“I was constantly told by adults that the war, which ended up lasting close to seventeen years, was going to end in “only a matter of days.””

― Nassim Taleb, The Black Swan

PERFORMANCE: Serenity Alternatives Fund I returned -5.6% in March bringing YTD returns to -3.7%. The MSCI US REIT index returned -21.6% bringing YTD returns to -27%.
PROCESS: Every production version of Serenity’s multi-factor model has outperformed the REIT index YTD. Our quant model + risk management process has our fund 23% ahead of the benchmark after only 3 months.
POSITIONING: REITs are cheap due to the recessionary environment, but we are only buyers of high-quality portfolios and balance sheets. There is an incredible amount of bad news on the horizon. BE CAREFUL out there.
NEW SHORT IDEA: Why MREITS have exploded and what may look SAFE…may not be.

The black swan! The global pandemic! What an easy lazy comparison to modern times. “We could have never seen this coming!” Said every talking head in the financial media over the last 6 weeks.

I’m not terribly interested in the black swan facet of Taleb’s philosophy right now. Besides he’s already come out and said the pandemic is not, in fact, a black swan…

What I am interested in is Taleb’s exploration of decision making amidst uncertainty. That is more salient…how we make decisions when the range of outcomes is wide or even un-knowable. THAT is where he is relevant to today’s environment.

In the quote above, Taleb discusses the illusion of understanding, which is the fact that “everyone thinks he knows what is going on in a world that is more complicated (or random) than they realize.” This attitude abounds in finance…from daily headlines describing what is moving the Dow, to confident projections of stock market bottoms made by people that did not predict the top.

Frankly, the narrative spinning gets tiring.

So, let’s dispense with the platitudes and examine some of the facts. First, over the last two weeks more than 9 million people have filed for unemployment. That’s 3% of the population out of work in a two-week span. Second, nobody in the REIT space is sure when, or how much rent, they are going to collect over the next 1-2 months. With over half the hotels in the US closed, most retailers and restaurants closed, and no one in office spaces, – for many landlords the answer is…not much. Third, a stock market recovery from here would be the second shortest recessionary bear market ever, at just under 6 weeks. The next shortest? 14 months.

I am not trying to scare anyone by weaving a doom and gloom narrative here. I’m trying to illustrate the fact that there is no way of knowing how this plays out going forward. That means investors need to examine their assumptions, especially if those include the assumption that “the stock market has bottomed.” That was a widely held belief in October of 2008 as well…and that did not work out too well over the following 6 months.

The best thing for investors at this point is WORK. Do some due diligence on your portfolio or find somebody that can do so on your behalf. We are entering an incredibly challenging time for the economy, and not every company is going to make it through. Yes, there are great opportunities out there right now, but there are also a lot of landmines, and buying too early can be much more painful than missing the first leg of the recovery.

This is why our advice continues to have two sequential components. First, clean out your portfolio to make sure nothing in it blows up. Then and only then should you start looking for deals. In a bear market it’s much more difficult to buy things correctly than sell things correctly. Do as we have done, sell the crap, then be patient in looking for the bottom.

Performance: -5.6% in March, -3.7% YTD

Serenity Alternatives Fund I returned -5.6% in March with an average net exposure of 38%. The MSCI US REIT index returned -21.6% for the month, while the S&P 500 returned -12.4%. For the year to date, our fund has returned -3.7% versus the RMZ at -27% and the S&P 500 at -19.6%. That’s 23% of outperformance relative to the REIT benchmark over the course of three months, and 15% relative to the S&P 500.

Since January of 2019, our fund has returned +28.3%, while the REIT index has returned -8.1% and the S&P 500 has returned +5.7%. That is 36% in savings for our clients over a 15-month period, with a Sharpe ratio of +2.1.

Performance starts with process, which is something we have emphasized from day one at Serenity Alternatives. While the ride hasn’t been perfectly smooth, our hard work and commitment to executing a repeatable (and industry unique) investment process is now clearly showing up in the data.

Since inception our fund has returned +21.4% (all performance stats discussed are net of all fees and expenses), versus the REIT index at +0.04%. It is a coincidence that the REIT market has fully round-tripped over the last four years, but it is no coincidence that our investors have made money. As we move through the most difficult economic environment since 2008-2009, we will continue to execute on our now well-honed strategy, building portfolios of high quality commercial real estate that can thrive in any economic environment. With the best opportunity set in REITs since 2008-2009 and a pile of cash to deploy, the team here is focused on sifting through the rubble and prudently deploying capital where and when appropriate.

