Serenity Amidst Uncertainty: Risk-Managing The Current REIT Market
• State of the market: REITs have returned -30.4% so far in March, bringing year to date returns to -35.2%. Serenity Alternatives Fund I has returned -8.9% YTD, +26% better than the benchmark.
• Game plan: Risk management remains our top priority, as we work to insulate our portfolio from the upcoming wave of negative economic data and likely surge in corporate bankruptcies.
• The long view: REIT valuations have fallen to 2008-2009 levels, and there are opportunities to buy high quality REITs with fortress balance sheets at very attractive prices. It’s too early to add significant risk, but the fund has opportunistically deployed small amounts of capital.
The Coronavirus Hammer: REITs get hit with the 2008 playbook
What a week. From 3/13/20 – 3/20/20 the MSCI US REIT index returned -25.5%, good for the worst week in the history of the modern REIT era (which began in 1990). No property type was spared, with data centers performing the best at -14.4%, while regional malls dropped -40%. This move came on the heels of the -22% drop which began on Feb. 21st, bringing the total draw-down in REITs to -41% over the course of less than a month.
Going into the week with 25% net exposure, Serenity Alts Fund I was spared from most of the carnage. The warning in our previous newsletter not to buy the dip turned out to me more correct than we hoped. So far this year we have been able to save our clients over 25% relative to the REIT benchmark and 15% relative to the S&P 500, and still have a large cash balance with which to be opportunistic.
REITs are traditionally a defensive investment, as they have highly certain cash flows generated by institutional quality commercial real estate assets. The recent volatility in REIT prices, however, illustrates that they are not immune to the fear and uncertainty that accompany global pandemics. Current performance suggests that investors have dusted off the 2008-2009 playbook, in which any publicly traded company with debt on its balance sheet was viewed as at-risk for bankruptcy.
While this may seem like an overreaction, credit spreads across the quality spectrum have widened to levels not seen since the great financial crisis. The overall economic impact of the coronavirus is still not known, but the market is signaling a coming wave of distress across a wide variety of businesses. The REIT market knows that tenant issues are going to need to be addressed over the next 12 months and is attempting to handicap REITs accordingly.
There are two things to consider here. 1) The 10-year cyclical bull market that just ended was punctuated by the proliferation of money-losing companies surviving on cheap financing, so it should be no surprise that a wave of bankruptcies is on the horizon now that the cycle is definitely over. 2) REIT balance sheets are in far superior shape in 2020 than they were in the 2008-2009 period.
This puts us in an interesting scenario, in which the market is pricing in increased default risk across the board. In many instances (We-work & others) this makes sense, as there are plenty of companies that are simply not prepared to deal with a pandemic induced recession. In the case of many REITs, however, balance sheet strength should allow them to weather the current storm and may create long term opportunities to buy extremely high-quality real estate at highly discounted prices.
At Serenity, this is a perfect environment for our process. We have preserved cash through the recent sell-off and are now fully equipped to deploy it once the time is right. Over the past 14 months we have outperformed the REIT index by 39.6%, the S&P 500 by 21.1%, and we now face the most opportunity rich environment since the fund’s inception. Below we lay out a few of the steps we continue to take to improve our portfolio and navigate the current volatility.
Balance sheet pandemonium: Keep calm and clean up that portfolio
As we mentioned above, in the current environment REITs are being handicapped for having tenants at risk for bankruptcy, and for having debt on their balance sheets. Share price declines of 60% for many REITs cannot be attributed to fundamentals alone, they reflect a general concern that some REITs may face insolvency. These types of worries made sense in the great financial crisis as many REITs had over-levered balance sheets, and large tranches of maturing debt that posed legitimate solvency risk to REIT portfolios.
