Income Fund Update - Q3 2022
Hello Partners,
Hope this update finds you well.
The average distribution yield YTD is 9.8%.
Below are the returns for the Income Fund.
I expect to outperform over long time periods, while shorter time horizons will be more random. That being said we have outperformed (at least for now) vs. REIT indexes in 2022 thanks to a few factors, including:
Above average income from growing dividends and selling options in a volatile market (we collect more money on option premiums when markets are volatile)
Our willingness to sell some overvalued holdings in Q1 & keep cash on hand when REITs were trading at high multiples
Our short call on the office sector (which is down 37% this year)
Our sector overweights in storage and casino real estate
Whether we are outperforming or underperforming, we’ll continue to focus on delivering great income by buying world class real estate with the most favorable forward outlooks. The scoreboard should take care of itself over time.
Performance Drag
Quality is a key factor to our strategy that negatively impacted our performance this year. The best real estate + management teams trade at the lowest cap rates (highest multiples). These longer duration assets (lowest cap rates) are therefore the most sensitive to sharp increases in interest rates, which have gone vertical in 2022.
REIT Sector YTD Performance:
Thankfully, many of the highest quality sectors have lower cap rates for good reasons: pricing power + embedded rent growth + low ongoing capital expenses. So while the valuation multiples have decreased in 2022, the earnings are still growing. And since real estate tends to trades in tighter multiple ranges, over the long term it’s actually more important to nail earnings growth than entry multiple.
This is good news since forecasting supply / demand is a lot easier than predicting interest rates.
Case in point, would you rather own best in class industrial, storage and medical properties and infrastructure at implied 5% and 6% cap rates (when private market trade at 4-5% cap rates) with a lot of baked in rent growth and some recession resistance?…
OR…
Older / commodity office assets, Taco Bell properties and strip malls (and to a lessor extent business travel hotels) that either need huge amounts of capital to remodel in order to attract tenants or have small fixed rent bumps in an inflationary world? They might look cheap at 6-8% cap rates, but should see negative to low real growth into a possible downturn.
This a long way of saying we believe that asset quality (pricing power) will be a tailwind in 2023 & 2024 assuming interest rates stabilize next year.
Balance Sheet Quality
As previously discussed, REITs are extremely well capitalized (see our Q2 update) vs. 2008 and vs. the typical private real estate owner. Most REITs have low & long term leverage locked in (sub 4% fixed rates) and are unlikely to experience real distress (excluding perhaps older office REITs) this cycle. However - just in case - we still want to avoid firms with the worst balance sheets and most exposure to near term debt refinancing needs.
See the dot plot chart below that details REIT debt levels and near term loan maturities. Highly leveraged real estate with short term refinancing risk is not a great place to be right now. Therefore, we are laser focused on the lower left quadrant of this graph (see the circle below).
Public markets have not been eager to reward companies with lower-leverage structures in recent years with interest rates at all-time lows and speculation at all-time highs. Debt was “free” and the Fed put was always waiting in the wings at the hint of any economic weakness. Those days are likely behind us for awhile.
So if we see a 2023 recession that is deeper or longer than expected, the market is likely to start prioritizing balance sheet quality.
REIT Earning Season
We are halfway through REIT earnings season. Tenant demand is still strong: of the 41 REITs that have provided earnings guidance, 28 REITs (67%) raised their outlook while just 4 REITs (10%) have lowered their outlook. These are solid results from REITs coming in a lackluster earnings season for the broader equity (only 48% of S&P 500 companies have boosted their outlook).
Private Market Color
Higher interest rates are flowing through the system. This has resulted in wide bid-ask spreads on potential deals and meaningfully lower transaction volume vs. early 2022. Sellers are clearly still anchored to 2021 pricing.
However, the best capitalized buyers are still looking to transact. They have low leverage and war chests of cash to go on offense next year. These firms will be the buyers of last resort for forced sellers that over leveraged & overpaid with floating debt when the punch bowl was out.
Best,
Brad Johnson