Quickly on the returns. We had a big quarter, with YTD returns up to 15.91% vs 9.3% for the S&P (my main target benchmark) and 16.96% for the USRT (again not really relevant comp these days but including for historical continuity). Since inception we are up to 236.3%, vs 181.29% for the S&P and 89.84% for the USRT. And we did it with no semiconductor exposure (and thus we have avoided the momentum bloodbath since Q2 ended), and a fairly good sized short book to boot.

I will lead with the star of the show this quarter, which was Uniqure, a stock I mentioned first in late 2025 I believe. As a reminder this is a biotech that has developed a promising treatment for Huntington’s disease, a relatively rare, 100% fatal neurodegenerative disease. It published results in September, the stock skyrocketed to ~$70, then in November the FDA changed tack on what seems to have been previously agreed to guidance accepting an external control group for an accelerated approval and the stock crashed down into the $20s (where I first bought). Then in March, the FDA fully refused to even consider Qure’s accelerated application, saying Qure needed to run a full phase 3, and the stock crashed down to as low as $9/share, below cash balances.

I doubled down near these lows, believing that if the drug worked (and no one really seems to think it doesn’t), that worst case you waited out the phase 3 (which Qure had cash to complete), and best case the FDA could change its mind either via personnel change, when additional data came out (they have year 4 data slated for September), or Qure could monetize via approvals abroad (which they are pursuing).

In an absolute whirlwind of a few months, the former FDA leadership was canned after what they did to Qure and several other promising disease treatments, and the new FDA interim leaders have allowed Qure to proceed with a filing for accelerated approval, with the stock now trading around $40s/share.

I will be honest and admit I didn’t think it would happen this quickly, but what a ride! Sadly for me I subscribe to some levels of risk/concentration management and sold some of my position after the initial pop from the lows around $10. But we still have a large position here. I was a bit worried about competition but after Roche pulled its latest trial I am increasingly convinced that drugs which lower wild type Huntingtins protein across the whole brain or body, which essentially all the major competitors do, are problematic1. This then makes Qure’s approach of selective targeting of the striatum all the more strategic, and I think there is still significant upside from here if Qure can get full approval.

All that said, Qure is not our biggest position right now, that honor goes to Gitlab, which has done quite well since we bought earlier this year.

Gitlab crashed significantly from fall of 2025 to today along with basically all other software businesses on a fear that LLMs would replace them all.

The basic thesis here is that as AI dramatically increases the velocity of code production, code control, review and approval (which Git sits at the center of), becomes even more critical than it ever was. The code repos also offer a very natural place to serve up coding agents - most easily visible in Microsoft pushing its Copilot agent through competitor Github.

The growth is already visible in Gitlab’s usage, with code pushes up nearly 50% YoY. Gitlab doesn’t get paid on usage (yet)2, but its a really good sign when people are using your platform a lot more generally speaking.

I believe Gitlab is well positioned to monetize this growth itself, or that it would present an incredibly strategic acquisition opportunity for one of the major AI labs or companies. The market cap is a mere ~$5.5B (and $4.2 ev after cash), a drop in the bucket against the trillion dollar plus valuations in play elsewhere. Gitlab serves a whopping 50% of the F100, and would be a really valuable distribution tool. Microsoft already bought major competitor Git Hub, so there is precedent here as well. One of the firm’s trying to produce an AI model that is struggling with adoption I think would find a company like Gitlab very tempting, such as Meta or SpaceX.

Stepping back, the investment book feels about as good as it has since covid times, there are many interesting firms trading at attractive valuations, and I feel fairly good about returns continuing to be strong from here despite significant economic uncertainty.

Macro Musings

And speaking of uncertainty, I am growing more concerned about our two big macro risks, the reclosure of the Strait of Hormuz, and the AI boom. In order to keep this letter brief I won’t spend too much time on Hormuz - but if a deal is not reached soon and the strait remains closed it looks like oil inventories could hit crisis levels in 1-3 months. I suspect/hope something will get done as Trump seems to be aware of this, although unfortunately it may involve paying off Iran or conceding Iranian control of the strait, an effective strategic defeat for the US.

The AI boom is a bit less binary, and therefore there is more to discuss. I believe the AI space is getting overheated, and as the scale has continued to ramp up I am worried that the impact of a bust is approaching a level that may cause a downturn.

The numbers involved here are absolutely staggering, and simply put, there does not appear to be any way that a reasonable return on the investment is earned barring the achievement of AGI within the next few years.

I have written about this several times before, but to repeat, at today’s level of investment (~$700 billion/year), there needs to be ~$1 trillion in end AI annual revenue (from the model cos / providers) by 2029, and that figure would ramp to nearly $4 trillion by 2036 assuming capex stays constant. Here is a link to a quick tweet summary of the math if you are interested3.

What is crazy to me is that many estimates have AI capex increasing significantly in 2027, and some even have it approaching $2 trillion by 2030! Obviously as the capex grows the required revenues also grow.

The tech industry is simply not prepared for their formerly asset light, high margin golden children to turn into low margin commodity capital intensive industrial companies. Almost no one in the industry has the heuristics or experience for this. I cannot tell you how many times I see supposedly knowledgeable Silicon Valley people talking about inference gross margins with no reference to capital investment or D&A - this is like talking about the marginal cost of running an oil well but ignoring the cost to drill it! Or its like asking - ‘is building apartments profitable’, and someone responding ‘ yes, the rental operating margins are very high'. The answer is absolutely and completely irrelevant on its own without reference to a return on capital invested & the cost to build the apartments.

Amusingly, the one group of tech people who viscerally understand this, the management team’s of the memory companies (a business famous for its boom/bust cycles), have opted into a strategy that seems to capitalize on this knowledge by riding the wave and maximizing their own profits, damage to the overall ecosystem be damned. This is, I suspect, the optimal strategy here, although if they push too hard they may incentivize the hyperscalers to enter into the memory game as well. I rather liked my friend Andrew Walker’s observation relating to Micron and its total capital investment vs Google. Micron has only spent ~$125 billion in capex in its entire history (or at least since 1992, if ChatGPT is accurate). Or alternatively, its book value is $73 billion - this is perhaps a more realistic assessment of the current ‘replacement cost’, if you will. Google is going to spend $185 billion this year. How hard would it be for Google to spin up a memory division? Or Amazon. Perhaps more likely is Apple or someone stands up a new player in China to secure and permanently commodify the memory supply chain so critical to their products.

Obviously such a thing would not be easy, but it would not be impossible, and if memory profits were to stay elevated it may happen. It also incentivizes chip designs and model utilization that would be less reliant upon memory as well - human ingenuity is a powerful thing, and I do not like betting against it long term.

More likely though I would guess the whole thing crashes down, and the memory executives know this is likely to occur before too many new entrants come into the space. They are also probably aware of China’s rapid ramp of memory capacity via the growth of CXMT (now almost as large as Micron in terms of capacity!) & YMTC, and the likely terrible price wars and margin pressure to come in several years from China’s entry into this market. China has successfully commoditized every other electronics sector they have entered, and have moved up the value chain into autos. I don’t see why memory should be any different.

How Much Longer

The big question is, how much longer can this AI capex boom last? It is hard to say, but I think the canary in the coal mine will be when model co revenues slow down. Given their epic growth thus far this year, it wouldn’t surprise me if this happens soon, but honestly I have no idea. It is notable that in the last few days we have seen the release of GPT 5.6, a new Meta Spark model, and Grok 4.5, and all 3 release put significant emphasis on their lower costs and price points. Not to mention a new open weights model out of China that is competitive with Fable and GPT 5.6 trained at what was supposedly a fraction of the cost.

These releases with an emphasis on cost mark a pretty big change from earlier releases which were really only focused on performance, and is potentially a dangerous sign of things to come for model providers.

It could even indicate that the model cos are seeing corporate users become price sensitive in real time, which would presage revenue growth beginning to slow down. Broadly speaking my read on the narrative is that frontier AI users are now actively working to rein in spend. However this may be counterbalanced or even overwhelmed by continuing diffusion throughout the broader corporate ecosystem. At some point though that diffusion completes and reality begins to set in.

A little rough AI generated summary of this concept - since diffusion is rapidly completing, the key unknown is where token intensity shakes out. It will peak or at least level off at some point, the question is simply when.

The adoption of AI in corporate America has been incredible - I don’t think any technology has ever diffused quite so quickly. McKinsey and BCG have some surveys on this subject - McKinsey estimates 88% of employees surveyed said their company was using AI, back in 2025. BCG had a survey with 72% of respondents (all corporate employees), saying they were regular AI users, over a year ago in June of 2025.4 We are likely approaching effective full employee diffusion, with recent revenue growth driven by more complex workflows and agent usage (aka each user spending more).

This rapid diffusion has been great for AI revenues, but also means that the end of the adoption cycle is going to come much faster than previous technologies, and that the crash could be all the more violent because of how compressed the cycle is.

We will have to wait for the Q2 financial leaks to see the latest. But the model cos will need to approach $300-400B of revenues in a year, and ~$1 trillion by 2030, to justify all the AI capex investment. They are growing quite quickly today, but would need to accelerate further to hit these lofty targets.

If revenue growth slows and/or the capex spend slows down, it could well take down the entire US economy given the size of the AI sector in the public markets5, and how important public markets are as a percentage of household net worth today.

From Bloomberg and Barclays. Stocks are at an all time high as a percentage of HH networth.

The stock market is also near a record on the cyclically adjusted PE measure, second only to the dotcom bubble.

The CAPE P/E uses inflation adjusted earnings over the last 10 years, in this way it can capture potential earnings bubbles and price bubbles. Today’s absolute P/E is not as high relative to prior figures, but the massive recent spike in earnings means the CAPE is much higher.

And setting aside the stock market, at this point a fairly large chunk of GDP is directly & indirectly tied to data center and power investments at this point. Even the automakers are re-orienting their battery operations around datacenters!

All that said, it is hard to predict with much certainty what is going to happen with the overall economy. While I am relatively confident the AI boom turns into a bust at some point, I do not know when, and I am not 100% sure it will cause a US recession, and even if it does it is very hard to know how bad that might be. Ideally it would be a shallow, concentrated one a la 2000.

There is some risk though of a broader, deeper crisis though, as one of the biggest differences this cycle is the asset & debt heavy nature of much of the investment, at least in the neocloud and datacenter space. Debt distress is much more likely to cause a longer, more painful crisis than equity. However much of this issuance appears to be backstopped by the still fairly good credit hyperscalers, so I am hopeful that a downturn wouldn’t lead to a full blown financial crisis (but I wouldn’t rule it out, especially the longer the boom goes!).

Fin

As always, thanks for reading. Despite the macro uncertainty I feel good about our portfolio, our stocks are quite cheap & may even benefit from a rotation out of momentum into value. And we have a significant short book that would hopefully offset a broader economic downturn.

Stay safe out there.

United Parks and Resorts (PRKS), the owner of Seaworld, Busch Gardens and a few smaller resorts, is a very interesting high yield hard asset opportunity right now.

First though, please take a look at my usual disclaimer.1 This post & research was created for & with Valyte Data, the hard asset data business I co-founded. Valyte provides investment data and research on hard asset business with a big focus on REITs. We released this report first to Valyte paying customers, and are now making it freely available as part of our marketing efforts. If you are interested in REIT, real estate, or hard asset data or research, check us out at www.valytedata.com.2 The idea is to move more REIT and hard asset commentary to Valyte, and increase the output quantity, while keeping this substack for more general write ups, commentary, updates and some company deep dives.

Discovery Cove in Orlando

With the housekeeping out of the way, here is the PRKS set up. At today’s price of ~$46/share the company is trading at a ~8 x EV/ebitda multiple or a ~11.85% implied cap rate using a real estate asset lens3. This alone is pretty attractive for durable hard assets, but what is really interesting here is the ownership situation and the potential for a short squeeze.

Somewhat uniquely, PRKS has a huge ~57% owner in the form of investment group Hill Path Capital4. While PRKS is especially cheap today, theme parks have always traded at fairly low EV/Ebitda multiples perhaps because they are somewhat of a unique, orphaned hard asset class. They have basically all the characteristics of a REIT, but they cannot easily turn into a REIT because the RIDEA structure only allows hotels and healthcare assets - entertainment is left out sadly.

Regardless of the why, Hill Path seems to have found a solution to this problem, and that is simply buying back as much of the company’s stock as possible. This mechanically forces yields higher for the remaining owners (of which Hill is the vast majority obviously).

