PERFORMANCE – Serenity Alternatives Fund I returned +0.09% in May bringing YTD returns to -0.1%. The MSCI US REIT index returned +0.19% bringing YTD returns to -20.8%.
PROCESS – While the stock market has celebrated “improving” economic data, companies still have to deal with the upcoming economic reality of 16% unemployment.
OPPORTUNITY – A multi-year bull market for REITs is on the horizon, but historically it is better to be late than early.

“That’s no moon” – Obi-Wan Kenobi

Star Wars references two months in a row? Really? Bear with me.

The Millennium Falcon drops out of hyperspace after a firefight at Mos Eisley Spaceport. Luke Skywalker, Han Solo, Chewy, and Obi-Wan find themselves navigating a field of debris amidst what they thought would be a friendly planet. At first, they are confused, until they spot a small moon out ahead of them, which, as they grow closer, turns out to be the Death Star. The massive space station then hits them with a tractor beam, inexorably sucking them into the empire’s clutches.

Out of the frying pan, into the planet-destroying space station.

See the connection to REITs? Allow me to clarify.

The stock market has celebrated as the coronavirus in the United States has come under relative control, and states and cities have begun the re-opening process. Pent-up demand has given companies a bullish narrative to feed investors, with many companies referencing “traffic” or “demand” that was actually UP year over year in May. Does this mean the worst is behind us? Is this the start of a new bull market?

Not so fast.

Unemployment is real, massive, and tends to have a delayed impact on the economy. We have yet to see the true effects of a jobless rate that rivals that of the great depression (remember…these numbers are WORSE than 2008-2009). Anyone sounding the all-clear is hoping that the #1 driver of our economy (jobs) goes from horrific to fine within the next few months.

While government stimulus checks and enhanced unemployment benefits have offered temporary relief, they are not permanent solutions. The Federal Reserve may be able to print money, but it can’t force companies to hire more staff when their revenues are down 20% year over year. At some point, public equities (and by extension REITs) have to face economic reality, as opposed to spinning hopeful narratives.

This does not mean it makes sense to be bearish on anything and everything. Some equities and some REITs have priced in a great deal of economic pain. At the same time, many have not, and until it is clearer which fundamentals have truly weathered this economic storm, we will remain cautious. We are hopeful but realistic in our expectations, convinced that there will continue to be compelling REIT opportunities for us to take advantage of over the next twelve months.

Performance: +0.08% in May, -0.1% YTD

Serenity Alternatives Fund I returned +0.08% in May, while the MSCI US REIT index returned +0.19%. On a year to date basis, the fund is down -0.1% net of fees and expenses, while the REIT index has returned -20.8%. Since 2019 Fund I has generated an annualized return of +24.1%, while the REIT index is annualizing at -0.4%.

The best performing position in the fund in May was Gaming and Leisure Properties, Inc (GLPI), up +24.4%. GLPI is one of the relatively new REITs that owns Casino assets across the country. GLPI has a more regional focus than its peers (meaning it has less exposure to Las Vegas), and has consistently traded at a discounted valuation. It was also one of the most adversely impacted REITs by the global pandemic, falling over 70% in the month of March from $45 to $13.04 at the low, before recovering back to $34 by the end of May. We regrettably owned a small position in GLPI through much of the carnage, but through some tactical trading and the temerity to stick with a name that we knew had very well protected cash flows, we have been able to reduce our loss to just over 10%. For a company that fell 70% at one point I consider that a positive outcome.

The worst performing position in the fund during the month was Boston Properties (BXP), which was down -12.6%. As the economy begins to re-open, the “work from home” trend is being viewed as a sticky solution for our modern economy. Many tech companies and other CEOs have made comments that work from home will become a greater part of their corporate culture, much to the delight of some, but the consternation of many office landlords.

This is one of the many interesting debates occurring in REITs today. Everyone has an opinion, and both sides have valid arguments. Clearly many companies will have the capability to keep people out of the office, and many workers will be nervous about returning to work in a highly dense environment. On the other hand, even returning a fraction of the original workforce to an office is going to require a much larger amount of physical space in a world of social distancing (six-foot spaces between seats reduces capacity by 40% on average). Where actual office demand ends up is anyone’s guess.

