“You cannot say with any reliability that a certain remote event or shock is more likely than another … but you can state with a lot more confidence that an object or a structure is more fragile than another should a certain event happen.”

– Nassim Taleb

• PERFORMANCE – Serenity Alternative Investments Fund I returned +2.36% in March net of fees and expenses and has returned -5.3% in 2022. The FTSE NAREIT All Equity REITs index returned +7.06% in March and has returned -5.3% for the year.
• TIME TO BUY REITS? – REITs were up big in March. Is it time to go all-in?
• BOND YIELD OMENS – BAA rates have increased REIT debt costs by roughly 100bps in 6 months. What does this mean for the average REIT?
• PATIENT SPECULATION – Pockets of opportunity exist for PATIENT investors within the REIT market.

With tanks rolling across Europe in late February and the Federal Reserve set to raise interest rates for the first time since 2018, many investors assumed a reckoning was on the way for US equities. Instead, on February 24th, the S&P 500 opened down almost -2%, closed up almost +2%, and went on to rally by +8.5% over the next month.

Even Nostradamus was left scratching his fortune-telling head. A tightening fed, rising interest rates, widening credit spreads and… rising stock prices?

Such a positive response indicates just how sound of footing the US economy was on coming into 2022. The jobs market was incredibly strong, rates were incredibly low, and asset prices were at all-time highs. The market, quite literally, has been nearly bullet-proof.

But even the best Kevlar can only withstand so much. So far, the market has weathered deteriorating credit conditions, high energy prices, and a single Federal Reserve interest rate-hike. With a recession likely in Europe, lockdowns in China, nasty persistent inflation, and more hikes on the way, is the economy still on firm footing? Or has the ice begun to melt beneath the market?

As we have written in the past, at Serenity we prefer to focus on market fragility as opposed to market events. Said another way, we are more concerned with the economy’s ability to absorb bad news than the news itself. While the market has so far proven resilient, cracks in the armor are becoming more and more apparent. We still have some risk in the portfolio, as fundamentals remain strong for many REITs, but the economy is becoming more and more fragile, and our outlook continues to get more cautious.

Long-term, the REIT market will always present us with opportunities. There are some in the market right now, but there is also a high level of danger associated with the risk factors we listed above. For this reason, we have chosen to remain patient, lower our risk levels, and prepare for the next great opportunity set. We have the tools to weather a potential storm and ride out the other side in style.

Which is precisely what we intend to do.

PERFORMANCE: +2.36% in March, -5.3% YTD

Serenity Alternative Investments Fund I returned +2.36% in March net of fees and expenses versus the FTSE NAREIT REIT index which returned +7.06%. Year to date, the fund has returned -5.3% net of fees versus the benchmark at -5.3%. Importantly, however, the funds volatility in 2022 measures +14% on an annualized basis, versus +22% for the REIT benchmark. Our portfolio has fluctuated much less than the broader market this year, due to our reduced level of risk taking amidst this highly volatile environment.

On a trailing 3-year basis Serenity Alternatives Fund I has generated annualized returns of +21.4% net of fees and expenses. Over the same time period, the REIT benchmark has returned +11.9% on an annualized basis. The fund’s Sharpe ratio over the past 3 years sits at 1.34, versus 0.66 for the REIT benchmark.

The largest positive contribution to the fund’s return in February was Switch, Inc (SWCH) at +18.6%. Switch is a Data Center REIT with a concentrated portfolio of data center “campuses.” From 2015-2021 Switch grew its revenue and adjusted EBITDA at a 14% CAGR. The company expects to achieve a 10-12% revenue CAGR and a greater than 12% AFFO CAGR from 2021-2026. Until very recently Switch traded at a discount to data center peers, but with Cyrus One (CONE) and CoreSite (COR) both being acquired, investor capital has flowed into Switch, driving its valuation multiple, and stock price, higher.

Switch has made monumental strides in investor relations and communication in recent years. Today the company is able to clearly articulate a compelling growth path that was laid out during 2021’s investor day. The company has a rapidly growing cross-connect business, a strengthening network environment within its campuses, sources 100% of its power from renewable sources, and sports one of the most impressive cash flow growth profiles in the REIT space. As we have become more familiar with SWCH, it has become more of a staple in the Serenity portfolio. While a bit on the expensive side relative to peers currently, we like the companies long-term outlook, and are likely to remain shareholders as long as the company can execute on its communicated growth path.