And at a ~11.85% cap rate, there is a good amount of cash to be funneled into buybacks. The AFFO yield is about ~9.3% or around ~$210mm /year, and management seems fairly intent on funneling almost 100% of that cash (after taxes) into buybacks.5

The market cap right now is about $2 billion. Given that Hill owns over ~2/3s, there is a little over $700mm in remaining stock available to trade, or about ~15.5 million shares. The current short interest on the stock is about 7 million6, or around 45% of the free float. Now as we all know a large portion of ownership is passive these days, so the short interest as a percentage of the actual effective float is much higher - the big 3 indices alone own another 7.6mm shares - this brings us to an effective actual free float of ~7.93mm. Days to cover is 7 days or so based on the recent ~1mm in daily volume.

In the top 10 owners there are 5 large hedge funds that own another ~8.9 million shares. I am going to go out on a limb and guess these investors understand the same potential short cover dynamics, and likely are not immediate sellers barring a big price increase. If we include these funds in the ownership structure, the float available to cover shorts is already essentially zero.

This is a bit oversimplified (the indices and hedge funds can sell, and Hill could too!), but the fact is that this set up makes PRKS effectively one of the most shorted stocks in the market relative to its true immediately available float.

You can probably see where I’m going here at this point but I’ll spell it all out anyways. Park has ~$715mm in free float at current prices. Park can spend ~$155mm/year in buybacks7 - in crude terms in 4.5 years there would literally be almost no more float remaining. Obviously that isn’t going to happen8, but it is pretty clear that Hill Path seems to be intent on buying as much of the company for itself as possible at today’s low prices.

All of this together means this situation is something of a potential perfect storm for a short squeeze. You have a company with a tiny free float plowing huge amounts of cash into buybacks. Its a mere $40mm away from passing ~100% effective short interest on the purchasable float - this may well happen before the Q2 earnings date and may already have occurred given the furious rate they have been buying back shares through Q1 earnings. PRKS could literally buy back all the remaining non passive float for ~$340mm, or just over 2 years of cash flow. This would perhaps not coincidentally match up with Hill’s 70% ownership cap laid out in the last share repurchase authorization9.

I don’t know if a short squeeze is going to happen or not, but this situation seems like an absolute powder keg. If Q2 earnings go well that could serve as a catalyst - and while Q1 was soft, pass sales (which drive 40% of visits) were up a whopping 12%+ through early April.

Now obviously a squeeze may never occur! The overall market could tank. Earnings could disappoint. Shorts could close out in an orderly manner before PRKS can buy enough shares to foment a squeeze. Etc etc.

But the beauty of this investment is that a short squeeze is just an upside scenario, a potential catalyst. The stock is cheap! And the continued buybacks will mechanically continue to drive the yield up higher. If the company buys back such that Hill is a 70% owner common owner, you get to nearly a 15% cap rate in 4 years, assuming the stock somehow doesn’t move at all and there is 1.5%/year noi growth. At a minimum though it sure seems like unless ebitda declines significantly from here shorts will have to cover in either an orderly or disorderly fashion. Combining that with the firm’s aggressive buybacks and it presents some favorable supply and demand fundamentals for the stock itself as potential shorts covering would add to buy interest.

Company Valuation

Here is the break down on the valuation I am using.

Base case assumes ebitda decline from 2025, upside assumes 3.5% revenue growth and 2% expense growth. PRKS has actually been able to reduce expenses on an ongoing basis since 2015, with expenses flat from 2016 to 2023, however 2025 had their highest opex growth in a long time ex covid at 3.12%.

I am valuing these assets through a commercial property lens, because they are basically just hospitality real estate companies. The only reason they are not REITs is that the RIDEA laws don’t allow it, and a sale/leaseback structure a la casinos would be difficult to make work due to prevailing ebitdar to rent coverage norms being designed for more volatile gaming businesses + theme parks are fairly capex intensive and putting that all onto the operator would be difficult to make work.

But other than the legal structure, its the same idea. They own huge pieces of property that they monetize by daily visitation, with a mix of tickets (a la bookings), and on site spending (a la F&B).

So, to normalize the comparison I calculate an NOI for PRKS, just like a hotel asset. In this case I subtract a 6% of revenues capex reserve, this reflects the capital intensive nature of the business and is what Six Flags charges in JVs or to third party operators10. Then I add back a G&A allowance, as NOI is meant to be a property level income figure. PRKS themselves gives a property level ebitda but it adds back too much G&A in my view, so what I use is 1% of the stabilized company enterprise value. This is a bit on the high end for REITs especially given this is a multi billion dollar business, but I wanted to be conservative.

Then, I use a cap rate to value the assets. In this case I use a 8.5% cap rate - again using hospitality as a benchmark this seems fairly conservative. Hotel assets are trading in the 7-9% cap rate range in the public markets, and a bit lower than that cap rate wise in the private markets. Theme parks have had less significant earnings drawdowns in recessions than hotels, so all else equal would warrant a lower cap rate than hotel assets11. But I am using a higher rate here because the inability to use a REIT structure definitely deserves some higher yield premium, and then the lack of a robust private market means its hard to enforce discipline on the public markets.

It is worth noting that historically these businesses traded around a 9x EV to ebitda for many years pre-covid. That is around a 10.5% cap rate, and in my view is just too cheap relative to entertainment alternatives, and also just in an absolute sense given the asset quality and earnings durability.

And this is something of the beauty of Hill’s strategy - PRKS has arguably been undervalued for awhile, and is more so today, even against these historical benchmarks. Rather than trying to sell the assets to a limited buyer pool, they are using massive buybacks to capitalize on the cheap pricing and drive either share price or yield higher.

Property Detail

I’ll go into a little more detail on what PRKS owns here. The company has a nice slide in their most recent deck showing their major parks.

Management estimates replacement cost at over $10 billion - I estimate its more like $7-8B, still a significant increase from the current ~$4.4 B EV.

For some sense of how important each park is, here is a chart with estimated visitors and potential revenues per park. The chart is LLM generated and may not be 100% accurate but is indicative of the approximate importance of each asset.

Demographically & weather wise, PRKS’s assets are well located. Orlando is the largest market, followed by Tampa and San Diego, then Virginia (in between Richmond and Norfolk), and finally San Antonio. Except for San Diego, these locations are all benefiting from strong ongoing population growth. The biggest negative here is that the Orlando market has seen significant new supply in the form of Universal’s new Epic Universe, which was a huge new park that opened in May 2025.

The Epic Universe opening almost certainly weighed on Orlando results, but as we are a year later so the remaining impact should hopefully be limited12. Seaworld’s tickets are significantly cheaper, $60 online vs $140 for the new Epic Universe, which has likely helped Seaworld be a bit more insulated from the new supply.

On the weather side, since PRKS’s assets are basically all in warm weather all year states they do not face quite as much weather seasonality risk as Six Flags does or operators located in more northern locations that are only open really in the warm season. This allows PRKS to have a higher margins as they get more utilization out of their fixed asset and labor base, again reducing earnings volatility.

Finally PRKS also has a much younger ride base, as they really moved more into the rollercoaster space in the mid to early 2010s after they reduced emphasis on their Orca shows in the aftermath of the Blackfish documentary controversy. This again is a net positive for PRKS, as these newer, higher quality rides likely require less maintenance capex. It is also worth noting here that PRKS invests a significant amount of capex into their properties above and beyond the 6% reserve that seems to industry minimum - they typically do 12-13% of revenues in total capex. I treat all of this as essentially maintenance in order to maintain quality and competitive standing given other parks also continue to improve their experiences.

So overall, PRKS’s parks sit in between Disney’s full destination high dollar parks, and Six Flag’s more regional drive to parks. PRKS’s sunbelt focus + fewer, higher quality parks allows it to maintain higher operating margins compared to near peer Six Flag’s.

Operations & Recent History

Despite the positives on the property front, operating performance has been soft for PRKS recently as EBITDA declined significantly in 2025. Management blamed lower international tourism and bad weather for the declines - frankly I’m not so sure, although weather is very important for PRKS and any theme park.

The parks are obviously outdoors, and as such when its rainy attendance is going to be slashed. Given the seasonality of the business, where the ~26 Q2 and Q3 weekends drive a very large portion of the business, a relatively small variance in rain out could well cause meaningful revenue swings. What makes me a bit skeptical of this is the consistent performance from 22-24, and then all of a sudden things go south in 2025 right when significant new supply hits the Orlando market.13

For 2026, Q1 was negative, but Q1 is the weakest quarter of the year so its hard to draw too much in the way of conclusions for the full year. Attendance was down ~5.5% but per capita spending was up 2%. Management blamed most of the decline on especially cold winter weather, and it is true that Florida saw a particularly cold January and February this year. However management also blamed much of 2025’s underperformance on bad weather, which again makes me a bit skeptical of how valid this really is.

On the bullish side, pass sales were up a very strong 10% in Q1 and 12% through the end of April, and pass sales holders are ~40% of PRKS’ visitation. The last time management noted pass sales being up 10% was 2018, which had a huge 33% ebitda growth over 2017 driven by ~8.6% overall attendance gains.

Management also said they ‘remained committed’ to FY ebitda growth despite a soft Q1. To be conservative I have assumed that FY 2026 is a moderate ebitda decline from 2025, but it seems fairly reasonable that it is roughly flat or possibly even up. If pass sales are really a meaningful indicator then 2026 results could be up significantly over 2025.

Industry History

To try and get a read on the overall industry we can try to compare PRKS to Six Flags. However this comparison is made difficult by the fact that Six Flags raised its prices significantly more than PRKS did post Covid (by 50% vs 28%), and saw a huge nearly 40% attendance decline. And unfortunately for Six Flags, ebitda actually declined 10% from 2019 to 2023, before the Cedar Fair merger boosted it. The price increase seems to have been overly aggressive and back fired. Most relevant to today, Six Flags had a ~4.2% attendance decline in 2025, much worse than PRKS’s ~1.2% attendance decline.

The difference in performance may also be attributed to differing value offerings between the parks - Seaworld is arguably a more differentiated offering than a general theme park like Six Flags.

But regardless, the only thing we can really infer from comparing to Six Flags historical performance is that Seaworld is some combination of better run or a more attractive destination to consumers.

Disney is the other big public theme park operator, but they don’t break out their data quite as cleanly as Six / PRKS because its lumped in with things like their cruises. Still from the data disclosed it looks like Disney performed similarly to PRKS, with a moderate attendance decline and large price / earnings increases from 2019 to post covid. However importantly 2025 showed continued strength for Disney with 8% Parks & Experiences ebitda growth, compared to PRKS’s decline.

Overall - for whatever reason it looks like attendance for theme parks was down in 2025, although Disney does not disclose attendance figures and the industry figures are not available yet so we can’t be sure Disney didn’t drive ebitda growth from pricing + non theme park experiences earnings.14

Historical Squeeze Precedents

Digging into the short squeeze potential a bit more, I cannot find a situation quite like this in the historic precedents (based on my AI research which admittedly is likely missing some instances!). Most other high short interest stocks are companies with weak businesses and poor cash flow generation. PRKS seems fairly unique in that the underlying business is healthy.

The best recent analogies are probably Kohl’s or Avis.

Starting with Avis as its the most recent comp. Avis similarly has a large ~50% owner in the form of SRS. A hedge fund, Pentwater, accumulated enough shares to push effective short interest over 100%. The revelation of this stake triggered panic in shorts and a squeeze, leading to a short term ~7x spike.

A key thing here is even after the squeeze the price was ~80% higher than the pre-squeeze price. This is common in many recent short squeezes (although definitely not all!).

There are two big differences here though. The first and most notable is that Avis had literally almost 100% of float tied up by its two major owners, before even factoring in passive ownership. The second is Avis is operationally much weaker, it had negative free cash flow in 2025 after accounting for investments in vehicles, and had a gaap loss. PRKS is only going to hit 100% of short interest potentially after factoring in passive owners (assuming no other large investors enter into the stock), however unlike Avis PRKS has significant ongoing buybacks reducing the total overall share count. Overall I’d say Avis was a stronger squeeze candidate, the complete tie up of float is hard to match.

The overall set up may be more similar to what happened with Kohls in 2025, although there are key differences here too.

Kohls had about 49% of its total float held short by mid July last year, and more like 70% after factoring in passive holdings.

