TIME TO DARE AND ENDURE: FEBRUARY 2022 NEWSLETTER

“This is no time for ease and comfort. It is time to dare and endure.”

– Winston Churchill

PERFORMANCE – Serenity Alternative Investments Fund I returned -0.28% in February net of fees and expenses and has returned -7.5% in 2022. The FTSE NAREIT All Equity REITs index returned -3.89% in February and has returned -11.5% for the year. • WAR – What are the implications of the war in Ukraine for US REITs? • INFLATION – We remain long REITs that can benefit from persistently high inflation. • CREDIT SPREADS – As credit spreads climb to 2020 levels, can investors protect themselves from potential financial contagion?

A kinetic war in Europe, inflation at 40-year highs, and a stock market that is down 11.1% from its all-time highs as of this writing. Does anything in your portfolio feel easy or comfortable? Are you smiling as you buy the dip or HODL your crypto currency? There are times for ease and comfort in your portfolio. For 18 months from late 2020 until late 2021, growth and inflation accelerated along with earnings, pushing the stock market and REITs to all time highs. It’s easy to buy dips when earnings growth goes from -20% to +80%. But this is a different world. It is a different world than 2021 and a different world than any time between 2010 and 2020. Globalization is fading, inflation is rampant, and valuations in many stocks remain SIGNIFICANTLY higher than their previous cycle averages. There are also disturbing trends percolating beneath the market’s surface. Credit spreads are widening at a faster pace than they did during the market correction of 2018. Overall financial conditions are worse than they have been since the early days of the pandemic in 2020. With volatility trending higher and the Fed actively tightening monetary policy, complacency is becoming increasingly costly. As the British Bulldog so eloquently elaborated…in this type of market investors need to dare and endure. Many financial advisors will stick with the “endure” portion of that quote. They will tell you to “just hang on, ride it out”. We can do better. At Serenity we have a playbook to preserve our client’s capital and profit from developing trends in the new economy. We can short companies that are uniquely risky in this type of environment and concentrate our portfolio in REITs that benefit from elevated inflation. We can dare, while other investors simply ride the market lower.

PERFORMANCE: -0.28% IN FEBRUARY, -7.55% YTD

Serenity Alternative Investments Fund I returned -0.28% in February net of fees and expenses versus the FTSE NAREIT REIT index which returned -3.89%. Year to date, the fund has returned -7.5% net of fees versus the benchmark at -11.5%. On a trailing 3-year basis Serenity Alternatives Fund I has generated annualized returns of +22.4% net of fees and expenses. Over the same time period, the REIT benchmark has returned +11.0% on an annualized basis. The fund’s Sharpe ratio over the past 3 years sits at 1.40, versus 0.61 for the REIT benchmark. The largest positive contribution to the fund’s return in February was Independence Realty Trust (IRT) at +9.8%. Independence announced earnings on 2/17, exhibiting accelerating SS NOI growth in the fourth quarter, and announcing a rapid realization in costs savings from their December merger with Steadfast Apartment REIT. IRT remains the largest position in our portfolio, with strong fundamentals, a large and growing portfolio of re-development opportunities, and potentially sector leading earnings growth in 2022. The worst performing position in the fund in February was American Tower (AMT), returning -9.8% for the month. AMT is a striking example of how different the investing environment is in 2022. While traditionally a defensive REIT due to its incredibly steady growth, huge market cap, and low leverage, AMT has been one of the worst performing REITs amidst the sell-off of 2022. We added some AMT to the book exactly for its defensive characteristics, and thus-far…it has been a mistake. Developments such as this are particularly notable. Elevated inflation is turning the traditional defensive playbook in REITs on its head. And while we still expect inflation to moderate later in 2022…until it does it is difficult to see when defensive names such as Cell-Tower, Data Center, and Net Lease REITs will outperform. We have adjusted our portfolio for the newly inflationary regime accordingly and will keep a wary eye on these high quality formerly defensive companies.

WAR IN EUROPE: A NEW PARADIGM WITH NO ROADMAP

My heart breaks for the people of Ukraine. The petty tribulations of an ultra-comfortable existence in the US seem increasingly petty next to the bloodshed in Europe. I am no geo-political expert, I have no insight into how this conflict may play out, and frankly, anyone on Wall Street who claims to understand the situation is for lack of a better term…full of $%*%. For these reasons I will not waste words prognosticating about what may happen or how the market will react. Remember the market RALLIED over 6% in a straight line after it was announced that Russian tanks had crossed the Ukrainian border on 2/24. What I will discuss is the implications for REITs of oil prices in excess of $110. I am old enough to have experienced the end of 2007 when oil prices breached $100 for the first time since the early 80s. I am also young enough to vividly remember the damage elevated oil prices caused a US economy already on shaky footing. While it may seem like a distant memory, it is important to acknowledge that elevated oil prices were a key precipitating factor to the great financial crisis of 2008. Are we facing another 2008-type of scenario here? Not necessarily. Consumers are in much better shape from a debt perspective, we are still in the early innings of an economic recovery, and a huge demographic wave of millennials continue to move into their prime spending years (we were just graduating college in 2008). These tailwinds aside, however, elevated oil prices traditionally have a tangibly negative impact on US consumer spending. Higher prices at the pump simply mean less discretionary dollars that US consumers can put to work in other ways. Think of higher oil prices as another form of “tightening.” Wallet tightening if you will. And while in a vacuum elevated energy costs are probably not enough to push the economy into recession, they are hitting concurrently with tightening monetary policy. This could be a problem. High oil prices = sticky high inflation = fewer options for the Federal Reserve.

