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  • Writer's pictureMartin Kollmorgen

Value Traps, Star Destroyers, and a REIT Pep-talk: September 2023 in REITs

“IT’S A TRAP” – Admiral Akbar, Star Wars: Return of the Jedi

  • PERFORMANCE: Serenity Alternative Investments Fund I returned +0.45% net of fees in September vs the REIT index at -6.8%. Over the past 5 years the Fund has returned +12.5% annually versus +2.8% for the REIT index.

  • IT’S A TRAP: Was the “REITs are cheap” narrative a value trap? Certain REIT property types appear alluring but have lacked catalysts.

  • TARGET THAT SUPER STAR-DESTROYER: While interest rates continue to climb, certain REITs can help investors regain the offensive.

  • RED LEADER STANDING BY: We remain long-term bullish on REITs. History and theory suggest the tide of battle will eventually turn…

Innumerate streaks of light quickly resolve into finite points as the rebel fleet emerges from hyperspace. Morale is high as the carefully planned assault against the new death star approaches its inevitable denouement. Grim determination grips the fleet.

Before them appears the seemingly peaceful forest moon of Endor, orbited by the sinister, menacing, bulk of the Galactic Empire’s death-dealing new battle station. As the fleet approaches, a sense of menace builds. Communications are jammed, the imperial fleet then suddenly appears on the rebel’s flank.

The iconic quip that ensues perfectly encapsulates the moment.

“It’s a trap.”

The stock market, for better or worse, sometimes seems as merciless as the Galactic Empire. Just as many companies and investors were getting comfortable with a new economic paradigm, the bond market re-ignited, sending long-term interest rates up over 100 basis points in the blink of an eye.

As liquid proxies for the commercial real estate market, REITs have suffered as rates have moved higher, down over -10% since the soft-landing optimism of late July. The hopes for a 2023 recovery in real estate values and transactions suddenly seems much more remote than it was only 2 months ago.

Like the fate of our iconic Star Wars heroes, however, this recent rally in long-term rates does not spell certain REIT doom. While challenging for the cost of REIT capital, higher interest rates have a much more pronounced impact on less well capitalized commercial real estate firms. In a world of higher-for-longer interest rates, this eventually spells opportunity for the publicly traded REITs, which tend to have the BEST balance sheets in commercial real estate.

For an industry with extremely attractive long-term historical returns, the largest and best diversified commercial real estate portfolios in the world, and some of the best CRE minds in the business, higher interest rates are a bump in the road, one that could arguably be a long-term positive for REIT market share.

This month we discuss how to avoid falling into ever-present REIT value traps, followed by a plan for re-taking control of a REIT portfolio. With Serenity’s help, investors can meet the challenge of higher interest rates head on with a potent fleet of high-powered REIT selection tools and an experienced pilot at the helm.

PERFORMANCE: +0.45% in September vs REITs -6.78%

Serenity Alternative Investments Fund I returned +0.45% in September net of fees and expenses versus the MSCI US REIT Index which returned -6.78%. So far in 2023, Serenity Alternatives Fund I has returned +0.38% vs the REIT benchmark at -1.95%. On a trailing 3-year basis, Serenity Alts Fund I has returned +15.6% annually net of fees versus the REIT index at +5.7%. Over the past 5 years Serenity Alternatives Fund I has returned +12.5% annually net of fees and expenses, versus +2.8% for the REIT index.

Last month investors were clearly nervous about higher interest rates, and in September they arrived, sending REITs down -6.8% while the 10-year yield climbed past +4.5%. Leading the way lower were CRE services companies, Diversified REITs, and Free-Standing Retail (also known as Net Lease REITs).

CBRE group (CBRE), one of the largest components of the “RE Services” sector acted as a microcosm for much of the commercial real estate space in September. Earlier in the year,

CBRE execs were optimistic regarding the second half of 2023. They expected a loosening in the capital markets and a subsequent return of commercial real estate transaction volumes. During earnings calls they cited the potential for improving CRE conditions, and guided to revenue and EPS estimates that reflected an improving market.

Alas, the turnaround they expected has not materialized, and in September, CBRE was forced to slash 2023 guidance estimates and push out their expectations for a recovery into 2024.

Adjacently, in September, investors rapidly shifted their expectations to reflect a higher probability of a “higher-for-longer” interest rate environment. This is observable in the performance of interest rate sensitive REITs in the Free-Standing and Diversified property sectors. Concerns about the federal deficit, a still hot employment market, and potentially accelerating inflation statistics have propelled rates higher at a rapid clip.

