“Some people don’t like change, but you need to embrace change if the alternative is disaster.”
– Elon Musk
• PERFORMANCE – Serenity Alternative Investments Fund I returned -2.5% in May net of fees and expenses and has returned -8.9% in 2022. The FTSE NAREIT All Equity REITs index returned -4.7% in May and has returned -13.0% for the year.
• CAPITAL PRESERVATION – The macro-economic landscape continues to dominate our decision-making process. This has resulted in continued alpha generation.
• SAFETY IN 5-CAPS? – Long ideas are hard to come by, but there is relative safety in blue-chip REITs trading at 5% implied cap rates.
Some things on Wall Street change rapidly.
Others never do.
While the loud, raucous trading floors of old are gone, there is still a vocal minority you can always find.
The “it’s different this time” crowd never truly changes. There are always those willing to sell you a story that has no basis in long-term reality. Tech companies should trade at 40x sales, inflation is transitory, Bitcoin is going to $1,000,000.
These stories end in disaster.
Serenity offers a real change. We offer the opportunity to protect and grow capital by investing in the highest quality commercial real estate portfolios in the world. We invest alongside our clients and make active, concentrated bets.
No over-diversified ETF. No promises of 30% indefinite returns from disruptive technology. No BS hidden fees or dubious IRR calculations.
A high-quality REIT portfolio, a monthly account statement, and a promise to treat your capital the same way we treat ours.
That’s it. That is a change we think investors can embrace.
As 2022 has taught us, the alternative (tech and crypto narratives) can be disaster.
PERFORMANCE: -2.54% in May, -8.9% YTD
Serenity Alternative Investments Fund I returned -2.54% in May net of fees and expenses versus the FTSE NAREIT REIT index which returned -4.68%. Year to date, the fund has returned -8.9% net of fees versus the benchmark at -13.0%, the NASDAQ 100 at -22.3%, the S&P 500 at -12.8% and the Russell 2000 at -16.7%.
On a trailing 3-year basis Serenity Alternatives Fund I has generated annualized returns of +20.0% net of fees and expenses. Over the same time period, the REIT benchmark has returned +8.6% on an annualized basis. The fund’s Sharpe ratio over the past 3 years sits at 1.25, versus 0.48 for the REIT benchmark (remember higher is better, more return per unit of risk).
The largest positive contribution to the fund’s return in May was Switch, Inc (SWCH) at +12.1%. The company announced on May 11th that it is being acquired by Digital Bridge (DBRG) at $34.25/share. We sold our position after the stock rallied just shy of its eventual take-out price. Switch has been an excellent performer for the fund in 2022, returning +16.9% versus the RMZ at -24% as of this writing. Digital Bridge clearly agrees with our assessment that Switch offered a compelling growth profile at an attractive price.
The worst performing position in the fund in May was Independence Realty Trust (IRT) at -14.1%. Independence was one of the funds best performing long positions through 2021 and remains one of our favorite names over the full cycle. Independence has a large re-development portfolio, exposure to growing markets with favorable demographics, and is likely to post top tier earnings growth over the next 3-5 years.
While we continue to love the company, in the current environment, IRT is not our favorite stock. IRT has certain characteristics that simply perform poorly in a risk-off environment. Namely, it is a small cap, high beta REIT with exposure to tenants closer to the median US household income level. These exposures have led us to trim our IRT position meaningfully, while also shorting a highly correlated Apartment REIT peer in order to hedge small cap, high beta risk from the portfolio.
This exercise in risk management is indicative of how our macro process informs portfolio construction in the fund. While the quant model and our fundamental research give IRT a thumbs up, right now the macro environment is more important. When credit spreads widen and growth slows, high beta REITs are not your friend. Our framework is intentionally designed to grant us the flexibility to identify and hedge these factors.
Capital Preservation: Priority 1, 2, & 3
It is exactly this flexibility, in fact, that makes our fund unique within the REIT investing ecosystem. Most REIT managers focus exclusively on fundamentals, effectively isolating themselves as pure stock pickers. Very few REIT funds actively risk manage their portfolio by hedging (shorting or selling) individual REITs based on the macro economic environment. And fewer still employ multi-factor quantitative models that allow them to build hedging portfolios.
They avoid active macro management for good reasons. First of all, macro economic analysis is the most difficult predictive space on Wall Street. The breadth of data available is immense, and it takes a huge amount of work to synthesize and analyze. For this reason, we partner with a firm that we believe is the premier macro provider on the street: Hedgeye Risk Management. Hedgeye employs an entire team of macro-analysts, and has a track record of making correct macro calls. Believe it or not, getting things right in macro is extremely rare on Wall Street.
As we have become more and more cautious through 2022, Hedgeye has been out in front of the current risk-off environment. They went bearish on the market in January, and we followed soon after. They were also instrumental in helping us preserve capital for our clients in 2020. A COVID year in which our fund returned +17.9% versus the REIT benchmark at -5.1%.
As the chart below illustrates, these periods of capital preservation via macro-awareness and risk management are hugely value-additive for our clients. When the market melted down in early 2020 the fund was properly positioned and saw a 20% jump in relative performance (versus the REIT benchmark) throughout that year. Similarly in 2022, we have pro-actively prepared our clients for an adverse market, raising cash and increasing our allocations to the short book. The orange outperformance line below continues to move up and to the right.
