PERFORMANCE – Serenity Alternatives Fund I returned +0.85% in June bringing YTD returns to 0.72%. The FTSE NAREIT All Equity REITs index returned +2.3% bringing YTD returns to -13.3%.
Q2 RECAP – REITs recouped some of their Q1 losses gaining +13.3%, while the S&P 500 bounced +20.6%
FUNDAMENTALS – REIT NAV estimates continue to fall as we approach an extremely uncertain earnings season.
POSITIONING – The Serenity portfolio remains low-risk, selectively finding opportunities amidst a minefield of value traps.

“There is nothing more deceptive than an obvious fact.”
– Arthur Conan Doyle – 
The Boscombe Valley Mystery

It is becoming more and more of an obvious fact that the stock market cannot go down. Refrains of “don’t fight the fed”, “V-shaped recovery”, and “better than expected data” dominated the tape in Q2, leaving skeptics and bears lonely on the sidelines. The Nasdaq 100 index is making all-time highs and the S&P 500 is now down only -1.9% for the year.

To many pundits, it is all very elementary. Fed money goes in, stocks go up.

The tale of the tape is slightly different in REIT land. REITs are still down 13% for the year, with multiple property sectors down almost 50%. Small-cap stocks (The Russell 2000) are down 15% YTD, while traditional economic bellwether Apartment REITs are down 20%.

Now, which market seems more reflective of reality? The REIT market which has seen NAV’s fall 14% and prices fall 13% or the S&P 500 which has seen earnings estimates fall 35% but it’s price only fall 2%?

Is it a fact that the fed has saved the stock market from ever falling again –or are we being deceived? The stock market is prone to exuberant outbursts but is eventually tethered to economic reality, a reality that companies are going to have to report over the next few weeks during the Q2 earnings season.

REITs face a similarly challenging Q2 earnings season, but from valuation levels that are not as stretched as much of the stock market. Uncertainty is high, volatility is elevated, and the longs and shorts are jockeying for position.

As always in the capital markets…the game is afoot!

Performance: +0.85% in June, +0.72% YTD

Serenity Alternatives Fund I returned +0.85% in June net of fees and expenses, bringing our YTD returns to +0.72%. The FTSE NAREIT All Equity REIT (FNER) index returned +2.31% bringing 2020 returns to -13.3%. We have decided to quote a new REIT index in our benchmark comparison this month despite the fact that it is a tougher comparison for our funds returns. The FNER index is a broader REIT index than the MSCI US REIT Index (RMZ) which we have used for comparisons in the past. As the REIT landscape has changed, the FNER has done a better job of adding REITs such as the towers and timber REITs. At this point, we believe it better represents the universe our fund uses to make decisions, and thus we will refer to its performance going forward.

The best performing position in the fund this month was GDS Holdings (GDS), up +39.8%. GDS owns and operates data centers in China, which is an incredibly rapidly growing data center market with only a few major players (GDS being one). In June the company announced a private placement in which they raised over $500 million from two large existing shareholders. The stock took off on the news as investors bet that an increased appetite for capital could represent a strong future pipeline of leasing for the company. GDS is a more speculative name in the data center space and thus carries a smaller weight in our portfolio. That being said it has the most attractive growth profile in the entire industry as it continues to capture an outsized portion of the growing Chinese data center market.

The worst performing position in the fund this month was Kimco Realty (KIM). Our short position in Kimco suffered in June as Shopping Centers and other pro-cyclical REITs rallied on continued re-opening headlines and improving expectations. Kimco remains firmly at the bottom of our model, with deteriorating fundamentals, a portfolio of mediocre quality strip center assets, and a valuation that is in-line with peers. While the risk-on mood may have buoyed shares in June, the Kimco portfolio will remain challenged, and until we see signs of fundamental stabilization in their business, the model is likely to remain short.

Q2 Recap: REITs rally off the lows

As has been widely reported, Q2 was one of the best quarters for stocks in a very long time. Stimulus from the federal reserve coupled with a steady stream of positive headlines surrounding the re-opening in the US economy spurred the REIT market to a +13.3% return and pushed the S&P 500 up +20.6%. This is of course after these indices had fallen -23.4% and -19.6% in Q1, respectively.

The Q2 rally in REITs was led by property sectors that had been especially hard hit in Q1 of this year. The chart to the right illustrates the fact that the best performing property types in Q2 (Mortgage, RE Services, and Timber), are all still down around -20% YTD.

This leaves the market at an interesting juncture. The fed has effectively taken insolvency off the table, assuring the broad market (and by extension REITs) that debt capital is available, and will remain so through the next leg of the crisis. This has had a tangible impact on the REIT market as Lodging REITs have been able to negotiate covenant grace periods with many of their lenders, removing or at least staving off the worst-case scenario of outright default and bankruptcy.