If we remove ourselves from the guess work, however, what is clear is that office REITs are incredibly cheap by historical standards. This alone does not make them good investments (see the retail and mall names) but makes the impact of good news especially pronounced. BXP in particular also has one of the highest quality management teams in the entire REIT space, few expiring leases in 2020 and 2021, a pristine balance sheet, and a long track record of creating value. In line with our strategy of buying high quality portfolios at distressed prices, we have added to BXP on large dips, and continue to manage our position through this environment of elevated volatility.

Process – Recovery imminent?

Optimism has abounded recently as the stock market marches back towards pre-coronavirus levels. Better than expected data from select individual companies and improving employment figures have emboldened the bulls and continued to confound the shorts. Many companies and a select number of REITs have traded to valuations significantly higher than they were at the start of the year despite earnings estimates for 2020 and 2021 that have fallen rapidly. Stocks going up on declining earnings is a strange phenomenon, and only happens in an environment in which a massively accommodative federal reserve meets an optimistic pool of equity market bulls.

To that point, our macro analysis has recently centered on the question “has the federal reserve really arrested economic gravity?” Has the unprecedented level of fed intervention and government stimulus really put the economy back on the path to a v-shaped recovery?

It’s an impossibly complex question, filled with nuance and approachable from an infinite number of angles. Bulls can easily assemble a plethora of positive data, while bears can just as easily do the same. The more analysis we perform, however, the more we come back to what seems to be the seminal question.

Can the federal reserve and congress overcome the worst employment situation in almost 100 years?

We present the chart above to illustrate the true gravity of the current state of the US labor market. Unemployment in the US peaked at 10% during the GFC (remember that stands for great financial crisis). It has already surpassed 16% in the current crisis and has done so more quickly than any time in history. That’s 16% of the US labor pool that is highly uncertain about its future.

Now let’s lay out the bull case. With the federal reserve expanding its balance sheet at a record clip, there is enough money being printed to keep the stock market elevated until earnings recover. This will be catalyzed by enhanced unemployment benefits that will allow jobless citizens to stay solvent until companies create or re-hire the 20 million Americans filing continuing unemployment claims. As the economy re-opens, demand will normalize, more jobs will be created, and the positive feedback loop will generate enough economic improvement to satisfy investors who will continue to buy stocks at all time price and valuation highs until fundamentals recover.

The bear case is a bit more straightforward. Record unemployment leads to structurally lower spending, which translates to lower revenues for REITs and other companies. With revenue down and expenses up, companies hire selectively if at all, postponing the creation of jobs needed to stimulate demand. As an earnings recovery looks less and less probable, investors incrementally lose conviction and <gasp> sell stocks.

In the first case, the federal reserve and the federal government need to suspend the laws of economic physics, somehow getting companies to hire or re-hire workers despite a revenue environment much more adverse than that of early 2020. Don’t get me wrong, it’s possible, and the fed has committed itself to doing “anything necessary”. Historically, however, the market tends to be a much more important actor than the federal reserve. Just re-wind the tape to 2008-2009 when a record amount of economic stimulus late in 2008 translated into additional 40% losses in the S&P 500.

This is the overriding reason we remain cautious on REIT fundamentals for the foreseeable future. While REITs have dealt with the impact of the coronavirus, they have yet to face the malevolent gravity of massive unemployment and its knock-on effects.

Opportunity – Riding the next Bull

On a more positive note, we do have our eyes on the horizon looking towards the next long-term bull market in REITs. In the aftermath of the 2008-2009 financial crisis, REITs delivered annualized returns of 28.6% over a five-year period from 2009-2014. Over that same time period, the S&P 500 returned 21% on an annualized basis, while the tech-heavy Nasdaq 100 returned 25%. This growth was driven by Net Asset Values (NAV’s) that increased 90% from their floor in mid-2009 and would go on to rise another 20% before peaking.

Those are exciting returns, which is why some investors badly want to believe that we have already entered the new bull. We are skeptical due to the macroeconomic reasons detailed above, and due to the fact that NAV’s are still being revised downwards. As companies report Q2 results and begin to better understand the impacts of unemployment on their portfolios, we will have a better view on where and when NAV’s will bottom, at which point we can become much more comfortable with a bullish stance.

If we are wrong in the meantime and the bull has already begun, we can take solace in the fact that our portfolio did not drawdown in the first place, and that we are well ahead of the benchmark for the year. When the time is right, our model will be ready, and our investors will reap the benefits. Until then, we remain patient, hopeful, but realistic, trying to not get sucked into the Death Star’s orbit.

Remember, this is the hedge fund that made the Kessel Run in less than twelve parsecs,

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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