“Rockets are cool. There’s no getting around that" – Elon Musk
PERFORMANCE: Serenity Alternative Investments Fund I returned +2.94% net of fees in September vs the REIT index at +2.66%. In 2024, the fund has returned +18.8% vs +15.8% for REITs.
PREPARING FOR LIFTOFF: Are Apartment fundamentals set to move higher in 2025?
CENTRIPETAL ACCELERATION: Healthcare REITs, cost of capital, and the virtuous cycle.
ASTRONAUT ICE-CREAM: A few strange tasting diversifying REIT ideas.
In Q3 of 2024, REITs initiated a new phase of their recent bull run, returning +16% versus +5.9% for the S&P 500 and +2.1% for the Nasdaq 100. Since late October of 2023, REITs are up +42%.
The REIT rocket-ride of 2024 has come amidst a decline in 10-year interest rates from nearly +5% in late 2023 to +3.76% as of the end of Q3. Inflation has moderated, the capital markets have perked up, and fundamentals in many REIT sectors are improving.
The question for REIT space pilots now becomes…is the ride over? Or is there still rocket-fuel in the tank?
With Apartment fundamentals preparing for liftoff, Healthcare occupancies rising rapidly, and supply pressures easing across the REIT universe, this REIT expedition may have, in fact, just left the platform.
Some of the low-hanging fruit has certainly been picked. REIT investors should not bank on another -100 basis point drop in 10-year interest rates. But the sustainable portion of the REIT story (accelerating growth) is still in its infancy. Cyclical REITs are still posting organic revenue growth between 0% and 1%. This should accelerate to +3% to +5% as supply pressures ease in coming years. Even Office REITs are beginning to see increases in occupancy, indicating a broad-based improvement in the commercial real estate market that may only be in its early innings.
While there will undoubtably be turbulence on this interstellar REIT journey, the trajectory of growth continues to become clearer. The CRE market is recovering, and REITs are leading the way. With a rate-cutting Fed now re-fueling the US economy, REITs are poised to potentially power even higher over the next few years.
PERFORMANCE: +2.94% in September +18.76% YTD
Serenity Alternative Investments Fund I returned +2.94% in September net of fees and expenses with +80% net exposure versus the MSCI US REIT Index which returned +2.66%. Year to date Serenity Alts Fund I has returned +18.8% with only +70% net exposure vs the REIT index at +15.8%. On a trailing 3-year basis, Serenity Alts Fund I has returned +7.5% annually net of fees versus the REIT index at +5.0%. Over the past 5 years Serenity Alternatives Fund I has returned +13.4% annually net of fees and expenses with a 1.08 Sharpe ratio, versus +5.5% for the REIT index.
One of the most profitable positions in the fund in September was American Healthcare REIT (AHR), up +26%, and topping the funds’ performance charts for the second straight month. AHR continues to be one of the best stories in the REIT industry, with superior growth to most healthcare peers, a discounted valuation, and a management team that continues to impress. AHR recently exercised its option to buy the remaining 24% of Trilogy, a high-quality Integrated Senior Health Campus (ISHC), signaling the beginning of accelerating external growth for AHR. With an improved cost of capital, we would expect AHR to post near sector leading earnings growth in 2025. Serenity remains long.
The least profitable position for the fund in September was Medical Properties Trust (MPW), a short position which rose +32% during the month. Regular readers will be familiar with MPW as we have been short the name since it was a $20 stock (now $5.60). In September, MPW announced a restructuring deal with their largest (and now bankrupt) tenant Steward Healthcare. In MPW’s “plan” the company claims that it will regain up to +95% of Stewards original rent by the end of 2026. We find this hard to believe, as MPW made a similar claim in February 2024, three months before Steward filed for bankruptcy. Simply put, the MPW management team has a track record of badly misleading investors, $1.5 billion in debt maturities to meet in early 2025, and few remaining levers to pull to stay solvent. Serenity remains short.
A few additional notes on fund performance this month. As seen in the table below, Serenity continues to lead the REIT investing industry from an absolute and risk-adjusted returns perspective. Since 2019, Serenity has delivered +18.0% annualized returns net of fees, versus +10.8% for our next highest ranked peer. The fund’s volatility has come in at +13.0% versus an average of +19% for other REIT funds. Our max draw-down (worst period of return from peak to trough) of -10% is 1/3 of the industry average of -30%. This puts our Sharpe ratio at +1.38 and our Calmar ratio at +1.73, both orders of magnitude higher than most actively managed REIT funds.
While long-only REIT mutual funds are not the perfect comp set for Serenity, they make up the majority of actively managed REIT assets. For better or worse, the universe of long-biased REIT hedge funds is non-existent outside of Serenity. But this is part of the point.
Our long/short hedge fund structure is intentional.
