“The board is set, the pieces are moving” – Gandalf
– Lord of the Rings by JRR Tolkien

Q2 REIT Report – Warehouses win and the Fed’s Fantasy land
• REITs returned 1.3% in Q2 bringing YTD returns to +17.8%
• Property types with economic tailwinds outperformed in Q2, while regional malls and lodging lagged.
• With economic data continuing to deteriorate, we believe defensive positioning is prudent.
• Negative data points in employment and consumer confidence suggest cyclical REITs could be at risk.

After a rollercoaster ride down and then back up over the previous six months, Q2 of 2019 was a less volatile period in the REIT market. While investors have become more comfortable with REITs, the landscape has also been changing, as capital allocators prepare for a back half of the year that promises to be extremely interesting. REITs are once again positioned as an attractive defensive alternative to the S&P 500, with the continued tailwind of falling 10-year treasury yields (now just above 2%).

The general equity market on the other hand, remains volatile and has to walk a dangerous line of fed-dependence into the second half of 2019. The S&P 500 was down 6.3% in May and up 7% in June, indicating that the bears and bulls are grappling for the upper hand as bad economic data increases the odds of a Fed rate cut. With the bulls re-asserting control in June, investors are betting that the Fed can fend off the evil forces of deteriorating economic data once again. From the perspective of Serenity Alternatives, negative data points have made our positioning more cautious, and we are warily eyeing employment and consumer confidence data.

While the Fed may in fact prove to be the white knight the economy needs, our outlook will continue to be data driven. Expectations for fed action are at this point still a fantasy, while poor economic data remains a stubborn reality. Until the data turns meaningfully more positive, we will not be bullish on cyclical REITs based on hope of a fantastic future rate-cut from the fickle Fed.

Sector Spotlight: Where-house? There-House… (+9.2% in Q2). Also, that’s a Young Frankenstein joke.

Warehouse REITs continued to post strong returns in Q2. The warehouse sub-sector returned 9.2% during the quarter and was only outpaced by the much smaller single-family rental sector (+10.1%). Investors continue to favor property sectors with strong underlying demand drivers, including data center REITs which also performed well in the quarter (+8.7%). We have previously written about the economic tailwinds in both the data center and warehouse sector, and they continue to drive strong performance relative to more traditional real-estate property types.

The warehouse sector in particular has shown remarkable resilience as Amazon and e-commerce have emerged as major game changers in the American economy. It was not that long ago that warehouse was considered a low-growth property type, and names such as Prologis (PLD) and Duke Realty (DRE) traded at cap rates 100-200 basis points higher than peers in the apartment sector. Since 2015 the relationship between these property types has changed meaningfully, with some warehouse names now trading at lower implied cap rates (higher valuations) than their still well-regarded apartment peers. While some investors may argue that this valuation discrepancy is not warranted, the warehouse companies have had better internal and external growth over the past few years than the apartment REITs, which is a fundamental change in the REIT landscape. Whether they can sustain this outsized growth has yet to be seen, but it’s clear that investors are betting that e-commerce tailwinds are not going away any time soon.

Secular growth in 2019: One of these things may not be like the others…

Looking back a bit further in the rear-view mirror, it’s evident that 2019 has continued to be a story of secular growth outpacing cyclical growth. What we mean by this is that long-term tailwinds have propelled the data center, warehouse, infrastructure, manufactured housing, and single-family rental REITs to the front of the pack so far this year in terms of performance. Each of these property types is benefitting from either a demographic or technological trend that is driving demand, independent of the broader business cycle.

Cyclical REITs, on the other hand, have struggled, with lodging, malls, and shopping centers all posting sub-par returns year to date. This then begs the question… if cyclical REITs are doing poorly, why are the Hotel C-corps (MAR, HLT, H, CHH, STAY) one of the best performing property sectors for 2019?

While there is a positive narrative surrounding external growth in the hotel c-corps (the large brands are consolidating the broader hotel market and adding flags rapidly), the stock prices of these companies have remained surprisingly immune to slowing growth across the globe. It is our belief that a portion of this performance is fed-fueled, as earnings estimates have come down for most of these companies, but their high correlation with the S&P 500 has driven strong price performance. Said another way, they are getting more expensive, while fundamentals are getting worse. For this reason, we are bearish on the the hotel c-corps. We would change our stance on these companies if a recovery in global growth became more likely, which would require meaningfully better economic data in the US, Europe, and Asia.

Positioning: D-Fense <clap, clap>, D-Fense <clap, clap>

We have been very vocal in our client newsletters and white-papers over the last 12 months regarding our outlook for GDP and the impact it would likely have on REITs over the past nine months. We correctly pointed out in Q3 of last year that REITs represented a compelling value proposition relative to the S&P 500. Since the publication of our Q3 2018 newsletter, REITs have returned 11.83%, the S&P has returned 2.78%, and the 10-year treasury yield has fallen from 3.2% to 2.1%. We were cautious regarding the direction of economic data, and in the last nine months, the market has come our way and REITs have reaped the benefit.

