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  • Writer's pictureMartin Kollmorgen

WIND, RAIN, STORMS, AND THE ROCK: FEBRUARY 2023 NEWSLETTER




The rain came down, the floods came, and the winds blew, and beat on that house; and it did not fall, for it was founded on the rock.”


– Matthew 7:24-27 - Word English Bible



THE ROCK: Blue-chip, battle tested, counter-cyclical REITs are cheap and their portfolios are likely insulated from recession risk.

THE SAND: High leverage, low ROIC, highly cyclical REITs continue to trade at lofty valuations despite elevated interest rates and percolating recession risk.

THE STORM: Rates are headed higher, housing strength has faded, and construction job openings have begun to fall. Rain, wind, and an incoming flood…

Investing in an uncertain environment is paralyzing.


When the storm clouds gather, our instincts are to batten down the hatches, and hope the ship holds up.


But not all portfolios are built to withstand a Fed tightening cycle.


Those built on the sand of cheap capital are slowly being washed away.


Those built on the rock of high-quality commercial real estate assets will stand the test of time.


Crown Castle, one of the largest portfolios of US Cell towers, yawns in the face of recessions.


Equinix, a cash-flow behemoth and gatekeeper to the world’s internet connections, powered through the great financial crisis like a locomotive (+12.2%/year from 2007-2010).


Prologis, the world’s pre-eminent warehouse landlord owns a portfolio with rents that are still +30-50% below market.


A recession will break over these portfolios like so many waves against the rock of Gibraltar.


Simultaneously some REIT portfolios will be unceremoniously washed out to sea…permanently impaired or highly damaged by the tempest of +5% short term interest rates and lower economic activity.


REIT ETF’s, by their nature, own both future winners AND future losers.


We think you can do better. Our portfolio is built on a foundation of blue-chip commercial real estate portfolios that have survived previous recessions. The Serenity portfolio is hedged with high leverage, low ROIC, highly cyclical REITs that cannot thrive in a high interest rate environment. The portfolio’s Beta is near zero, protecting our clients from current volatility.


The harsh winds of reality continued to blow on REIT investors in February to the tune of -4.76%. At Serenity, our fund returned +1.17%. Wind, rain…meet rock.

PERFORMANCE: +1.17% in February vs REITs -4.76%

Serenity Alternative Investments Fund I returned +1.17% in February net of fees and expenses versus the MSCI US REIT Index which returned -4.76%. So far in 2023, Serenity Alternatives Fund I has returned +1.22% vs the REIT benchmark at +5.3%. On a trailing 3-year basis, Serenity Alts Fund I has returned +15.9% annually net of fees versus the REIT index at +4.2%.


Regular readers will be familiar with the fact that we significantly reduced the net exposure of the fund in 2022 as our economic outlook darkened. In July of last year, the fund’s net exposure dropped below +10%, a 3-year low. Over the following 8 months (through the end of February 2023), Serenity Alternative Investments Fund I has returned +3.59% net of fees with an average net exposure of just +3%. The volatility of the fund over that time has run at an annualized pace of +2.89, giving the fund an annualized Sharpe ratio of +1.88. In other words, the fund has generated annualized returns of over +5%, with almost no market risk since July of 2022 (the funds’ Beta has hovered close to 0 over this period).


Contrast this with the REIT market. Over the same interval, REITs have returned -8.45% with an annualized volatility of 26! That puts the Sharpe ratio of the REIT benchmark at -0.46. Serenity has generated +12% better returns with almost 10x less volatility than the REIT market since last July.


We mention this because the capital markets remain precarious. The Federal Reserve is set to continue raising interest rates in 2023. The yield curve is extremely inverted, and leading indicators of all shapes and sizes continue to point towards recession. As we documented last month, construction spending is poised to flip from an economic tailwind to a headwind, and the market is NOT pricing in a sustained move higher in unemployment.


Serenity clients can rest easy knowing their capital is well protected, and that we will continue to grind out returns independent of broader market movements. We have done so successfully over the last 8 months and have a full quiver of ideas for the turbulent days ahead.

ATTRIBUTION: The ticking time bomb…MPW (Medical Properties Trust)

The largest positive contributor to the fund’s return in February was Medical Properties Trust (MPW). We originally shorted MPW in February of 2022 at $20.50. The stock closed the month of February 2023 at $10.52, following an earnings report in which MPW guided to 2023 FFO that was -9.7% below street expectations. The stock fell -16% following the report. MPW has consistently obfuscated and denied a very simple truth that is now blatantly obvious to investors. The rent they charge hospital operating companies at their assets is simply too high and must come down.


