“Let it roll, baby, roll

Let it roll, baby, roll.”

– Roadhouse Blues – The Doors

PERFORMANCE – Serenity Alternatives Fund I returned +1.45% in June net of fees and expenses versus the FTSE NAREIT REIT index at +2.77%. Year to date the fund has returned +25.7% versus the REIT index at +21.4%.
NEXPOINT RESIDENTIAL TRUST (NXRT) – Why a sunbelt Apartment REIT with a knack for value creation continues to find its way into the Serenity portfolio.
LET IT ROLL – Rents are moving rapidly higher for the Apartment REITs. Could this inflationary trend have broader implications?

By most accounts, the great lyrical poet Jim Morrison was not one to shy away from a good time. His lyrics are infused with Dionysian calls for revelry and enjoyment. We can imagine then that the self-proclaimed Lizard King was probably not one to leave a party early. As he says repeatedly in the classic tune referenced above…let it roll, baby, roll.

Investors, on the other hand, seem perfectly content to quietly bow out of this cyclical recovery just as it begins to gather steam. Calls for “transitory” inflation, doubts about demand, and a return to high-duration (read high multiple) stocks all continue to circulate in the investing ether. Memories of the slow growth 2016 – 2020 period permeate the mindset of portfolio managers of all stripes, prompting a return to “safety” on any piece of news that shows evidence of a slower pace of growth.

In our view, this willingness to leave the party comes much too early. The labor market is extremely tight and has only just begun to truly heal. The US consumer is flush with cash, the millennial spending wave is starting to gather steam, and many parts of the world are just beginning to re-open. Will we move past the extremely easy comps of 2020 over the next few months and see absolute growth rates decline? Yes, or course. But base effects are not the end-all-be-all of macro investing. If demand continues to show strength, growth rates will have to be revised higher, “transitory” inflation narratives will start to fade, and interest rates may increase meaningfully.

In this scenario, party-pooper investors will certainly regret an early cyclical exit. At Serenity, we will continue to roll with the data, which in this instance points to continued momentum. Apartment rents in particular show few signs of “growth slowing” at this point in the economic recovery. As things change, as always, we reserve the right to change our minds, but for now, we will continue to own pro-cyclical REITs that benefit from continued economic momentum. Let the cycle roll, baby, roll.

PERFORMANCE: +1.45% in June, +25.7% YTD

Serenity Alternatives Fund I returned +1.45% in June net of fees and expenses versus the FTSE NAREIT REIT index at +2.77%. The fund has now returned +25.7% for the year, versus the REIT benchmark at +21.4%.

On a trailing 3-year basis Serenity Alternatives Fund I has returned +19.3% on an annualized basis net of fees and expenses. Over the same time period, the REIT benchmark has returned 12.0% on an annualized basis. The fund’s Sharpe ratio over the past 3 years sits at 1.17, versus 0.66 for the REIT benchmark.

REIT property sector performance in June illustrates the proclivity of investors to jump back into high-growth, high duration REITs that were stars from 2016-2020. Infrastructure and Data Centers, in particular, performed well during the month, despite few changes in fundamentals.

While both of these property sectors have steady high single-digit levels of growth, they come at a price well in excess of much of the rest of the REIT space. With cash flow multiples close to 30x, the question for investors becomes how much are they willing to pay for a high level of certainty in earnings growth? Is 2-3% excess growth per year worth a 10-15x higher multiple for these names?

Late in an economic cycle this may make sense, but in our view, the current accelerating growth in the economy should lift all boats. This includes much cheaper REITs in other property sectors that may begin to put up growth numbers not terribly different than their much more expensive Data Center and Infrastructure peers.

Again, how much is growth worth when it is widely available? This is a question investors have not had to ask since 2013-2015.

NXRT: A Rough-Cut Sunbelt Diamond

One of the best performing positions in the fund in June was Nexpoint Residential Trust (NXRT). NXRT is the 7th ranked name in our CORE quant model, owns a portfolio of apartment assets across the sunbelt (Dallas, South Florida, Phoenix, etc), and returned +6.72% during the month.

NXRT possesses a combination of characteristics that our model and our fundamental outlook find favorable in the current economic environment. First of all, NXRT’s sunbelt exposure has allowed it to uniquely benefit from the de-urbanization that has occurred in part due to the pandemic. As millennials have moved out of urban centers in favor of faster growing, smaller, more affordable sunbelt markets, NXRT has benefitted with lower occupancy loss, and a faster recovery in rents than its urban Apartment REIT peers.

NXRT also has a size advantage to peers. At $1.4b in market cap, NXRT is significantly smaller than the peer average of $10b in the apartments sector. This is an advantage in a growing economy due to NXRT’s ability to grow its portfolio through acquisitions without having to do incredibly large deals. In the last cycle, NXRT demonstrated an impressive ability to buy lower quality multi-family assets and repurpose them, earning mid-teens returns on invested capital, and allowing them to grow earnings at a pace superior to their peer group.

Despite their potential for above peer growth on both an organic and external basis, NXRT still trades at a valuation discount to most other Apartment REITs. Relative to 2022 AFFO (cash flow), NXRT trades at a 21.0x multiple, versus a market cap weighted average of 26.8x for other Apartment REITs. From a cap rate perspective, NXRT trades at a 4.47% implied cap rate, versus many peers in the mid to high 3% range (lower cap rate = more expensive REIT.)

