Q3 REIT Recap: Value awakens, employment weakens

• REITs were up 7.6% in Q3 and have returned 26.8% YTD.
• Data centers, after having been left for dead in 2018, have returned over 50% in 2019.
• Defensive positioning has become consensus, but some defensive REITs carry risk exposures that may not be properly discounted by the market.

“Trying to lull us in, before the havoc begins, into a dubious state of serenity” Tool. Fear Inoculum: 7empest

In September the prog-rock band Tool blasted their way back into the music world with the release of a new album “Fear Inoculum.” It had been 13 years since the release of their last record. It is rare for a rock band to make headlines these days, which is why it was shocking to see Fear Inoculum replace Taylor Swifts “Lover” on the top of the Billboard 200 chart the week of its debut. Rock music may not be dead after all…

Similarly, in September value stocks surged out of their downtrend in what has been described as a 6 standard deviation move relative to momentum stocks. This huge reversal flies in the face of prevailing trends; an uptick in an investing style that has under-performed and waned in popularity in recent years. Value investing may not be dead after all…

Investors and music fans alike have to decipher what to make of these recent resurgences. Are they just flashes in the pan, or are they early indications of a change in the overall landscape? Are we on the verge of the triumphant return of rock music and value investing?

It is dangerous to extrapolate single data points into such sweeping narratives, but it is similarly dangerous to completely ignore them. What we can say for sure is that the awakening of value stocks has re-introduced volatility into the performance of common stock selection factors. Those that were blithely long momentum and short value were jarred awake in September, after being lulled into a “dubious state of serenity.”

Are there other trades in the REIT market that could suddenly and violently un-wind in the months to come? We believe so. As economic data has continued to deteriorate, trades many investors consider “defensive” have in our view become riskier.

The beauty of having a model built on a blend of value, momentum, and quality is that it does not implode when two factors move rapidly in opposite directions. Whether value investing returns or not, our model will continue to seek out high quality real estate companies growing the value of their portfolios. And if rock music makes a comeback, after years of waning popularity, we will be happy to fire up the record player and crank the volume up to 11.

Factor Performance: Value REITs rip in September

As we alluded to above, value factors saw a surge in performance in September, returning 7.6% on average versus the benchmark at 2.81%. Momentum factors returned 0.76% for the month, while quality factors returned 3.7%. Value as a strategy has fallen on hard times in recent years, with many investors either diminishing its role within investment processes or abandoning it all together. While we acknowledge its recent weakness, it is not the first time value has under-performed as a strategy. It remains a core component of our model because we believe in the long term efficacy of not over-paying for REIT stocks. We also believe that in a recessionary scenario, value could exhibit large amounts of out-performance as a strategy, much as it did in the 2008-2009 time period.

One of the best performing individual REITs during the quarter was CyrusOne (CONE) up 37.9% during the period. It’s not the first time CONE has found itself as a top performing REIT, but alas, it’s days in the REIT universe may be coming to a close. As data center REITs have continued to trade at a discount to private market data center valuations, private equity investors have taken notice and have reportedly engaged CONE in discussions to be taken private. Peer and competitor Digital Realty Trust (DLR) has also been rumored to be interested in CONE, and the potential bidding war has driven the entire sector (and especially CONE) higher over the past few months. We believe that CONE is a willing seller, and that a deal would still require a premium to where the company is currently trading.

Sector Spotlight – Data Centers: Remember the “cloud capex slowdown?”

It seems like just yesterday that investors were extremely concerned with the data center leasing market, citing the slow-down in hyperscale demand as a reason for driving data center multiples to multi-year lows. As recently as February of this year, data centers traded at 2020 EBITDA multiples around 15.5x, while the average REIT traded closer to 17.5x, and private data center portfolios fetched prices well over 20x. We wrote at the time that “too much negativity is priced into a sector that has a history of exceeding expectations” and “we think the combination of higher growth and discounted valuations will be too sweet to pass up.”

Well a quick 7 months later and the sector has returned 32.4% which leads the REIT industry over that period (we published our bullish data center piece on Feb. 14th). That brings the total returns of the data center companies to 53% year to date, which is once again the best in REITs.