Top and bottom performers – Short book to the rescue…

The top performing position in the fund for this quarter was not surprisingly in our short book. Nextpoint Residential (NXRT) is a multi-family (apartment) REIT with a portfolio concentrated in value-add and rehab deals in the southern part of the United States. NXRT has an excellent track record of creating value, and into this year had led the apartment REITs from a performance perspective due to higher than average same store NOI and FFO growth.

Throughout February, however, NXRT traded to valuation levels that were stretched. At one point the company traded at a meaningful premium relative to its’ apartment peers with much higher quality portfolios and much safer balance sheets. The company was not alone, as numerous lower quality REITs, with high levels of leverage, and outsized late-cycle growth, reached valuation levels that were on par with higher quality, safer peers. This is a phenomenon that happens very late in the cycle, when revenue growth from lower quality properties tends to peak. In the fund, we concluded that downside risks were not being properly discounted in these highly levered, riskier, REITs, and added a number of them to the short book.

Fast forward a month and the coronavirus pandemic has, in short order, accomplished what we believed would take months or quarters to occur. NXRT has fallen 41% from its February highs. The company now trades in-line with peers from a valuation standpoint – but may issue negative earnings revisions as we enter the teeth of the current recession. We have covered our short position as the company now trades at a meaningful discount to the value of its underlying portfolio, but we are not ready to get bullish on the name. Going forward, NXRT is going to have a much more difficult time coping with the current economic environment than larger, better capitalized apartment REITs, and is a good example of how dangerous it is to buy high-risk assets near the end of the cycle.

As a quick aside, I want to emphasize the importance and uniqueness of our short book. We are one of the few real estate funds that can save, or even make, our investors money in an adverse environment. Without the ability to short REITs, many investors are forced to talk themselves into opportunities that may not have good risk-reward profiles, purely for the sake of putting capital to work.

At Serenity, we have intentionally structured our fund to make bets in both directions. With a process that is designed to be dispassionate, we can step back and profit from situations in which risk far outweighs reward. Q1 of 2020 is a shining example of this, as the top 5 names in our short book all fell by more than 25% during the quarter, saving our investors meaningful amounts of their hard-earned capital.

Property Sector Performance – The bell tolls for retail…

The worst performing sectors in the REIT universe this quarter were regional malls (-51.2%), hotels (-50%), and mortgage REITs (-50.9%). Shopping centers (-47.8%) were not far behind, as the coronavirus pandemic has disproportionately impacted retailers and hospitality companies.

This will certainly be the curtain call for many struggling retailers and may even be the straw that breaks the camel’s back for some retail REITs. The B and C-mall companies are already trading as if they are going out of business, and even the highest quality retail portfolios have fallen in excess of 30%.

Simon Property Group (SPG) currently trades at an AFFO multiple of 5x, its lowest level since…you guessed it…2009. That’s a 25% cash flow yield for a REIT that has been a blue-chip stock for most of its history. It now appears that the systematic elimination of old-guard retailers – which e-commerce started – may be finished by the coronavirus. Zombie retail companies that populate mall portfolios may finally be forced to close en-masse, with landlords forced to re-tenant large amounts of space, most probably at much lower rents, eating up untold amounts of cash flow over the foreseeable future.

This puts the malls and strip retailers in a similar position to most of the REIT market. They look extremely cheap by almost any valuation metric, but nobody knows how bad things will actually get for many of these tenants and landlords. This is the overriding reason we are still exercising caution in the fund and are only willing to buy companies with extremely high-quality portfolios and balance sheets. The fact is, things could get much worse than most expect, and frankly the market is signaling that this is not only possible, but LIKELY.

In the retail space this is easy to imagine as physical retailers have struggled for a long time and the coronavirus will only make things worse. But what about for companies like the apartment REITs? During the 2008-2009 recession, same store NOI went negative when the unemployment rate went to 10%…what happens if it goes to 15% as some economists are predicting? While the apartment REITs look cheap, they may not be pricing in -5% to -10% SS NOI growth. To be clear, we are not making that call, but that scenario is quite possible. That means that apartment REITs may be cheap, but they could easily continue to get cheaper.

Again, I don’t want to sound like doctor doom here, but investors still need to BE CAREFUL. It’s no secret that REITs are cheap, a fifth grader could come to that conclusion, and in a recessionary (or possibly depressionary) environment, that data point could be temporarily irrelevant. As an investor you should still be vetting EVERYTHING you put in your portfolio and have confidence that the news is not going to get worse in that company before it gets better. If you cannot say that for every investment in your book during the worst economic shock in at least 10 years, then why own it? The people that were NOT prepared for this in the first place and are saying “buy REITs now they are cheap” have no choice. They are already fully invested…they are probably down 20-30% YTD, and they NEED REITs to go higher.

