“Patience you must have” – Yoda

• PERFORMANCE – Serenity Alternatives Fund I returned +3.7% in April bringing YTD returns to -0.2%. The MSCI US REIT index returned +8.25% bringing YTD returns to -21.0%.
• PROCESS – REIT fundamentals continue to deteriorate. Risk management and patience remain points of emphasis.
• OPPORTUNITY – Bargains exist in the REIT market but are not widespread. Having an expert in your corner is important now more than ever.

In our modern world of Zoom meetings, same-day delivery, twitter, and streaming video, it’s not surprising that many investors lack patience. If my e-mail inbox is any indication, within the last two months, investors have gone from petrified to chomping at the bit, ready to snap up bargains across every asset class.

Investing, unfortunately, is not as easy as just buying things when they go down. The stock market tends to zig just when you are sure it’s going to zag, manipulating investors’ emotions, and then punishing those without an investment process.

To succeed over the long term takes emotional discipline and patience, something the OG Jedi-Master Yoda tried to impart to Luke Skywalker. Part of the reason Star Wars remains so socially relevant is that these core tenants are still difficult to master, maybe today more than ever.

So if you find yourself licking your lips imagining the epic returns you are going to generate buying distressed assets during the current recession…take a minute and consider the Jedi master’s advice. We are only two months into a period of significant economic distress and buying a security when even the people running the business don’t know what is going on is extremely risky.

Performance: +3.7% in April, -0.2% YTD

Serenity Alternatives Fund I returned +3.7% in April with an average net exposure of 1.2%. The fund’s Sharpe ratio for the month was 4.52, illustrating a large amount of return per unit of risk delivered to our investors. The fund is now down -0.2% for the year, while the REIT index is down –21.0% YTD. From here REITs have to achieve a +25% return to get back to even, while our fund is back to its high-water mark. From this position, we can continue to grind out low-risk returns while waiting for fundamentals to stabilize.

It’s rare for our strategy to carry such low levels of risk, but as everyone knows we live in exceptional times. We remain of the opinion that many REITs still have serious downside risk and are happy to wait and watch for more compelling opportunities. As we have previously stated, the fund will continue to increase its exposure to high-quality real estate portfolios with fortress balance sheets at highly discounted valuations. The fact that our net exposure remains very low is reflective of the fact that few of these opportunities currently exist.

Process – Value vs. Fundamentals

The reason we are stressing patience this month stems directly from our REIT investing process. While uncertainty is high across the board, one thing we can say for sure is that REIT fundamentals are deteriorating. Asking rents have fallen for almost every property type, development pipelines are paused, acquisition pipelines have dried up, and even the most optimistic REIT management teams are, at best, reiterating guidance (most REITs have pulled their full-year forecasts).

This is important because investing in businesses with deteriorating fundamentals is NOT part of the Serenity process. As laid out in the chart below, we only want to be buying REITs when fundamentals are accelerating. This is where investors have the best chance of generating positive forward returns.

The chart below lays out our process philosophy in four quadrants. Value is on the X-axis with fundamentals on the Y-axis. You’ll notice that with fundamentals accelerating, REITs qualify as either a “BUY” or “HOLD”. The same does not hold for value. Buying REITs that are cheap only works when fundamentals are moving in the right direction. The bottom left of the chart below is an example of the classic “value trap” scenario. That would be a REIT that looks cheap but just continues to get cheaper as their business gets worse. Our quant model and investment process are designed explicitly to avoid these types of scenarios. You’ll also notice the majority of REITs currently fall into the “value trap” quadrant.

Another thing to point out is that the value trap quadrant is labeled with the word “WAIT.” i.e. wait until fundamentals turn positive, then push your chips into the middle. We do NOT believe REIT fundamentals have bottomed, thus the theme of patience.

Perspective – NAV’s in the age of the coronavirus

There are a plethora of reasons that we believe fundamentals have further to fall before bottoming out and creating a more investable scenario for the REIT market. A massive surge in unemployment is likely to pressure consumer-facing landlords across the REIT universe (apartments, self-storage, retailers), as consumer’s ability and willingness to pay rent decreases meaningfully. Similarly, on the corporate side, continued uncertainty and falling revenues have put most corporate CapEx expenditures on ice, which will lead to lower leasing velocity and reduced pricing power for landlords of corporate tenants (office, warehouse, data center).

Put these together, and the result is likely to be lower occupancy, falling asking rents, negative same-store results in both revenue and NOI across the board for the REIT market. Some of these phenomena have already been confirmed in first-quarter earnings, many of which contained updates that included the month of April. And this was BEFORE the second-order effects of massively higher unemployment and our new socially distant working environment had truly taken hold.

To add a bit of perspective, we can examine the history of one of our favorite data series: Consensus Net Asset Value (NAV) estimates.