Many Lodging REITs that were trading at distressed levels have come roaring back, and the broad sector has traded to multiples of 2021 EBITDA that are in-line with historical average. Similarly Shopping Center REITs have recovered from distressed 2008-2009 level valuations to trade more in line with the low end of their normal historical range. While the market is not pricing in a rosy outlook for these two property types, the distressed pricing that occurred in March and April has disappeared.

So where do we go from here? With the threat of bankruptcy seemingly in the rearview mirror for most REITs, we believe the markets focus will be forced to shift back to boring old operations. Move over insolvency risk, it’s time to discuss the building blocks of fundamental analysis again…occupancy, rate, earnings, and Net Asset Values (NAVs).

Fundamentals: Declining NAV’s and eroding discounts

We stress the direction of fundamentals in our strategy because they ultimately decide the direction of REIT prices. While valuation is important, value traps are real and can be extremely difficult to avoid without a strong sense of the direction of fundamentals. Just ask any REIT investor who has bought Mall or Shopping Center REITs over the past few years on “valuation”. Cheap gets cheaper when fundamentals continue to deteriorate.

Our framework was designed to account for exactly these scenarios. We’ve been extremely selective on the long side for this exact reason: REIT fundamentals are moving in the wrong direction. If history is our guide, then it may be extremely dangerous to assume that they bottomed in the second quarter.

The chart on the previous page illustrates the relationship between fundamentals, prices, and valuation for the broad REIT universe. As you can see REIT share prices (the orange line) over time converge to REIT NAV estimates (the blue line). This is why understanding the general trend in fundamentals (we use NAV, the blue line, as a high-level proxy for fundamentals) is extremely important. Notice that in 2009, REITs did not find a bottom until NAV’s stopped going down in March/April.

Prior to bottoming in 2009, REIT NAV estimates spent the majority of 2008 about 14% below their trailing twelve-month peak (this is the definition of a NAV draw-down). It was not until October that estimates really started to fall, and by 2009 had corrected by 49%.

This is the danger of buying REITs at a “discount”. When fundamentals are rapidly deteriorating, discounts arise and then disappear as valuations move rapidly lower. With REIT NAV’s currently 14% off their February peak, we are in the midst of just such an environment.

This is not to say that the REIT market is on the precipice of disaster. REITs are much better capitalized today than they were in 2008-2009, the fed is much more aggressive, and as we discussed above, the threat of insolvency has been mostly removed.

Fundamentals (occupancy, rents, earnings), however, are moving lower, and by an unknown magnitude. While some assume that the bottom was reached in Q2, we remain skeptical due to persistently high unemployment statistics, and the fact that it takes TIME for the knock-on effects of unemployment to work their way through the system. While we don’t expect REIT NAV’s to draw down 49% in the aggregate, a further 10% decline is entirely possible, which would mean that REITs are NOT a bargain at current prices, and actually maybe expensive relative to NAV (in the aggregate).

This is the overriding reason that we remain patient with the majority of the REIT market at the current juncture. It takes time and space for damage to work its way through the economic machine, and one-quarter of liquidity injections by the fed may not be enough to counteract the effect of the highest unemployment rate in 100 years. We will continue watching REIT fundamentals like a hawk, but until they stabilize, we will not be size buyers of REITs.

Positioning & Opportunity: A cautious approach to 2H 2020

As is probably obvious by now, the fund continues to carry relatively low levels of risk in an environment that is extremely volatile and highly uncertain. Our long portfolio is concentrated in sectors that have been relatively sheltered from the coronavirus crisis. Our largest weights are in the Data Center and Warehouse property types.

On the short side, our model continues to favor shorting lower quality Lodging and Shopping Center REITs. We are exercising caution and risk managing this portion of the book very actively as well, due to the danger of shorting cheap and volatile REITs at the wrong time.

We also continue digging through the REIT universe for compelling long-term opportunities at favorable prices. As REITs emerged from the previous crisis of 2008-2009, it was non-core real estate property types that led the 10-year bull market that just ended. Watching firsthand as the Data Center and Self-Storage property types grew from obscure, off the run, real estate investments into mainstays of both the public and private market has uniquely equipped us to hunt down these types of trends in the next bull market.

As we wrote last month, we are not blindly hoping to be on the precipice of a new bull market, but we are looking forward to it. The damage inflicted on the US economy by the coronavirus will take time to discover and heal, but it will eventually pass. When it does we will be ready and active in deploying capital precisely and intelligently.

It will be, as they say, elementary,

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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