• With 200+ companies, invested in over 19 different property types, the publicly traded REIT market offers investors the opportunity to tilt their real estate exposure in countless different directions
• As the cycle has matured and growth has slowed from recent peaks, it’s been important to avoid cyclical REITS, and embrace bond-like REITs
• For investors looking to lower portfolio risk this late in the cycle, high quality REITS with strong balance sheets offer a compelling portfolio allocation

You don’t have to look too far in the financial press to find an article about how we are “late in the cycle.” It’s common knowledge that the economic recovery is long in the tooth, as we pass the 10-year mark since the depths of the last recession. But how does that knowledge help us as real estate investors? How are investors supposed to change behavior knowing that the cycle is very mature?

In many cases, unfortunately, real estate investors have limited options. Selling assets can trigger tax events and sitting in cash is not what most clients want from their managers. With high quality assets commanding premium valuations, how can real estate investors add protection to their portfolio if they think the cycle is closer to its end than it’s beginning?

One answer lies in the publicly traded real estate market. Real estate investment trusts, or REITs offer a myriad of different ways in which real estate investors can maintain real estate exposure while protecting their downside. While the REIT market is complex, for savvy investors it represents an opportunity to enhance their returns as we enter the last phases of the cycle.

REIT Property Sectors: What are you betting on?

For investors that are new to the REIT market, it makes sense to start at the property sector level when discussing the real estate cycle. The publicly traded REIT market is comprised of over 200 companies, most of which specialize in a particular property type within commercial real estate. While there are over 15 property sector groups in the REIT space, this article will focus on four that have particular cyclical exposure; Hotels, Apartments, Healthcare, and Free-Standing Retail (also known as Net-Lease).

Hotel (or lodging) REITs are the most cyclical component of the REIT universe. This is because turnover in the Hotel industry is much higher than in any other property sector. Simply put, most people only stay in a hotel for one or two nights, so when the economy starts to slow, hotel owners notice immediately as their occupancies begin to fall. For this reason, when the cycle slows, it’s best to avoid the Hotel REITs.

The Apartment (or multi-family) REITs have a slightly different character than the Hotel REITs. Apartments tend to be tied to the employment cycle, and with leases that average one year in length, they do not immediately feel the impact of the cycle once it rolls over. They are, however, still cyclicals in that their performance will eventually reflect the health of the labor market. Apartments are best to avoid when jobless claims are rising, and employment growth is falling.

On the other end of the cyclical spectrum lie the Free-Standing Retail or net-lease REITs. These companies are almost counter-cyclical. This once-again has to do with the duration of their leases. Free-Standing Retail owners lease most of their buildings for 10 or more years. This means that while Apartment owners are forced to mark down a significant portion of their portfolio to market during a downturn, Free-Standing Retail landlords may only have a few leases rolling over in any given year. The cash-flows from these long-term leases simply have less downside volatility than short-term leases, and thus, less cyclicality.

Our final sector (Healthcare) is also defensive in nature, but it derives its defensiveness less from the term-structure of its leases, and more from its relationship with the bond market. The Healthcare REITs (along with Free-Standing Retail) have some of the highest inverse correlations with the 10-year treasury yield of any of the REITs. That simply means that as the yield on the 10-year treasury goes down, Healthcare and Free-Standing Retail REITs tend to go up. This makes the sector defensive, because as the economy loses steam, the yield on the 10-year tends to fall, and these stocks tend to perform well.

Case Study: When playing defense pays off

As a quick exploration of the cyclicality of these sectors we can examine an episode from recent history, particularly the period from 2018 in which the 10-year treasury yield peaked and began to fall along with expectations for economic growth.

In October of 2018 the yield on the 10-year treasury hit 3.2%. This occurred in an environment in which economic growth expectations were still high, following 9 quarters of sequential acceleration in real GDP growth. Investors will likely remember the turmoil in the stock market that followed the October peak in yields. Since then, the 10-year yield has fallen to below 2.0% as economic expectations have fallen and estimates of GDP growth have been trimmed.

Over that same time period, the Bloomberg REIT Healthcare index has returned 23.9%, while the Bloomberg REIT Single Tenant (Free-Standing Retail) index has returned 26.6%. Apartment REITs returned 19.2%, while the Hotel sector has returned -20.6%.

The gap between cyclical and counter-cyclical REITs could not be more evident than in the 30% spread that has occurred over the course of 9 months between Hotels and bond-like REITs. As economic data has deteriorated, investors have flocked into Healthcare and Free-Standing Retail names, while simultaneously trimming exposure to Hotel REITs.