Serenity’s deliberately flexible structure allows our strategy to be opportunistic when deploying capital and gives us the ability to actively manage key REIT risks such as rising interest rates. We can harness REIT beta and enhance it by generating REIT alpha. The result is +18.0% annualized returns since 2019. And that includes a two-year REIT bear market…
PREPARE FOR LIFTOFF: Checking in on Apartment Fundamentals
One of the primary reasons Serenity remains bullish on REITs is that the year to date move higher for REIT prices has occurred without a realized increase in cyclical REIT fundamentals. This would suggest that much of REIT performance has been due to falling interest rates. If that is the case, REITs have ample room to run in 2025 as cyclical growth is likely to accelerate higher.
For evidence of this, let’s queue one of our favorite REIT charts, the YoY change in Apartment rents from ApartmentList.com.
The trend here, which we have discussed in the past, was meaningfully negative from early 2022 until late 2023 (along with Serenity’s disposition towards cyclical REITs). Since that time, rents have moved mostly sideways in 2024, as Apartment REIT portfolios absorb the largest wave of Apartment supply in 50 years.
Notably, however, Apartment rents ticked slightly higher on a YoY basis in August, despite continued supply deliveries. This is a very bullish signal for future Apartment fundamentals.
One thing we can say with certainty is that new Apartment supply is set to moderate meaningfully in 2025 and 2026, as very few Apartment buildings have been started over the past 2 years. All else equal, falling competitive supply almost always translates into better organic growth for the Apartment REITs. This trend should take hold strongly in 2025 (and potentially even late in 2024).
Hence the title of this section…prepare for liftoff. As of this writing, we should expect a move higher for Apartment REIT fundamentals over the next 12-24 months.
Now the usual disclaimers are in order here. At Serenity, we continue to vigilantly monitor the changes in the employment market which, frankly, are concerning. There is a non-trivial chance that an increase in unemployment delays the Apartment trade by reducing demand. For that to happen, unemployment likely must move closer to +5.5% (from current levels of +4.2%).
But with the data we have today regarding Apartment supply, it is likely a matter of “when” not “if” apartment fundamentals begin to improve.
The Bottom Line: Apartment fundamentals showed encouraging signs in August. Every month that goes by gets us closer to an environment in which new apartment supply is much lower, which traditionally translates to accelerating Apartment REIT fundamentals. Serenity remains long Apartment REITs and is inclined to add to our positions on pullbacks. We do, however, continue to monitor the employment situation closely.
CENTRIPETAL ACCELERATION: Healthcare REITs in orbit
One property sector that has firmly left the launch pad and achieved a nicely sustainable orbit in 2024 is the Healthcare REITs. Seniors Housing in particular has led the REIT industry with Welltower (WELL) +44.6% YTD and Ventas (VTR) +31.1% YTD. American Healthcare REIT (AHR), one of our favorite longs, has returned +127% since its February IPO.
With the market better understanding the fundamental tailwinds within seniors housing (SHOP), it begs the question…has the sector run too far too fast? Have Healthcare valuations hit unsustainable levels?
For a variety of reasons, we think the answer here is “No.” Despite their strong run in 2024, we believe Healthcare REITs can still generate strong (potentially double digit) returns for investors in 2025 and 2026. And one of the key reasons has to do with centripetal acceleration, the acceleration experienced while in uniform circular motion.
Just kidding, the key reason has to do with “cost of capital”. A much simpler topic, but one that is not often discussed outside of REIT circles. Cost of capital in the REIT industry is just what it sounds like…the cost a REIT has to pay in order to raise capital. Remember, commercial real estate is a capital-intensive industry, meaning that to develop commercial real estate assets, or buy large commercial real estate portfolios, you need to raise capital. And that capital…always comes with a cost.
For REITs we can think of this in two ways. Cost of debt, and cost of equity. The cost of debt for a REIT is very straightforward. What would the interest rate be if a REIT borrowed in the debt market? A good proxy for this at the industry level is BAA bond yields. Many REITs have BAA ratings, so BAA yields tend to proxy REIT costs of debt very well. BAA bonds currently yield +5.47%.
Cost of equity is a bit more complex, but in simple terms we can examine a REITs “implied cap rate” to gauge their cost of equity. This is the valuation multiple of a REIT that is implied by the company’s stock price. This number takes a bit of underwriting to calculate accurately but is an extremely valuable piece of information. In this example, let’s assume REIT XYZ has an implied cap rate of +5.5%, in line with the company’s cost of debt.
Now assume REIT XYZ wants to buy a $1 billion Seniors Housing portfolio. They have decided to finance the purchase with 50% debt, and 50% equity, so they will need $500 million in bonds, and $500 million in equity. Assuming they can raise both at around +5.5%, the cost of capital for this acquisition will obviously be +5.5% (+$55 million).
Now for the fun part. One way in which REITs create value for shareholders (increase their earnings/share and NAV/share) is by buying assets with cap rates HIGHER than their cost of capital. Simply put, if you buy $1 billion of Seniors Housing assets at a +7% cap rate, your NOI yield is +$70 million. If you finance that deal with a “cost of capital” of +5.5%, it will cost you +$55 million annually. That is +$70 million in the door, and $+55 million out the door. The +$15 million difference between the two goes straight to the REITs bottom line as additional cash flow, the vast majority of which accrues to investors.
