PERFORMANCE – Serenity Alternatives Fund I returned +0.77% in August bringing YTD returns to +5.1%. The FTSE NAREIT All Equity REITs index returned +0.14% bringing YTD returns to -9.87%.
NEAR-TERM HEADFAKE? – Lodging and Regional Malls led REITs in August, while Warehouse and Infrastructure stocks lagged. Is this the beginning of a sustained move higher for risk-on sectors?
LONG-TERM OPPORTUNITY – More evidence continues to accumulate that REITs could be on the cusp of a multi-year bull market. Patience, however, remains paramount.

Investors are not a patient bunch. We want the next big move in the market, and we want it now. Unless that move goes against our positioning. Then we want time to stop and think…to reassess the environment so that we can get to the right answer.

Unfortunately, the market rarely cooperates. As the old axiom goes…the market inflicts the most pain, on the most people, the majority of the time. This is why investors need to be vigilant, form a plan, and be ready to react when the market moves in an unexpected direction.

Right now, REIT investors are flexing their critical thinking muscles, trying to decide if they need to adjust their plan. Is the recent rally in hyper-cyclical Lodging and Mall REITs sustainable or not? Are investors simply taking profits in sectors that have had excellent performance year to date, or covering shorts in beaten down names? Or are we on the cusp of a longer-term shift in REIT sector performance?

While we firmly believe there will be a time to buy Hotel REITs, Mall REITs, and New York Office REITs, we do NOT believe that time is now. There is little evidence that corporate travel is returning, that retail bankruptcies have peaked, or that office usage is set to accelerate meaningfully. Betting on those names at this juncture could quickly result in 20-30% losses.

A Case in Point: When the model gives us the green light, we will happily go long New York City real estate. It is one of the most dynamic cities in the world, largely supply-constrained, and a market that foreign investors will pay top dollar to enter. SL Green (SLG) has a portfolio of New York City real estate headlined by 1 Vanderbilt Plaza, a 1 million square feet office tower right on top of Grand Central Station. After twenty years of planning, four years of construction and $3 billion dollars in development cost the building officially opened this week. In the midst of a colossal shift to work from home. Not…great…timing.

Unsurprisingly SLG is trading at a deeply discounted 10x AFFO multiple (a 10% cash flow yield). In the near term, the direction of NYC Office rents is certainly downward, and until they stabilize, SLG is likely to remain extremely cheap.

We have seen this movie before, however. New York office has recovered from disaster (9/11) and work from home has been in and out of vogue for the better part of the last two decades. New York office will return, and when it does, our model will be ready.

So despite our near term caution, we are very bullish on REITs longer-term. Over the next five years we may see a bull market in REITs that rivals that of 2003-2008 (13.8% annual returns) or 2010-2015 (16.9% annual returns). As always, timing matters, which is why we are happy to be patient and wait for a more compelling setup before we add cyclical exposure to the portfolio. When will then be now? Soon.

Performance: +0.77% in August, +5.1% YTD

Serenity Alternative Investments Fund I returned +0.77% in August net of fees and expenses bringing our YTD returns to +5.1%. The FTSE NAREIT All Equity REIT index (FNER) returned +0.14% bringing 2020 returns to -9.87%. The fund’s Sharpe ratio for the month was 1.64. Since the beginning of 2019, the fund has generated a Sharpe ratio of 1.85 versus 0.46 for the FTSE NAREIT index, indicating far better returns per unit of risk than the benchmark.

The best performing position in the fund this month was, wait for it…Innovative Industrial Properties (IIPR), up +18.12%. This is the second month in a row that IIPR has led the fund in performance, as outsized value creation via the acquisitions market continues to entice investors to the name.

IIPR has become an excellent example of how our firms fundamental research efforts complement our quantitative process. During a month in which the quant model performed poorly (Long Warehouse positions fell while short Lodging positions went up), the fund still had positive performance, and performance that beat the benchmark. This was a direct result of our fundamental risk management process and our continued exposure to IIPR, which is a fundamental best idea in the fund.

A New Paradigm? Lodging and Malls lead REITs higher

Augusts’ striking reversal in property sector performance stood out as the most noteworthy development in the REIT market during the month. Lodging REITs led the space higher, returning +12.5%, with Regional Malls rising +7.2%. Hotel C-Corps and Real Estate Services companies also performed well due to their high correlation with the S&P 500.