INFLATION: HANDCUFFS FOR THE FED

This leads us to arguably the most significant implication of war in Europe for US investors. The prospect for energy prices that remain elevated, leading to inflation that is more persistent than previously thought. All else being equal, elevated inflation keeps the US Federal Reserve on an extremely hawkish monetary policy trajectory. This begs the question…will the fed abandon its plans to raise interest rates and shrink it’s balance sheet if the stock market continues to fall? After more than 10 years of being consistently back-stopped by the fed, equity markets have arguably developed a pavlovian response to bad news. See the immediate rally in stock prices following the Ukraine invasion. Only in a world in which bad news equates to dovish fed policy should stocks go up on such headlines. And since the great financial crisis, this is the world we have lived in. Investors are conditioned to expect the fed to ride in and rescue the market once enough bad news has reared its ugly head. But as we said earlier, this is a different world. “This time is different” are famous last words, I know, but that does not change the fact that inflation is already at 40 year highs, is a key concern for average Americans, and is clearly on the mind of the administration based on the extensive coverage it got in the state of the union address. Inflation could prove to be the dragon that eats the white knight Fed before it can ride to the markets rescue. So what does this mean for REITs? Less accommodative monetary policy makes capital more scarce, and REITs are capital intensive entities. Those that depend EXCLUSIVELY on cheap capital are likely to come under increasing pressure as financial conditions become more restrictive. For this reason we are avoiding and actively shorting REITs that depend purely on levered spread investing. This includes mortgage REITs, some specialty REITs, and certain REITs in the Net Lease sector. On the other hand, elevated inflation can actually benefit Apartment and Self-Storage REITs. This is already occurring, as rental rates in both property types moved meaningfully higher in 2021 and show few signs of abating. While comps get more difficult for many of these companies through 2022, conservative earnings guidance has many companies set to post similar earnings growth to 2021, which is astounding. Simply put, things are good for these property types, and until they meaningfully deteriorate, they will make up the majority of our portfolio longs.

FINANCIAL CONDITIONS: CREDIT SPREADS FLASHING RED

A more pressing concern for the overall market (REITs included) is the rapid widening of credit spreads and deterioration of financial conditions over the last six months. In 2018, it took almost an entire year for BBB spreads relative to the 10y treasury to widen 0.69 basis points, at which point the junk bond market had shut down, the stock market was down over 20%, and the fed was forced to punt on further rate hikes and pivot to a dovish stance. As of this writing, BBB spreads have widened 0.68 basis points over the last six months and are only 17 bps shy of the level they reached in December of 2018. The chart below illustrates how rapidly spreads for these poorly rated companies have moved relative to their history.

Spread widening is never a positive sign. It indicates lenders are less willing to take risk and leads to higher capital costs for those companies already in arguably poor financial condition. If there is one sure-fire sign that credit stress is beginning to mount, this would be it.

A similar story is playing out in the Bloomberg US Financial Conditions Index, which measures…you guessed it…US financial conditions. Over the past six months, and more particularly since mid-January, US financial conditions have gone from modestly positive (accommodative), to negative (restrictive). The last two times these levels were reached were in 2018 and 2020. In both instances, stocks fell more than 20 percent (they are currently 11% off all-time highs).

This is not to say that the end of the world is nigh. Consumers are still in solid shape and the labor market continues to improve. Well capitalized companies that can pass along inflation can continue to thrive absent a significant deterioration in demand, which there is little evidence of, thus-far. But signs of stress are showing in the credit market, to an extent we have not seen since 2018. And this time there is a real threat the Fed can not immediately reverse course. Remember this is the first time in almost 40 years that the Fed has had to deal with elevated inflation.

ENDURANCE IS NOT ENOUGH

It pains me to watch the tragic events unfolding in Europe and it pains me to watch investors stand pat while the market changes rapidly in front of them. The days of buying the FANG stocks and leaving to play golf are gone. The new paradigm requires creativity and flexibility, as we wrote last month. Remember, in the tech wreck of 2000/2001 the Nasdaq fell 85%! It is currently down -17% with a price to sales ratio still 59% above its 20-year median. Instead of buying expensive cash incinerating companies amidst the highest inflation in 40 years, we are content to own boring old Self-Storage and Apartment REITs, along with a robust short book and an abundance of cash to put to work when financial conditions begin moving in a more favorable direction. Our list of excellent companies to buy is long, but for many, now is not the right time. Widening spreads, sky-high energy prices, and a hawkish federal reserve are a potent cocktail, and not one that traditionally sends the stock market higher. In the meantime, we will wait and react, watching the data like a hawk and positioning accordingly. Dare and Endure,

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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