REIT Total Return Portfolio Analysis Heading into 2024

Opportunities on the Horizon

The start of the new year marks a great time to update our portfolio’s strategy and positions.  There are certain aspects of the 2nd Market Capital REIT Total Return Portfolio (RTR) that are unlikely to change as they are rooted in our philosophy:

• Concentrated positions
• Trading based on opportunity
• Diversification based on economic exposure rather than nominal category
• Stock selection based on fundamental quality and value
• Long investment time horizon

The individual positions, however, are continually subject to change and this update will discuss the stocks presently under consideration for inclusion in the portfolio.  Let me begin with the enduring philosophies of RTR and follow with performance and then the upcoming opportunities.

Concentrated Positions

We want each stock to be impactful to the portfolio’s performance, so positions need to be high enough weight to move the needle.  At the same time, we don’t want any individual position to be so large that a single point of failure can crater the portfolio’s value.  In my opinion, holding 15 to 20 names at any given time strikes the optimal balance of impactful weights while still allowing for diversification.

These reasonably concentrated weights necessarily mean we cannot include every stock on which we are bullish.

At 2nd Market Capital we research the equity REIT universe which is around 170 stocks.  We also cover opportunistic mortgage REIT preferreds and a few non-REIT infrastructure plays.  That is a coverage universe of about 250 investments.  We are often going to be bullish on somewhere around 30 to 50 stocks at any given time, bearish on a similar number and the bulk are roughly neutral with the stocks priced close to fair value.

Out of the roughly 45 stocks we presently believe to be positioned to outperform the market, RTR consists of the best of the best.

Sell discipline

It is a constant measure of opportunity cost.  The stocks in the portfolio are measured against the next best thing and if other stocks present a superior opportunity, the portfolio stock will be sold and replaced by the better opportunity.

We feel quite strongly that having a fixed holding period going in is a huge mistake.  Instead, a stock should be sold when either of the following things happen:

• Market price moves above fundamental value
• A different stock surpasses it in opportunity

Without perfect knowledge of the future, the outcome of such trades is not going to be perfect. We think it is dangerous to try to hit the exact tops and bottoms of the market.

Diversification

While company specific fundamentals and valuation are the primary drivers of trading the portfolio, diversification does play a role.  In our opinion, retail is by far the most opportunistic sector right now.

Demand is high, occupancy is high, and new supply is virtually non-existent.

Thus, if we were to list our top 20 stocks a large portion of them would be retail real estate, but that would make for a highly imbalanced portfolio.

We are indeed overweight retail, but with some sense of moderation.  9.9% of RTR is in shopping centers, and 5.9% in single tenant triple net retail.

Another 6.2% is in malls but that is a stock specific bet rather than sector level.

Sector weights are a consideration of 3 things:

• The individual stocks within the sector
• Valuation
• Supply, demand, and other fundamentals

This shows up in multiple places.  The industrial REIT sector is fully valued, perhaps even slightly overvalued, but there are quite a few individual stocks within the sector that trade at reasonable or even cheap valuations which allows for an overweight in the sector via the undervalued individual stocks.

Tech real estate is in the opposite place in that we would like to have a much higher weight than the 6% in RTR, but the individual stock situation makes it difficult.

Tactical price movement versus long term fundamental value

Some investors try to profit by catching upswings in stock prices based on near term events or other timing plays.

Others look to buy stocks discounted to fair value and then wait however long it takes for that value to be realized in the stock price.

We do both, but the second route is a prerequisite.   In other words, we will trade in anticipation of near-term price appreciation, but only if the stock is also a fundamental value.

For example, the start of 2024 is a great time to catch some rebounds from tax loss selling in 2023.  These sorts of non-fundamental catalysts can be great for accelerating gains, but they are also risky.  Sometimes they just don’t play out and then you are stuck with the stock.

That is why we only trade near-term price catalysts if the underlying security is otherwise a good fundamental value.  That is what separates investing from speculation.

Overall RTR investment philosophy

REIT Total Return has been and will continue to be actively managed with a goal of maximizing total return.  We believe the best way to achieve outperformance is through hand-selecting stocks that offer a superior mix of quality and value.  REITs are a strong asset class in general, but the main reason we concentrate positions in REITs is because that is our wheelhouse.  We believe there is an advantage in knowing the companies thoroughly, knowing their histories, and knowing their management teams.

So far it has worked out fairly well and we intend to continue the same strategy.