If you can’t tell already, I am fired up. Anyone telling you that this bear market is over after just six weeks is peddling bull excrement. People are way too complacent into an economic shock that has not even truly begun to unfold. Do not be complacent…do your work.

The fact is that we just don’t know how bad or long this downturn is going to be, and until there is some clarity in that regard, we will continue to exercise caution in the fund. If you are buying REITs with two hands right now, you are betting on the swiftest recovery in bear market history from an unprecedented economic shock that has not even peaked in terms of its negative impact. Don’t be lured in by the siren song…cheap often times gets cheaper…or just plain blows up. Speaking of which…

Physics Lesson – Why grenades explode

I hate to waste too much of my breath here, but over the past month we have gotten a disconcerting number of incoming inquiries regarding the mortgage REIT market. As illustrated in the table on the page above, mortgage REITs have lost about 50% of their value this year, and many are down more in the realm of 70-80%.

This is what I have to say about most mortgage REITs in a nutshell…they are financial grenades, and when they explode, nobody should be surprised. A company buying mortgages that yield 3.5-4.5% and paying a dividend between 9.0% and 10.0% sounds too good to be true BECAUSE IT IS. There is only one way to get from 4% to 10% yields …and it’s called leverage. Leverage is great in a bull market, but it wipes you out in a bear market.

Mortgage REITs are levered bond portfolios…they have a capped upside and unlimited downside. We invest in the equity REITs because they have tools to grow the value of their portfolios over time, and rarely go bankrupt. In other words, they are the opposite of mortgage REITs, unlimited upside with less leverage, and therefore less chance of blowing up. The long term returns of mortgage REITs are around 4% annually…again with dividend yields between 8 and 10%. That’s called consistent value destruction.

High dividend REITs tend to be dangerous investments, which is something we try and make clear when educating investors on the REIT market. If you want a better strategy for picking REITs than blindly buying a 10% dividend yielding mortgage REIT that then goes down 80%, please reach out to us.

Now while we’re on the topic of things to avoid…

New Position – short SAFE – Long irony?

Safehold (SAFE), formerly Safety Income and Growth, Inc. is a fairly new REIT that specializes in ground leases. SAFE is the perfect example of a portfolio bomb waiting to go off. Up to this point investors have been duped into thinking it has created a bona-fide printing press and is minting money. We shorted SAFE above $60, after getting numerous inquiries to look at the company as an idea on the long side.

SAFE’s business model is that it offers ground leases, or more accurately ground lease like structured products, to real estate owners. The transaction looks like this…SAFE writes a ground lease to a building owner for 30-45% of the property’s value, netting a return to SAFE of 3%-4%, then levers its balance sheet by 50% in order to create a higher levered return. Look familiar from the last section? Effectively SAFE is lending to real estate owners for a fraction of their property value at rates of around 3%-4%. If that sounds kind of like a mortgage…again…don’t over-think it…it is, just in a different package.

Over the past few years, SAFE has put out about $2.8 billion in these types of deals, which effectively add a layer of leverage to the real estate that sits on top of them. They have then levered their company by adding $1.4b in debt, giving them a debt to book value ratio around 50%, which is extremely high for an equity REIT, but pretty par for the course for a mortgage REIT. But SAFE is not technically a mortgage REIT…and while the mortgage REITs are down 50% YTD, SAFE is up 22%.

As of April 4th, SAFE trades at 27.5x 2020 EBITDA, 30x 2020 FFO, 57.6x 2020 AFFO (cash flow), and 120% of NAV ($50 stock vs $22 NAV). That basically makes it the most expensive REIT in existence. Compare that to one of SAFE’s largest tenants Park Hotels (PK), which trades at a 4.5x 2020 FFO multiple, and a 50% discount to consensus NAV. Or compare it to the REIT average FFO multiple of 14.6x…it’s twice as expensive!

SAFE bulls will argue that this reflects a flight to safety based on the senior position of ground leases within the capital stack. We have reasons to be skeptical that these leases truly have such seniority. For example, SAFE derives 10% of its cash revenue from the DoubleTree Airport Hotel in Seattle. As explained in their 10-K, their ground lease of this asset is actually the second ground lease on the property. Meaning their ground lease is actually junior to another ground lease that expires in 2044. Effectively that makes their ground lease look much more like a 24-year bond than an actual ground lease. And that’s on 10% of the company’s revenue.

