• PERFORMANCE – Serenity Alternatives Fund I returned -2.49% in September bringing YTD returns to +2.4%. The FTSE NAREIT All Equity REITs index returned -2.67% bringing YTD returns to -12.3%.
• DISTRESS!!! – Investors looking for deeply discounted commercial real estate can find it in the REIT market. And buy it immediately with almost 0 frictional cost.
• FAKE NEWS – The categorization of REITs as defensive investments is a myth. REIT returns trounce private market returns early in recoveries, making them prime investments early in the cycle.
“To know that we know what we know, and to know that we do not know what we do not know, that is true knowledge.”
– Nicolaus Copernicus
How many times did you have to read that quote? In between all the knows and the do not knows, there is some beautiful ancient wisdom. Being confident in your knowledge and yet humble in your approach goes a long way in investing. There is always more to know, the landscape is infinitely complex, and there are always things to learn that can improve your perspective.
And who better to remind us of the importance of the limits of our knowledge than a 15th-century cosmology loving mathematician heretic. Seriously…Copernicus existed at the edge of scientific knowledge and brutally entrenched perceived wisdom.
In that spirit, it’s worth examining our assumptions regarding today’s commercial real estate market. Is our current knowledge rooted in data and observation, or gut feeling and intuition? Are cheap assets abundant and easy to buy, or does it just feel like they should be?
I cannot quantify the variety nor magnitude of available “deals” in the private market, but I can quantify and present some incredible opportunities in the REIT market. REIT deals exist, and they can be accessed without enduring a long competitive bidding process that may or may not result in a deal being consummated. If you are looking for real estate deals are you examining the REITs? I’ll bet Copernicus would.
Similarly, the REIT market as a whole is worth re-considering in light of perceived wisdom. Many investors view REITs as a defensive investment, but REITs actually produce their best returns EARLY in the business cycle. History shows that REIT portfolios recover from recessions much more quickly than private real estate assets due to their high location quality and the opportunistic nature of their management teams. So while REIT valuations may be very attractive currently, these deals might not be around for long…
Performance: -2.49% in September, +2.4% YTD
Serenity Alternatives Fund I returned -2.49% in August net of fees and expenses bringing our YTD returns to +2.4%. The FTSE NAREIT All Equity REIT (FNER) index returned -2.67% bringing 2020 returns to -12.3%.
The best performing short position in the fund this month was RLJ Lodging Trust (RLJ), down -8.07%. The fund continues to maintain short positions in select Lodging REITs, as fundamentals remain depressed and valuations relative to consensus estimates are not particularly attractive. We have offset most of our short exposure in the space with longs in high quality lodging portfolios and names that are less dependent on corporate travel.
The worst performing position in the fund this month was CyrusOne (CONE). As one of the top performing property sectors in 2020, Data Center REITs were due for a pull-back, falling -4.4% during the month after many of the names made all-time highs in August. We remain bullish on the sector from a secular perspective but have tempered our return expectations with valuations hitting all-time highs. As we move closer to the bottom of the economic cycle, return expectations in out of favor value REITs will start to look more attractive than the Data Centers.
DISTRESS!!! Deals for the diligent…
Speaking of out of favor REITs…we have recently decided to dust off the Serenity “Deep Value” model, as we start to look forward towards a more normal world in the future (as unlikely as that may seem today). Distressed investing is typically very painful, and the graveyard of value investors is large and growing. As we say often, however, timing matters. Some economic environments are much better for deep value investing than others. The bottom of economic recessions tends to be these sorts of times.
With that in mind, we have taken the output of our Deep Value model, blended it with some fundamental research, and started to assemble a list of holdings that fit into the portfolio as long-term deep value investments. While we won’t share our entire watch list here (unless you are a client, in which case ping me), it’s important to acknowledge that distressed investing should not be limited to private real estate transactions. There are a variety of distressed REITs, some of which may be once in a decade opportunities.
The table on the next page illustrates some of the highest 5-year expected returns in the Serenity REIT universe. Many of these names are in distressed property sectors and have the potential to double in value over a 5-year time horizon from a combination of cash flow growth and multiple expansion. This is assuming the world goes back to “normal”, i.e. something reasonably resembling 2019 throughout the course of the next economic upswing.
It’s important to note that this is a contentious assumption. The reason many of these names are so cheap is that most investors assume that we are NOT going back to a 2019 type environment, or at least not any time within reason. Deep value investing, however, is by its nature a bet on mean reversion. As investors tend to linearly extrapolate recent trends into the foreseeable future, a deep value strategy takes the opposite view, betting that for many REITs the worst-case scenario is already priced in. In those instances, a return to normal economic activity would lead to extremely attractive returns.
Like any investing style, deep-value investing is not perfect, and we don’t expect to get every name on this list 100% correct. We can, however, allocate a portion of our capital to these high potential return scenarios, adding to the differentiation of our strategy and the fund’s potential upside over the next five years.
FAKE NEWS: REITs are defensive investments
While I don’t love using politically charged phrasing in these newsletters, sometimes it takes a bit of shock value to dislodge incorrect information that has taken up residence in investors psyches. From my experience, many investors think of REITs as defensive investments. Unfortunately, they also never allocate to defensive investments, and therefore never end up owning REITs. This is a perfectly acceptable strategy when prospective REIT returns are low. Now is not one of those times.
Contrary to popular belief, REITs actually exhibit their best returns EARLY in the economic cycle. In the five years following recessions, average REIT returns are an order of magnitude larger than their long-term average. That would indicate that the best time to own REITs is coming out of economic downturns.
The table at the bottom right displays the annualized returns for REITs over each five-year period following every recession since 1975. The average 5-year annualized returns for these periods was 19.6%, well in excess of the sectors full-period returns of 11.4% per year. This illustrates the cyclical nature of REIT returns, and the incredible ability of the average REIT to emerge from downturns with a roar as opposed to a whimper.
Now, let’s compare this to the returns of private equity commercial real estate over the same time periods. If we examine the NCREIF Property Index, which is an institutional-quality private equity real estate benchmark, we find that average five-year returns following recessions (excluding 1975 due to lack of history), averages 9.5%, compared to 19.3% for REITs.
That’s almost a 10% difference PER YEAR during these post-recession periods, going back almost 50 years. For the visually oriented, this kind of performance is best captured in the chart on the next page, which is focused on the most recent post-recession time period and the performance of REITs versus other asset classes.
REITs: The Center of the Investing Universe
I do not expect many investors to have the laser focus on publicly traded commercial real estate companies that I have. In fact, my ability to make REITs the center of my investing universe is a part of what gives our firm an edge in our investment process. I do not have to worry about the performance of the FANG stocks in order to make a case for REITs over the next 5 years; data and a few simple charts can do that for me.
The bottom line is this; REITs have an excellent track record of delivering compelling returns coming out of recessions that stretches back almost 50 years. At the current moment, there are opportunities to invest in distressed property types without the hassle of direct investment and going through a competitive bidding process. There are also opportunities to buy REITs in emerging property types that will grow their portfolio values rapidly over the next five years, leading to incredible annualized returns.
I certainly do not know exactly what the market will do over the next five years. I know that I do not know that. I do know, however, that the REIT market is presenting opportunities that are waiting to be seized. Our process is built to capitalize on those opportunities. As sure as the earth goes around the sun, Serenity Alternatives will be allocating to high-quality real estate portfolios run by the best real estate investors in the business.
Conventional wisdom be darned,
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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