The trigger for Kohl’s was a meme type surge in interest fueled by Redditors, which drove a 100% intra day price increase in mid July, and ultimately a ~40% single day jump. However the stock continued to climb, and peaked in the mid 20s in December after relatively less bad earnings, up 2.5x from before the surge, before falling back down to ~$18 today.

A couple of major differences here. Kohl’s is much more levered, so the total EV swings were actually relatively not that large (although I’m not sure squeezed short sellers nor Redditors ultimately cared much about this). The biggest though is that Kohl’s was and still is struggling operationally. Same store sales declined throughout 2025, and the Q4 ‘strength’ was still negative same store sales. Department stores remain a very challenged sector, and the business has huge amounts of additional effective leverage due to its large number of leased stores. In other words, there remains a pretty real risk of a terminal zero here.

You could argue that PRKS is also struggling, given its significant ebitda declines from a few years ago, but I think this is more an uneven normalization from covid recovery, with revenues being frontloaded while expense inflation being a bit back loaded, combined with new supply pressure in their Orlando market15. These factors shouldn’t be a huge influence going forward, and I don’t think anyone is arguing the theme park business is in terminal decline. And most importantly free cash flow remains strong, and PRKS seems committed to continuing to run its huge, aggressive buyback program, providing fuel that Kohl’s never had available.

So the set up overall seems much better than Kohl’s, although weaker than Avis. What is missing is a spark to ignite the fire.

Risks

The investment here is obviously not without risks.

Beyond a mass consumer exodus from theme parks or mismanagement, operating performance declining during a recession is the most obvious downside. And the AI boom is feeling quite frothy although a crash doesn’t seem as imminent if this Hormuz deal really does get done16.

Seaworld/PRKS was not public during the GFC, but Six Flags was public for both the 2000 tech bust and the financial crisis so we can look at its performance during each to give us some indication of how things might go for PRKS in the next downturn.

Surprisingly (to me at least), is that Six Flag’s EBITDA really wasn’t that terribly impacted from the two downturns.

During the 2000 bust, earnings declined slowly from 2000 to 2002, but only went down about 5.55%, which is really not bad at all.

Heck today PRKS’s (and also Six Flags) Ebitda is down much more than 5% from 2022/23 peak earnings, due to a mixture of some covid bullwhip demand unwind + new supply + delayed inflation pressure on the cost side.

During the GFC, pretty amazingly 2008 was actually a banner year driven by strong attendance and revenue growth. Six Flags is highly seasonal and the true crisis didn’t really begin until later in the fall, so arguably the 2008 season was mostly unmarred by the downturn and 2009/2010 are more representative.

If we take that as being true, then the 2009 decline may be more indicative, at a pretty hefty 26% from the 2008 figures.17 However as you can see results rebounded amazingly quickly the following year, and even grew a good deal in 2011 above 2008 levels. Some of this may been ongoing operational improvements made, but nonetheless the results are actually not bad at all for a proper crisis. It may be that amusement parks actually do relatively well during recessions, especially the more affordable regional drive to parks, because they offer up one of the cheaper vacation experiences out there. Even today Seaworld tickets are ~$60 for what can easily be a full day of entertainment - that is less than the per person bill at many fine dining restaurant today, and pales in comparison to a real vacation for which the travel and hotels alone can easily run over $1,000 even for a basic trip.

That said, PRKS’ Orlando assets and San Diego assets likely do draw a decent chunk of traffic from destination tourism to both those markets, which may make PRKS a bit more susceptible to a downturn than Six Flags. However potentially offsetting this is the fact that Six Flag’s margin is a good bit lower than PRKS, so PRKS would need a larger revenue decline to lead to the same level of EBITDA declines (given the cost base is relatively fixed).

So - overall the EBITDA declines from a downturn seems pretty manageable and even with a 25% decline PRKS would be able to easily service its debt and have extra cash to spare for debt repayment or capex. To put this in CRE terms, its quite a bit better than hotels did during the GFC for comparison.

Another risk is another pandemic with lockdowns - covid was way worse for entertainment than the GFC was (obviously). I won’t spend too much time on this as I think everyone is still pretty fresh on this & understands it would be bad, but the odds of this are pretty low it seems.

The last risk may be most important, since it is specific to PRKS, and that is what might happen to the stock if the company succeeds in buying back a ton more shares without pushing the share price up much. In this scenario you could see Hill Path owning 70-80% of the stock and feeling stuck if the additional buybacks didn’t push the share price up at all. I actually don’t think this would be so bad - obviously it would be disappointing to see the stock not move, but as I mentioned above this would mechanically further drive up the yields on the existing shares. To repeat myself, enough buybacks to get Hill to 70% would bring the yield on cost to close to a 15% cap with only 1.5% noi growth per year. At that point, I suspect Hill would switch over into dividend paying mode, which would generate a very nice yield for existing investors. If they funneled 100% of the free cash flow into dividends, as opposed to buybacks, this could generate a 12%+ dividend yield in a few years. At that point it doesn’t really matter if the share price appreciates.

The AI Angle

Or, the least the government can do for the permanent underclass is buy them all theme park season passes.

I feel slightly absurd writing about AI in discussion of a theme park operator, but we are in the heat of the AI boom so I couldn’t help myself. Not to disappoint, but there really isn’t a direct AI angle. I mean sure maybe PRKS can save a little bit of G&A cost with AI, but the impact here, if any, really is indirect. More specifically - if you really believe AI is massively transformative and that all the datacenter capex is going to earn a huge ROI18 and the semiconductors stocks will stay elevated forever, then you are also making a bunch of downstream assumptions on the overall US economy. As the only way the current AI booms works out without a bust is if revenue growth (or cost savings) associated with AI grow massively from here, on the scale of hundreds of billions of dollars a year. And really the only way that happens is if AI generates a huge productivity boost, and creates massive amounts of wealth and consumer surplus.

Which means, basically, a bet on the AI boom continuing is a bet the US economy has many years of elevated economic growth ahead of it. And if that happens, consumer leisure assets like United Parks and Resorts are likely going to do well. So there you have it, we have a new bottleneck trade - the leisure bottleneck! Its the ultimate downstream implication of the AI boom.

Fin

In sum, we have a durable consumer hard asset business trading at an attractive yield well below replacement cost. As a bonus we have a near term catalyst in the form of big share buybacks and stretched short coverage, which could potentially even result in a short squeeze. While Q1 was soft, its a small portion of annual revenues and there are signs the rest of the year could be quite strong given the 12% YoY pass sales through April.

And if Q2 earnings do go well and it is revealed that PRKS continued to buy back stock that could potentially be a trigger moment. But even if no squeeze ever happens the buybacks will continue to drive yield higher, generating an attractive investment either way so long as NOI continues to grow.

Risk feels manageable and more generalized to the economy than specific to the company. There is no major secular headwind against amusement parks. I believe the outcome here is asymmetrically skewed to the upside, which is one of the main things I look for in an investment.

As always thanks for reading.

Valyte is launching with coverage of the REIT space1, something near and dear to my heart, and we plan to expand soon into other hard asset sectors, most notably energy given the current crisis.

Valyte is a data platform that aggregates and publishes the key data points for publicly traded REITs, including arguably the most important metric of Net Asset Value, or NAV2. Valyte also gathers and calculates a slew of other metrics, such as implied yield on cost3, NOI & rent growth, occupancy, leverage, G&A costs, and many many more.

Here is a teaser of what the data looks like - this is Q4 data for the multifamily sector.

Valyte’s companies table. N/A means the data is not available - BRT doesn’t report specific figures for new leases and renewals consistently.

The idea is for Valyte to be the first place you go to understand or underwrite a REIT, and to help surface potentially interesting REIT investment opportunities ( and other hard asset sectors soon). We aim to have all the relevant public info available on our system - we aren’t quite there yet, but I believe its already better than almost anything else available, and its only going to improve from here.

If you are interested in the platform and want to learn more, please feel free to drop me a line. Otherwise if you’d like to sign up for this, you can use this sign up link below. We are offering a 5 day free trial right now, and afterwards the pricing is $150/month for all sectors on an annual subscription, or $42/month for a single sector on an annual commitment. Monthly subscriptions are available as well.

Sign Up for Valyte

We are offering a 25% launch discount for early users, you can use this code FRIENDSOFWARDENCAPITAL to get the discount.

How It Works

The way it works is we have built an AI powered engine to gather the relevant data from company financials and SEC documents. Critically, we were able to use my investment expertise combined with a cutting edge AI system to create a framework which is able to actually manage the hundreds of different edge cases and adjustments that are needed across the different data points and companies in our coverage universe. Things like treatment & allocation of management fees & G&A burden, cash vs non cash accounting, non consolidated JVs, the list goes on and on. All of those little manual checks and adjustments you would have to do by hand, Valyte now does automatically.

Most importantly of all, we combine this AI engine with actual humans in the loop to underwrite NAV and verify & review data. Every data series we have is manually reviewed and initialized by a person, and is monitored by error tracking algorithms and humans on an ongoing basis. The reason we do this is that while AI is amazing and capable of many things, as we all know it makes mistakes and can still be brittle. This review not only ensures our data is as accurate as possible, but it means our system is ever improving, as we are able to fix errors before they are visible to the user and then improve the system so they aren’t made again.

And we all know how important accurate data is in the investment business - many interesting investments happen around those edge cases or the margins, where you are looking for an outlier in some way. Valyte is designed to help you find those outliers.

Company Details

You can dive into a specific company’s details to get more granular data than what is shown on the companies table, including our detailed NAV calculation and any relevant analyst notes we publish.

Things like geographic portfolio data, or historical operating history can also be viewed on the company details page.

Or here is office REIT Vornado’s leasing volume - you can see a steady increase reflecting the strengthening office fundamentals in the NYC market, which has helped drive VNO’s occupancy up.

We are rolling out total leasing right now across the relevant asset classes. This is a great example of how quickly we can spin up new data coverage - I only created this item Friday and we should have full coverage on it this week. So if there is something you want us to track and we don’t please feel free to ask about it!

We have a pretty big roadmap to continue to beef up these company detail pages, so I’m excited to share more here as we release more features over the coming months.

A Note on NAVs

NAVs are a huge part of the value offering of our platform, so its worth spending a bit of time discussing how these are calculated. The Valyte platform gathers and aggregates the data, but at the end of the day a human analyst (currently me), does the actual underwriting to generate a NAV. The most important variable in a NAV is the cap rate - I select these based on individual company underwriting and review of market data to understand where the types of assets a given REIT owns are trading. The other critical adjustments I make are to non cash flowing assets, such as developments or land, and where necessary I will haircut these (sometimes significantly) if the value a company has given or spent diverges significantly from market values.

What NAV does not incorporate is any company level adjustments - it is meant to be an estimate of the private market value of the company’s assets. While it is fairly hard for a REIT management team to be so amazing that the firm is worthy of a big NAV premium, it is unfortunately much easier for a team to be so bad, or misaligned with shareholders, as to create a large NAV discount. The classic example of this is with many externally managed REITs - the external manager is often incentivized to grow the business at all costs, and to maximize their profits, but not necessarily the REITs. Sometimes this leads to disastrous results, or situations where the fees owed to the external manager are so high that share holders are only left with scraps. While this structure has thankfully become less common over time as investors push back against it, it still exists and many of the largest NAV discounts are driven by misaligned or poor management teams.

Our NAV calculations are not perfect, but I aim to make them as high quality as possible and I am able to leverage my extensive investing experience to do so.

The Value of Accurate Data

You can also use the platform to screen for REITs that stand out on a given metric (such as say NAV discount). All of our work on accuracy and edge cases means that our screens are actually useful, unlike those of most of the major data providers.

If you have ever used one of the major financial data providers to run a screen, you will understand the value of accuracy and the kind of edge case adjustments we make. All too often when you run some kind of screen, the top results are almost all just wrong or not applicable. As a user this is frustrating and a big waste of time - you have to re-run all the numbers yourself, and at that point, what even is the value provided? Valyte is able to use our AI platform and massive context library to fix this.

Sector Summaries

I also wanted Valyte to be a platform where you can easily understand overall operating trends & data for things like rent, occupancy or NOI growth. For example here is a summary of Q4 apartment operating data, where you can easily see a quick summary of how the sector overall performed, and individual stand outs.

A multifamily Q4 2025 report. As you can see here, the sector is trading over a 6.55% implied yield on cost, and has slightly negative NOI growth along with declining occupancy. These declining fundamentals may explain the large NAV discount the sector is trading at.