The Apartment sector is the notable exception as employment data had remained mostly positive until very recently. The Apartment REITs are still cyclical, however, and it’s safe to assume that investors are eyeing the employment statistics carefully if they own Apartment REITs.

Not a sector picker? Enhance your balance sheet.

While it’s clear that sector performance can create large return opportunities, sector timing is notoriously difficult. For investors that prefer not to choose favorites amongst property types, the REIT market still offers options for enhancing the risk profile of a portfolio.

The REIT market allows investors to very easily assemble a portfolio of high-quality real estate assets that is diversified across both geographies and property types. While this is a compelling value proposition in itself, a key component of REITs that is less-often discussed is the quality of their balance sheets.

Anyone that invested in real estate through the downturn of 2008 knows how important leverage levels are, and how dangerous it can be to carry excess leverage into a cyclical slow-down. After 10 years of favorable market conditions and low rates, it may be time to carefully consider the amount of leverage real estate portfolios are carrying.

Private real estate investors tend to lever their assets at 50% or more (on debt/asset value), however, the REIT universe tends to run closer to 35% leverage. This higher base of equity capital limits the risk of REIT portfolios relative to higher levered investments of the same quality.

The relative safety of REIT balance sheets can also act as a self-reinforcing mechanism during a downturn, as investors flock to real estate investments with low leverage. This flight to safety bid further enhances REITs cost of capital relative to their private peers, and allows them to better take advantage of any opportunities a down cycle will offer.

Putting it all together: Diversify and de-lever to fight the cycle.

Timing the real-estate cycle is near impossible, but after a 10-year bull market in most risk-assets it has become clear that the current cycle is losing steam. As economic growth has slowed over the last 9 months, defensive exposures have outperformed both in the broad stock market and in the REIT market. For real estate investors looking to tilt their portfolio in a new direction, adding REITs could make the difference between outperformance and under-performance during the next cyclical downturn.

By assembling a diversified REIT portfolio with low leverage, investors can maintain exposure to high quality, cash flowing, commercial real-estate, while insulating themselves from swings in the cycle. These swings will be magnified in real estate carrying high leverage levels. Add to this the fact that well capitalized companies (REITs) will be in the best positions to buy distressed assets during the next downturn, and the case for adding REITs to a portfolio late in the cycle becomes compelling.

  1. Intro – After 10 years of economic expansion post GFC, many real estate investors are wondering how long this cycle can last.
    a. Everyone knows the cycle is long in the tooth, but the playbook for navigating the next 12-18 months is very much up for debate.
    b. What options do most RE investors have…go to cash? Sell? What happens if you miss another move higher?
    c. The REIT market offers solutions via the sheer # of expressions a REIT portfolio can take.
  2. Sector Tilting – how cyclical versus defensive REITs can add defense or offense
    a. Highly cyclical REIT sectors – Hotels, Billboards, Apartments, c-corps
    b. REITs with low-cyclicality – Net lease, Healthcare
    c. High duration REITS have been on a tear – watch Apartments for degradation in the employment data
    d. Counter-cyclicality – look for REITs with secular tailwinds (Data, Warehouse) and avoid those with headwinds (Retail/Mall).
  3. Risk Tilting – how investors can reduce risk by adding low-levered, high quality REITs
    a. For those worried about carrying cash, high quality diversified REIT portfolios offer a compelling allocation option
    b. REITs are not without risk, but tend to recover from downturns very rapidly
    c. REITs have almost 0 risk of bankruptcy – it’s much higher for private real estate with high leverage.
  4. Conclusion – use REITs to tilt a RE portfolio in the right directions
    a. With growth slowing, we are tilting defensively
    b. Look for sectors with secular tailwinds (DC, IND)
    c. For shorts – find high leverage names with cyclicality levered to slowing property sectors and watch the Apartments

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

DISCLAIMER: This document is being furnished by Serenity Alternative Investment Management, LLC (“Manager”), the investment manager of the private investment fund, Serenity Alternative Investments Fund I, LP (the “Fund”), solely for use in connection with consideration of an investment in the Fund by prospective investors. The statements herein are based on information available on the date hereof and are intended only as a summary. The Manager has been in operation since 2016 and the Fund commenced operations on January 14th. The information provided by the Manager is available only to those investors qualifying to invest in the Fund. By accepting this document and/or attachments, you agree that you or the entity that you represent meet all investor qualifications in the jurisdiction(s) where you are subject to the statutory regulations related to the investment in the type of fund described in this document. This document may not be reproduced or distributed to anyone other than the identified recipient’s professional advisers without the prior written consent of the Manager. The recipient, by accepting delivery of this document agrees to return it and all related documents to the Manager if the recipient does not subscribe for an interest in the Fund. All information contained herein is confidential. This document is subject to revision at any time and the Manager is not obligated to inform you of any changes made. No statement herein supersedes any statement to the contrary in the Fund’s confidential offering documents.