There are a few reasons for this valuation discount. The first is NXRT’s higher than peer leverage. At 50% Debt/EV, NXRT has higher leverage than its large cap Apartment REIT peers, which tend to run with between 20% and 35% Debt/EV. While we considered this a significant risk in early 2020, when the economy was slowing and risk of a recession was rising, we are in a very different economic situation today. With economic growth accelerating and a recession very closely in our rearview mirror, leverage is much less of a concern at this point in the cycle. In fact, it may be a benefit, as NXRT’s organic growth translates into more rapid earnings growth.

The other reason for the company’s valuation discount has to do with corporate governance. NXRT is an externally managed REIT, meaning the company pays an outside organization (Nexpoint Real Estate Advisors) to manage its assets and provide advisory work. Traditionally this is not an efficient arrangement as the drag on earnings and cash flow created by management fees tends to be higher for externally managed REITs. NXRT, however, does not have as onerous a management contract as many poorly run externally managed REITs, and during the previous cycle (2010-2019), NXRT had superior earnings growth and share price performance to peers IN SPITE OF their external management structure. Said another way, external management is a net negative, but it should not act as a significant drag on the company’s ability to create value over the next 3-5 years.

In the end, NXRT has the potential for above-peer growth at a discounted multiple. The company is small enough to do meaningful value-add deals, is exposed to some of the fastest growing markets in the US, and has a track record of adding significant value through an expanding economic cycle. It should be no surprise that NXRT ranks highly in our model and will remain an over-weight in the portfolio until the data changes or other opportunities look more attractive.

RISING APARTMENT RENTS: No Signs of Flagging Demand…

Data dependence is an oft echoed refrain of these pages and our current outlook is no exception. While analyzing top-down macro-economic data can prove insightful, it becomes much more powerful when coupled with on the ground fundamental data.

There are fewer more important data series in the REIT universe than those of apartment rents. Apartment (or multi-family) REITs make up about 10% of the REIT universe and have perennially strong performance. Equity Residential (EQR), one of the blue-chip Apartment REITs and a large part of the Sam Zell real estate empire, has returned 12.12% on an annualized basis since 1993. That’s 1.5% better on a yearly basis than both the REIT index and the S&P 500. Said another way, $1 invested in EQR in 1993 would now be worth $23, versus only $15 if invested in the REIT index or S&P 500.

Apartment rents are incredibly important because they are the key driver of growth for the Apartment REITs. With the majority of apartment units operating on 1-year leases, the level and direction of apartment rents translate into Apartment REIT revenues very rapidly. Apartment rents tend to be pro-cyclical, meaning when the economy does well, rents tend to rise, and when the economy does poorly, rents tend to fall. This can been seen starkly in the charts below, which display median apartment rents in San Francisco and New York since 2018.

Clearly, apartment rents plummeted throughout 2020 as these two major cities remained in lockdown, saw skyrocketing unemployment, and bore the brunt of the pandemic-induced recession that occurred last year. What may be more interesting, however, is the recent direction of rents in each of these charts. While still well below 2019 levels, apartment rents are unequivocally rising in the two hardest-hit markets in the country.

The velocity of increasing rates is not insignificant either. This is not a slow and steady climb back to normal, this is a “V-shaped” recovery. As vaccination levels have increased and restrictions have been eased, apartment landlords have seen demand return rapidly, allowing them to raise rents consistently and quickly.

But is this trend consistent across the country? Is demand growth waning in markets that did not suffer as much through the pandemic?

The two charts on the next page show rent levels in Orlando, FL and Dallas, TX. These two markets saw less rent degradation during the pandemic, re-opened sooner, and have already surpassed 2019 rent levels. And yet, rental rate growth shows no signs of abating. This would suggest that rent GROWTH is no longer a truly regional story, it is widespread and significant.

This is the type of bottoms-up fundamental data that it is important for investors to incorporate into their overarching view of the world. For those investors skeptical of the recovery or inclined to believe that inflation is transitory, these charts somehow need to be explained away. The “shelter” component of CPI (the literal government definition of inflation) is largely influenced by rent and house price growth. And these charts make clear that this component of inflation is moving higher and doing so rapidly.

So what does this mean for our portfolio? First of all it gives us confidence that the economic growth cycle is alive and well, as demand for apartments is clearly healthy across a wide range of major metros. It also gives us confidence in the fundamental outlook for the Apartment REITs in our portfolio (see NXRT, above).

Last of all rising inflation makes us slightly nervous regarding the current level of interest rates and their ability to remain low. If demand is this strong for high priced apartment units, it may be a sign of a broader demand surge that has yet to show up in the economic data. Such a growth “surprise” could easily send the 10y treasury yield towards 2% and beyond. The 10y is currently hovering around 2019 levels of 1.4%.

THE FUTURES UNCERTAIN, THE END IS ALWAYS NEAR…

Jim Morrison was a lyrical powerhouse. The future is uncertain, and the end of something is always near. In this instance, however, that something is not the economic cycle. While this recovery has been much more rapid than that of 2008-2009, there remain few (zero) economic expansions that have ended after six months of growth.

The burden of proof remains on those betting on the narrative of “transient” inflation. In order for that worldview to be correct, there has to be evidence of flagging demand or rapidly expanding supply in the economy that would keep prices in check. In the world of Apartment REITs, evidence of either of these sits somewhere between non-existent and very little.

For this reason, we continue to stick with cyclical REITs, remain wary of duration, and continue to tilt our portfolio towards those companies that can rapidly grow the value of their portfolios along with the broader economy. Value, momentum, and quality remain the cornerstones of our process, which so far in 2021 has delivered market-beating results. As the data change, we will change with it, but in the meantime, we will let it roll. Roll, baby roll.

Feel the Mojo Rising,

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

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

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