Right now you have to run these reports yourself, but one of the next features we are working on is a way to push these out automatically as REIT’s report earnings, and hopefully this is something we can have ready for the Q1 2026 data coming out now.

Why did we build this?

The reason I wanted to build Valyte is that LLMs have opened up new possibilities in the software and data space. In particular for our business, there just isn’t a great source for investment data on hard asset businesses. The big data providers do a very poor job of coverage, and are missing a lot of critical sector specific data. You can get similar coverage from equity research firms who do all of the work manually, but unfortunately this means the cost is very high, and the coverage is limited! And that means limited to no small cap coverage, which is often where some of the more interesting opportunities are.

What really got me going was the case of Plymouth Real Estate, which was my largest investment in 2025 (although I wish I had bought more in hindsight). Plymouth was a small cap industrial REIT whose stock got crushed last year and fell to a huge discount to NAV / a very high implied yield on cost despite a reasonably nice portfolio and the rest of the industrial space doing fairly well. I try to monitor for these kinds of situations, and so I noticed it and bought a bunch - which worked out nicely when it rallied ~50% on a take out offer. But because it was a small cap, no one was covering this and I had to do all the work myself. Which is hard to do for every REIT out there - I just happened to be looking in the right place at the right time.

I realized that what I needed was a system to track the entire REIT universe so I wouldn’t miss any future Plymouths, and that LLMs had gotten to a point where they could be used to build such a system. And so Valyte was born. Rather than create an internal tool for REITs, I realized there was an opportunity here to create a platform not just for real estate, but all hard assets. So I partnered with my two technical cofounders, Nic Novak, a cofounder and head of engineering of Sequoia backed Magic, and Alex Quinlan, the second engineer at Blue Apron, to create a true platform.

Coming Soon

While we offer full coverage on most of the REIT sectors, we still have more work to do in order to expand coverage to the entire REIT universe. Next up we will be working to add storage and then likely hospitality REITs in the core REIT product. We also intend to deepen the core REIT offering as well by continuing to roll out new data tracking & analysis.

But as I mentioned in the beginning, we are also working overtime to roll out a beta version our basic energy offering. Energy is another sector that is perhaps even more buried in industry specific figures than even real estate, and I look forward to codifying the relevant context in this sector in order to offer up high quality data and combining the static financials & assumptions with live strip pricing data. This is especially relevant given crude oil’s significant rally this year.

So this is our plan, but of course plans can change and if there are any sectors or firms you are really interested in us covering, I’d love to hear it. I’d also be interested in hearing if there are any specific data fields we don’t have you are interested in seeing.

So again, if you are interested in the platform and want to learn more, please feel free to drop me a line. Otherwise would love for you to sign up and check us out using the free trial period.

Sign Up for Valyte

And don’t forget we are offering a 25% launch discount for early users, so use this discount code FRIENDSOFWARDENCAPITAL when signing up.

We are also exploring potential API integrations or white label usage, so if you work for a larger institution and want to talk, please do reach out.

Finally, a note on my writing here. I will be re-focusing on writing about REITs as part of the Valyte launch, and will try to feature interesting situations I find from the Valyte data. I probably will stop doing my general investment writing in order to make more time for REIT oriented writing, although I may still do some general posts along those lines. Otherwise, I am still running my real estate and public equity investments and there are no changes there. But Valyte is obviously going to be a big area of focus for me moving forward and is something I am quite excited about.

We will also be launching Valyte’s own social platforms this week, where we will feature shorter, more frequent data drops or teasers. Whereas I will try to keep this page more focused on longer deep dive write ups.

So if you aren’t already subscribed to my Substack and are interested in hearing more, please sign up below. I will be doing more REIT commentary, and probably will still do a few non REIT write ups as well, as there is a lot of interesting stuff going on outside the REIT world as well.

As usual, per see my typical disclaimer HERE. Nothing here is investment advice, and I may hold, buy or sell positions in this stock at any time. The stock is a small cap biotech, so this is likely going to be much more volatile than the REITs I often discuss.

All of that said, one of the more interesting opportunities I have found recently is a stock called Vor Biopharma. I think conservatively this stock could be worth ~4.2x+ its current market cap if its two main phase 3 trials are successful.

This company has an interesting history, but what is relevant to us is that in June, Vor licensed the international rights for a drug called Telitacicept from a Chinese biotech company called RemeGen. Along with this licensing, Vor brought in a new CEO, and did a $175mm PIPE lead by RA Capital and Forbion (two well regarded biotech specialist investors) along with several other firms.

Vor’s previous drug candidates had failed and its stock was trading in the gutter - this series of events basically completely re-invented Vor as a whole new company, focused around Telitacicept.

Vor has been a bit of a rollercoaster to say the least. It spiked on the licensing news, but fell when they did another share offering at $10/share in November.

Vor did two more rounds of financing with RA, Forbion, and others, which has lead us to today, where Ra and Forbion both have board seats1, and the firm has around ~$400mm in cash and a market cap of ~$1.15 billion2. Vor intends to use this cash to fund two different phase 3 trials for Telitacicept, one for generalized Myasthenia Gravis, the other for Sjögren’s syndrome.

The set up feels very interesting. We have a company with two blue chip biotech investment firms on the board, and a big slug of cash raised to fund two phase 3 trials in large addressable markets based on promising clinical data. If the trials are successful Telitacicept could have a drug with billions in potential revenues, which would mean huge upside from the current stock price. But what makes this really attractive is that the phase 3 trials are very clinically de-risked because RemeGen has already successfully completed trials in China! That’s not to say there is zero clinical risk, but Vor has a drug that has already completed phase 3 trials and has been on the market in China for years.3

And the market isn’t just these two conditions - Telita is a multi-purpose autoimmune drug. RemeGen has 3 approvals already and a 4th successful phase 3 in China. And there are several other immune conditions Telita may be effective for. But zooming in on the immediate future, the total addressable market of just gMG and Sjogrens alone is very large. Vyvgart, a drug from Argenx, is on pace to do around $5-6 billion in revenues in 2026 per analyst estimates, with the vast majority of that revenue coming from gMG (it is also approved for Chronic Inflammatory Demyelinating Polyneuropathy, with several diseases in trials currently). Sjogren’s has no specific approved drugs currently, so estimates for its size are just that, estimates, but it appears to be around $1-2 billion per analyst estimates.

Indeed it is worth looking a little more at Argenx, the company which owns Vyvgart. Their stock currently trades at over $50 billion, and Vyvgart is their only commercial product currently. This is because analysts expect Vyvgart revenues to continue to ramp in the currently approved diseases, and also for Argenx to receive approval in other immune diseases. Telitacicept and Vyvgart have different mechanisms of action, but ultimately both are applicable across a range of auto immune diseases (with some overlap but also some differences), and most importantly they both overlap in Vyvgart’s biggest current condition, gMG. So conceivably if Telita could outperform Vyvgart, it wouldn’t be insane to think that Vor could achieve a similar valuation. This feels a bit crazy given that is ~45x the current market cap of Vor, but it shows what an upside scenario might look like!4

Potential Returns

Returning to earth, lets say there is a conservative ~$5-7 billion in addressable market across these two conditions (the large majority of which is gMG). At a ~33% market share that could be ~$1.6-2.3 billion in potential revenues. And gMG continues to grow quickly, so combined with the strong efficacy data the revenues may be well above the level I laid out above. But lets say $2 billion in revenues as a base case for easy math - at 2x revenues that is $4 billion in potential value, at 2.5x, $5 billion. $5 billion would be ~4.2x from the current valuation! And back in the biotech boom drugs could trade for 4-5x revenues or even higher. It isn’t crazy here to think that this drug could be worth a higher multiple than 2.5x, because it looks to potentially be best in class for both conditions, and there are several other potential conditions it can treat, meaning it has a very large addressable market.5 Again just look at Argenx’s valuation - over 45x higher! On the negative side, Vor does owe royalty fees to RemeGen in the high single digits to mid teens based on sales tiering. 6

And of course, if the trials fail then the stock is likely essentially a zero. The more likely ‘fail’ scenario in my view is probably a black box warning which hamstrings sales, but at least this scenario isn’t a total loss as some patients who don’t respond to other drugs would potentially try Telita7.

Competitive Positioning

As I hinted earlier, Telitacicept has a very strong efficacy profile. Indeed this is actually probably its biggest risk, that the drug is too effective and carries the potential risk of getting a black box warning in the US if any patients in the phase 3 have a severe illness. But as I detailed in a prior footnote, this risk is I think manageable. SAE’s were comparable or lower than placebo overall for the relevant trials.

The efficacy means it is likely very well positioned to be potentially best in class in its two initial target markets.

For gMG, Telita had a massively higher effect vs placebo, however there is a caveat here. In China it is common to have less of a placebo effect, so it is important to also consider the absolute benefit. Luckily, Telita’s absolute benefit is still the best of any drug currently approved or in the pipeline, at -5.74 change in MG-ADL (the primary measure of disease on a 24 point scale, lower is better). Vyvgart, the current leader, is only -3.2. The leading new competitor would be Nipocalimab, a drug from J&J approved in 2025 which has a score of -4.7. Here is a table comparing Telita to all the other gMG drugs. Vyvgart was such a breakout success because it was the first drug available which didn’t carry a black box warning, which significantly expanded the market.

Worth noting that Telita calculates a response rate on a 3 point change, as do several of the black box drugs. Vyvgart is a sustained 2 point, and nipo is just 2 points. The exact Telita discontinue rate was not disclosed but was similar to placebo.

As you can see from the table above, Telita appears to be by far and away best in class. A much larger effect, much higher response rate, and a relatively convenient method of administration, combined with minimal side effects (the biggest was a higher rate of colds).

Sjogrens as I mentioned before has no approved drugs. But there are several competitors in clinical trials, as you can see below.

ESSDAI is a clinical measure, and ESSPRI is patient reported symptoms - lower is better for both. The NAV ESSPRI data is because those drugs had no meaningful effect. Discontinue / SAE rates are low for all drugs.

Again I didn’t list here the placebo adjusted scores, in those Telita demolishes the competition. As I mentioned before, there is often a reduced placebo effect in China, so to be conservative I am assuming that occurred here and am instead focusing on the absolute changes.8 But there is some chance the global P3 trials for Telita translate into even higher absolute scores!

Regardless, even assuming the absolute scores don’t change, Telita is arguably best in class based on the above data alone. While the ESSDAI data is a bit worse than competitors, the response rates are much higher, as are the ESSPRI data. If you wanted to overweight ESSDAI I’d still argue Telita is roughly on par with Dazo, and certainly any patient who fails one of the other drugs would likely be put on Telita given the much higher response rate.

So in sum - Telita looks very well positioned in both its initial target markets, and in a base case could generate significant revenues and value if these two trials are successful. And given the significant clinical data out of China, success seems fairly likely (although not assured!).

Drug Details

Telitacicept is a type of drug called a fusion protein. I’ll try not to get too far into the weeds on the science here, but basically the drug works for autoimmune conditions by suppressing B cell activity, the overexpression of which is often responsible for autoimmune diseases. Telita has already completed its phase 3 trials in China, and has been on the market there since 2021. It is approved for 3 conditions in China, Systemic Lupus Erythematosus, Rheumatoid Arthritis, and generalized Myasthenia Gravis.9 It also completed a successful phase 3 in China for Sjögren’s syndrome.

However the FDA generally will not accept accept Chinese clinical trial data, so this is why RemeGen is partnering with Vor to run its international trials.

There is also some history here worth noting for a similar drug which failed, which may also be a reason the stock is so cheap. That drug is called Atacicept, and was being tested in a study for Lupus Nephritis. It suppressed the immune system too much and one of the first patients died from pneumonia, which obviously lead to the trial being cancelled. There are a few big differences here. The first and biggest is that unfortunately the Atacicept trial paired it with another immune suppressant during that trial10. So it isn’t even a read on just Atacicept by itself, as the immune system was hit by a double whammy. But further the RemeGen team specifically made alterations to the drug to reduce its immune suppressive effect & make the drug more ‘stable’ - one of the issues with the prior drug is it may have delivered its payload in a more lumpy manner, causing dangerous spikes in immune suppression. Finally Lupus patients are generally much sicker than gMG or Sjogrens, hence the reason Vor is focused on the latter two first.

All that said, I am not terribly worried about this history given the thousand of patients who have received Telitacicept in China - the only way it could have some horrendous safety profile would be some kind of wide scale fraud and coverup11. Not impossible but seems highly unlikely and I’m trusting the RA & Forbion teams to have confirmed this is not the case.