Performance

RTR was funded with $100,000 and commenced trading on 7/1/16.  We have intentionally not added or removed capital from the portfolio to make performance tracking clean and straightforward using data from our custodian, Interactive Brokers.

As is it a predominantly REIT portfolio, our benchmark is the longstanding MSCI U.S. REIT Total Return Index (RMS).  Since inception on 7/1/16 through 12/31/23 we have returned 69.73% net of fees compared to the RMS at 37.00% for the same period.  5 year and 1 year returns are also shown below.

While we are proud of this performance, it is the forward performance that matters.

At a portfolio level we are on the value side with an overall price to FFO of 12.9X compared to the Dow Jones Equity REIT Index at 15.68X.

This deeper value provides more cashflows which fuel a larger dividend yield of 5.23% while leaving cash for reinvestment.

We have attempted to attain value without sacrificing quality or growth.  This is done through stock selection.

New Years is a time for looking forward, so here are 3 stocks that are on the cusp of being added to the portfolio.

Why are they not already in the portfolio?

There are 3 main reasons why a stock might be on the watchlist but not yet in the portfolio:

• Still in due diligence
• Timing might not be quite right
• The stocks in the portfolio are slightly better

So, with that in mind, here are some of the top stocks on our watchlist.

Equinix

Equinix (EQIX) is the superior data center REIT.  Its operations are leagues better than those of Digital Realty (DLR).  This has been apparent for many years with an uninterrupted streak of rapid growth.

The challenge here is that Equinix’s strength is well known to the market, making it a consistently high multiple stock.

However, its market price has pulled back a bit in the last couple of years.

While price has stalled, AFFO/share has continued to grow which has lowered the multiple to 23.9X forward AFFO.

That’s not cheap, but it is cheap relative to EQIX’s history and perhaps cheap relative to the forward growth rate.  This idea is still in due diligence.  In particular, we will be looking deeper into:

• AFFO versus FFO accounting intricacies
• Industry trends
• Trying to identify the “secret sauce” as to why EQIX’s leasing outcomes are so much better than those of DLR
• Incoming competing supply

Apartment REITs

Ross Bowler ran several screens encapsulating 2023 REIT performance data and some of them were quite illuminating.  Take a look at the 2023 multifamily heat map.

The coastal multifamily REITs had a fairly strong 2023 while the sunbelt focused apartment REITs almost universally cratered.

This was due to 2 factors:

• The sunbelt REITs got a bit too hot in 2022 and their stock prices did indeed need to cool
• Supply growth has been heavier in the sunbelt

The market is anticipating construction deliveries cutting sunbelt rents by as much as 20% which is much sharper than that estimated by industry analysts.

2024 will indeed be a challenging year, due to timing of deliveries, but we think the market’s myopic focus is missing the bigger picture.

Demand growth is strong in 2024 and looks like it will remain strong for 5+ years given the business activity flocking to these areas.  Supply growth, however, falls off a cliff in 2025 and beyond.  Thus, we see the following pattern for sunbelt apartment REITs:

• 2024: flat to slightly negative NOI growth
• 2025: moderately positive NOI growth
• 2026 and 2027: above historical average NOI growth

The fundamentals are frankly much stronger than the market price action suggests.  Timing of this one is tricky as this will be a tough year fundamentally, but we do think the ideal window to get in valuation wise is approaching.  Perhaps now is the bottom, perhaps the bottom will be in 5 months. We don’t think it is feasible to pick the exact bottom but we think it is entirely reasonable to start limping in and building exposure.

RTR has had minimal exposure to multifamily for a while, but we expect that weighting to increase in the near to medium term.  Specifically, we like NXRT, BSRTF, and CPT given the reduced price points and property level strength.

Which ones are included in the portfolio going forward will be a matter of relative price movements and fundamental news that affects them disparately.

There are a handful of other stocks on the watchlist that could also be added.  These are the most on the cusp presently but that is all subject to change.

Stay tuned. We think it will be a very active 2024.

