REIT Total Return Positioning Heading into the 2nd Half of 2024

As fundamentals and macros are shifting significantly, we want to focus this review primarily on the environment for REITs broadly and for specific REIT sectors.  Price movements of individual REITs have not properly matched fundamental changes making some areas opportunistic and others wise to avoid.  Rather than prices moving on individual company fundamentals or sector fundamentals, they have largely continued to just track interest rates.

Below is the year-to-date implied probability of multiple rate cuts by March 2025.

As the chances of a cut plummeted in April and May, so did REIT prices.

REITs began to rebound in late May and early June as inflation data started to soften which revived the chances of Fed cuts.

It is fairly impossible to predict the Fed so instead, we balance interest rate exposure based on what is implied by the futures market.  As of right now, the market is calling for 1 or 2 cuts in 2024 with a few more in 2025.

Importantly, REITs do not need rate cuts to generate strong earnings.  We have intentionally invested in companies that operate smoothly in a wide range of interest rates due to either low debt balance sheets or termed out fixed rate debt.

Cuts, whenever they may happen, would merely be a catalyst for market pricing.

While interest rates have been the primary movers of market prices, there are more intriguing things going on in sector level fundamentals.  We will spend a large portion of this update discussing recent industry-level data and its investment implications.  Let us go over the positioning of REIT Total Return as of 6/30/24 and then dig into the sector-level fundamentals.

In recent periods we have gone a bit deeper into value, particularly on the NAV side with RTR now trading at 70.77% of NAV on average.  This is partially the result of a growing disconnect between private and public pricing of real estate and partially intentional selection of larger discounts.

Industry reports continue to show real estate asset values rising in industrial, single-family homes, shopping centers, timberland, and data centers.  Transaction volume at the asset level remains somewhat low, but on a national scale, there is plenty of data to demonstrate where asset values are.

RTR is also significantly discounted on a cashflow basis with a P/FFO of 11.8X compared to 16.26X for the Dow Jones Equity REIT index.

It is even more discounted relative to the S&P which is sitting at 21X forward earnings.  We believe the 8.44% FFO yield of 2CHYP sets up for a nice total return going forward.

Diversified sector exposure with large bets in industrial and shopping centers

Managing RTR’s stock weightings is a constant effort to maintain diversification while overweighting areas of enhanced opportunity.  Presently, we are substantially overweight industrial and shopping centers with 23.7% and 20.1% exposures, respectively.

There are 2 main reasons behind the excess weights:

• Fundamental data keeps coming in really strong (we will show the data in a bit)
• Valuations are quite low relative to asset-level performance

In combination, these factors set up for outsized growth relative to the price we are paying for these stocks, and in the long run we think that will generate outperformance.

Strong fundamental data reports for industrial

Yardi Matrix published a June report on national industrial property data which disclosed the national average asking rent at $10.25 per square foot compared to existing rents of $8.00.

That suggests REITs will be able to raise rents another 28% to get to current market rates.  Additionally, market rates are likely to continue to grow from here due to low vacancy  (5.6%), moderating supply of new units, and an uptick in warehouse employment.

A couple of years ago, Amazon recognized that they overbuilt after the pandemic so they cut back on employment and subleased some of their space.  A few other large players followed the same pattern which reduced industrial demand in 2023 and early 2024.  However, Amazon appears to be back in expansion mode and is once again signing new leases with the REITs.

At a national level, warehouse employment has begun rising again indicating that others, beyond Amazon, are also going back to expansion mode.  This bodes well for future demand for square footage and given the moderate supply outlook, market rates should continue to have an upward bias.

Industrial real estate values are rising as well, just hitting $142 per foot according to Yardi Matrix:

“The national average sale price of an industrial property so far in 2024 is $142 per square foot, 15.4% higher than last year and 71.2% higher than it was in 2019.”

Retail, particularly grocery-anchored centers, is performing

Retail assets have become undersupplied with a paucity of construction since the Financial Crisis.  This low supply was not all that beneficial through 2020 as demand was also fairly weak, but over time, demand has risen and materially reduced vacancy.

Today, vacancy is quite low and demand is still rising due to strong sales.  Marcus and Millichap recently published a retail spending report disclosing that in-store spending has reached an all-time high.

“Spending at supermarkets reached a record level in April, eclipsing the prior benchmark set at the onset of the pandemic”

In response to strong in-store sales, retailers are doing 2 things:

• Hiring more employees
• Leasing more space

Retail employment is approaching 15.7 million.

At the same time, point-of-sale technology upgrades and improved store layout are reducing the number of employees needed per store.  Instead, the increased volume of employees is going toward additional stores as a wide variety of retailers open new stores.

With so few new retail properties being built, the retailers are leasing existing space and as occupancy gets fuller there is increasing competition among renters which is what is allowing the REITs to raise rents as much as 20-40% on new leases (see the 1Q24 earnings reports of any of the retail REITs).

Key underweight

We have essentially 0 exposure to self-storage as it is materially overvalued and has troubling fundamentals.

Self-storage street rates (the price charged to new customers) are down double digits nationally yet construction activity continues at a high pace.  High vacancies, falling rental rates and high incremental supply is a bad combo, yet the sector still trades at a median P/FFO of 17X.

With Public Storage and Extra Space at market caps of $50 billion and $33 billion, respectively, these are significant weights in the REIT index.

We want no part in that.  High valuation and bad fundamentals are a big red flag.

Market prices not tracking properly with fundamentals creates opportunity

There is usually a dispersion in fundamental performance, so when prices are moving together, the market prices no longer reflect the differences in strength.

We think today represents a situation in which valuations are seemingly unrelated to quality.

Sectors like Self-Storage have terrible forward fundamentals while industrial and shopping centers are facing strength.  Despite the difference in outlook, self-storage is trading at about the same multiple as industrial and a much higher multiple than shopping centers.

We think it represents a clear opportunity to get quality and growth without paying the premium that would normally be attached to it.

Heading into the 2nd half of 2024 we like our existing portfolio but will continue to flex with opportunity.  In particular, we are looking to get into high yield preferreds and multifamily if these opportunities surpass that of existing holdings.

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 settlement), 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.

S&P Global Market Intelligence LLC. Contains copyrighted material distributed under license from S&P.