Q1 2023 Letter - Taking The Plunge
- Daniel Fas
- Apr 5, 2023
- 7 min read
Updated: Apr 12, 2023
Interest rates continue to rise, banks are collapsing, and it's only getting started.
Quarterly Performance
The first quarter of 2023 was a volatile one with Seaside Private Capital (SPC) finishing up 7.46% vs. the S&P 500 at 7.03%. We'll dive into more detail on our individual holdings later in this letter, but our performance in Q1 was driven primarily by our worst performers from 2022. Meta Platforms (NYSE:META) rebounded dramatically over the quarter as the company finally got serious about cost cutting and fully embracing their "Year of Efficiency". META ended 2022 hovering around $120 per share, and as of 3/31/23 their stock price ended at $211.94 or an increase of roughly 76%. Our second best performer was Warner Bros. Discovery (NASDAQ:WBD). The company hit their EBITDA and FCF guide for 2022 and now that all the merger accounting and restructuring is in the rearview mirror, 2023 will be focused on growth and profitability. WBD ended 2022 around $9.50 per share, and as of 3/31/23 the stock sits at $15.10, or an increase of 59%. Our REIT holdings continue to struggle, although fundamentally they are performing very well.
Taking The Plunge
As noted in our 2022 Annual Letter I said the following, "I imagine things will start to break". And oh boy, things sure did start breaking. Silicon Valley Bank, Silvergate Bank, and Signature Bank all went into receivership during the quarter with a few other banks facing serious bank runs. The FED and FDIC are working hard to plug the holes and competitor banks are even offering a helping hand. A syndication of 11 banks led by JP Morgan deposited $30 billion into First Republic Bank (NYSE: FRC) to renew confidence back into the banking system and stem the deposit run on regional banks. The banking struggles are not over. Moving forward banks will have to continue fighting for deposits, which wasn't the case over the past few years. Money market funds and CD's are yielding 5% while savings and checking accounts are paying .01% in interest (looking at you Bank of America!). Money will naturally trickle out of these low cost deposits unless banks increase the interest they are willing to pay depositors. In other words, funding costs for banks are going up and there's probably more regulation coming down the pipeline after the recent bank collapses. That means earnings are going to get hit. I've never been a fan of banks as they are highly regulated subpar businesses that can implode on a moments notice. Oh, speaking of subpar banks I almost forgot to mention Credit Suisse. The never ending problem child of the finance world was taken over by their main rival UBS Group AG (NYSE: UBS) with help from the Swiss government. So yeah, things definitely broke.
There are now rumblings on the next shoe to drop - $1.5 trillion of commercial real estate mortgages that need to be refinanced over the next 24 months. In addition to banks losing low cost deposits, there are definitely landmines hidden in bank CRE portfolios - loans that can't be refinanced at current interest rates. I also mentioned this in our 2022 Letter. The economy has already taken the plunge into the deep end of the pool. Now it's time to figure out who can swim and who can't.
We believe a few key risks are still hanging around that haven't been flushed out quite yet as it takes time for interest rate hikes to flow through the economy. A few key risks we're watching include:
Commercial real estate loans
$1.5 trillion in loans needing to be refied in next 24 months.
Single Family Home Prices
Based on current mortgage rates, home values are unhinged from fundamentals.
I'm primarily focused on the local market here in San Diego where the data shows home prices need to drop 25%-30% for home prices to become reasonable again. Another option is that incomes rise significantly, but given pay raises are 3% vs. 8% inflation, I place that probability near zero. See Appendix I.
Unprofitable zombie companies
SVB's collapse was only the beginning. There's plenty more carnage to be had in the start-up space including companies with failed business models.
Profit Margins/Over-leveraged companies
Companies that operate profitably but are using decent amounts of leverage, or have thin margins (ie. restaurants, consumer goods, etc.) are at great risk.
Businesses exposed to rising labor costs and inflation are getting hit.
Frauds
Fraudulent companies start collapsing in full force once the period of excess has ended, and we've already seen the unraveling of some of them (FTX, TerraUSD, Luna, etc.).
U.S. Debt
Servicing the U.S. federal debt consumed 6.1% of federal spending in 2022 and that's based on the average interest rate of 2.1% on public debt as of Sept. 2022 (fiscal year-end). Obviously, rates are way up since then and this debt burden won't get any easier. See Appendix II.
Energy Prices
Energy prices have moderated due to a relatively mild Winter in Europe, but I'm still somewhat cautious as there is still a real risk of oil prices spiking over $100/barrel due to lack of drilling and exploration Capex over the past decade.
Interest Rates
I'm a believer in a "higher for longer" rate environment, which is not necessarily a bad thing. It's actually quite normal, but everyone has been addicted to ultra-low rates for a long time. As Bruce Flatt like to say, "rates may not be low, but they're still low-ish".