Errata

One thing worth discussing is how this stock trades, which is a bit strangely. The daily volume has been around 500-750k, which is over ~1% of shares outstanding, not bad you would think. But I have found the stock ‘feels’ like it trades like something with a far lower volume/market cap. I’m not a trading expert so I honestly don’t know what’s going on here, but its odd (another possibility frankly is I am just misreading things here!). The blocks available for sale are typically pretty small, so perhaps this is related to it. And to top it all off, if you search for $ vor on twitter, its just tons and tons of bots posting the exact same messages about it.

I asked Gemini about this, and it suggested there may be a bunch of wash trading by bots to try and give an illusion of false liquidity, which sort of matches all the Twitter bot posting. If this is true, and I’m not sure it is, its unclear what their end goal is (pump stock up, or dump their holdings), and I’m not sure how much it matters if you have a long term perspective based on success in the underlying business. But I wanted to make sure people aware of this strangeness!

Another item worth highlighting in a bit more depth is the significant major shareholder selling history. RA sold a bunch of shares in 2025 when the stock was in the upper 20s, and right before the issuance of new shares at ~$10/share in November (which RA bought into, not a great look generally but good for them). I don’t know if this was RA closing out an older investment (they were invested prior to the RemeGen deal), or simply capitalizing on the opportunity to sell the stock at a healthy price, but regardless it put some pressure on the stock and shows RA is clearly willing to sell if the share price gets high enough. Reid Hoffman was also an older investor and sold a bunch of shares around this time, but not all of his holdings. All this is to say - if the stock rallies strongly again we could see some more large sales by either of these two large shareholders, which could hold down the share price some. But I’m not too worried if a large shareholder decided to sell at ~2x+ from the current price, that is a good bit of upside from now.

Conclusion

To bring it all together - we have a significantly de-risked clinical asset with a very strong competitive profile with a large addressable market. The company is being led by new management and has huge ownership by multiple blue chip biotech funds, two of which have seats on the board. And the company has enough cash to complete their two phase 3 trials, which should wrap up in 2028. The set up is almost as clean as you could ask for, and yet the stock trades for far below what the potential pay off might be. The upside appears to be around ~4.2x on the base case, possibly much higher, and while the downside is significant (as is usually the case in bio), the odds seem relatively low. At 80% chance of a 4.2x, 20% of a 0 (and no credence to an upside scenario), the EV is 3.36 - very attractive over a mere 2-3 years.

First as always, the returns. We unfortunately had a poor year, with returns basically flat at an .8% net return for the year. This compares to ~17.08% for the S&P, and 2.87% for the REIT index. Longer term we are still outperforming, at 190.15% vs 61.27% for the REIT index and 155.29% for the S&P, although the S&P gap is narrowing1. 2026 has been off to a better start but the market is obviously volatile.

The drivers of the weakness are broadly two fold. The first is we are very defensively positioned with a good sized short book - these positions obviously did not take off given the continued euphoria in the markets (although they are looking better today!).2 The second is that my other investments are primarily value oriented, and these frankly performed quite poorly.

The flip side of this is that I actually feel very good about our positioning currently, and think there is a lot of value & potential upside in the portfolio.

Our new largest position, Vail Resorts, is probably the best example of this.

Whistler, one of Vail’s major resorts.

I started buying in February, when the stock was in the upper $150s. Unfortunately the stock is now trading at $133 (which I think is an incredible opportunity on the flip side) - I bought more as it fell, but our cost basis is around ~$148, so we are still down a decent bit here. Vail deserves it own write up entirely, but the quick thesis on it is that Vail owns irreplaceable assets with very limited new competition, and is cheap on almost any metric you want to use. For context the first new ski resort in 30 years opened adjacent to Deer Valley, and it took 10 years, usage of a government permitting loophole, and cost ~$1.5 billion to build3. Or you could buy Vail’s 15 major resorts (and a host of minor ones) for just over $7B in EV today. The big risk is snowfall - the current weak snow year is likely one of the main reasons the stock has fallen back down. But snowfall trends are generally up actually over the last several years, and I believe the risk to be manageable (and the epic pass helps smooth out revenues significantly), although it does bring a bit of random year to year variance with it.

Alexandria is another - in attempting to catch a falling knife, I didn’t quite time the bottom right, but I still believe we have a very attractive basis, and the stock looks even better today. ARE is the largest life sciences landlord in the US - this sector has struggled with a double whammy of a biotech bust and big oversupply (triple if you want to count WFH, though lab space wasn’t hit quite as hard as normal office in this regard). I believe the stock is currently oversold - their portfolio is by far the highest quality with some truly top tier assets. The bio sector is coming back, and I believe strongly in its long term growth. In fact it began to recover somewhat in 2025, just take a look at the XBI.

The stock market is a leading indicator, real estate leasing is very lagging (indeed it really just started hitting ARE’s results in 2025 nearly 3 years after the collapse!). If the bio rally continues we should see a turnaround in bio leasing fundamentals in the next year or two, although ARE will likely still see hefty NOI declines from here given move outs etc. ARE is trading at an ~10%+ cap rate today, which I believe falls to low 9s on future NOI declines - too cheap given the strong lease terms & asset quality (top life science assets were solidly among the lowest cap rates in CRE pre-bust).

On the bigger picture

Not a whole lot has changed overall since my last letter, so I won’t spend too much time on this subject. Broadly my position remains the same - AI capex is at unsustainable levels and it won’t be possible to generate economic returns on it unless we have true AGI imminently. The rest of the economy continues to be soft - unemployment continues to tick up, real estate is soft, and job growth has slowed to almost nothing. So I still believe if the AI bubble bursts, it could get rough for the rest of the economy.

I remain quite confident the current tack will not yield AGI anytime soon, although it has continued to improve, and I expect it to continue! Again the best use case is coding, and LLMs have continued to improve here4. The markets have finally woken up to the consequences of this for the software space - if its easier to build software, all else equal that would certainly be negative for incumbent software firms. Unfortunately the software firm I am short, Palantir, has surprisingly not fallen very much despite being massively more highly valued than any other software firm. Perhaps I should have taken a broader basket, but I remain convinced that Palantir has a lot of potential downside given its rich valuation. And it is especially nice as a hedge against a downturn.

Interestingly on the model progress front - we have reached what seems to be the first time that the current state of the art models are not universally better than previous models. This indicates to me we may be getting pretty close to the potential performance frontier of what LLMs can do. And the reason I can state this confidently is that as I have hinted, I am working on an AI project in the finance space (which we will be launching quite soon!), and Gemini 3 is, for several of our use cases, inferior to Gemini 2.5. Overall G3 is still better when looking at a range of use cases (I use it all the time for quick high level research or questions), but we may be getting close to the point where returns are diminishing.5 And that has significant consequences - I continue to believe the bubble will burst either when model progress slows, or revenue growth slows. So we may be approaching A (although I frankly underestimated how far RL could take us so I could be wrong here too!).

But speaking of revenue growth - we may also be getting close to things slowing down here too. OpenAI’s Q4 traffic showed extremely weak growth per SimilarWeb’s numbers below.

OpenAI bulls would note that the business has seasonality to it and that Q4 is always weak (this seems to be due to the large student usage, which IMO is also bearish but a whole other can of worms). The problem with this view is that Gemini had a massive Q4, and Claude also continued to grow strongly. So its a bit harder to argue its seasonality when the other competitors don’t seem to be affected in a similar way. Even worse - OAI’s traffic has been anemic since basically May of 2025, whereas in from May to November 2024 OAI saw ~50% increase in traffic.

Here is data from SimilarWeb I cobbled together using Gemini (fun note I gave this to both Gemini and GPT, Gemini did this in about 30 seconds, & GPT took 10 minutes. IMO this huge speed gap is why people are switching to Gemini en masse).

Data assembled from 4 different charts SimilarWeb published in their ongoing Global AI Tracker Series. They have nice data, check out their website here or twitter here

As you can see, GPT traffic appears to be stalling out and even declining, which would explain why it seems like OAI is flailing about looking for a new hit product or way to make revenue. This can be seen in their flip flop from ‘never ads’, to recently announcing they are going to put ads in their platform. And the Sora app feels like a desperate attempt to revitalize user growth (which seems mostly to have failed).6

Interesting mobile data vendors are showing a spike in mobile traffic in the new year for OAI - my best guess is this reflects growing usage in emerging markets which are much more mobile first than developed. OAI has been aggressively offering free trials and partnerships through other apps in many emerging markets, which I suspect helped drive these mobile figures. Obviously this is still beneficial to OAI but the revenue per user in these countries is far lower than the developed markets, so this kind of growth isn’t nearly as valuable.

We will see what happens over the next few months, but barring a big change it looks like OAI’s days of heady affluent user growth are behind it. And that is going to make it much harder to increase revenues at the forecasted rates.7

Needless to say - if OAI’s growth slows down even a little that would have massive repercussions for the AI space as a whole. If you want to assume 10x sales is a reasonable multiple (which I would argue its not, due to the capital intensive and commodity nature of the business), then to justify its rumored new ~$800B valuation8, OAI needs to quadruple its revenues from its current ~$20B run rate. To get there in say 4 years would require a 40%+ annual revenue growth rate. It also requires acceleration in terms of absolute dollars of revenue growth - again something that is very hard to do if your core user growth is slowing or even declining.

So all this to say - things are mostly playing out thus far as I expected. I am not fully confident the AI hype will burst in 2026, but I think almost certainly by 2027 we will see a big slowdown9. And I continue to think long term AI will generate a ton of revenue and economic value... just not enough to justify the current wave of investments, and I’m also not sure how much of the value will actually accrue to the current largest players. Its hard to see things working out for OAI et al when Chinese firms are able to deliver open source models that are ~97% as good for 10% of the cost. And as models get better that 3% difference looks less and less meaningful. The best way to describe whats going on in my view is a mix of a tech bubble with a capex/commodity bubble. The problem with this is that no tech investor has any experience with capital intensive commodity businesses, so I suspect their previous heuristics are going to fail them very badly.

I think the main way I’m wrong here is if we do see continued rapid progress for several more years, to the point people can rationalize investments in the name of achieving AGI. But it feels like the narrative has already moved away from that, with many of the top AI researchers saying LLMs are a dead end on that road, and my own first hand intensive usage also says otherwise. As relates to my investment portfolio though - I don’t have much in the way of direct AI shorts, so I don’t necessarily think this is a huge disaster for my investments if I’m wrong. As basically it just means the economy continues to grow nicely, which is good for most investments! Our short book is full of things that are specifically overvalued and would hopefully still come down even in a growth scenario.10 And just to reiterate - the reason I spend so much time on this subject is it appears to be by far the biggest & most important economic driver right now, especially given the weakness pretty much everywhere else. So if the AI bubble bursts I fear it could have significant repercussions elsewhere.

Portfolio & CRE

As some of you may have noticed, there was no CRE REIT commentary last quarter. Unfortunately I was just too busy to write an article for Q3 - hopefully I can do more writing in this area in 2026. But I’ll try to cover bits and pieces that caught my eye here.

Broadly, I would say we have seen little in the way of major changes in the CRE markets from my previous commentary, so frankly there isn’t all that much to write about. Apartments remain soft due to oversupply and weaker than expected demand in the sunbelt. Industrial has picked up a little and continues to improve, although it still remains a bit soft overall (PLD had pretty positive Q4 earnings & commentary & noted that overall vacancy has begun to decline). Office is weak outside of NYC, but has continued to improve a bit especially in class A. Retail continues to do well, primarily due to the lack of new supply. Hospitality is soft - frankly a bit softer than I expected, but the consumer seems to be weakening relative to the rest of the economy. There have been several good sized REIT take privates and liquidations, and I expect this trend to continue into 2026 so long as the economy holds it. It is by far the best way for big players like BX to deploy capital in the CRE space.

We have some big updates to the portfolio beyond what I noted in the intro, which hopefully I will be able to spend a bit more time diving into in more depth in the future. One of those is that I have been ramping up non CRE investments, an interesting example of which is uniQure. This is a biotech stock which has a potential groundbreaking gene therapy for Huntington’s disease called AMT-130. They presented their initial results back in September which showed disease progression slowing by ~75% 3 years after treatment, and the stock rocketed up to as high as $70/share.11 In a twist, the FDA came in 2 months later and rescinded their previous agreement to use an external matched control group to compare Qure’s treatment to, which has caused the stock to crash down to its current price of ~$23/share. What is interesting here to me is that very few argue that the drug isn’t effective - the worst case scenario seems to be that the FDA makes Qure do a randomized phase 3 control study, which they have been trying to skip based on their strong data, the lack of any treatment for Huntington’s (which is fatal), and the difficulty in actually enrolling enough patients for a phase 3 trial in a rare disease.

