Hello Partners,
Below are the Q3 returns for the Income Fund.
The Fund started accepting outside capital on August 1st. For the two-month period ending September 30, 2021, the Income Fund declined 4.4%, marginally underperforming its primary benchmark index, which decreased by 4.2%. However, we fared better on our primary goal, as the the Fund generated more than 3x the yield of the index.
We expect to continue outperforming on yield, however, due to REIT dividend timing, the October income yield should come in lower than Q3 to get us in the blended 8% yield range.
September was an especially rough month for REITs. Markets reacted negatively to wide ranging fears including: inflation, supply chain issues, labor shortages, federal reserve tapering, debt ceiling drama and possible contagion stemming from the Chinese real estate developer Evergrande.
Some of these are valid short term concerns. Others are just noise. Unlike today’s labor market, there will never be a shortage of Wall Street worries. Rather than wasting time trying to divine the unknowable (macro trends) we will continue to focus on cash flow.
Most of our holdings are reporting Q3 numbers over the next two weeks. The early reports have been excellent and are in direct contrast to the market pullback we saw in September.
Real Estate Market Color
Of the 20 different property sectors only three realized a positive return in September. Those were office, hotels and billboards. Some other sectors that outperformed the average REIT in September included malls and shopping centers.
While were not 100% opposed to owning great real estate in these sectors, The Fund is underweight all five sectors. While office and hotel REITs might offer short term reopening value, most are not great long-term businesses. They don’t exhibit pricing power (largely due to excess supply) and they require substantial maintenance capital just to tread water (maintain occupancy).
Therefore, these sectors do not generate high, reliable and growing cash flow through cycle. They boom and bust. We might selectively buy the best in class of the above sectors, but I suspect we’ll consistently underweight them as the overwhelming majority of office, retail, hotel, etc. REITs don’t deserve a spot in our portfolio.
That being said, several of these sectors are historically cheap and could outperform over the near term as the reopening plays out. This might be a short-term headwind to our relative returns. But once multiples normalize, their lower cash flow returns should start to weigh on their stock prices relative to the cap-ex lite, cash machines we prioritize.
Fund Sector Weights
Our largest sector weighting is in industrial. There is a lot to like about industrial fundamentals today:
Obvious secular shift to online shopping expedited by COVID.
Ecommerce requires 3X the warehouse space compared to more traditional industrial tenants.
Supply artificially low (for now) - building delays (covid) and building supply constraints
Defensive sector should re-opening stall further
Thanks to the above, it’s not a surprise that Industrial demand is currently at a fever pitch. Some of the largest industrial REITs are effectively 100% leased and are passing through record, double digit rent increases.
We especially like some of the mid-small cap players that - given their current discount to private market transactions - are likely to see some multiple expansion (cap rate compression) or be acquired by a PE firm or a larger industrial REIT given the near insatiable need for more warehouses. Case in point, here is some recent M&A activity:
The market is reacting favorable to early Q3 industrial operating results which is translating to multiple expansion (price increases). We’ll see, but this should lead to some near-term portfolio rebalancing back into other sectors during Q4.
Thank you,
Brad Johnson
EVERGREEN