We have written about this in previous newsletters. In healthcare real estate, most landlords and healthcare operators (the companies that provide healthcare services within hospitals or senior housing facilities) have a semi-contentious relationship. Operators cannot survive if real estate landlords charge rent that is too high, and landlords cannot operate medical facilities themselves, and therefore have a vested interest in keeping their operating partners in business (while trying to maximize the rent they pay). Most (honest) landlords resolve this issue simply by adjusting the rent they charge to a level that is sustainable for the operator given the profitability of a given building/portfolio. MPW, in stark contrast, lends money to its tenants on a regular basis, effectively bankrolling them in an effort to keep them paying a rental rate that is too high. This is both a dishonest and unsustainable solution to the problem, and investors have taken notice. We remain short MPW and think there is a 40-50% probability the stock goes to 0.


The worst performing position in the fund this month was Crown Castle (CCI). Crown Castle is a cell-tower REIT and one of the major players in the US tower market. If you are reading this newsletter from a mobile device, there is a good chance the information arrived at your phone via a CCI tower. CCI owns the second largest portfolio of towers in the US and has built a phenomenal business over its 25-year history (since its 1998 IPO the stock has returned +11.3% annually).


Recently, however, CCI has seen organic growth slow as tenants have churned within the portfolio, and the much-heralded roll-out of 5G internet has taken longer than expected. In February, the stock fell by -10%.


We still like CCI as a long and are likely to add to our position if the name continues to move lower. Over the past 10 years, CCI has traded at an average AFFO multiple of just over +18x. Today it trades at +16.4x, with an implied cap rate of +6.3%. For a company with a 10-year cash-flow CAGR of +6.3%, we believe today’s valuation represents an attractive bargain for a company with almost no cyclicality in its revenue stream. Assume a conservative +3.5% growth rate and +20% leverage, and an expected +12.2% levered annual return for CCI at current prices is very achievable.


THE ROCK: Not the one starring Sean Connery

Crown Castle is a good example of the bedrock that Serenity’s portfolio is built upon. While REIT stock prices are volatile over time (we can debate the merits/disadvantages of this in another newsletter), the value of their underlying portfolios changes much more slowly. Crown Castle owns a portfolio of over 40,000 cell-towers in the US, takes in over $1.5b in rental income every quarter, and has posted organic growth of at least +4.1% in every quarter since 2015 (which is as far back as our model goes). The company generates over $3.2b in cash every year and pays out a dividend yield of +4.74% that historically grows by over +8% per year.


Importantly for 2023, the state of the US economy has little bearing on the cash flow of CCI. The company derives it’s revenue from long-term leases to the largest telecommunication companies in the world (AT&T, Sprint, Verizon, T-Mobile), with almost no direct exposure to US consumers. Even if a large swath of people in the US decided to abruptly cancel their phone plans (an event we see as unlikely…), CCI still has a contract in place to receive rent from its tenants. Even a deep recession would likely have little to no impact on CCI’s bottom line, making their cash flow stream, in our view, extremely valuable amidst heightened recession risk.


Now for a quick thought experiment that is important with short-term interest rates approaching 5%**. Why own CCI when the 2-year yield is at or above the companies dividend yield? The answer is in the first paragraph of this section. +8% historical dividend growth. When given the choice between a risk-free return and an incredibly secure growing dividend at CCI, we would still gladly choose CCI (which is why it’s one of the Serenity portfolio’s largest long positions).


The same can be said for Equinix (EQIX), another of the fund’s largest long positions. EQIX owns the worlds’ premier data center portfolio. The company was literally created to house the earliest connection points of the internet, and now acts as the global switching center for a huge percentage of the world’s internet traffic. The internet (like the physical world) has hubs of activity in which vast amounts of information is exchanged at every given moment, and where physical proximity is key to keep the system functioning smoothly. EQIX controls many of these highly important internet nodes.


Like crown-castle, Equinix’s portfolio is a key component in the modern world’s digital infrastructure. You don’t send text messages, receive emails, watch YouTube videos, or connect to Facebook without the help of both CCI and EQIX. These are the modern railroads, the connective fabric of the American digital age. In order for the cash flow of these firms to be seriously impaired, a large percentage of the country would have to throw out their phones and cancel their internet access. Again…not a likely outcome in our opinion.