Qure has a significant amount of cash on hand (~$700mm as of Q3, relative to its ~$200mm/year burn rate), and could fund a trial if they had to worst case. But waiting 3 more years for an approval would not be the end of the world given the potential value here - arguably the stock could be worth well over $70 if the drug is approved, but even if we just assume its a 3x from here to match pre-FDA reversal pricing, that is an extremely good return over 3-4 years.12 My expectation is actually that something else good happens before this - either the FDA allows them to progress with some additional data (most likely either a confirmatory P3 after approval, or waiting for additional patient data to hit 3 years, or even the full cohort to hit 4 years which would be this August), or that the European Medicines Agency may break with the FDA and allow approval before the FDA does. This is rare, but I think all bets are off given RFK being in charge of the FDA has created a lot of chaos to put it gently and European’s opinions of America being at basically an all time low. And interestingly, not only has this happened before, but it happened with uniQure and another gene therapy, in fact the first one ever approved commercially back in 2012! Here the EMA approved the therapy on early results, but the FDA asked for a full phase 3.13

Ultimately, if the therapy works, and we should know this with a very high degree of certainty by August simply by watching the patients Qure has already treated14, it is really hard for me to imagine this treatment not getting approved. There is some risk here (unknown side effects, and treatment not being as effective w/a larger treatment group are the biggest), but the balance of upside vs downside feels very favorable to me.

Fin

As always, thanks for taking the time to read this. I feel very optimistic about our portfolio, and look forward to seeing how the investments play out over the next several years. I am also excited to share the AI project I have been working on hopefully fairly soon!

That is because these investors are applying their old heuristics for the tech business built over the last 30 years to a new market dynamic which has evolved into something quite different.

What has happened with AI is that tech (or at least the LLM part), has moved from a zero marginal cost business to a business with marginal costs. And equally importantly, it has become a business reliant upon large investments in physical infrastructure with relatively short useful lives & declining cash flows over time2. This is completely and fundamentally different from the prior tech market structure.

What it is very similar to is the energy business3. Oil & gas requires large up front investments in projects which produce declining cash flows over time, requiring constant reinvestment to generate new earnings & evaluation of investment returns on capex spend. Unfortunately for tech investors, this is the new reality for their business as well - they just don’t know it yet.4

GPU vs shale well cash flows over time.5

There are all kinds of issues with this business structure, of which energy investors are painfully aware & which tech investors will soon be learning all about.

As always, nothing here is investment advice. Please see my general disclaimer here.

Tech’s new reality

Asset heavy businesses are inherently prone to boom & bust cycles, as multi year construction timelines to deliver new supply means that supply and demand can become very mismatched, both to the positive and the negative.

This is doubly true for businesses with assets that have declining cash flow curves - operators will charge whatever they can get to maximize revenues during the relatively short peak earnings window of their assets. Thus the only floor on price is the actual marginal operating cost, which is very low for both LLMs & oil.

The final cherry on top is that by their very nature, commodity asset-heavy business also invite significant competition. It is fairly easy to start up a new entrant if you have the money. This can be seen in all the small oil & gas wildcatters, and now in AI we see it in the massive proliferation in AI ‘neoclouds’.

The AI cloud computing business is transitioning from an oligopoly with just 3 major players, into something more like the energy business with several ‘majors’, and hordes of smaller players as well. Below is a table from industry research provider Semi Analysis (https://semianalysis.com) detailing the new AI neocloud universe.

What oligopoly?

This chart is extremely bad news for the economics of the GPU cloud business. And it in fact understates the scope of competition! This is because many of the large LLM research firms are also building out their own in house cloud capacity - most notably xAI and Meta, but OpenAI and Anthropic are moving in this direction too. And these are some of the largest GPU clusters out there. I believe it is almost inevitable these firms will begin to rent out their GPUs to third parties, as their internal demand loads are insufficient to actually monetize the enormous investment they made. Indeed Zuckerberg hinted at this recently, and there are rumors that xAI is already staffing up a salesforce.

Long term this dynamic may even erode the big tech oligopoly on cloud computing generally. Just as the hyperscalers found it relatively easy to move from general cloud computing to AI cloud computing, I believe the largest and most sophisticated neoclouds will find it relatively easy to move into the traditional cloud business. This probably won’t occur until the next business cycle, as these firms begin to look for new revenue sources outside of their brutally competitive core business, but it may occur sooner. This could then become a drag on investment returns in the core cloud business for AWS, Microsoft and Google.

Investment implications

So if all of this is accurate, what might that mean for investors?

Some basic comparisons between the energy and the tech sector may be helpful. Below is a chart showing the market cap of the S&P 500 IT sector vs the entire energy sector - as you can see, IT is massively larger.

Nvidia alone is greater than the entire market cap of the energy sector!

Nvidia has fallen a little bit since I made this chart but you get the picture.

However, when we look at relative revenues of the two sectors, things are much more even.

Why the big difference? Relative profit margin, and the multiple assigned to said profits (a function of tech’s strong recent earnings growth). These charts obviously have very troubling implications for generative AI investors.

One of the key problems is that a multiple isn’t even the proper metric to use for cash flowing short lived assets. You can’t just slap a multiple on something which only generates meaningful cash for 5-7 years - instead what is needed is a project level IRR. Energy investors know this, and that is why you only see sector tourists talk about multiples when it comes to oil & gas producers6. Tech investors will learn, eventually.

I believe that even in a best case scenario, the generative AI GPU business looks something like the oil & gas industry, in that even if it generate significant revenues & societal value, profits and high investor returns will prove much more elusive.7

A comparison to past oil booms

So we may find it informative to look back at the many oil booms & busts as something of a parallel to our current situation. The recent shale boom I believe may prove particularly informative given the analogous steep revenue decline curves.

There are obviously many differences here8. The most notable is that the oil business was very large and established during the prior boom, and that the relative demand / supply mismatches were fairly small. Overall oil production grew only from ~4,000 Mtoe (million tons of oil equivalent), in 2007 to something like ~4,500 by 2017, a mere 12.5% total increase over 10 years. And this relatively small supply growth caused oil prices to fall from over $100/ barrel to as low as $33 in 2016.

Once you adjust for the ~30% inflation we have seen, oil prices today are actually much lower than they were pre-covid.

Meanwhile datacenter supply in terms of MW of power is up ~15%/year over the last few years, and is projected to triple from here by 2030 according to Cushman & Wakefield’s industry report from May (and the number is almost certainly much higher now than May given the huge slate of announced deals).

Given the improvements in chips and some algorithmic improvements as well, the actual token production is up massively relative to the simple power figures. Thus far, demand growth has if anything exceeded supply. The issue is that given supply is going to triple9 from a power perspective alone, if demand doesn’t keep up the supply/demand mismatch could be enormous. Another way to look at this is - given chip and algorithmic/model improvements, the ~15% annualized datacenter power supply growth we have seen has been roughly sufficient to meet demand. We are entering an era of more like ~25%/yr power supply growth, so if we hold chip & algo gains constant, demand actually would have to accelerate from today’s already strong levels to simply meet the new supply.

Can you imagine how far chip prices will fall if we have a 15% supply/ demand mismatch, let alone a 25% one or even higher? Conceivably from an end token perspective if demand slows down and we get some big algorithmic efficiency gains you could see a scenario where supply outstrips demand several times over within a few years.10

Flying Blind

The big issue we have is that no one knows how big demand for generative AI will be, and many in the tech world have convinced themselves that artificial general intelligence is nigh and that these investments are existential.

The problem is that if AGI doesn’t come soon, these investments will have to pay for themselves the boring old fashioned way, with ads, user subscriptions and business use cases. At current pace of spending we will be approaching $1 trillion in total capex soon, maybe as soon as the end of 2026. At a 25% margin, that capex would require $4 trillion in revenues to just break even, and $8 trillion to earn a reasonable return!

Unfortunately, we are already seeing some signs of a slowdown in end AI demand. If this data is accurate, OAI’s traffic is essentially flat since May. And the industry overall has stalled out since the mid September bump, likely caused by return to school.11

So LLMs are potentially already stalling out in traffic, and we have a monstrous supply wave still incoming. This could get really ugly.

There are some important caveats here - daily traffic is not the same as model usage, nor is it equivalent to monetization. AI providers are in the early days of monetizing their users, so revenues can likely climb significantly just by getting additional revenue from the existing user base (ads for example are fairly low hanging fruit). Of course demand could also pick back up - growth has slowed several times in the past, but accelerated again with big new model releases. The big problem for OAI is that they just released their latest models (GPT 5 and now 5.1), and the release didn’t do anything for overall traffic.

Unfortunately for OAI, daily time spent also appears to be down per recent Apptopia data shared by crunch base (full story here).

Apptopia is an investor oriented mobile app data firm.12

And all of this data is before Gemini 3’s release, which likely has taken further share from OAI. It may also have grown overall industry usage, though that remains to be seen.

The one area that seems to still be growing strongly is what I believe to be generative AI’s best use case by far, which is coding. This can be seen in Cursor’s recent fundraise which notes ARR is now over $1 billion, over double the last reported figures in early June. LLMs also continue to deliver improvements in coding quality which bodes well for continued growth here.

I personally doubt that coding alone is going to be able to drive the monster increases in revenues the LLM providers are going to need to earn a return on all of the capital being invested. The capex numbers are simply too large such that even revenue figures that would be considered wildly successful by any other measure would fall incredible short - by my estimates by 2027, if current spending pace continues, $2 trillion in revenues per year could be needed to earn a ~cost of capital return on the capital investment13. That is frankly patently absurd, the only thing that can even get you close is AGI.

Timing it all

While I am very confident that this shift has occurred, I am less confident of when the whole thing blows up and becomes obvious. My guess is sometime from now to mid 2026 as that is when the current round of build outs should start to wrap up, but if LLM progress continues rapidly it may push out farther14. Already though, two of the major GPU buyers, Meta and xAI, seem to have almost zero return on their massive investments, and it is hard to imagine them stepping those investments up to the next tier required by an additional level of scaling. OAI and xAI fundraising will be the canary in the coal mine - once they miss on a raise the entire thing is over. I suspect Zuck breaks last given his history of awful capital investment - this is the guy who spent tens of billions to create something lower quality than Second Life, a mid 2000s MMO that was probably developed for sub $20 million originally (and indeed Zuck is still spending on the metaverse!).

The problem for the model makers is that they are stuck in a brutal competitive cycle - because switching costs are almost as low as I’ve ever seen, if you fall behind just slightly you can lose customers en masse. This means it is quite likely that most if not all of the major model providers will invest all the capital for nothing, and be left attempting to rent out the GPUs to others to salvage their investments. I suspect the last person standing will be Google, as their TPU’s give them a fundamental cost advantage over the other players.15

Fin

As always, thanks for reading. You can subscribe below if you find this interesting. I also want to emphasize again that I do believe LLMs are a very useful technology (which will continue to improve), and will generate a lot of value for society, and associated revenues. But I also believe the current AI capex wave is going to end very poorly, and the overall business model of the LLM space does not look very attractive from an investor’s perspective at the GPU and model layer. I do think software built using AI is likely to be very attractive though - the winners here will be the consumer, and businesses which can establish real moats and switching costs for their users.

Please read the disclaimer HERE - nothing here is investment advice.

First performance – the quarter was up healthily at 4.57% over Q2, and YTD performance is now positive at 2.32%, vs 13.96% for the S&P and 4.77% for the REIT index. Since inception we are at 196.66%, still outperforming the S&P and the REIT benchmark of 148.58% & 64.26%, respectively.

It is worth noting that as the year has progressed the REIT index has become a worse benchmark for us as the portfolio has diversified, but I will keep it here for continuity and as for the historical returns it remains a good benchmark.

The reason we are only up a little despite a big win in Plymouth Industrial & a bull market is that I have moved the portfolio to a very defensive positioning, with a large cash balance and significant short positions. The shorts obviously have not taken off yet as the markets continue to notch all time highs.

And the reason I am so defensive is that I believe we have entered a full blown mania stage of the cycle. The evidence for this is everywhere you want to look.