It is difficult to triangulate the reasons for renewed optimism in these beat-down property sectors during August.
RevPAR data for the Lodging REITs did not improve significantly, and retail bankruptcies continued to percolate. Macro-economic data did not meaningfully improve either, with unemployment still elevated, enhanced unemployment benefits expiring, and consumer confidence leveling off as re-opening momentum broadly stalled.

The continued slow grind lower in new coronavirus cases is probably the easiest factor to point to that could drive optimism in the Lodging and Mall REITs. The other explanation could be that a combination of retail investor speculation and short covering combined to produce large gains in such distressed REITs.

Whatever the cause, such a stark reversal in performance is noteworthy. While it’s tempting to write these moves off as a short-term bounce (a similar phenomenon occurred in early June), the possibility exists that the market is signaling the beginnings of a rally in risky assets. The beginnings of a durable recovery would certainly benefit Lodging and Mall REITs, and the market almost always moves before the data improves. For these reasons we are extremely respectful of these performance divergences and give them a great deal of thought.

That being said, the signs of a durable economic recovery that would drive corporate travel higher (a necessary condition for the Lodging REITs, which mostly cater to business clientele), or catalyze a rapid increase in broad-based retail spending remain few and far between.

The employment market is healing extremely slowly (while permanent unemployment is actually worsening), government aid and loan/rent forgiveness are coming to an end, and large population centers such as New York and Los Angeles remain highly restricted from a mobility standpoint.

As always, we will continue to monitor the fundamental data closely, alert for signs of an improving business and retail climate. In the meantime, we will continue to own REITs that can create value in spite of the pandemic, and REITs that can preserve value in spite of the economic recession.

The Long Game: Triangulating Opportunity

While our near-term outlook for cyclical REITs remains bearish, our long-term bullish outlook for the REIT sector continues to gain conviction. The more data we collect, the clearer it becomes that REITs exhibit some of their best performance early in economic cycles, historically outperforming almost all other asset classes.

A compelling illustration of this phenomenon is spelled out in the chart on the next page, which displays rolling 5-year annualized returns for the REIT market since 2000.

The first thing to notice here is the yellow line just above 10%. This represents the average 5-year rolling annualized performance of the REIT market going back 30 years. Said another way, on average, buying REITs and holding them for 5 years has generated a 10% return historically. That is a solid level of performance, and one of the main reasons most sophisticated institutional investors maintain meaningful allocations to REITs.

The second thing to notice is that following recessions, 5-year annualized returns in REITs tend to accelerate, with rapid moves higher during the 2003-2008 period, and the 2010-2015 period. This makes sense as fundamentals tend to fall during recessions, and then accelerate rapidly in the early innings of new economic bull markets. Since REITs own some of the highest quality commercial real estate assets in the US, and are typically opportunistic in deploying capital, their portfolios tend to recover more quickly than lower quality, less well capitalized private real estate peers.

So, what does this mean for investors from a practical perspective? If history is a guide, REITs tend to return 13-15% annually following recessions, and we are currently in a recession. Is this a guarantee that REITs are about to leap higher in the near future? No. But with interest rates low due to a committedly dovish Fed and portfolio fundamentals grinding through the pain of the current economic downturn, we are nearing a scenario that has historically been very bullish for the sector.

The Bottom Line: Then is not now…yet

Defining your time horizon and setting your expectations accordingly is an important exercise in investing. It may sound strange, but we remain near-term cautious on the REIT market and at the same time long-term bullish. With a 15% lead on the REIT index YTD, we can afford to be patient in deploying client capital, knowing that the REIT market will ALWAYS provide opportunities.

While we currently focus on preserving capital, our eyes are towards the horizon as we begin to assemble a stable of long-term ideas with huge return potential. There are a handful of high-quality REIT portfolios that continue to trade at or near distressed levels…but will continue to do so until better economic data arrives. During bouts of negativity we can begin building positions in these names with a solid margin of safety, awaiting the day that we put the coronavirus behind us and begin the next economic cycle.

Waiting for that day may be painful, but it will be worth it. When will then be now? Soon.

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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