With a spate of poor economic data now priced into the market, it’s tempting to become more bullish on the economy, especially with interest rate cuts from the fed looking more and more likely. There are two distinct economic data series, however, that have recently caused us to become increasingly cautious. While many data series rolled over (declined or showed smaller increases) in the first part of 2019, consumer confidence and employment (which are considered coincident indicators), remained broadly robust for the first six months of the year. It has only been more recently that these data series have showed signs of weakness, and continued deterioration in these key indicators would be extremely concerning.

From a confidence perspective, we find it worrisome that expectations fell across all three major consumer confidence series in June. The conference board, the University of Michigan, and the NFIB all reported June expectations that were well below their 12-month averages and sequentially worse than their May values. Similarly, in May, ADP and the BLS reported a meaningful lull in job creation. While the jobs data improved a bit in June, 2019 has now seen two ADP employment prints below 100,000. This has not happened in a year since 2016, when real GDP growth was closer to 1% and the 10-year treasury yield hit 1.5%.

It’s very possible that the weakness in both of these major data series is temporary. Employment has slowed for short periods in the past, and consumer confidence will dip periodically and then rebound. This late into the cycle however, with increasingly poor global manufacturing data, a possible earnings recession looming, and continued poor results from the lodging companies (weekly RevPar results were poor in June), the backdrop for this downturn in confidence and employment should at least be noted and monitored carefully.

This is relevant from a positioning standpoint because poor employment data tends to have an outsized impact on apartment REITs and office REITs. While office REITs already trade at discounted valuations due to lack-luster fundamentals, the apartment REITs trade at premium valuations to their NAV’s and to peers. The narrative surrounding apartments is almost uniformly bullish, with most analysts expecting guidance increases in Q2. Continued pressure on employment, however, could turn the apartment trade on its head, resulting in a large unwind of a sector bet that has become increasingly one-sided. While we are not explicitly bearish on the apartment sector yet, we are monitoring the data incredibly closely for continued signs of weakness. A few more poor employment reports would signal that the cycle has truly ended, and at that point, it will not be prudent to have any pro-cyclical exposure in REITs or otherwise.

Quant Corner: Serenity core factors continue to work broadly, but value continues to suffer

Quant Factor performance continued to recover in Q2, with 10/16 of Serenity’s core factors outperforming the REIT benchmark and the average factor out-performing by 0.5%. The best performing factor in our suite so far this year is 1-year dividend growth, with top quintile performance of +26.6%. NAV growth factors trailed closely behind, with 1y and 6m NAV growth returning +26% and 24.9% year to date.

Value factors continue to under-perform, with concentrations in the hotel and mall sectors that have seen cheap REITs only get cheaper. This is why it’s important to combine value with momentum and quality factors. The Serenity composite model, which is a blend of these three factor groups has still outperformed the benchmark in 2019 despite a roughly 1/3 weighting in heavily lagging value factors.

Q2 Summary: “We come to it at last…the great battle of our time.”

That’s probably hyperbole, but it’s undeniable at this point that the federal reserve is engaged in a battle with their old timeless enemy, economic data. They have a daunting task in the back half of this year, as they face-off against deteriorating economic conditions in the US and a market that is clamoring for rate cuts. Can they navigate the end of the cycle perfectly? Can they ease enough to revive growth without causing chaos in the capital markets? As one of my favorite economic commentators likes to ask… “can the fed smooth economic gravity?”

Color us skeptical. While Gandalf was able to help save middle earth from legions of invading orcs, in the real world deteriorating economic conditions may prove too much for the fed to handle.

We remain cautious while we monitor the macro data, hedging cyclical exposure and preparing to get overtly bearish on high priced pro-cyclical names in the apartment, hotel, and hotel c-corps sectors if employment data continues to deteriorate. If the fed does manage to revive growth and put the economy on firmer footing, we will be ready to change our minds and switch our positioning. Until then, the burden is on our policy makers to navigate this data downturn carefully. Will they stand firm or be dragged into the abyss?

BAD DATA…SHALL NOT…PASS!

Martin Kollmorgen, CFA
CEO and Chief Investment Officer
Serenity Alternative Investments
Cell: (630) 730-5745
MDKollmorgen@SerenityAlts.com

**All charts generated using data from Bloomberg, LP, S&P Global, and Serenity Alternative Investments

DISCLAIMER: This document is being furnished by Serenity Alternative Investment Management, LLC (“Manager”), the investment manager of the private investment fund, Serenity Alternative Investments Fund I, LP (the “Fund”), solely for use in connection with consideration of an investment in the Fund by prospective investors. The statements herein are based on information available on the date hereof and are intended only as a summary. The Manager has been in operation since 2016 and the Fund commenced operations on January 14th. The information provided by the Manager is available only to those investors qualifying to invest in the Fund. By accepting this document and/or attachments, you agree that you or the entity that you represent meet all investor qualifications in the jurisdiction(s) where you are subject to the statutory regulations related to the investment in the type of fund described in this document. This document may not be reproduced or distributed to anyone other than the identified recipient’s professional advisers without the prior written consent of the Manager. The recipient, by accepting delivery of this document agrees to return it and all related documents to the Manager if the recipient does not subscribe for an interest in the Fund. All information contained herein is confidential. This document is subject to revision at any time and the Manager is not obligated to inform you of any changes made. No statement herein supersedes any statement to the contrary in the Fund’s confidential offering documents.