Now from a financial standpoint EQIX is a bit different than CCI. They do have more exposure to the end-consumer and small businesses, making their cash flows slightly more cyclical. EQIX also pays a lower dividend yield than CCI, opting to re-invest cash into building new data centers as opposed to returning it to investors. With yields on new data center builds in many instances approaching +15-20%, this is prudent capital allocation on the part of management.


From a total return standpoint, EQIX trades at a +5.93% implied cap rate, and a +4.2% cash flow yield (on 2022 cash-flow). The company has historically grown their cash flow by about +10% per year (over the last ten years). If we handicap this growth by 50%, and apply +20% leverage, we can still get to a +13.66% levered return expectation going forward (cap rate + growth)/(1-leverage).


Again, compare the +13.66% levered return (that carries some cyclical risk) with a virtually riskless +4-5% yield on a 2-year treasury note. In our view the added return is well worth the risk.


The point here is that Serenity is building our REIT portfolio on companies that can weather economic storms. In times of change, this type of bulwark in a portfolio is extremely valuable. Investors can sleep at night knowing the cash flow these companies generate is extremely secure, and that their capital is earning a real return well above the risk-free rate.


**Note: Much of this newsletter was written prior to the recent collapse in the 2-year yield from 5% to 4%. While this is a significant development, it does not change the conclusions here one iota. In fact, it arguably makes both companies MORE attractive.


THE SAND – The high leverage, high beta, low ROIC REIT morass


Investing in bulletproof portfolios is the current emphasis within Serenity’s long book but is only part of the fund’s risk-management story. REITs, as we mentioned, have higher volatility than their private market peers due to their correlation with the equity market. In turbulent times, volatility can be problematic as it translates into something that all investors fear. Losses.


In order to insulate our clients from the volatility inherent in an equity portfolio, we hedge our REIT portfolio using individual stocks (REITs). While shorting real estate companies makes some investors nervous, Serenity has over 7 years of experience doing so successfully, and over that period (from 2016-2023) our short book has made money. That is amidst a REIT market that returned +4.6% on an annualized basis. Said another way, we have a demonstrated track record of success on the short side.


Part of the reason for our success is a slightly unconventional view of the REIT market. While most REIT investors focus on property type characteristics to drive their short thesis, at Serenity we tend to focus on style factors and other sector agnostic company characteristics to drive our shorts. Simply put, property sector performance is more volatile than factor performance, and arguably less predictable. So instead of focusing on shorting “Apartments”, or “Warehouse” or “Malls”, we focus on shorting “high beta”, “high leverage”, “low ROIC” REITs regardless of property type. While this will lead to certain property sector tilts, those tilts become the outcome of, not the genesis of our short book.


Let’s elaborate with a few examples.


The first happens to be an Apartment company called Nextpoint Residential (NXRT). We have owned NXRT on both the long and the short side historically, and it is one of the most profitable names the fund has invested in over the years. NXRT has a good portfolio, a great re-development business, and a solid management team. It also, unfortunately, stands out relative to peers in one important way. Leverage (high level factor).


NXRT has (as of Q4 2022) a +56% debt/asset value ratio. For a private real estate company, or an individual asset, this may not seem high. Relative to publicly traded REITs, however, it is very high. Most REITs have +30-35% leverage using this same metric, with Apartment peers Mid-America at +17%, and UDR at +25%.


The effect of this higher leverage is that NXRT has guided to same-store NOI growth for 2023 of +11%. Their earnings growth guidance, however, is +1.4%. This indicates that close to 100% of NXRT’s potential growth for 2023 is being eaten by higher interest expense. This is the cost of higher leverage coupled with higher interest rates.


Because of this headwind, we continue to short NXRT as it trades at a similar valuation to much lower-levered peers. Over the short term, leverage will be a headwind to earnings and cash-flow that is not shared by other Apartment REITs with higher quality portfolios. All things equal, better capitalized Apartment REITs will have less drag on earnings and NAV growth, which should garner them a premium valuation.


Another REIT characteristic we wish to be short (in the current macro-landscape) is low ROIC (return on invested capital). ROIC is a measure of how much cash yield a given REIT can achieve by deploying capital. Equinix, as discussed above, can invest capital in data center projects that yield between 15-20%. Some of the REITs in our short book have ROIC’s closer to 3-4%.


Why is this important? Because ROIC is one input in the NPV equation at the heart of real estate investing. Put simply, an investor should only deploy capital into commercial real estate if their ROIC is above their WACC (weighted average cost of capital). If you can buy an Apartment building at a +5% yield, and raise capital at +4%, the NPV of that investment is positive. The inverse is also true, if your cost of capital is +5%, but you are investing at +4%, you are immediately NPV negative. This is the basic math used by every REIT management team each time they buy, build, or sell an individual property.


