. We are currently in a bear market; it will eventually end. So how should we think about maximizing profits when the market turns?

Let’s start with the public vs private debate. While many investors prefer private real estate investing to investing in REITs for a variety of reasons (tax advantages, lower perceived volatility, high levered IRRs from 2010-2021); it should be clear to all investors that the public market at this point LEADS the private market in terms of asset pricing. Said another way, REITs tend to sell-off before their private peers and begin recovering before their private peers.

This can be seen acutely in the chart below during the 2006-2009 period (the last true recession and commercial real estate cycle correction). REIT prices peaked in 2007, while the price of the NCREIF commercial real estate index (a proxy for institutional quality private CRE) did not peak until late 2008. REIT prices then bottomed in early 2009 along with the broader stock market, almost a full year before private market pricing hit bottom in early 2010.

*Quick side note: Examining the historical data from NCREIF during the GFC is fascinating. Using NCREIFs data, commercial real estate prices did not peak until 9/30/2008 (it’s a quarterly series). At this point the stock market had already fallen -30%, Bears Stearns had gone belly up, and the unemployment rate had increased to +6.1% (from +4.9%). From that extremely late cycle peak, CRE prices fell -24% over the next 15 months.

The pattern of the market thus far in 2022 would suggest events are playing out in a similar sequence. REIT prices have fallen about -25% YTD, while CRE prices according to NCREIF are just now topping. While the historical analogy does not tell us with clarity where this all bottoms out, we can assume that publicly traded REITs are likely to find a bottom BEFORE their private market counterparts.

This would suggest that incremental capital deployment in commercial real estate should HEAVILY FAVOR THE REITs going forward. The argument is simple…why buy a house for full price when the exact same (or potentially higher quality) house next door is selling for -25% less?

Now this does not mean investors should go out and buy REITs with 2-hands. Remember…the NCREIF index peaked in September of 2008…after which REITs fell -67% over the next 6 months. But if given a choice between REITs and private real estate…the destination for incremental capital should be glaringly obvious.

TURN OF THE TIDES? Encouraging data points from the Data Centers

So what are REIT investors to do in the face of continued uncertainty headed into a possible recession? If you NEED to deploy capital into real estate, and have decided to invest in the REIT market…which houses are the best in the neighborhood?

One component of the Serenity playbook for the current environment is to own or tilt towards non-cyclical property types relative to cyclical property types. For cyclical sectors such as Apartments, Industrial, Retail, and Hotels, there exists a very real risk that fundamentals will deteriorate sharply over the next 3-4 quarters. Some companies are already guiding to a steep deceleration (see ESS, EXR) into Q4 of 2022 and next year (2023). Can REIT investors find a home for capital that is somewhat insulated from this threat?

Enter the Data Centers.

While much maligned recently as a high-profile short (by an investor we very much respect), the Data Center REITs present an interesting risk-reward profile amidst a recessionary scenario. Recent data points also paint an intriguing picture of improved pricing power that could be a borderline game-changer for the sector. While traditional tailwinds have not supported the space thus-far in 2022 (interest rates), the potential return of pricing power could be a key differentiator for Data Center REITs.

One of the valid criticism’s leveled at the Data Center REITs recently by Jim Chanos has been their lack of organic growth. Specifically, DLR and EQIX have had 0 or negative same-store NOI growth consistently for the better part of the last 5 years. This is due to a combination of factors, the primary of which was simply that Data Centers went from a niche asset class to an extremely popular (to the point of over-built) asset class. As more and more capital came into the space…surprise…availability of Data Center space increased, pricing power evaporated, and levered private equity developers drove returns lower and lower.

With capital costs increasing and data expansion trends remaining robust, however, much of this over-supply has been absorbed, and for the first time in half a decade, prices per kilowatt (how Data Center leases are priced) have recently ticked modestly higher. The chart below is from CBRE’s 1H 2022 Data Center solutions report. The trend in the chart is clear. Lower prices from 2014-2020, then a tick higher in 2022. Various other sources have reported the same phenomenon, with some estimates that hyperscale pricing has increased +30% YTD.

Why does this matter? Because for the past 5 years Data Center REITs have depended on external growth (development and acquisitions) for almost 100% of their growth. With development slowing (a prudent move amidst a more capital scarce environment), REITs which can grow their NOI organically are likely to be in high demand. We already know that rate growth is slowing for Apartments, Self-Storage, and other cyclical REIT sectors, so the possibility of accelerating same store growth stands in stark contrast.

Now this is not a risk-less bet. The Data Centers still face headwinds shared by many REITs. They tend to be high-duration names, meaning the higher interest rates move, typically the worse Data Centers perform. The industry is also sensitive to capex cycles, and while less economically sensitive than many peers, there is still some economic cyclicality in the Data Center business. Lastly, energy prices are a significant cost to Data Center customers…meaning the space’s occupancy cost moves higher as energy prices do.

To summarize, in an environment of slowing economic growth, rising interest rates, and an aggressively hawkish fed, it becomes very difficult to find investable real estate assets. While we see significant fundament headwinds for many cyclical REITs, the Data Center sector may be able to buck this trend in a way that stands out. As always, we are watching the space vigilantly, deploying capital opportunistically, and will adjust our thinking as more data comes in (all data puns in this section intended).

THE LONELY BEAR: Just say NO to hopium…

In September of 2008 there was a narrative of hope blowing on the Wall Street wind. Stocks seemed cheap after falling -30% from their peak. Bears Stearns had been absorbed by JP Morgan without destroying the economy. Lehman Brothers looked to be set for the same fate. Economic data was bad…but it couldn’t get much worse right? Also, the Federal Reserve had cut rates from 4% at the beginning of the year to 0. I remember this because I bought stocks in September of 2008 thinking they had bottomed…

Over the next 5.5 months REITs returned -57%, the NASDAQ fell -26%, and the S&P 500 dropped -34%. The US banking system almost collapsed, and the largest federal stimulus bill of all time was met with…3 more months of continued selling. Property development firms went bankrupt en masse. Unemployment spiked to 10%. There was no uncertainty…it was an economic bloodbath.

In March of 2009, at the bottom, nobody was bullish. The buy the dip crowd was quivering in the corner, nursing a bottle of cheap scotch, while CNBC ran their famous “panicked trader” photos on repeat.

2022 is not 2008. Asset prices started this year much higher from a valuation perspective than they did in 2008. Leverage levels are lower than they were in 2008, but inflation is much higher. And pivotally…in 2022 the FED IS STILL RAISING INTEREST RATES.

For investors hoping for a rapid return to 2021 levels of interest rates and cap rates…we wish you the best of luck. In the meantime, we will continue to sequence and analyze the data for signs of improvement that would turn our outlook more bullish. Right now, they are few and far between.

Don’t hope for the old world, prepare for the new one,

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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