The worst performing position in the fund in March was Century Communities Inc (CCS). CCS was down -15.6% in March, slightly worse than peers in the homebuilding space. As 10-year yields have risen rapidly, mortgage rates have followed, sending homebuilding stocks lower in 2022. We have owned CCS for quite a while, as the company benefitted handsomely from the homebuying surge of 2020 and 2021. We were not quick enough to exit, however, and our small position in the name has been whittled down as the year has progressed. CCS is now extremely cheap on any valuation metric and continues to grow at a rate higher than its peers. Mortgage rates, however, will likely need to stabilize in order for the homebuilding sector to find its footing.

Buy REITs? March was fantastic…are we in the clear?

At Serenity we love buying REITs. There is nothing better than pounding the table on a sector you know extremely well. In December of 2018 and October/November of 2020 we did just this. It doesn’t get much more straightforward than this quote from our November 2020 newsletter.

“This is the most compelling opportunity in REITs I have seen in my career. Period. End of sentence.”

Between November 1st 2020 and Dec. 31st 2021 REITs returned +63.85%, while our fund returned +73.5%.

At the time REITs sported extremely attractive valuations, positively inflecting fundamentals, and an identifiable catalyst in the introduction of COVID-19 vaccines. They were also an incredibly un-popular investment based on their deep discount to most S&P 500 stocks.

Fast forward to April of 2022, however, and many of these trends are moving in reverse. While fundamentals remain strong, growth is unequivocally decelerating for most property types relative to 2021. At the same time, valuations have risen significantly, in many instances to well above historical norms. While strong fundamentals may justify lofty valuations, the second pillar of REIT multiple expansion is rapidly eroding. That of REIT debt costs.

Bond Yields: A series of scary omens…

As a capital intensive industry, the REIT market is traditionally very sensitive to changes in bond yields. As bond yields rise, it becomes more expensive for REITs to finance external growth and to refinance existing debt. More expensive debt translates into lower earnings (all else equal), higher cap rates, and lower NAV’s. For this reason, REITs tend to be negatively correlated with bond yields (or more precicesly, with credit spreads).

In March, however this was not the case. 10-year tresury yields increased by 37 basis points during the month from 1.96% to 2.33%. BAA rates (a good proxy for REITs cost of debt) bottomed at 3.96% in March and have since risen to 4.5%. BBB spreads relative to the 10-year yield were actually flat during the last month, but have risen almost 40 basis points since January (from 1.2% to 1.6%).

Why is this noteworthy? Because these are incredibly rapid moves in bond yields. The 5-year chart of BBB spreads tells the story well. After a full year of languishing below 1.2%, BBB spreads have rapidly broken out to levels not seen since the March of 2020 pandemic panic. BAA rates similarly are back to 2018 levels, a time period in which REIT AFFO multiples were much lower than they are today. While bond yields are only one piece of the REIT investing puzzle, they are sending a pretty straightforward signal, and it is not a positive one.

The other geometric configuration that should be of concern to investors of all stripes is the shape of the yield curve. As rates have moved rapidly higher, the yield curve has flattened massively, with the 10’s vs 2’s spread (the difference between 10-year treasury yields and 2-year treasury yields) actually going negative in March. This has not happened since the summer of 2019, and tends to be a pretty good predictor of recessions 6 to 12 months in advance. While it may be startling to throw the “R” word out amidst such a seemingly strong economy, massive monetary tightening within a very short time period is bound to have fairly rapid negative effects on US economic activity.

An inverted yield curve in itself does not garauntee an economic recession or negative returns for stocks. Throw in a tightening Federal Reserve, 40 year highs in inflation, and oil above $100 however, and the economy’s “solid footing” begins to look a lot more wobbly.

Patient Speculation: When not even the fed can dampen your enthusiasm…

It should be clear to our readers by now that we are increasingly cautious with regards to REITs and the overall market. The Fed is committed to slowing inflation, and that means slowing demand, which means slowing economic growth. If they are not extremely careful, they can cause volatility to spike in the capital markets and send stocks (and REITs) 10-20% lower. This is not a low probability scenario, hence our caution.