If you are interested in investing in the REIT Total Return portfolio or have any questions feel free to call or email us. We are happy to discuss.
Phone: 608-800-7267
Email: dbowler@2ndmarketcapital.com

Important Notes and Disclosure

Material Market and Economic Conditions.   March 2022-2023: Significant increases in the Federal Funds Rate by the Federal Reserve have caused REIT market prices to decline more than the broader markets. REITs rely on debt financing to acquire properties and fund their operations; expiring lower-cost debt is being refinanced at higher interest rates due to prevailing market conditions. March 2020: REIT Total Return’s value declined substantially as COVID shut down the economy.  It recovered in 2021 as the economy reopened.  January 2019: Tax-loss selling’s calendar expired and the government reopened on January 25, 2019. The combined effect caused our shares to rise more than the broader markets.  December 2018: Another Fed-Funds rate hike, unresolved US-Chinese trade, a partial government shutdown, and an exaggerated tax-loss selling season put extreme downward pressure on equity prices.  All of these factors contributed to diminished liquidity and more significant share price declines in small-cap/value issues; REIT Total Return is focused on small-cap/value issues, so our decline was significantly more precipitous.

Material Conditions, Objectives, and Investment Strategies.  REIT Total Return is an actively managed investment portfolio of real estate equities, primarily common and preferred shares of REITs, with an aim to generate high total returns from a mix of dividends and capital appreciation.

All REIT Total Return Portfolio performance information on this page is based on the performance of the Portfolio Manager’s account, using the manager’s own funds. Performance of the Portfolio Manager's account is calculated by Interactive Broker on a daily time-weighted basis, including cash, dividends and earnings distributions, and reflects the deduction of broker commissions (when commissions were charged). Actual client returns will differ. **2nd Market Capital’s advisory fees are simulated and applied retroactively to present the portfolio return “net-of-fees”.

None of the performance information displayed on this page is based on the actual performance of any 2MCAC client account investing in this portfolio. The performance in a 2MCAC client account investing in this portfolio may differ (i.e., be lower or higher) from the performance of the account managing this portfolio and portrayed on this page based on a variety of factors, such as trading restrictions imposed by the client (resulting in different account holdings), time of initial investment, amount of investment, frequency and size of cash flows in and out of the client account, applicable brokerage commissions (when commissions were charged), and different corporate actions. Clients investing in this portfolio may view the actual performance of their investment in this portfolio by logging into their Interactive Brokers account and reviewing their customized dashboard.

Clients may restrict any of the securities traded in their account but should note that any restrictions they place on their investments could affect the performance of their account leading it to perform differently, worse or better, than (a) the above-portrayed account or (b) other client accounts invested in the same portfolio.

Forward-looking statements. Commentary may contain forward-looking statements which are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts, and findings in these documents.

Past performance does not guarantee future results.  Investing in publicly held securities is speculative and involves risk, including the possible loss of principal.  Historical returns should not be used as the primary basis for investment decisions.  Although the statements of fact and data in this commentary have been obtained from sources believed to be reliable, 2MCAC does not guarantee their accuracy and assumes no liability or responsibility for any omissions/errors.

Use of Leverage or Margin. REIT Total Return Portfolio will utilize margin only for trading purposes (the ability to use the proceeds from stock sales immediately for new purchases instead of waiting for the usual 2-day settlement period), but not for borrowing purposes.

Benchmark Comparison. Our REIT Total Return Portfolio is compared to the Dow Jones Equity REIT Index and the MSCI U.S. REIT index because they are common REIT Indices.   The Dow Jones Equity All REIT Index is designed to measure all publicly traded equity real estate investment trusts (REITs) in the Dow Jones U.S. stock universe. The MSCI US REIT Index is comprised of equity real estate investment trusts (REITs) eligible included within the eight Equity REIT Sub-Industries of the Equity Real Estate Investment Trust (REITs) Industry. It is not possible to invest directly in the Dow Jones Equity All REIT Index or MSCI US REIT index.  Index returns do not represent the results of actual trading of investible assets/securities. Index returns do not reflect payment of any sales charges or fees an investor may pay to purchase the securities underlying the index. The imposition of these fees and charges would cause the actual performance of the securities to be lower than the Index performance shown. The results portrayed include dividend income. Our REIT Total Return Portfolio may include REITs that are not eligible for inclusion in the Dow Jones Equity All REIT Index or MSCI US REIT Index.

There can be no assurance that a benchmark will remain appropriate over time and 2MCAC will periodically review the benchmark’s appropriateness and decide to use other benchmarks if appropriate.

Expenses.   Returns reflect the deduction of any transaction expenses. REIT Total Return's advisory fees are simulated and applied retroactively to present the portfolio return “net-of-fees”.

Calculation Methodology.   Returns are calculated by 2MC with data from Interactive Brokers LLC using the Modified Dietz method, a time-weighted measure of performance in which cash flows are weighted based on their timing.    Dividends in REIT Total Return are reinvested.

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