A careful reading of their 10-K shows the following:

“It is also possible that, if a tenant were to become subject to bankruptcy proceedings, a bankruptcy court could re-characterize the lease transactions as secured lending transactions depending on its interpretation of the terms of the lease, including, among other factors, the length of the lease relative to the useful life of the leased property.”

Effectively, a bankruptcy court could very well rule that these mortgage-like “ground leases” are in fact mortgages, moving SAFE down in the capital stack and potentially reducing or eliminating the value of the given lease. Suffice it to say that the companies ground leases might not be truly as “safe” as the company would have investors believe.

Now what about the safety of their tenant’s cash flows? Is there really any threat of bankruptcies in SAFE’s portfolio leading to reduced rent payments? Well let’s go back to the 10-K…specifically the risk-factors section.

“For the year ended December 31, 2019, our two largest tenants by revenues, the tenants of our 1111 Pennsylvania Avenue Ground Lease and our Park Hotels Portfolio Ground Lease, accounted for approximately 17.3% and 14.9%, respectively, of our total revenues.”

So 15% of the company’s revenue comes from a ground lease deal with the hotel REIT Park Hotels & Resorts (PK). Park currently trades at a 50% discount to the value of its underlying assets, has one of the highest leverage levels in the hotel sector, and currently has closed 50% of its hotel portfolio. Some of SAFE’s revenue from Park is actually performance contingent as well, meaning if the hotel does not perform…SAFE does not get paid. Well, with half the portfolio closed… I have a feeling that portion of SAFE’s revenue might no longer exist.

Next, 20% of SAFEs book value is in hotels, while 65% is in office. And 12.9% of that office concentration is an office building at 425 Park Avenue in New York. 425 Park is an un-finished re-development that is scheduled to be delivered in 2021 and is 50% leased. Note construction has stopped in New York.

So just to re-cap…30% of the company’s portfolio is “ground-leases” on hotels which are currently closed, and an office building that is not finished. That would be concerning if we weren’t in the midst of a full-on recession but should be down-right scary to SAFE investors in the current environment.

The cherry on top here may be SAFE’s corporate governance. I’ll spare some of the details, but the management team gets paid based on the appreciation of the real estate that sits on top of their ground leases (what the company calls UCA). This occurs despite the fact that NONE OF THIS VALUE ACTUALLY ACCRUES TO SAFE SHAREHOLDERS. So SAFE collects a fixed rent payment, and the management team pays themselves based on appraised value of real estate that they do not own an equity position in. Again, if that does not smell good, it’s because it, in fact, STINKS.

At the end of the day SAFE is another mortgage REIT masquerading as an equity REIT. It’s absurdly expensive relative to anything in the REIT space, with a portfolio of “ground leases” that are backed by extremely risky real estate assets… some of which are currently un-occupied. The company sports 50% leverage, which is dangerous on its own. Throw in a recessionary economic environment, couple that with risky cash flows, bad corporate governance, and a valuation that makes no sense, and…well, we are short, and are likely to get more short if the company moves back near $60.

Process is Paramount! – And other alliterations

Over the past 4 years I’ve seen bad investment ideas gather assets like cartoon snowballs rolling down-hill, hurtling towards the end of the cycle like crash test dummies. I’ve found it difficult to convince anyone to manage their risk during the later stages of an all-time bull market for real estate. But that cycle is now over, and those investors who put money to work in late cycle deals with too much leverage are about to, unfortunately, pay the price.

At Serenity, we were proactively prepared for a weak economy, and reacted swiftly when it became evident that we are headed into something much worse. Year to date our investors have saved +23% relative to the REIT benchmark, and they are up more than +28% since early 2019. Our process is humming, and we are uniquely positioned to take advantage of current dislocations thanks to our large cash balance and flexible framework.

We remain cautious, however, as the economic damage caused by the coronavirus has only just begun to emerge. We have vetted our entire portfolio for quality and offset our long exposures with shorts in REITs that could experience significant challenges over the next 12 months. The road back from this pandemic will not be short or smooth as some may have you believe, but our process will act as a steady guide.

My hope is that our commentary here can help our newsletter subscribers protect and grow their hard-earned capital. If you have made it this far, thank you as always for reading, apologies for the excessive CAPS this quarter, and as always, don’t hesitate to reach out with any questions.

Socially distantly yours,

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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