• PERFORMANCE – Serenity Alternatives Fund I returned +3.5% in July bringing YTD returns to 4.3%. The FTSE NAREIT All Equity REITs index returned +3.82% bringing YTD returns to -9.9%.
• EARNINGS – REITs began reporting Q2 2020 earnings in July, adding much-needed insight into the magnitude of Covid-19’s impact.
• POSITIONING – Gross and net positioning in the portfolio have increased as stable fundamentals have been confirmed in Warehouse and Data Center portfolios.

“Life breaks free. Life expands to new territories. Painfully, perhaps even dangerously. But life finds a way.”

– Michael Crichton, Jurassic Park

The US economy in April and May felt a bit like that scene in Jurassic Park when the T-rex is smashing a Land Rover to smithereens and everyone is just trying to stay alive. The stock market was imploding, most major cities had issued shelter in place orders, and there was a general feeling that things were out of control.

Fast forward a few months, and while the outlook is far from sunny, we can at least survey the damage and begin to move forward. As earnings season has progressed, many companies (including many REITs) have reported results that are much more positive than the doomsday scenarios many investors feared.

Life…and the US consumer…has seemingly found a way.

Don’t get me wrong, we are not out of the woods. We still have to navigate a volcanic island landscape (unemployment), ongoing power-outages (November elections), and avoid a roving T-rex (Coronavirus) in order to arrive safely back at economic growth.

It won’t be easy or fun, but there are signs of life: with Warehouse portfolios sustaining little damage, Data Center REITs continuing to see absorption, and even some Retail names showing glimmers of stability, there are stable sectors in the REIT market. If we’re lucky, at some point in the next six months the industry might even break free and expand to new territories…

Performance: +3.5% in July, +4.3% YTD

Serenity Alternatives Fund I returned +3.5% in July net of fees and expenses with net exposure below 30%, bringing our YTD returns to +4.3%. The FTSE NAREIT All Equity REIT (FNER) index returned +3.88% bringing 2020 returns to -9.9%. The fund’s Sharpe ratio for the month clocked in at a whopping 8.35, as we delivered almost 100% of the markets return with less than 1/3 of its net exposure. Since the beginning of 2019, the fund has generated a Sharpe ratio of 1.21 versus 0.39 for the FTSE NAREIT index, indicating far superior returns per unit of risk than the benchmark.

The best performing position in the fund this month was Innovative Industrial Properties (IIPR), up +17.13%. IIPR is increasingly becoming a fixture in our newsletters, just as CoreSite (COR) and CyrusOne (CONE) have been in the past. The common thread being that each of these companies have shown an above average ability to create value for shareholders, which compounded over time leads to significant excess returns.

Over recent quarters, IIPR has accelerated its acquisition activity, acquiring more than $500m in assets in Q4 of 2019 and Q1 of 2020, thereby doubling the size of its portfolio in less than a year. The company continues to achieve returns on invested capital above 12.5%, while raising equity at an implied cap rate closer to 6%. This makes every deal the company does phenomenally accretive, and makes consensus estimates of 66% EBITDA growth in 2021 achievable despite being lofty. As cannabis consumption in many of IIPR’s key markets continues to trend higher year over year, the demand for capital from local operators should keep fueling the company’s growth in the near term.

The worst performing position in the fund this month was our short position in the ISHARES US Home Construction index (ITB). The fund has maintained a long position in homebuilding company DR Horton (DHI) for over a year now, based on the secular shift of the millennial generation out of apartments and into the housing market. Our position in DHI has returned over 60% since it’s initiation, and with the stock making all-time highs amidst the worst job market since the recession, we decided to hedge our exposure using ITB. Alas we were too early, as since that time the homebuilder sector has moved higher by about 20%, with the gains from our ownership of DHI being offset by our losses in ITB. As always, timing is important when short selling, and in this instance, we were early.

Earnings: The great mysteries begin to unravel…

As we move through the early days of August, REIT earnings season has arrived in force, with most companies reporting over the last two weeks. As this will likely go down as one of the most important earnings seasons of the last ten years, we thought it would be helpful to share some insights we have gleaned in the aftermath of the second quarter.

1) Rent collections vary widely across the Strip Center, Mall, and Free-Standing Retail REITs.