And yet…there are also pockets of the REIT market that we find extremely interesting. Remember our criteria for pounding the table on REITs from earlier? Compelling valuations, positively inflecting fundamentals, and widespread investor apathy. Most REIT sectors no longer pass the valuation or fundamentals tests, and some never passed the investor apathy test. A few though…may pass all three.

Now before we dig into a contrarian “buy” in REITs I need to issue a short disclaimer. This trade is speculative. The property sector I am about to discuss has higher volatility than the average REIT, and therefore can be inherently more dangerous within a REIT portfolio. We currently have positions in this sector that are smaller than average and will likely never approach our max allocation limits due to their volatility.

It is also likely to induce a cringe. Most seasoned REIT investors have at least one horror story about owning <gasp> the Lodging REITs.

In our view Lodging REITs are interesting here for the reasons we detailed above. Fundamentals are improving as the Omicron wave wanes, valuations are attractive relative to history, and Loding REITs are almost always un-popular investments. Let’s look at our best long idea in lodging as an example.

Host Hotels (HST) can be considered the most “blue-chip” of the Lodging REITs. It has a well-respected management team, a strong balance sheet (relative to peers), and a track record of creating Net Asset Value (NAV) despite operating in an incredibly difficult industry. Host has suffered the same setbacks as most hotel owners through the pandemic and into the recovery. Occupancy fell precipitously in 2020 and has been slow to recover back to 2019 levels. Every wave of a new COVID variant has stalled hotel demand, delayed returns to the office and business travel, and kept group bookings from achieving sustainable momentum.

At this point, many prognosticators view the hotel industry as permanently impaired. They don’t believe that business travel will ever return to normal levels, and that group travel may recover very slowly. This on the surface does not bode well for Host, as its business is evenly split between leisure travel, business travel, and group travel. Having 1/3 of your revenue permanently impaired does not sound like an attractive business to invest in.

For these reasons Host has (in our view) very conservative sell-side estimates for revenue and EBITDA in 2022 and 2023. Consensus estimates that Host will generate $4,371 million in revenue in 2022. This is -19.7% below the revenue the company posted in 2019. In 2023, consensus estimates that Host will generate $5,089 million in revenue, or -6.5% below that of 2019. This assumes that Host grows their revenue at about $94 million a quarter in 2022. In 2021, the company grew their revenue by on average $182 million a quarter.

The metrics for sell-side EBITDA estimates are similar. Based on consensus estimates, Host will not reach 2019 EBITDA levels until 2024. In 2022, it is estimated that Host will grow EBITDA at on average $21 million per quarter. In 2021 the company grew EBITDA by on average $86 million per quarter.

Despite the omicron wave being firmly in the rearview mirror, RevPAR hitting 2019 levels in March (based on Smith Travel Research data), and ADR well above 2019 levels across the board, the sell-side still has revenue growth and EBITDA growth slowing meaningfully for Host in 2022.

These assumptions seem incredibly conservative to us especially in the face of a large uptick in business travel reported in March. Add this to the fact that Host trades at a forward AFFO multiple below the 25th percentile of its history, and you have a REIT that is cheap on almost any metric, with a high probability of beating and raising consistently for at least the next 4 quarters.

Again, it is worthwhile to stress that Lodging REITs are the most volatile property type in the broader REIT market, and that a sell-off in the space would likely not be friendly to Host or any of its lodging peers. That being said, there are few property sectors with deep discounts to NAV, low multiples, inflecting (positively) revenues, and conservative sell-side numbers.

Patience, Patience, Patience.

In a society with the attention span of a goldfish, it can be PAINFUL to be patient and wait for opportunity. As a relatively young portfolio manager, I want good ideas that I can execute on NOW, but I consistently find that my best ideas are those that require the most patience. In a market that looks increasingly fragile, risk-taking can often lead to disaster, while patience and planning lead to success.

So, we wait and watch. The REITs we own are likely to continue to grow rapidly regardless of the whims of the market, while we plan for a day when the REIT market has better opportunities and a more solid footing. In the meantime, we can take calculated risks in companies that are extremely cheap with improving fundamentals. If the fed is able to thread the needle, some of these companies could soar. If not…well, we have a pile of cash prepared for any stock market havoc that ensues.

Don’t push the teacup off the table,

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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