First and at the heart of things is the AI bubble, led by Nvidia, Open AI and a web of circular deals announced in the last few months. OAI has committed to spending over 1 trillion dollars over the next several years in various chip and data center deals – an absolutely astronomical sum, especially when you consider that OAI’s revenue is on pace for something like $13 billion if company projections are correct (indeed the commitment is now probably over $1.5 trillion after this mornings Broadcom announcement). This ratio would be wild enough if it were not for the fact that Open AI is losing money hand over first right now - in H1 2025 they apparently made $4.3 billion and had losses of $7.8 billion!1

The only way OAI can come close to meeting these spending announcements is to raise massive amounts of money. Indeed OpenAI itself projects it will need well over $100 billion in cash through 2030 before it begins to make money - just wild, wild projections. $100+ billion even combined with revenues paying for some capex doesn’t get anywhere close to $1 trillion, so OAI’s projections would also require significant investment by other parties.

And yet, the private market may be beginning to get some heartburn over OAI’s funding needs combined with their cash burn, as recently we saw that OAI has turned to its largest supplier, Nvidia, for financing.

Nvidia announced it would invest $100 billion in OAI to fund data center build outs – funds which would primarily be spent on Nvidia chips. We haven’t seen this kind of vendor financing since the dot com boom, and it is a very bad sign in my opinion. And its not just Nvidia and OpenAI, these circular relationships are rife in the AI space.

Simple and clean, right?

Or, in layman’s terms, something like this

Frankly the audacity of this deal surprised me, and it may delay the inevitable reckoning a while longer if Nvidia is willing to wholesale fund the AI capex bubble. Nvidia is seemingly much less concerned about returns than most private investors are, since it will receive most of its investment right back in the form of chip purchases, and thus they may extend the cycle by making investments where other capital otherwise would not.

On Capital Expenditures and Necessary Revenues

I wrote a bit about the needed revenues to make all of this capex work a bit back in February, but it is worth revisiting a bit now over half a year later. AI Capex spending appears to be up to a ~$400B annual run rate. I estimated it was more like 200-250b earlier in the year, and it was already quite substantial in 2024 & even 2023, and will be if anything higher in 2026 if the major players are to be believed (although I personally think it begins to fall off in 26). But if you assume they are right and so we say ‘just’ another ~$400 billion in 2026, we have roughly over $1 trillion in AI capex investment through year end 2026. At a 50% margin2, that needs $2 trillion in cumulative revenues to break even3. This figure of course ratchets up every single year as more capex is spent. But even ignoring that huge issue, simply paying for the current batch of capex will be an absolutely massive mountain to climb, just to break even!

Given the relatively short lifespan of GPUs (although admittedly other parts of the data centers have a longer lifespan, but GPUs appear to be the majority of spend) lets say we have through ~2030 to make this $2 trillion. So 5 years, or $400 billion a year. For comparison the entire US software market is something like $360 billion / year. So the world needs to add another America of software spending, and it needs to do it in the next 12 months. Obviously that isn’t going to happen - perhaps eventually one day it will but the problem is we may have a whole generation (or two !) of GPUs that are a capital loss in the interim.

The AI business itself is on track (or was in July, according to the Information’s reporting) for about $18.5B in revenue at the core large AI startups, with the vast majority of that being OAI and Anthropic. There is a bit of revenue elsewhere - lets generously assume its $25 B total. So we need revenues to 16X just to break even! If these companies want to actually make some money on their capex investment, multiply all these figures by 1.5 to 2x, or 24-32x.

Realistically, the only scenario in which that might happen is if we truly create a general super intelligence, and soon. And based on everything I am seeing, we are just not on track for that. Model improvement has slowed down dramatically recently - scaling began to slow last year, and then reinforcement learning extended the ramp out further into this year. But the latest generation of models simply are not that much better than their predecessors, something most clearly seen in the disappointing GPT 5 release.

Where we are seeing continued good improvement is fields which are amenable to reinforcement learning (most notably coding), video generation4, and also importantly in bringing the lower cost models closer to the performance frontier (this last one bodes very poorly for good returns on said capex). These are all important, and make no mistake generative AI is going to be a big business. But it simply cannot justify the current capex spend, again barring an AGI breakthrough.56

Many people saw the early exponential improvement and extrapolated that out into the future until we hit AGI. The problem is that technological progress is often more like a series of log or sigmoid curves, where we experience rapid advancement in certain areas only to then slow down dramatically, as opposed to progress being one big exponent. A good example of this is the ‘physical sciences’, as a catch all term for tech in the physical world, back in the first half of the 20th century. We went from horse calvary to nuclear energy and landing on the moon in ~50 years, an astounding rate of progress, and so no surprise the 50s and 60s were full of predictions that such progress would continue and by 2020 we’d be a spacefaring civilization with flying cars, colonies on mars, and limitless energy. Sadly these prior exponents did not continue.

All evidence I am seeing thus far is that we seem to be on a similar track for AI. As a little teaser - I am working on an AI product for financial research (who doesn’t have an AI startup these days) with some friends in the tech world. I am very excited to share it soon, and I think we will have something very useful and cool when we launch in hopefully a few months. But as a bonus this gives me a pretty good front line perspective on LLM progress and limitations, which gives me more confidence in these predictions.

Bubbles all around

It is not just AI though, you can see the mania throughout the market. The best example is probably quantum computing stocks (although nuclear stocks are trying to give quantum a run for its money). There are 4 publicly traded quantum computing stocks with a current combined market cap of ~$54 billion (actually even higher today as of this writing somehow), against revenues of ~$100mm, or an insane 600x sales multiple (the firms of course don’t make any money, so the PE is not calculable).7 Quantum computing has no proven current applications, and the primary usage many believe is possible, factoring very large numbers to break encryption, is many many years out even if technological pace continues at a very rapid pace.8

So we have an industry which may begin to serve a serious use case in 10+ years, trading at a valuation that is arguably higher than even the revenues from that use case could ever support, if said revenues are even ever achieved! Just madness all around. I believe quantum computing represents an excellent shorting opportunity, and have taken out short positions on several of the quantum firms.

There are many more examples - crypto and the proliferation of of crypto treasury companies is another example (although this one is cracking), numerous public companies with huge valuations and no revenue, new memestocks springing to life, hell even Chamath has raised another SPAC!

In my view there is no question we are in a mania today, the only question is how long can it last. I do not know, but if history is any guide at most another year to a year and a half (although it could happen much sooner!). I previously guessed things would begin to unwind Q1 2026 as funding ran out for the AI capex boom, but Nvidia stepping in to fill the void may now push this back several quarters.

Coming Down

A related question is, can the mania unwind without a recession? We just lived through a successful example of this in the 2021 bubble and unwind thereafter, so it is certainly possible. However what frightens me is just how narrow the scope of this bubble is, and how the rest of the economy seems to really be softening. In contrast in 2022 we had the huge upswing of the covid normalization bullwhip, where many real economy sectors such as travel & retail were still recovering in a big way9. Not only that, but the massive increase in construction triggered by low rates and big price increases in 2021 was only just beginning to hit the real economy in 2022. This provided a multiyear stimulus that has only just began to wear off.

In fact if you look at national multifamily deliveries, we can see that construction is about to fall off a cliff in the next few months. Those workers are going to roll off their current jobs into an economy with extremely limited new construction outside of data centers, and very limited hiring anywhere.

But it is not just multifamily. Single family housing, a huge driver of GDP, is seeing major cracks spread across many of the boom markets.

Single family construction has declined dramatically - here is FRED’s single family units under construction.

The builders were able to hold out for awhile by slashing their margins (which were historically high), but as I noted in my last letter, single family starts may be about to slow even further as large building supply company BLDR noted demand has fallen further for them recently. This can also be seen in the single family land market, which is beginning to cool off per Burn Consulting.

There are problems in housing beyond just construction - home price declines are beginning to spread across the country in the covid boom markets. Here is an analysis by ResiClub of Zillow home data by metro.

It is worth noting how regional the housing weakness is currently - the northeast and midwest remain fairly healthy. It is easy to forget but recessions were much more regional historically, so perhaps our next downturn will be more regional as well.

The rest of the economy (ex tech), is also showing signs of weakness. Manufacturing is in contraction territory, and has been majorly negatively impacted by Trump’s tariffs. The ISM services index is hovering at 50 (below 50 in contractionary). Hiring has fallen to nearly zero (the latest official data has been delayed due to the government shutdown), with ADP reporting 2 negative quarters for the first time since 2020.

The biggest contra to this weakness in my view is simply the massive deficits we are running at a whopping ~6% of GDP. This deficit spending boosts growth, and may be able to offset the weakness in the ‘real’ economy. We can see this in the jobs data - a huge share of all the jobs being created over the last 6 months are in healthcare. But an economy cannot run on government spending forever.

My fear is that the bubble bursting combined with weakness in the real economy might make for a potentially fairly rough recession. In the dot com era the tech bubble burst but the US consumer & the rest of the economy (particularly housing) was able to power through and keep the downturn fairly mild. Of course there was arguably a price to be paid for this several years later… but regardless this does not seem to be an option for today’s economy.

Now what might be the trigger for the bubble to end? Frankly I have no idea - perhaps it will be Trump trying to increase Chinese tariffs to over 100%. But perhaps it will be something else. My best guess though is it happens sometime in 2026 as the AI capex spending slows down, taking fuel out of the engine.

Interest Rates & Inflation

AI & manias are of course not the only thing happening in the markets - interest rates and inflation remain critical & this corner of the market remains a bit of a tricky situation.

Core PCE has rebounded to the 3% range recently, however much of that is imputed from rising stock prices. Here is economist Jason Furman’s commentary.

Interestingly services inflation has slowed recently, but has been offset by rising goods inflation from tariffs.

Due to all of this plus I’m sure a healthy fear of our massive government spending, bond rates have stayed fairly high and the Fed has been cautious on cuts.

But if the economy slows, and the tariff goods inflation proves to be one time and doesn’t cause a cascade, we could see inflation fall again soon which would clear the way for further Fed cuts in 2026. The Fed is not unaware of the softening labor market, which helped spur their recent cut, and all of this combined gives the markets some confidence in two more projected cuts in 2025.

A bull market thesis might be that the Fed can thread the needle here and cut enough to stimulate enough demand to offset weakening growth, while also not further inflating the bubble we are already in, and we nail the landing. I am doubtful given the delayed effects of monetary policy on the real economy, but it is certainly possible! But even in this scenario I would wager we see a 2022 style bubble cool off - historically the manic phase of a cycle usually lasts only a year or two.10

CRE

Now dear reader, you might be thinking that was a lot of commentary on the economy, and not much on CRE! And you would be correct. But I just published my last CRE notes a month ago, and not a lot has changed. So you’ll have to wait until after Q3 REIT results for more CRE news - apologies to the CRE buffs who have to sit through all my economic thoughts.

Fin

As always, thank you for reading. I am perfectly happy to continue to underperform the market as the mania continues, so as to better preserve capital in what is I believe a likely downturn.

Now that Q2 REIT earnings are wrapped up, I wanted to share some thoughts on the REIT and CRE markets. But first a little general update, as a lot has happened since my last article - if you are only here for the real estate feel free to skip this next bit.

The biggest overall macro change since my last update was probably the weak August jobs release, with only 22k jobs added, and the previous big negative jobs revisions for the July jobs release, where June and May jobs numbers were each revised down by over 100k1. Job growth was negative in June, which is the first negative month since covid, and if you dig into the numbers basically all the growth we did have in July and August was concentrated in the Education and Health Services sector.

Now if you have been following the numbers you would know that this category (along with leisure & hospitality) has been the main jobs driver for several months now - the main difference is now the headline number is slowing as well. This is a problem because healthcare is simply not a driver of actual economic growth, it just reflects an aging populace and ever increasing government spending2.

Adding to the negative jobs news, the semi annual adjustments of the BLS estimates to match with lagging state level payroll tax data just released September 9th, and it was a quite large downward revision of ~ -910k to the total jobs added for the year ending March 31, 2025. If there is a similar downward revision to the current numbers, job growth would have been basically negative since April. 5 months of negative job growth is pretty much unprecedented outside of a recession, so this is a very concerning development.

Interestingly unemployment hasn’t increased all that much, yet, although it is up ~30 bps since the January low. More worryingly is that labor force participation has declined a good bit, which offsets unemployment rising. If you held this rate constant at April’s level, unemployment would be much higher.

Chart from Parker Ross, handle @Econ_Parker on Twitter.