During the 2008-2009 crisis, NAV’s for the broad REIT industry fell 51% from peak to trough. That was accompanied by a 60% drop in REIT equity prices. In the current environment, NAV’s have fallen 11% from their February peak, while REIT prices are off 22%. The unemployment rate peaked at 10% in 2009, while it has already hit 14.7% in 2020.

Now there are numerous puts and takes here when trying to triangulate where REIT NAV’s shake out. During the last crisis, REITs carried significantly more leverage, more development risk, and faced higher amounts of over-supply in many product types. That would suggest NAV’s should not fall as much in this downturn. Then again, unemployment is already significantly WORSE in this episode than it was in 08-09, which is not a positive leading indicator for REIT demand, and thus net asset values.

The point here is that the current 10% draw-down in REIT NAV’s maybe only the beginning. Any “discounted” valuation being cited as a reason to buy REITs may evaporate over the course of the next 6-12 months as NAV estimates continue to fall.

If we say hypothetically that REIT values fall 25% during this recession, and at the bottom trade at a 10% discount to NAV, that means the entire space is at risk to fall an additional 15%.

Bottom Line: The direction of fundamentals is extremely important when evaluating REITs, as it can be the difference between buying a value stock and a value trap. With NAV’s moving in the wrong direction, we prefer to wait and watch for more fundamental stability before wading into REITs with two feet.

Opportunity – Difficult, distressed investing is…

We would like to make one more point on valuation based on the questions I field every day. It’s important to understand what is actually cheap in the REIT space currently, and what is not. Many investors have extremely quickly developed an appetite for “distressed assets,” which in their view may include the REITs. When I inform them that distressed valuations are only truly available in lodging and retail REITs, they quickly decide to look elsewhere.

In my view, this attitude completely misses the point of distressed investing. Finding bargain basement prices requires investors to dig deeply into areas that the majority of investors hate (cough, retail, cough). But I digress…

For context regarding the chart on the next page, most REIT property types traded to AFFO multiples (cash flow multiples) in the 10-15x range during the 08-09 downturn. What you can clearly see is that the only property types in this bucket currently are healthcare, regional malls, and shopping centers (Lodging as well, if you substitute in 2021 AFFO estimates). That’s it. The remainder of the REIT space trades in the 15-25x multiple range, which tends to be the normal range from the 2010-2020 cycle. Said another way, most REIT sectors are slightly cheaper than normal, but not significantly so.

Add to this the fact that some REITs are more expensive than any time in their history. Infrastructure, manufactured housing, and data centers continue to trade near all-time highs from both a price and multiple perspectives. The chart below is from a recent blog post of ours exploring the question “Are REITs Cheap?”

From that blog post “The divergence within the REIT industry shown in this table is glaring. The top 4 tech focused REITs in our universe (AMT, CCI, DLR, EQIX) make up almost 30% of the REIT industry’s market cap, and they trade at a 13x premium to the average REIT. Lodging and Retail REITs meanwhile, trade at less than 10x cash flow, and have shrunk to make up just 11% of the industry’s market cap.”

This all illustrates that serious context is needed when discussing whether or not REITs are truly “cheap”. If you focus on property types that are mostly empty, then yes, REITs are cheap. If you would rather invest in REITs with secular tailwinds such as data centers or warehouses, then the answer is a resounding “He#@ NO”.

Finding Serenity – Unlearn what you have learned

Investing takes patience. Especially during a global pandemic, when 1/5 of the country has become recently unemployed. Investors would be best suited to ignore the ever-changing narrative, conquer their inner FOMO (fear of missing out), and embrace the force data.

REIT NAV’s are moving in the wrong direction, macro-economic data is moving in the wrong direction, and many “cheap” REITs have a high probability of getting “cheaper”. At Serenity, we continue to monitor high-quality REITs with strong management teams for truly distressed pricing (which has been rare since mid-March). We also continue to be active on the short side, finding plenty of opportunities to hedge our portfolio using extremely expensive REITs with fundamentals teetering on the edge of deterioration.

As the current crisis unfolds, we will be patient and vigilant, consistently monitoring the REIT universe for signs of fundamental stabilization. As our favorite Jedi Master said “You will know (the good from the bad) when you are calm, at peace. Passive.” Sounds like Serenity to me.

May the force data be with you,

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

DISCLAIMER: This document is being furnished by Serenity Alternative Investment Management, LLC (“Manager”), the investment manager of the private investment fund, Serenity Alternative Investments Fund I, LP (the “Fund”), solely for use in connection with consideration of an investment in the Fund by prospective investors. The statements herein are based on information available on the date hereof and are intended only as a summary. The Manager has been in operation since 2016 and the Fund commenced operations on January 14th. The information provided by the Manager is available only to those investors qualifying to invest in the Fund. By accepting this document and/or attachments, you agree that you or the entity that you represent meet all investor qualifications in the jurisdiction(s) where you are subject to the statutory regulations related to the investment in the type of fund described in this document. This document may not be reproduced or distributed to anyone other than the identified recipient’s professional advisers without the prior written consent of the Manager. The recipient, by accepting delivery of this document agrees to return it and all related documents to the Manager if the recipient does not subscribe for an interest in the Fund. All information contained herein is confidential. This document is subject to revision at any time and the Manager is not obligated to inform you of any changes made. No statement herein supersedes any statement to the contrary in the Fund’s confidential offering documents.