The information contained herein does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made by means of delivery of an approved confidential offering memorandum and only in those jurisdictions where permitted by law. Prospective investors should inform themselves and take appropriate advice as to any applicable legal requirements and any applicable taxation and exchange control regulations in the countries and/or states of their citizenship, residence or domicile which might be relevant to the subscription, purchase, holding, exchange, redemption or disposal of any investments. The information contained herein does not take into account the particular investment objectives or financial circumstances of any specific person who may receive it. Before making an investment, prospective investors are advised to thoroughly and carefully review the offering memorandum with their financial, legal and tax advisers to determine whether an investment such as this is suitable for them.

There is no guarantee that the investment objectives of the Fund will be achieved. There is no secondary market for interests and none is expected to develop. You should not make an investment unless you have a long term holding objective and are prepared to lose all or a substantial portion of your investment. An investment in the Fund is speculative and involves a high degree of risk. Opportunities for withdrawal and transferability of interests are restricted. As a result, investors may not have access to capital except according to the terms of withdrawal specified within the confidential offering memorandum and other related documents. The fees and expenses that will be charged by the Fund and/or its Manager may be higher than the fees and expenses of other investment alternatives and may offset profits.

With respect to the present document and/or its attachments, the Manager makes no warranty or representation, whether express or implied, and assumes no legal liability for the accuracy, completeness or usefulness of any information disclosed. Certain information is based on data provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed and should not be relied upon as such. Performance information and/or results, unless otherwise indicated, are un-audited and their appearance in this document reflects the estimated returns net of all expenses and fees. Investment return and the principal value of an investment will fluctuate and may be quite volatile. In addition to exposure to adverse market conditions, investments may also be exposed to changes in regulations, change in providers of capital and other service providers.

The Manager does not accept any responsibility or liability whatsoever caused by any action taken in reliance upon this document and/or its attachments. The private investment fund described herein has not been registered under the Investment Company Act of 1940, as amended, and the interests therein have not been registered under the Securities Act of 1933, as amended (the “1933 Act”), or in any state or foreign securities laws. These interests will be offered and sold only to “Accredited Investors” as such term is defined under federal securities laws. The Manager assumes that by acceptance of this document and/or attachments that the recipient understands the risks involved – including the loss of some or all of any investment that the recipient or the entity that he/she represents. An investment in the Fund is not suitable for all investors.

This material is for informational purposes only. Any opinions expressed herein represent current opinions only and while the information contained herein is from sources believed reliable there is no representation that it is accurate or complete and it should not be relied upon as such. The Manager accepts no liability for loss arising from the use of this material. Federal and state securities laws, however, impose liabilities under certain circumstances on persons who act in good faith and nothing herein shall in any way constitute a waiver or limitation of any rights that a client may have under federal or state securities laws.
The performance representations contained herein are not representations that such performance will continue in the future or that any investment scenario or performance will even be similar to such description. Any investment described herein is an example only and is not a representation that the same or even similar investment scenarios will arise in the future or that investments made will be profitable. No representation is being made that any investment will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between prior performance results and actual Fund results.

References to the past performance of other private investment funds or the Manager are for informational purposes only. Other investments may not be selected to represent an appropriate benchmark. The Fund’s strategy is not designed to mimic these investments and an individual may not be able to invest directly in each of the indices or funds shown. The Fund’s holdings may vary significantly from these referenced investments. The historical performance data listed is for informational purposes only and should not be construed as an indicator of future performance of the Fund or any other fund managed by the Manager. The performance listed herein is unaudited, net of all fees. YTD returns for all indices are calculated using closing prices as of Jan 14th, the first day of the funds operation. Data is subject to revision.

Certain information contained in this material constitutes forward-looking statements, which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “target,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Such statements are not guarantees of future performance or activities. Due to various risks and uncertainties, actual events or results or the actual performance of the Fund described herein may differ materially from those reflected or contemplated in such forward-looking statements.

Our investment program involves substantial risk, including the loss of principal, and no assurance can be given that our investment objectives will be achieved. Among other things, certain investment techniques as described herein can, in certain circumstances, maximize the adverse impact to which the Fund’s investment portfolio may be subject. The Fund may use varying degrees of leverage and the use of leverage can lead to large losses as well as large gains. Investment guidelines and objectives may vary depending on market conditions.