This trend has continued in June, with REITs down -11.6% so far this the month, while Serenity Fund I has only fallen -3.76%. There is a term for this type of outperformance… ALPHA.
I stress our ability to integrate macro-analysis into our strategy because it is a differentiating feature of Serenity Alternatives Fund I. We intentionally designed the fund with capital preservation in mind, knowing that our clients would appreciate the ability to sleep at night while the rest of the investing market occasionally goes up in flames.
This is one of those times. Serenity’s investors are down less than -10% through the end of May, with ARKK down -53.4%, Bitcoin down -40.0%, and the FANG stocks down -29%. AARK at $0.50 on the dollar, you have to post a +100% return just to get back to even. That is a tall order, particularly with a Federal Reserve that is firmly committed to raising interest rates.
When I say I run a long/short REIT hedge fund I often get a sideways look. People’s expression often seems to conceal the question “why would anyone ever need that?”.
My question at this point is different. How can any portfolio live without it?
5-Cap Compounders – Hiding in Blue-Chip REITs
From an outlook perspective, we remain bearish on the economy and continue to have an outsized cash balance and active short book. The Fed remains hawkish, economic indicators are rolling over rapidly, credit spreads are elevated, and the capital markets are destroying investor wealth at an ever increasing rate.
Interestingly, very little economic damage has seeped into REIT fundamentals thus-far. At the recent REIT week conference hosted by industry trade group NAREIT, the tone of almost every company was extremely positive. Business travelers continue to return to urban hotels, renters continue to pay more for apartments, and warehouse users continue to lease space at an incredible clip.
Juxtapose this against a REIT market that as of this writing is down -23.9%. What the market is saying is that the go-go days of incredible REIT fundamentals may be drawing to a close.
For this reason the Serenity portfolio has taken on more and more defensive characteristics. In a market in which spreads are widening and volatility is high, historically, low beta, low leverage, blue chip REITs offer a modicum of protection (particularly when compared to high leverage, high beta peers).
Two of our core allocations that fit this description are detailed below.
Equity Residential (EQR)
EQR is a blue-chip Apartment REIT specializing in coastal gateway, “A” quality, multi-family assets. A member of the Sam Zell real estate empire, EQR has a long and distinguished track record of generating cash flow growth and total returns for investors (+12.4% annual returns since 1993 IPO). EQR’s tenant base has an annual average income of $166,000, and the company sports a low levered balance sheet with a debt/asset-value ratio of about 20%.
From a historical valuation perspective, EQR trades near the low end of it’s historical forward price/AFFO (cash flow) multiple, as can be seen in the chart to the right. It also trades at a 5% implied cap rate on 2022 NOI. For the sake of context, B quality Apartment portfolios were trading for 3.5% cap rates as recently as December of 2021. This would indicate that EQR trades at (at least) a -35% discount to a late 2021 NAV.
EQR posesses all the qualities that we look for in REITs during a risk-off environment. Low leverage, low beta, a customer that is somewhat insulated from econmic shocks, and an irreplaceable portfolio of some of the highest quality apartment assets in the country. While a recession would certainly impact EQR’s portfolio, the relative safety of a name like this makes it a high quality long during the current economic paradigm.
Crown Castle International (CCI)
Crown Castle is one of the many unique real estate portfolios within REITs where investors have underallocated. CCI owns over 40,000 cell towers, about 115,000 small cells, and over 80 thousand route miles of fiber optic cable. Since 2014, CCI has grown it’s dividend at a 9% CAGR, has grown its cash flow per share at over 6.5% per year, and has returned +13.4% per year to investors. The company sports low leverage (18%), and remarkably consistent organic growth in the 5-7% range going back to the dawn of time (this is an exaggeration but not by much).
On a price to forward cash flow basis, CCI does not look quite as attractive as EQR, trading at 20.5x AFFO, north of the historical median of 18.1x. This median, however may be meaningless, as investors have in the past 5 years become much more familiar with the cell-tower companies and how robust their cash flow streams are. While no valuation is safe in the world of the hawkish Fed, 20x seems very reasonable for a company compounding growth consistently at 6% per year.
Like EQR, CCI trades at an implied cap rate a bit north of 5%. If we were to grow this cap rate at 6% for the next ten years, CCI’s NOI would be yielding 8.9% on the current stock price. After 20 years it would be yielding 16%. This powerful compounding and the companies ability to re-invest cash flow (saving it from having to issue equity often), make CCI a cash-flow juggernaught within the REIT space. Combined with the companies large market cap, low beta, and low leverage, and we have another blue-chip safety pick trading at a 5% cap rate.
Change or Disaster
With the investing world currently upside-down and snake-oil salesman being exposed left and right, where do you turn for honest and transparent risk management?
Do you allocate to the now-cheap tech company with negative EBITDA that is laying off workers in hopes of a rebound?
Or are you investing in unique real estate companies with strong cash-flows that grow their NAV’s consistently over time?
I’m no oracle, but I know where my money is.
Change or disaster,
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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