So why the diatribe into basic real estate math? Because some REITs have seen their ROIC compress to unsustainably low levels over the past 5 years.


Take Safehold (SAFE), another Serenity short idea. SAFE’s business is in originating what are called ground leases. These are super long-term (+99 year plus) leases that some real estate companies use as an inexpensive source of capital within the capital stack. SAFE, according to their disclosure, sports a +3.4% cash yield (4Q supplemental disclosure). This means SAFE is originating ground leases at less than a +3.5% cash yield, meaning their ROIC IS EXTREMELY LOW.


In a world of +1.5% interest rates, where you can borrow at +2-3%, this business model makes sense. In a world of +4-5% short term interest rates, however, it makes much less sense. Not to say SAFE is not a good business for the owners (corporate governance and management pay is a whole separate BIG problem with this company), but in a world in which investors can earn +4-5% virtually risk free, investing capital with SAFE (who is putting it out at +3.4%), does not make a lot of sense for most investors.


Does SAFE need to go to $0 for Serenity to make money? No, and we don’t expect it to. If SAFE can raise capital at a rate below their ROIC, they will survive.


But will our investors profit from shorting SAFE and re-investing in a CCI or an EQIX with a much higher cash yield and much higher historical growth? Absolutely.


THE STORM: Housing demand cratering to 27-year lows

Now before we continue with some updated thoughts on the macro-economy it’s worth reiterating a short and simple fact. At Serenity, we are in no way rooting for a recession. We are not in favor of job losses or bankruptcies. Nobody enjoys economic pain. Our job, however, is to PROTECT, and then grow our client capital. That is in our mission statement. Therefore, if we see a recession coming (and we do), we have a duty to prepare, and alert our valued, intelligent, and very good-looking readers as such. This has been our goal for the greater part of twelve months now.


With that being said, the headwinds we have discussed in these pages ad nauseum for the past 12 months continue to play out. As interest rates remain elevated (even after a steep and disconcerting 2-day drop here in March), commercial real estate activity has remained moribund, with housing activity falling AGAIN after a slight uptick in January.


The chart below is quickly becoming (we would argue) one of the most important charts in macro. It shows the weekly series of mortgage purchase applications as tracked by the mortgage bankers association. In January of this year, this series moved rapidly higher after falling rapidly in Q4 of 2022. This led many homebuilding companies to issue positive outlooks for 2023, assuming the worst was over and the recovery was on its way. We were skeptical at the time, and recent data throws the “all clear” call many have made into the blender.


In February and March, MBA purchase apps have fallen to levels not seen since 1996. This is not a sign of a healthy housing market. In order for demand to return to housing (and arguably for economic activity to bottom and improve) either interest rates have to move lower, or housing prices have to fall significantly. We view the latter as more probable with +3.6% unemployment and a Fed that seems committed to re-setting the economy to a more normal level of interest rates.


So what does this mean for REITs? Simply that it is not time to sound the all-clear. With credit stress clearly spreading, the risk to equity prices and real estate prices remains skewed to the downside. Fundamentals are falling but not yet bottoming. At some point REITs and other equities will be cheap enough that the market will clear and the worst will be behind us. We are not there yet (in our opinion).


**One note of optimism on this front. Distress has begun to appear in the Office REITs and select Lodging REITs. Again, we are not ready to jump into either sector with two feet, but prices are depressed enough to merit extra vigilance. Any M&A activity could cause 20-30% moves higher in either sector.


THE TEST: Who survives an era of elevated volatility?


The economy has not experienced a real recession since the great financial crisis of 2008-2009. That was over 15 years ago. Within the last few days, we have seen the first bank run, bankruptcy, and resolution since that time. How many portfolios are prepared for a repeat of 2008?


Many REITs barely survived the last recession but emerged much stronger because of it. It taught the industry the importance of a well laddered debt maturity schedule, the danger of an outsized development pipeline, the pitfalls of leverage, and the importance of capital preservation going into a crisis. You can already see these lessons shaping REIT behavior in 2023. The sins of the REIT past have crafted some battle-hardened and recession resistant portfolios and balance sheets.


We have built our long book on these rock-solid REIT portfolios. Our short book is replete with companies that failed to learn the lessons of the great financial crisis. REIT ETF’s own the whole pie. Winners and losers alike.


Choose your REIT foundation carefully,

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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