You can even “cap” that $15 million in additional NOI using the REITs implied cap rate to measure the “value creation” of the deal. So, divide $15 million by +5.5%, and you get a value of +$272 million. That is $272 million added to the REIT’s Net Asset Value (NAV), simply by doing this transaction. $272 million in “value creation”.
Why am I taking us through this convoluted example of REIT value-creation math?
There is an important concept that emerges here for investors to appreciate. In REITs we call it the virtuous cycle. It refers to the fact that when REIT stock prices go up, it means that REIT costs of capital go down. Think back to our example above. Lower cost of capital increases value creation. In that same example, if we assume a +5% cost of equity (instead of +5.5%), the value creation on the deal increases to +$350 million (an increase of +28%).
This is important when discussing the Healthcare REITs because this type of value creation is occurring as we speak. Year to date, Welltower (WELL) has bought close to $4 billion in Seniors Housing assets and financed it with a cost of capital near +4.5%. Assuming those acquisitions have a cap rate around +7% (this may be conservative), that amounts to $2.2 billion in value creation. That is a big deal, and only possible because Welltower has an attractive stock price (i.e. cost of capital).
This virtuous cycle of raising capital at attractive prices and deploying it at attractive yields is one way in which REITs compound cash flow and NAV over time. It is also the silver lining to higher valuations, meaning that REITs that screen as “expensive” actually have a cost of capital advantage over their peers.
The Bottom Line: The strong performance of Healthcare REITs in 2024 has increased valuations, but simultaneously enhanced costs of capital and will allow these companies to grow at an accelerated rate going forward. Welltower is a good example of a company aggressively utilizing their cost of capital to create NAV/share for investors.
ASTRONAUT ICE-CREAM: Diversification ideas.
While I have never sampled it personally, I would imagine Astronaut Ice-cream tastes…interesting, to say the least. Anyone who has ever eaten on an airplane can attest to how strange high-altitude flight makes food taste.
In keeping with that analogy, the two companies I am going to discuss below may have a slightly unsettling effect on investor palettes.
That, however, is the point. Proper diversification means allocating capital to companies outside of your “best ideas” in case the market moves in a different direction than you would expect. When done well, diversification smooths the ride for investors and enhances a portfolio’s risk adjusted returns over time.
Enter Park Hotels (PK) and COPT Defense Properties (CDP). One Hotel REIT and one Office REIT, two of the more challenged property types in the REIT industry.
Park Hotels has recently made its way into the Serenity portfolio after moving into the top 10% of our CORE model ranks. Since the end of July, following a guidance cut in the second quarter, PK has fallen -3.4%, while REITs have returned +5.76% and Hotel REITs have returned +3.4%. This level of underperformance, per our model, has made Park a relative value play within the Lodging REITs.
On a fundamental level this makes sense, as PK trades at +9.7x 2025 EBITDA, versus +11.1x for the Lodging REITs on average. And while PK reduced its guidance (as every Lodging REIT did in 2Q), 2025 earnings estimates have only fallen slightly, down -3.1% over the past 6 months. Similarly, NAV growth for park is positive and above +5% over a three-, six-, and twelve-month time horizon.
This indicates that investors have very low expectations for Park, as bad news is priced into the company’s valuation, despite continued positive momentum in analyst estimates. These are the types of opportunities our model is built to find, relative value discounts with little justification in underlying fundamentals. Add Park’s outsized exposure to the New York City lodging market, and Serenity likes the company’s chances to exceed expectations going forward.
COPT Defense Properties (CDP) is another example of a REIT with steadily improving fundamentals and solid growth trading at a discounted valuation due to its property type. As an “Office” company, CDP has for the last few years traded below 15x AFFO, firmly in the “value” section of the REIT universe. It currently trades at +15.9x AFFO, below the REIT average, despite growth that is in the top 25% of all REITs.
CDP has an incredibly steady business leasing space to high-clearance government agencies, very few lease expirations over the next few years, and an excellent balance sheet. With the size of the government not set to shrink any time soon, CDP should continue to benefit as a preferred provider of highly sensitive space.
Bottom Line: CDP and PK are highly ranked REITs within the Serenity CORE model in very unpopular property types. With solid fundamentals and cheap valuations, these companies have been included in the Serenity portfolio, providing excellent diversification benefits from a property sector perspective.
TO THE MOON
After an excellent run in 2024, investors may be tempted to view REITs with skepticism going into 2025. How can these sleepy real estate companies follow up a +42% move off the 2023 REIT bottom?
Investors asked the same question at the end of 2009, after which REITs went on to return +28%, +8.3%, and +19.7% over the following three years.
While the future path of interest rates is unknowable, the picture for REIT fundamentals continues to take shape, and it looks more promising by the day. Healthcare REITs have strong internal growth and accelerating acquisition pipelines. Apartment REITs are poised for growth to accelerate as new supply fades in 2025. Even Office REITs are seeing occupancies increase, and Hotel REITs are deeply discounted.
The rocket is in flight, and the fuel tanks are still reading full.
Houston, we have lift-off,
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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