In 2020, however, REIT balance sheets are much cleaner than they were in 2008, management teams are meaningfully more risk-averse, and debt maturities in general are much better spaced out over the next few years. This means that REITs are far better prepared to weather a demand shock and run much lower risk of becoming insolvent or going bankrupt. As can be seen in the chart below, most property sectors have their annual interest expense covered by liquid assets by over 5x. That means that even if cash flow dries up, REITs have a significant amount of capital to burn through before running into debt payment trouble.
While REITs are much better off in their current form than they were in the great financial crisis, we continue to shift our portfolio towards high quality balance sheets amidst the current volatility. This means examining individual REITs for liquidity (cash + credit facility availability), and maturity risk (upcoming debt maturities). For REITs with little cash on hand and significant debt maturing in 2020, the path back from distress will be much longer and more difficult. As the market has given us opportunities, we have also shifted the portfolio towards REITs with fewer at-risk tenants.
For investors with questions regarding individual REITs and balance sheet strength, don’t hesitate to reach out to Martin Kollmorgen (Mdkollmorgen@SerenityAlts.com).
Dry Powder: Navigating the opportunity minefield
After eliminating REITs with heightened balance sheet and tenant risk, investors can begin to survey the REIT landscape for opportunities either to deploy or re-allocate capital. As we mentioned above, at these valuation levels there is no shortage of opportunities to buy high quality commercial real estate exposure at massively discounted prices. Some opportunities, however, are better than others, and in the Serenity portfolio we are emphasizing portfolio and management quality, while avoiding REITs with lower quality assets and at-risk tenants.
Portfolio quality is important to emphasize at this juncture because investors tend to pay a premium for safety at the very end of the cycle, as well as through the early stages of a cyclical recovery. When we refer to “quality” when discussing real estate portfolios, we are explicitly referring to how crucial a portfolio’s assets are to its tenants. Buildings that are “irreplaceable” are labeled such because almost no matter what, someone will want to rent space in that given building.
Last-mile warehouses are an excellent example of high-quality real estate in the current economic environment. REITs such as Prologis (PLD) and Duke Realty (DRE) have portfolios of critical warehouses that service e-commerce tenants daily. While traditionally demand shocks tend to lower economic activity and depress leasing in the warehouse space, the current surge in e-commerce demand should help to buffer any negative impacts to high quality warehouses. With excellent balance sheets and proven management teams PLD and DRE are both good examples of REITs in which you can check the “high quality” box across almost every important category.
Oh, and did we mention that they trade at 23% and 19% discounts to the value of their underlying portfolios? While they are not the cheapest names in the REIT universe, both companies have seen their share prices fall over 30% in the past month. The path forward for PLD and DRE may not be seamless, but high-quality portfolios and balance sheets should allow them and others in their position to recover more quickly and possibly capitalize on distress caused by the current global pandemic.
For two more examples of high-quality portfolios at huge discounts, see our recent blog post on Boston Properties (BXP) and Host Hotels and Resorts (HST).
The Bottom Line: Hunker down with QUALITY
The emergence of the coronavirus has plunged capital markets into their most chaotic period since the great financial crisis of 2008-2009. As a levered asset class, REITs have absorbed a large share of the de-risking that has occurred across portfolios over the past month. Despite much better capitalized balance sheets, improved liquidity positions, and seasoned management teams relative to 2008-2009, REITs find themselves again trading at huge discounts to NAV, and at cycle low multiples.
Opportunities to buy high quality commercial real estate portfolios at attractive prices abound, but as savvy investors know well, valuation is an incredibly poor timing tool. Most investors would be well served by improving the quality of their REIT holdings, both in terms of balance sheet and asset quality, while waiting until economic uncertainty begins to wane before jumping into discounted names in size.
At Serenity we will wait and watch, selectively deploying capital into high quality opportunities. Our risk management process has saved our investors over 25% relative to the benchmark this year, and our framework is primed to flip into risk-on mode when the time is right.
For more information regarding individual REITs or Serenity Alternatives, reach out to Martin Kollmorgen (Mdkollmorgen@SerenityAlts.com).
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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