“You have to let it all go, Neo. Fear, doubt, and
disbelief, Free your mind.”

Morpheus – The Matrix

• PERFORMANCE – Serenity Alternative Investments Fund I returned +1.42% in July and +3.98% in August net of fees and expenses. Year to date the fund has returned +32.6%.
• THE ANTI-CYCLE – A convergence of factors have put the cyclical recovery on hold. Is the defensive posture of the market here to stay?
• VALUATION – At all-time highs, are REITs too hot, too cold, or just right?
• OPPORTUNITY – The market is fearful, is it time to get greedy in GDS?

Very rarely are REITs a trendy asset class. Investors tend to think of them as boring bond proxies best used as a fixed income substitute or as a defensive portfolio allocation. In the depths of the COVID crisis in 2020, most investors saw few reasons to allocate to REITs. Why invest in real estate when you can buy Zoom or Amazon?

Well fast forward 12 months and REITs have outperformed the S&P 500, the Nasdaq 100, the bond market, Zoom, and Amazon. REITs are up over 40% over the last year, our fund is up over 50% over the same time period, and investors still have fears, doubts, and disbelief.

Free your minds!

REITs are not boring bond proxies; they are the cream of the crop of the commercial real estate market. Their portfolios are the highest quality in the world, their historic returns are compelling, and their management teams are made up of the best real estate investors that exist.

Should REITs always and forever be the #1 position in your portfolio…NO! But ignoring the space ignores huge potential opportunities. With over 200 companies across 19 different property types, compelling commercial real estate investments are consistently available.

So, what will it be? Take the red-pill and add REITs to the portfolio? Or take the blue pill and continue to live in a world of REIT-less ignorance. The choice is yours.

PERFORMANCE: +1.42% in July, +3.98% in August, +32.6% YTD

Serenity Alternatives Fund I returned +1.42% in July net of fees and expenses, and +3.98% in August. The FTSE NAREIT REIT index returned +4.36% and +2.08% over the same two months. The fund has now returned +32.6% for the year, versus the REIT benchmark at +29.3%.

On a trailing 3-year basis Serenity Alternatives Fund I has generated annualized returns of +20.9% net of fees and expenses. Over the same time period, the REIT benchmark has returned +13.1% on an annualized basis. The fund’s Sharpe ratio over the past 3 years sits at 1.27, versus 0.69 for the REIT benchmark.

As of the end of August, investors who came into the fund in December of 2018 have doubled their money in less than three years net of fees, while only drawing down by -8% amidst the carnage of 2020. Over the past 12 months, the fund has returned over +50% net of fees, outperforming the REIT index as well as the S&P 500 and the tech-heavy Nasdaq 100.

Our call for a “REIT Renaissance” in November of 2020 looks accurate to say the least in retrospect. In our October of 2020 newsletter (published in November) we wrote “This month we get straight to the point. This is the most compelling opportunity in REITs I have seen in my career. Period.” Since that newsletter was published the fund has returned over +35%.

I’m not trying to take a victory lap here or experience some sort of “I told you so” catharsis. I am challenging our newsletter readers to… in the words of Morpheus “Free your minds”. We had a large number of conversations last year about the compelling opportunity in REITs, which were mostly met with fear, doubt, and disbelief.

It is incredibly difficult to harness market-beating returns. It requires vigilance, an open mind, and guts. Not everyone has the time or inclination to consistently monitor the market and jump into opportunities that can be emotionally challenging. This, however, is exactly why we founded the firm. We offer our clients the ability to consistently take advantage of opportunities in liquid real estate securities. Over the last 12 months that opportunity set has yielded a greater than 50% return.

The Anti-Cycle: The Delta variant puts investors on defense…

While the REIT market continues to grind higher, the primary story over the past six months is a familiar one to most investors. As the delta variant of COVID-19 has spread the pace of the economic recovery has slowed. This pause in cyclical momentum has impacted REIT sector performance meaningfully.

The chart to the right shows the profound difference in sector performance between the six months from September 2020 to March 2021, and the six months from March 2021 until now. As the cyclical recovery gathered steam along with vaccination efforts in the back half of 2020, highly cyclical REIT sectors (Hotels, Malls, Shopping Centers, etc) led the REIT index higher. Around mid-March, however, performance shifted towards secular growth REITs (Warehouse, Infrastructure [Cell Towers], Manufactured Housing, Single Family Rentals) as vaccinations peaked, COVID cases troughed, and the economy’s animal spirits started to fade.

This return to defensive positioning has driven growth stocks to new highs while cyclicals have taken a back seat. But with delta variant cases in the US potentially peaking, where do we go from here? Will the final few months of 2021 witness a return of cyclicality, or will economic momentum continue to wane as sentiment headwinds counteract cyclical tailwinds?

While we can spend hours exploring various scenarios as to how the remainder of the year plays out, the beauty of our process is that we do not HAVE to make a significant macro-economic call, in order to make our investors money. Our quantitative model continues to react to incoming data, illuminating REITs with attractive valuations relative to peers that are growing their cash flows more rapidly than average. Said another way, as the data changes, our model changes its robot mind, consistently orienting our portfolio towards those REITs with the highest probability of outperforming.

At this point Self-Storage, Apartment and Single-family Rental REITs dominate the top ranks of our model and make up the majority of our portfolio. The majority of these REITs are growing their NAV’s rapidly as rents move higher and can continue to perform well in either a high or low-growth environment. These REITs are also typically excellent inflation hedges, because lower unemployment and higher wages lead to higher rents.