For most commercial real estate companies, this was a potent one-two punch. Many in the commercial real estate industry were hoping for easing financial conditions in the fourth quarter, but the economy has delivered the exact opposite. This further increase in capital costs will continue to stress the commercial real estate ecosystem, with the highest leverage, highest duration portfolio’s seeing the most damaging impact.

This is one of the many reasons Serenity emphasizes balance sheet strength in multiple facets of our REIT selection process. Most of Serenity’s long exposure to REITs is in companies with fortress balance sheets. These companies will see less cash flow impact from higher rates, and some may even benefit in the long term. This is also why Serenity has an flexible (long/short) portfolio, so that we can hedge interest rate exposure in adverse environments (like this one).

IT’S A TRAP! How to avoid value traps? Focus on the direction of fundamentals…

It’s worth revisiting Serenity’s mission statement briefly this month as the REIT market struggles in the face of rising interest rates. Serenity’s mission is to preserve then grow client capital by investing in the REIT market. The order of that phrase is intentional. Every decision we make at the firm should be in service of our goal to first preserve, then grow client capital.

The preserve part, believe it or not, is the hard part.

Which is why this month we want to briefly touch on three REIT property types that have been luring investors with false signals for more than a year now. These property types have all been “cheap” based on the consensus narrative but have been significant money-losers since early 2022. Serenity has mostly avoided net long exposure to these property types and has, in certain instances, made money in these property sectors via successful stock picking on the short side.

1) Apartments

Multi-Family or Apartment REITs are bellwethers of many REIT portfolios. With some of the best long-term NOI growth in the REIT universe, over the full cycle, Apartment REITs are excellent allocations on the long side.

Apartment REITs have been arguably “cheap” since June of 2022 when they originally traded to a -20% discount to NAV. The problem has been that Apartment fundamentals have been deteriorating since they peaked in November of 2021. This can be seen in the two charts below. As rent growth moderated from +17.4% in November of 2021 to -1.2% in August of 2023, the Apartment REITs have predictably struggled.

At a current -19.9% discount to NAV, Apartment REITs are again arguably “cheap” relative to private market values. But we need to have confidence that there is not a further leg downwards in Apartment REIT NAV’s on the horizon. This is the KEY to avoiding value traps. Making sure the direction of fundamentals is bottoming before adding significant exposure on the long side.

Now this is where the Apartment trade gets interesting. September was the first month with a positive movement in the second derivative for Apartment rents in 21 months. While it is too early to load up the boat, a bottoming in Apartment rents is the first thing we look for on our bull-market checklist for this sector. We need to see more data over the coming months, but consider our interest piqued. A turnaround in Apartment fundamentals would meaningfully change the posture of the Serenity portfolio within this property type.

2) Cell Towers (Infrastructure)

The cell-tower property type has been a pain point for many REIT investors over the last year, Serenity included. As a historically excellent business from a cash-flow and reinvestment perspective, many REIT investors were lured into a false sense of security with these names in 2022, because they thought that organic growth of +7-8% would never fall, and that risk-off capital markets would always be favorable for the tower companies on a relative basis within REITs.

In 2022, both of those assumptions were turned on their heads. Similar to Apartment REITs, Cell tower REITs looked cheap as early as June/July of 2022, trading to the low end of their 3-year historical multiple range. They looked even cheaper in March of 2023, falling to the bottom of their 10-year valuation range at 16x forward AFFO. They look even cheaper today at 12x forward AFFO.

This is the classic value-trap in action. Cheap gets cheaper as the fundamental outlook weakens, and cost of capital goes up. That combination hits even the best REIT business models like a semi-truck. American Tower’s (AMT) 10-year historical cash flow growth of +10% has not mattered over the last 18 months as the name has re-rated lower along with peers Crown Castle (CCI – pictured below), and SBAC Communications (SBAC). Investors looking for a bargain have consistently lost money in these names and will likely continue to do so until either interest rates or fundamentals stabilize. As always Serenity is watching fundamentals like a hawk but will be on the sidelines until they improve.

3) Self-Storage

Another exceptional long-term business and full cycle REIT winner, the self-storage REITs have had abysmal performance over the last two years. Since January of 2022, Public Storage (PSA), Extra Space Storage (EXR), and Cubesmart (CUBE) have returned -20.2%, -42.8%, and -27.7% respectively. This in a business, that in the case of EXR, has generated compound cash flow per share growth of +15% over the past 10 years.

That is not a typo… a +15% AFFO per share CAGR over 10 years is INSANE (in a good way). And it HAS NOT MATTERED. The story of Self-Storage is a combination of the Apartment and Cell-Tower story. Well respected companies with deteriorating fundamentals that have continually looked cheap and continually gotten cheaper.