The information contained herein does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made by means of delivery of an approved confidential offering memorandum and only in those jurisdictions where permitted by law. Prospective investors should inform themselves and take appropriate advice as to any applicable legal requirements and any applicable taxation and exchange control regulations in the countries and/or states of their citizenship, residence or domicile which might be relevant to the subscription, purchase, holding, exchange, redemption or disposal of any investments. The information contained herein does not take into account the particular investment objectives or financial circumstances of any specific person who may receive it. Before making an investment, prospective investors are advised to thoroughly and carefully review the offering memorandum with their financial, legal and tax advisers to determine whether an investment such as this is suitable for them.

There is no guarantee that the investment objectives of the Fund will be achieved. There is no secondary market for interests and none is expected to develop. You should not make an investment unless you have a long term holding objective and are prepared to lose all or a substantial portion of your investment. An investment in the Fund is speculative and involves a high degree of risk. Opportunities for withdrawal and transferability of interests are restricted. As a result, investors may not have access to capital except according to the terms of withdrawal specified within the confidential offering memorandum and other related documents. The fees and expenses that will be charged by the Fund and/or its Manager may be higher than the fees and expenses of other investment alternatives and may offset profits.

With respect to the present document and/or its attachments, the Manager makes no warranty or representation, whether express or implied, and assumes no legal liability for the accuracy, completeness or usefulness of any information disclosed. Certain information is based on data provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed and should not be relied upon as such. Performance information and/or results, unless otherwise indicated, are un-audited and their appearance in this document reflects the estimated returns net of all expenses and fees. Investment return and the principal value of an investment will fluctuate and may be quite volatile. In addition to exposure to adverse market conditions, investments may also be exposed to changes in regulations, change in providers of capital and other service providers.

The Manager does not accept any responsibility or liability whatsoever caused by any action taken in reliance upon this document and/or its attachments. The private investment fund described herein has not been registered under the Investment Company Act of 1940, as amended, and the interests therein have not been registered under the Securities Act of 1933, as amended (the “1933 Act”), or in any state or foreign securities laws. These interests will be offered and sold only to “Accredited Investors” as such term is defined under federal securities laws. The Manager assumes that by acceptance of this document and/or attachments that the recipient understands the risks involved – including the loss of some or all of any investment that the recipient or the entity that he/she represents. An investment in the Fund is not suitable for all investors.

This material is for informational purposes only. Any opinions expressed herein represent current opinions only and while the information contained herein is from sources believed reliable there is no representation that it is accurate or complete and it should not be relied upon as such. The Manager accepts no liability for loss arising from the use of this material. Federal and state securities laws, however, impose liabilities under certain circumstances on persons who act in good faith and nothing herein shall in any way constitute a waiver or limitation of any rights that a client may have under federal or state securities laws.

The performance representations contained herein are not representations that such performance will continue in the future or that any investment scenario or performance will even be similar to such description. Any investment described herein is an example only and is not a representation that the same or even similar investment scenarios will arise in the future or that investments made will be profitable. No representation is being made that any investment will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between prior performance results and actual Fund results.

References to the past performance of other private investment funds or the Manager are for informational purposes only. Other investments may not be selected to represent an appropriate benchmark. The Fund’s strategy is not designed to mimic these investments and an individual may not be able to invest directly in each of the indices or funds shown. The Fund’s holdings may vary significantly from these referenced investments. The historical performance data listed is for informational purposes only and should not be construed as an indicator of future performance of the Fund or any other fund managed by the Manager. The performance listed herein is unaudited, net of all fees. YTD returns for all indices are calculated using closing prices as of Jan 14th, the first day of the funds operation. Data is subject to revision.

Certain information contained in this material constitutes forward-looking statements, which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “target,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Such statements are not guarantees of future performance or activities. Due to various risks and uncertainties, actual events or results or the actual performance of the Fund described herein may differ materially from those reflected or contemplated in such forward-looking statements.

Our investment program involves substantial risk, including the loss of principal, and no assurance can be given that our investment objectives will be achieved. Among other things, certain investment techniques as described herein can, in certain circumstances, maximize the adverse impact to which the Fund’s investment portfolio may be subject. The Fund may use varying degrees of leverage and the use of leverage can lead to large losses as well as large gains. Investment guidelines and objectives may vary depending on market conditions.