Retail REITs have had an extremely varied experienced through the coronavirus pandemic, with the most impacted retail portfolios collecting as little as 15% of rent (EPR), while the least impacted portfolios have collected closer to 98% of rent (GTY). REITs that managed risk through the previous ten-year bull market have fared the best, as large investment-grade tenants have caused few problems, while smaller riskier credit tenants have had much less ability to pay rent in a timely manner.

This varied portfolio impact has turned some conventional wisdom on its head. While once regarded as a blue-chip name in the retail space, National Retail Properties (NNN) has seen significant bankruptcy risk percolate in multiple of its largest tenants (AMC and Chuck E Cheese), driving its valuation down towards that of conventionally perceived “lower quality” peers. While normally this would be an excellent relative value opportunity, NNN has peers with similar valuations that are collecting significantly more rent from tenants and who have resumed acquisitions activity. Going forward this could lead to further re-rating within the space to the benefit of those portfolios that can continue growing while NNN triages its tenant roster.

Similarly, in the Strip Center REITs, Federal Realty (FRT) has seen its blue-chip status come into question as collections have been poor relative to peers, despite the perceived higher quality of FRT’s portfolio. While FRT’s reputation and excellent management team have allowed the company to maintain its premium valuation to peers, investors have to be wondering how long a premium valuation can last in the face of fundamentals that are worse than average?

2) Secular trends in e-commerce and data growth remain intact and continue to power fundamentals in Warehouse and Data Center REITs.

Warehouse and Data Center REITs have been amongst the best performers in the REIT market in 2020. As e-commerce continues to grow, logistics and distribution companies have struggled to keep up with surging demand. After the first quarter, however, it was an open question as to whether e-commerce driven absorption would be able to offset bankruptcy losses in Warehouse portfolios. After multiple earnings beats and guidance raises, the answer so far has been a resounding “yes”.

Similarly, in the Data Center sector, enterprises have shown that technology spending is no longer seen as a luxury line item. Companies have continued to expand their cloud and co-location footprints, giving the Data Center REITs enough clarity to re-instate or reiterate guidance that was given pre-pandemic. While there is always the threat that enterprise leasing slows prospectively, the supply picture in Data Centers is rationalizing, and Q2 absorption in the space was very strong. If fundamentals move sideways or accelerate from here, we could see all-time highs in Data Center valuations within the next 12 months.

3) Things can’t get much worse in Lodging but hopes for a late 2020 or early 2021 recovery are fading.

Lodging has suffered disproportionately so far during the pandemic, and while the worst may be behind the sector from a lockdown perspective, the continued extension of the runway to re-gain profitability is making a second round of distress within the Lodging REITs more and more likely. While many of these companies have re-structured bond covenants with their lenders, they are still burning cash on a monthly basis. Many of the lodging REITs are measuring their solvency in months…meaning they can only burn cash for a certain period of time before having to raise capital to survive. Raising equity at distressed stock valuations is a last resort move, but if things don’t improve meaningfully in the back half of this year, we may see the most levered and distressed hotel REITs tap the equity market out of necessity.

Positioning & Opportunity: Don’t get eaten (lose money).

We have increased risk slightly in the fund over the past few weeks as earnings have brought much-needed clarity to the fundamental outlook for most REITs. For the secular growth Warehouse and Data Center names, it’s business as usual after a short break in March and April. For this reason, we have added to positions in these sectors on pull-backs, and with interest rates falling, would not be surprised to see them continue to make all-time price and valuation highs.

On the other end of the spectrum, Retail and Lodging REITs are still struggling to find their footing, announcing same-store NOI declines of as much as 20%, and RevPAR for the second quarter that was down between 80% and 95%. While collections and fundamentals have improved off of the bottom, there is still significant wood to chop for both property types, with the weakest players still at risk of needing to raise capital in an un-friendly market to do so. For this reason, our short book is mostly concentrated in these two property sectors and focused on names with less margin for error in the current environment.

As the world heals from the coronavirus pandemic, our process continues to grind away, searching for opportunities and capturing them while assuming lower levels of risk than the benchmark. As fundamentals for many REITs remain challenged, we remain patient, ready to pounce once they stabilize and begin moving in the right direction. It is worth remembering that we are not out of the woods yet, and that assuming too much risk at this juncture might be as dangerous as taunting a hungry Velociraptor. Stay patient, take opportunities, and try not to wake the T-Rex.

“The fences are electrified right?”

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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