The information contained herein does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made by means of delivery of an approved confidential offering memorandum and only in those jurisdictions where permitted by law. Prospective investors should inform themselves and take appropriate advice as to any applicable legal requirements and any applicable taxation and exchange control regulations in the countries and/or states of their citizenship, residence or domicile which might be relevant to the subscription, purchase, holding, exchange, redemption or disposal of any investments. The information contained herein does not take into account the particular investment objectives or financial circumstances of any specific person who may receive it. Before making an investment, prospective investors are advised to thoroughly and carefully review the offering memorandum with their financial, legal and tax advisers to determine whether an investment such as this is suitable for them.

There is no guarantee that the investment objectives of the Fund will be achieved. There is no secondary market for interests and none is expected to develop. You should not make an investment unless you have a long term holding objective and are prepared to lose all or a substantial portion of your investment. An investment in the Fund is speculative and involves a high degree of risk. Opportunities for withdrawal and transferability of interests are restricted. As a result, investors may not have access to capital except according to the terms of withdrawal specified within the confidential offering memorandum and other related documents. The fees and expenses that will be charged by the Fund and/or its Manager may be higher than the fees and expenses of other investment alternatives and may offset profits.

With respect to the present document and/or its attachments, the Manager makes no warranty or representation, whether express or implied, and assumes no legal liability for the accuracy, completeness or usefulness of any information disclosed. Certain information is based on data provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed and should not be relied upon as such. Performance information and/or results, unless otherwise indicated, are un-audited and their appearance in this document reflects the estimated returns net of all expenses and fees. Investment return and the principal value of an investment will fluctuate and may be quite volatile. In addition to exposure to adverse market conditions, investments may also be exposed to changes in regulations, change in providers of capital and other service providers.

The Manager does not accept any responsibility or liability whatsoever caused by any action taken in reliance upon this document and/or its attachments. The private investment fund described herein has not been registered under the Investment Company Act of 1940, as amended, and the interests therein have not been registered under the Securities Act of 1933, as amended (the “1933 Act”), or in any state or foreign securities laws. These interests will be offered and sold only to “Accredited Investors” as such term is defined under federal securities laws. The Manager assumes that by acceptance of this document and/or attachments that the recipient understands the risks involved – including the loss of some or all of any investment that the recipient or the entity that he/she represents. An investment in the Fund is not suitable for all investors.

This material is for informational purposes only. Any opinions expressed herein represent current opinions only and while the information contained herein is from sources believed reliable there is no representation that it is accurate or complete and it should not be relied upon as such. The Manager accepts no liability for loss arising from the use of this material. Federal and state securities laws, however, impose liabilities under certain circumstances on persons who act in good faith and nothing herein shall in any way constitute a waiver or limitation of any rights that a client may have under federal or state securities laws.
The performance representations contained herein are not representations that such performance will continue in the future or that any investment scenario or performance will even be similar to such description. Any investment described herein is an example only and is not a representation that the same or even similar investment scenarios will arise in the future or that investments made will be profitable. No representation is being made that any investment will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between prior performance results and actual Fund results.

References to the past performance of other private investment funds or the Manager are for informational purposes only. Other investments may not be selected to represent an appropriate benchmark. The Fund’s strategy is not designed to mimic these investments and an individual may not be able to invest directly in each of the indices or funds shown. The Fund’s holdings may vary significantly from these referenced investments. The historical performance data listed is for informational purposes only and should not be construed as an indicator of future performance of the Fund or any other fund managed by the Manager. The performance listed herein is unaudited, net of all fees. YTD returns for all indices are calculated using closing prices as of Jan 14th, the first day of the funds operation. Data is subject to revision.

Certain information contained in this material constitutes forward-looking statements, which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “target,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Such statements are not guarantees of future performance or activities. Due to various risks and uncertainties, actual events or results or the actual performance of the Fund described herein may differ materially from those reflected or contemplated in such forward-looking statements.

Our investment program involves substantial risk, including the loss of principal, and no assurance can be given that our investment objectives will be achieved. Among other things, certain investment techniques as described herein can, in certain circumstances, maximize the adverse impact to which the Fund’s investment portfolio may be subject. The Fund may use varying degrees of leverage and the use of leverage can lead to large losses as well as large gains. Investment guidelines and objectives may vary depending on market conditions.