The chart above was published in our Feb 14th piece titled “Data Center REITs And The 2018 Cloud Explosion”. You’ll notice Regional Malls trading at a 17.3x 2020 multiple. Since that date Data Centers have outperformed malls by over 50%.

We bring the data centers up because they are a good example of the herd mentality that can push REIT prices into irrational territory. Using a short-term view, data center fundamentals clearly slowed into the end of last year, and their poor performance in the second half of 2018 is understandable. However, taking a long-term view (as our model does) of their business provided ample evidence that the slowdown in leasing they faced was temporary. Data centers never had the threat of long-term impaired fundamentals that has plagued the mall and shopping center REITs, and yet they traded at similar (or lower) forward multiples to both of these property types in February.

It’s these types of opportunities the Serenity REIT model looks to capitalize on within the REIT universe. The model is designed to find high quality REITs that consistently grow the value of their real estate, and trade at reasonable valuations. Data centers checked all three of these boxes in the first part of this year, and our bullish thesis has played out nicely.

Caution: 1+1 ≠ 3: Defensive flows mask fundamental risks

While data center REITs suffered from an abundance of pessimism earlier this year, the flight to safety of equity market investors has resulted in a current abundance of optimism in other property sectors. Apartment and self-storage REITs in particular have recently seen valuation levels reach cycle highs, despite fundamentals that can be described as mediocre at best. Over the past month we have had conversations with numerous other REIT investors, and the general sentiment is that fundamentals could improve as supply headwinds start to fade. We’ve also heard a lot of the now common refrain “what else am I supposed to own in REITs?”

Most individual investors have the luxury of examining and taking advantage of the last point in the paragraph above. Long-only investors that have to stay invested will default to property types they know and feel they can rely on when fundamentals are un-inspiring in other REIT sectors. This has the perverse effect of causing crowding in these names, as a large majority of REIT funds end up over-weight the same REITs. We believe this is currently the case in the apartment and storage REITs.

The fundamental case for owning these companies has some merit, but also carries significant risks. As seen in the chart of Essex Property Trust (ESS) below, same-store (SS) revenue growth has ticked up recently from around the 2% mark to the mid 3% range. Over the same period, the companies’ price to forward AFFO estimate (a measure of valuation) has increased from around 19x to over 25x. While multiples are not a perfect valuation measure, it’s clear from the chart that previous periods of such high multiples were associated with much higher levels of SS growth.

Source: Bloomberg/Serenity

The bull argument in apartment and self-storage REITs is that supply growth is set to drop in 2020 relative to 2019. Said another way, there are fewer new apartment buildings set to open next year than opened this year. It follows that ESS and peers may be able to keep driving SS revenue growth higher in the coming quarters. While that certainly may be the case, in our view a continued acceleration in SS revenue growth is already priced into the apartment REITs. If that is the case, in order for these companies to see even higher valuation levels they need to exceed already rosy expectations. To us, this seems more like a “hope” trade than one that fits with the macro-economic landscape.

Macro: How am I supposed to get BULLISH, with that going on, Doug?

As one of our favorite risk management vendors likes to say, “hope is not a risk management process.” While apartment bulls are hoping for continued acceleration in SS revenues, there are risks to this thesis present in current macro-trends. While the vast majority of economic data series we monitor have gotten worse in 2019, there are a few that we find especially concerning, and particularly relevant to the apartment and storage REITs.

The first is a data series that we have written about previously, the year over year change in private market jobs. As seen in the chart below, job growth has slowed in 2019 from 2.1% to 1.7%. An optimistic reading of this data series would suggest that it has room to re-accelerate as it did in 2017. We would remind our readers, however, that the 2017 re-acceleration in jobs growth was catalyzed by the largest stimulus in the history of the Chinese economy, coupled with historic corporate tax cuts in the US. While the “trade deal” is a possible catalyst for renewed job growth, as of this writing there is no deal of substance, and it looks un-likely that the US or China has significant monetary or fiscal stimulus in the on-deck circle.