To be clear, we're not macro forecasters here at SPC and instead we focus on fundamental bottoms-up research. But it's always prudent to keep an eye on potential landmines out there. Taking into account these various risks, we believe the market is presenting some pretty attractive investment opportunities for those with the skill to sift through all the noise and focus on fundamental research. Some risks we avoid entirely due to the data (ie. home prices are just unaffordable and prices need to come down), and others we understand the risk, but we believe we have the skill and conviction to pick winners (ie. commercial real estate). In this environment we continue to put our heads down and focus on owning and investing in great companies, and avoid the short-term musings of the market.
Portfolio Update
There will certainly be stress in the commercial real estate sector, but at SPC we remain confident of our CRE exposure, and our specific holdings continue to show strong fundamental performance. What doesn't show up in the news is the bifurcation between high quality assets versus everything else. Office properties, for example, are in the heart of the storm with work from home and hybrid models significantly hurting occupancy levels and declining leasing activity in the U.S. However, trophy office properties are actually obtaining market leading rents and occupancy. Our holdings in Kilroy Realty (NYSE: KRC) and American Assets Trust (NYSE: AAT) are showing double digit rental spreads in Q4 2022 (KRC - GAAP rent up 31.1%, cash rent up 12.3%, AAT - GAAP rent up 25%, cash rent up 15%). Real estate economics will continue to disproportionately accrue to the best properties while everything else will continue to deteriorate. I believe Class A office and Class A shopping malls will not only survive, but actually thrive once the dust settles. Class A malls are already well on the recovery path and more data points continue to print that support our investment thesis on the sector.
Here's a list of Class A mall transactions over the past year that may surprise some people:
Santa Anita Mall (U.S.) - sub 6% cap rate, 2022
Village at Topanga (U.S.) - 5.6% cap rate, 2022
Boulevard Berlin (Germany) - 5.1% cap rate, Dec. 2021
Scottsdale Fashion Square CMBS Refinance (U.S.) - 4.8% cap rate, 2023
Malls are arguably the most hated CRE asset class out there (office also competing for that title). But the facts show there is value in the sector. Kleppierre (EURONEXT: LI), a French mall company, reports the appraised value of their shopping malls on an annual basis (they contract major appraisal firms like JLL to do this), and the weighted-average cap rate of their portfolio is 5.4% as of 12/31/22. Kleppierre has a solid history of selling assets in-line with their appraised values (Boulevard Berlin, shown above, sold 3% above appraised value) so the appraisals seem reliable. URW (EURONEXT: URW.AS) also ordered third party appraisals and received similar valuation metrics. Flagship US malls obtained a 4.2% cap rate (basically trophy Class A+) and 8.6% cap rate for regional malls (they loop in some class A, but predominantly Class B and lower which drags the weighted-average down).
We underwrite our holdings based on conservative estimates, and we believe our two mall holdings Macerich (NYSE: MAC), and Simon Property Group (NYSE: SPG) are trading at significant discounts to their intrinsic values. We underwrite MAC at a 6.1% cap rate, although given MAC's property performance is superior to the comp set we've seen, the weighted average cap rate is most likely in the mid 5% range (Scottsdale Fashion Square, shown above, was appraised at 4.8% cap rate according to Fitch Ratings). In sum we think MAC is worth about $27 per share today, with management guiding to an incremental $55 million in NOI over 2023/2024, which nets a value of ~$31 per share. SPG is currently trading around $110 per share and we believe their intrinsic value is around ~$200 per share. We're being paid healthy dividends from both MAC and SPG while we wait for their valuation gaps to close. We're also comfortable holding both positions over the long-term.
Here's a quick valuation summary of our REIT holdings (ex-MAC and SPG, shown above).
Armada Hoffler Properties (NYSE: AHH) - We believe shares are worth ~$29 vs Q1 closing price of $11.18 or a discount of 59%. Valuation table below.
Kilroy Realty (NYSE: KRC) - We believe KRC is worth ~$95 per share vs. Q1 ending price of $32.40, a 66% discount to intrinsic value. Valuation table below.
American Assets Trust (NYSE: AAT) - We think AAT is worth $41.22 per share vs. Q1 closing price of $18.59, a nearly 55% discount to intrinsic value.
In all, we think all of our REIT holdings are trading at very attractive discounts to their underlying values. Although commercial real estate will inevitably take some shots, we firmly believe that our holdings are well positioned to weather the storm.
There isn't much else to report on the remainder of the portfolio at this time. We added a small amount to our AAT position and have been tracking a few names we see as fairly attractive but haven't pulled the trigger yet. We still hold positions in 14 companies, same as 12/31/22, and we're happy to report that Q4 earnings were solid across every one of our holdings. The strong underlying fundamental performance gives us confidence that our investment thesis is still on track, regardless of what prices do in the short-term.
Sincerely,
Daniel Fas
Founder & CIO at Seaside Private Capital
Appendix I.
Appendix II.
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