As the year progresses and more clarity emerges regarding the direction of economic growth, our portfolio will expand to incorporate either more defensive or more risky positions depending on the environment. In the interim, we have sufficient REIT exposure to generate returns for our investors without taking on significant risk in a particular set of macro factors.

A strategy that can make money while the portfolio manager is wrong is at the least well balanced and at best, anti-fragile. We still believe that we are in the early innings of a new business cycle, and that cyclical stocks will return to vogue over the next few years. In the intermediate term, however, our framework is extremely flexible, ready to adapt to changing economic conditions as they arise. The model will continue to grind out high probability ideas, while our fundamental research will continue hunting for hidden gems. With multiple sources for alpha discovery, our process will almost always have a component creating value for investors.

VALUATION: Have REITs run too far too fast?

With the REIT market making all-time highs it is natural for investors to begin to worry about valuation. While a complex topic, we believe a few simple charts can shed light on whether REIT valuations are concerning or not.

The chart below on the left displays REIT earnings multiples versus those of the S&P 500. As can be seen from the chart, the multiple of the overall market (S&P 500) exploded higher in 2020 as the federal reserve injected stimulus into the capital markets while earnings fell. While they have fallen from recent highs, S&P 500 earnings multiples still lead REITs by a wide margin. Historically these gaps do not tend to persist for extended periods of time, and REITs have made up significant ground over the last 6 months. That being said, relative to the rest of the equity market, REITs do not look over-valued.

The second chart to the right displays the earnings yield of the REIT market versus the yield on the 10-year treasury. The spread between these two measures is a good indicator of the valuation of REITs relative to bonds. While REITs clearly tend to trade at a higher earnings yield than the 10y note, its significant to point out that in the past this spread has been much narrower. While investors in 10y bonds currently earn under 2% per year, REIT investors from an earnings perspective can still achieve a yield well north of 4% (and much greater than this in many individual REITs).

The takeaway here is that REITs are not expensive relative to either stocks or bonds based on these two measures. While valuations are higher in many REITs than they have been in the past, the same can be said for just about every major asset class. Remember, investing is a relative game, with money flowing into assets that are relatively attractive, and out of assets that are relatively unattractive. Using this framework, REITs still look attractive from a valuation perspective on a relative basis.

GDS: Fear and Greed in the People’s Republic

Opportunity, opportunity, opportunity. The more I think about it, the more I realize that I study the REIT market because it is awash in opportunity. There is nothing I hate more than thinking about opportunities in real estate securities that have passed me by. This is why we built a repeatable process…to continually highlight and act on opportunity.

But opportunity is not always comfortable and is often dangerous. Enter the dragon that is GDS Holdings (GDS). GDS is the premier data center owner and operator in China. The company is listed in Hong Kong, as well as in the US on the NASDAQ stock exchange, with its portfolio primarily consisting of data centers on the mainland of China. GDS is the most rapidly growing portfolio in the data center sector but is not a REIT and is not contained in any of the REIT indices.

As many investors are aware the Chinese government has recently taken regulatory actions designed to reign in the ambitions of Chinese technology companies. Particularly they have passed extremely strict data privacy laws, imposed restrictions on the gaming hours of children, and in some cases even taken ownership stakes in private companies. This burst of regulatory activity has sent Chinese share prices, and tech companies in particular, sharply lower. GDS is no exception, trading from over $115 in February, to under $60 earlier this month.

We have always considered GDS a high-risk name for exactly this reason…that you cannot predict foreign policy or know exactly how regional dynamics might affect the name. With such a steep sell-off though, GDS has become extremely interesting. While the average US data center REIT trades at 24.6x 2022 consensus EBITDA, GDS has fallen to 18.8x.

This discounted valuation is in spite of the fact that EBITDA grew by 50% in 2020, 38% in 2021, and is set to grow by 34% and 29% over the next two years. Using consensus estimates, that would indicate that the company is trading at 14.6x 2023 EBITDA, an 8 turn discount to US peer Digital Realty (DLR).

The regulatory risks to GDS in the current environment are real, and there is a distinct possibility that the company is in fact worth $0 as opposed to it’s current $60 share price. However, there is much higher probability that the Chinese government will continue to allow GDS to provide power and space to their ever-growing digital economy, in which case the company is worth closer to $100 (or more) than the current $60. Even with a 5% chance that GDS is a $0, with a 95% chance the portfolio is worth $100, the expected value of the stock would be $95, a tidy 62% higher than its current price.

There are plenty of reasons to be fearful of GDS. Investors can fear regulatory changes, they can fear hedge fund sellers of the name, they can even fear new competitors in the data center business in China. And these fears are well founded…it would not be prudent to go sell the house and use the proceeds to buy GDS. The potential opportunity, however, is that these fears are over-blown, causing a high-quality portfolio of rapidly growing assets to trade at a fraction of its true intrinsic value. GDS might be a zero, but it also might be a distressed opportunity in an extremely fast-growing obscure corner of the real estate market. The small but growing position in our portfolio indicates which we believe it is.

The rabbit hole to REIT wonderland…

Regular readers of our newsletter know our mantra of process, process, process. We maintain, however, that it should be a paramount concern of investors of all stripes looking to actively protect and grow their wealth. Do you have a process for consistently allocating to compelling real estate opportunities? Or are you happy to drift by in an investing daze, oblivious to the REIT world all around you?

Serenity was founded for those willing to chase the white rabbit and pursue REITs with calibrated ferocity. While we may not know Kung-Fu, we do know how to construct an all-weather REIT portfolio. We don’t try and bend the investing spoon; we only try and realize the truth. What truth?

There is no spoon,

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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