This chart is the primary driver of concern for apartment landlords and self-storage REITs. Fewer incremental jobs means lower aggregate purchasing power for the US consumer, and fewer young professionals ready to move into expensive new multi-family apartment complexes. The conference board employment trends index series shows a similar trend, as growth has fallen from 7% to 0.7%, its worst since 2016.

While employment bulls will point to a record low unemployment rate as evidence that the labor market is still strong, it’s important to remember that unemployment is a lagging indicator. These charts represent the most leading indicators in the labor market, as employers will traditionally stop hiring well before they start firing people. Said another way, once jobless claims and the unemployment rate start to tick higher, we may already be in a recession.

While we don’t intend to freak anybody out with the dreaded “R” word, a few more poor data points in these series will put them both firmly in “worst since the 2008 recession” territory.

At the end of the day it’s hard to make a bullish case for REITs that have strong ties to the employment cycle (apartments and storage REITs) with leading indicators for employment continuing to deteriorate. Were the fed to take drastic action (50bp cut), the Chinese to massively stimulate, and the Trump administration to get a trade deal across the finish line, the bullish narrative would make more sense. Until any of those events occur, however, there is a clear trend in the data, and that trend is down.

Looking forward into Q4: Could value be the new defense?

It’s been a fascinating 2019 watching consensus and investors flock to defensive sectors as economic data points have slowly ground lower. REITs, Utilities, and Treasury bonds have certainly benefitted from this flight to safety, and it has brought us to a very interesting and crucial juncture. At this point, defensive exposures are at all-time high valuations, while many economic data series bump up against cycle lows. So what happens when everyone is already playing defense? Can the risk-off trade keep going in its current form?

It is our view that defense is going have to take on a different character going forward, as continued deterioration in economic data will start to increase the odds of a recession at an increasing rate. So far the economy has been able to avoid the self-perpetuating cycle of slowing revenue, sinking margins, laying off employees, etc, but at some point defensive exposures fall prey to the business cycle, and correlations start to creep towards one. Said another way, if the data continues on its’ current path, at some point there is no playing defense. At some point everything goes down (except cash, and maybe gold and treasuries). This scenario is concerning and increasingly likely each time a macro data point comes in worse than its previous value.

September’s value explosion is evidence that investor behavior is already starting to change. A simple explanation for the huge performance reversal in such a short time period is that investors simply could no longer find defensive exposure with valuations they could stomach. At that point what do you buy? You buy the absolute last thing on your list, which at this point is probably value stocks. Combine this with the fact that many hedge funds are/were short value as a factor, and you have a recipe for a rip higher, off of a very low base, which is exactly what took place.

The fact remains that many value stocks in REITs are hugely under-owned and heavily shorted, especially in the regional mall sector. If stimulus appears and the economy re-accelerates, these stocks would greatly benefit along with hotel REITs and office REITs. If the economy continues to deteriorate and heads towards recession, well, there simply aren’t that many people that own value stocks and will need to sell them. This sets up an interestingly convex trade, and gives us confidence that the value components of our multi-factor model are still valuable (pun intended).

Q3 Summary: Rock N Roll is dead…

Anyone who has invested for long enough on wall street knows the dangers of becoming complacent. As the lyric quoted above suggests you are likely to get lulled in, just before the havoc begins. Just when everyone thought value investing was dead and gone…a 6 standard deviation move brings it back to relevance in the blink of an eye. A crusty old metal band releases a new album to little fanfare, and suddenly rock music is blasting past the pop-queen herself on the billboard charts.

With a 27% return through three quarters of the year, the REIT market has had an excellent 2019. Investors would do well to remain vigilant as economic data continues to deteriorate. It may be tempting to take comfort in defensive exposures, but it’s important to acknowledge that many have become increasingly expensive yet remain levered to the economic cycle.
In the meantime it might be time to dust off the old Les Paul, plug it into my 2×10 VOX, and blast my neighbors into the next dimension with some tasty, tasty rock music.

Long live Rock n Roll,

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

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

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