This is why REIT investing is brutally difficult and why it pays to check your emotional baggage at the door. Making money owning the self-storage REITs was easy for the better part of 10 years. Over the last 2 it has been almost impossible.

Now for the silver lining. Like Apartment REITs, Self-storage fundamentals have recently shown signs of getting “less bad”. Again, this is only the first step, and much more data is needed, but these companies tend to be some of the first REITs out of the gate during REIT bull markets and can potentially out-perform in recessionary bear markets as well. For these reasons, our ears have also perked up recently with regards to self-storage, and Extra-Space (EXR) in particular. More data is needed, and the last few months of 2023 will be very important for the evolving outlook for these names. As always…we are vigilantly watching.

TARGET THAT SUPER STAR-DESTROYER: In a challenging investing environment…use the right tools to fight back

While valuation is an important component of any investing process, it can be dangerous to use as a one factor model. As we discussed above, value traps are easy to fall into. They can, however, also be easily avoided by diversifying your investment style. Serenity, as many readers know well, has a process that blends value, momentum, and quality factors to find REIT opportunities.

This allows us to play offense, even in a challenging REIT market like the one we find ourselves in today. So where does the Serenity compass continue to point? Below are three companies that have recently dominated our model rankings.

  1. Marriot International (MAR) – While we have written about Marriot quite a bit lately, the company continues to dominate our multi-factor model ranks with continued positive momentum in both NAV and fundamental estimates. A recent investor day bolstered analyst confidence about the company’s growth trajectory, and MAR continues to be a prolific returner of shareholder capital. While the threat of recession is always a risk worth monitoring when discussing hospitality focused companies, at the current juncture the light for MAR remains green. Until the fundamentals change, or the macro data takes a meaningful turn for the worse, we will remain long MAR.

  2. Equinix (EQIX) – Again, Serenity may sound like a broken record with this company but similar to MAR, EQIX refuses to relinquish its hold on a top ranking in our multi-factor model. Data Centers remain one of the few property types in REITs with accelerating same-store revenue growth. We believe the company is benefiting from higher interest rates as highly levered private data center investment capital has all but dried up. This has left EQIX and DLR as the only games in town. At +20% leverage with an investment grade balance sheet, EQIX remains well positioned to thrive in the new economic paradigm.

  3. Brixmor (BRX) – Brixmor is a new addition to this list, as it has steadily climbed the Serenity model rankings over the past few months. With a perceived lower quality portfolio but comparable 10-year cash flow growth to Strip-Center REIT peers, BRX trades at a valuation discount that our model views as unwarranted. Strip retail has seen basically no new development for the better part of 10 years, and the retail ecosystem remains relatively healthy as employment continues to hold up. This bodes well for steady (if not exciting) growth for BRX. That combined with an attractive valuation and a very well-respected management team puts BRX firmly in the sweet spot for the Serenity multi-factor model. BRX is a new addition to the long portfolio, and we are excited for the alpha opportunity it represents.

RED LEADER STANDING BY: Reasons to get excited about REITs long-term

2022 and 2023 have been tough years for REIT investors, and it can be hard to maintain REIT optimism in the face of interest rates that seem determined to continue climbing higher. Serenity has extolled a decidedly un-exciting message recently as well, which is not fun to read or write, but has demonstrably saved our clients money.

Do not, however, mistake our patience and urged caution for complacency or a lack of enthusiasm. Every day draws us closer to the next REIT bull market, and when it arrives, investors will not want to be standing on the sidelines. This month it’s worth reviewing some of our favorite long-term REIT charts as we contemplate the next bull. The minute you count them out, REITs are likely to catch fire. The charts below illustrate how powerful that can be when included in an investor’s portfolio.


As we enter a new economic and geo-political paradigm, a diversified set of investing tools is more important than ever. Investing is not as simple as buying REITs that look “cheap” or chasing whatever the new “trend” is. The graveyard of investors that have fallen into value traps or piled into narratives at the top is large and growing.

We should similarly resist the temptation to give into fears of a broken REIT market. While today’s high interest rates may be daunting, the long arc of history reveals a favorable REIT story over the full cycle, and brighter days are certainly ahead for the industry.

As we move into this new era, a new paradigm calls for a novel set of investing tools. A model that blends the best aspects of value, momentum, and quality investing with disciplined execution and deep REIT knowledge. To protect and grow client capital, that is our sacred mission at Serenity. We have the tools and the track record, and are looking forward to the next REIT bull market.

Resist the temptations of the dark side,

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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