That said, prime age participation is still high, so it is hard to read too much into this stat on its own. But taken together with a constellation of other factors and it is worrying.

Further, the economy’s breakeven job growth figure is much lower likely due to decreased immigration, so the lower growth may not be quite as bad on a population growth adjusted basis. But we may be getting close to a tipping point. Another negative indicator is wage growth - the Indeed wage growth data has taken a big turn down recently3.

Total hours worked is also down quarter over quarter by ~-0.3%, but is relatively flat within this quarter.

So we are seeing several leading labor market indicators stalling out or deteriorating, and rapidly. I fear we may be at the inflection point of reaching a recession. Yet stocks are close to all time highs, a risk reward ratio that feels quite poor.

Government spending and the AI boom have been propping up growth, but the slowdown in the rest of the economy may be beginning to outpace these factors.

And speaking of the AI boom, the other big piece of news we had was GPT 5 also released earlier in August, and the results have been pretty underwhelming.

Here are Artificial Analysis’s rankings - basically GPT 5 is barely any better than Grok 4, or surprisingly even OpenAI’s own o3. This has led to what I believe is the beginning of a vibe shift among tech and AI types, with Altman himself even essentially saying in an interview that AI was a bubble4.

I think this is a really big deal that the market isn’t appreciating. If scaling has run out of steam, that means even the biggest AI bulls are going to have a hard time justifying the next step up in model training scaling. And that means model training capex spend should fall dramatically, and soon5. Given AI related capex seems to be running around ~$400 billion a year, this is a huge deal economically.

My guess is that AI capex begins to slow in Q1 2026, as the last round of announced and financed build outs are completed (specifically xAI’s Grok 5, Meta’s next mega cluster, OpenAI’s next round of clusters, and general Blackwell deployments)6. This could be a catalyst for the whole AI bubble to begin to burst as some of the hype begins to fade. This subject really deserves its own post, but the key take away here is that it looks like our last major economic driver ex government spending may be on its last legs, right as the overall economy is slowing down even further. It feels like a dangerous combination.

That said big tech earnings have been very good so far, and AI related end user spending growth has been very strong (albeit way below the levels required to justify the capex wave). So if that spending continues to scale rapidly the party could keep going for awhile longer.

OK back to real estate and my investments.

Portfolio

The biggest news for me is a buyout offer for Plymouth Industrial. Plymouth is an industrial REIT focused on assets in secondary markets in the midwest and a bit of southeast - mostly slower growth markets but with higher yields compared to more coastal or core markets.

I was intending to give Plymouth a bit of a spotlight in this letter, as it was my largest position by a good margin. But now it probably isn’t worth spending as much time on, because the value gap is significantly smaller. The stock was sub $15, and Sixth Street made an offer for ~$24 / share. My NAV is $27 - the stock is at ~$21-22 today and so what is left is more of an event type situation. This might still be interesting for a different set of reasons, but I won’t go into it here.

This is just such a great example of the inefficiencies in the REIT space. Plymouth was trading as low as a ~9.25% cap rate, when their assets are likely worth around a ~7% cap rate. It is hard to say exactly why it got so cheap, but this gap was far too large in my view7.

What is crazy here to me is that unlike other cheap REITs, Plymouth had good operating results! The other examples of huge public/private value gaps are in the hotel space, where earnings have been meh, and office, where there has been huge disruption from remote work. In other words, situations where conceivably the private values might be headed a good bit lower. This is not the case in industrial.8

So, a very nice win for me here, although I wish I had owned even more in hindsight. This also just reemphasizes to me the importance of bet sizing - it is rare to find something so clean with minimal downside and strong upside, and so a big swing is warranted in these kind of scenarios.

Onward to some sector specific commentary.

Industrial

Elsewhere in industrial, several other REITs trade at moderate NAV discounts, albeit much smaller than Plymouth. This is despite good NOI growth, which is driven by continued mark to market of rents catching up to the covid era boom. The reason here I believe is that industrial fundamentals have continued to soften due to weak demand and a supply hangover from the last boom. Deliveries have fallen off dramatically and continue to decline (along with starts), so this should provide a little bit of relief. But once the industrial REITs have completed their mark to market on rents, NOI growth should slow dramatically given overall market conditions are fairly soft. Still, the discounts available in the public markets combined with the last of the rental increases makes for fairly attractive stabilized yields in a few years, and a few REITs are interesting here.

Office

Office continues more of what we saw in Q1, which is an ongoing uneven recovery that has picked up steam in 2025 vs the last two years. High quality buildings are doing much better than lower end, and performance across markets is also highly varied.

A good example of this can be seen in the occupancy over time of the office REIT Cousins, which owns primarily class A sunbelt assets. Cousins’ physical occupancy is basically back to the lower end of pre-covid figures, and their leased occupancy is 1-2% off. The last few quarters have been quite strong, and at this rate they may well get there by early 2026 barring a downturn.

Compared to overall office occupancy levels in its markets, Cousins is outperforming by a good deal. Taking a look at Atlanta (their largest market), we can see that overall market vacancy is around ~17.5%, down from a high of over 19%, but still well up from the ~14% pre-covid levels still. This weaker performance highlights the flight to quality trend we are seeing in office space.

Market wise, NYC continues to lead the pack, with vacancy down to ~14-15% depending on the data provider. Interestingly the visits data is back above precovid at least by the measure of one data provider, Placer.ai, although it really isn’t clear to me how that can be the case given the lower occupancy figures today. Certainly anecdotally to me walking around midtown it feels as busy as ever.

The west coast continues to lag, but the quarter over quarter leasing gains have been quite strong for SF and Seattle to a lesser degree. The size of the hole is still very large, but AI is finally starting to show some dividends for the west coast tech markets & the tide has hopefully turned out there. While I am concerned about an AI bubble, the actual employment here is still quite small and I do think long term the sector will be quite significant. So I believe AI will be a nice demand driver over the long term even if in the short run things soften.

Finally, and this saddens me greatly to report but REIT BXP is starting a huge new midtown Manhattan development at a combined basis $2.1k psf, which would be a record. This historically has been one of the great problems with the office sector, that it has some of the most aggressive developers of any asset class and a continual propensity to build more supply than the market needs.9 Given VNO and SLG have also talked about new developments, I worry that NYC’s nascent landlord’s market may be hobbled by new supply before it even gets off the ground. Hopefully we get a few good years in at least.

Multifamily / SFR

In the residential rental space we continue to see sunbelt weakness with relative coastal strength. This is easily seen in EQR’s market but market results below.

Other expansion markets are mostly Atlanta and Dallas with a bit of Austin.

To me the most interesting thing is just how weak the Sunbelt remains - negative 10% YoY new rent growth is absolutely brutal. But, it is a bit better than Q1.

The next most interesting thing is the acceleration in San Francisco. The REITs spoke about this a bit in Q1, but that market seems to have really starting to blow up here in Q2. Anecdotally I also see & hear people complaining that the market has begun to get a bit crazy out there, presumably due to the flood of AI spending & capital.

Prices for apartment REITs have fallen ytd on the operational weakness, and now many trade for ~6% cap rates. A few companies are somewhat interesting at this level, and certainly it is a better option that buying private deals at a ~5% cap rate.

SFR results are a bit better, but not by much & less than many analysts predicted. They seem to be somewhat held back by the rise in new development build to rent communities & declining apartment rents, increasing competitive pressure.

Finally the single family for sale space continues to slow down. The big builders tried to put on a good face, but starts and margins continued to erode (albeit for several at a better pace than earlier in the year). But I thought the CEO’s commentary of Builder’s FirstSource (BLDR), a large supplier, was pretty interesting where he is basically saying ‘ things are worse than you think’.

BLDR, given its position in the supply chain, should be a leading indicator for single family starts, implying starts are going to slow more soon. It seems that many of the public builder’s positive results may be more burning off starts & lots from earlier in the year vs new starts, implying Q3/Q4 might start to look uglier.

It really feels like the housing market is starting to slow significantly, and I worry things could break. But I am hopeful the downturn will be more regional as we have seen in many past recessions, likely concentrated in sunbelt markets like TX and FL.

Hotels

The hotel market continues to be ‘meh’, held back by economic uncertainty and reduced foreign visitation. Revpar growth has been ~flat, but ebitda is slightly negative due to continued margin erosion.

Interestingly, group growth has petered out, frankly way earlier than I thought. This is a miss on my end and is unfortunate for Park’s group centric portfolio. That said while group is no longer outperforming, it isn’t bad by any means, and encouragingly 26 looks to be set up for strength again.

Prices have picked up a bit here from fairly depressed levels earlier in the year, so the risk/reward doesn’t look quite as good but still overall attractive due to the high yields despite mediocre operating results. Realistically though it may be awhile for a big rally, at least until fundamentals improve a bit.

Interestingly for hotels, and really all REITs, is that the fall in yields due to expectations of potential recession is driving values higher - in other words the market is assuming the changes in cap rate & financing costs will outweigh any potential declines in income. This usually doesn’t happen, but it did in the 2000s bust (for most asset classes, office got crushed), so perhaps if we have a 2000 type replay something similar will happen here10.

Retail

Retail has had the strongest year so far among asset classes, fundamentals wise, a marked contrast from the covid era weakness. The retail REITs are doing ~3-4% NOI growth, really by far the strongest performance of any REIT sector11. This continues to be driven by strong tenant demand and low supply growth, a good combination for landlords. Combined with higher going in yields and capex numbers that should come down as the redevelopment cycle winds down, and I continue to think cap rates will compress relative to other asset classes. So private market returns probably look the best among the major asset classes, at least for stabilized properties. This in turn should help retail REITs despite trading around NAV.

Interestingly tenant demand has seemingly not been impacted much by tariffs, at least not yet, despite retailers’ significant exposure here. Here is Simon’s commentary from their last earnings call.

Tariffs remain to me a significant risk, but lower overall tariff rates and the recent appeals court ruling the IEEPA based tariffs are entirely illegal (which on the face of it seems correct to me) has reduced the risk somewhat. This case though will go to the supreme court, and it is difficult to handicap how they may rule, so I do think there is still meaningful tariff based risk out there for retailers. Overall it is a situation that bears watching closely, but the outlook here is much more positive than it was last quarter (albeit still worse than beginning of the year!).

The key value driver here in my view is the de minimis supply growth - in a few markets values are now getting to the point where new construction can be justified, but in most places values and rents are still safely too low to warrant new construction. This provides a nice retail value tailwind and should continue to do so for awhile longer.

Financial markets

The financial markets continue to be fairly open despite high rates and macro chaos. This is probably seen most easily in the nearly record low credit spreads, and in the small YoY total issuance growth we have seen.

Now it is worth noting that spreads were low for an extended period of time pre GFC, as well as post, so this may well be fairly sustainable in and of itself.

Real estate specific lending feels a bit weaker than the overall corporate market, as many smaller banks still are not lending much as they digest their covid era low rate loans. But the CMBS market has largely stepped into the banking void, with first half issuance up a whopping 35% over 2024.

The real wildcard here is where inflation and interest rates go. It seemed like we were firmly on a path to lower inflation before the whole tariff debacle, now it is harder to say. Recent readings have come in a bit higher, driven by stronger goods inflation, but it is difficult to know if these are more one time in nature due to the tariffs, or if this could kick off a second wave of inflation.

Even worse is the potential for a disconnect between the Fed’s rates and inflation. Trump and his goon Bill Pulte have attempted to weaponize the federal housing agency’s information on housing loans to remove Fed governor Lisa Cook, as part of an overall attempt to force lower interest rates. Specifically, Pulte claimed Cook fraudulently claimed two homes as primary residences on mortgage applications made fairly close to one another. This charge, if true, would be pretty dubious grounds for removal (it even turns out Pulte’s own parents did something very similar!), but recent evidence has come out that it isn’t even true.

This is really ugly, nasty behavior by the Trumpistas, something you’d expect to see in a third world country. It is frankly shameful to see this in America - Pulte is an embarrassment and should resign.

The investment repercussions, beyond the erosion of rule of law (which is a really big deal), are that if Trump is successful in installing new governors / intimidating those who remain into lowering rates, we could have a situation where the short end of the curve drops quite low while the long end stays relatively high. The would likely encourage a lot of short term borrowing in order to take advantage of lower rates, and could create a volatile dangerous situation in the future. But we are not there yet - Cook is fighting her firing, and Trump has only one minion on the fed, although he will likely have another within the next 6-10 months due to an upcoming lawful appointment. At 3 of the 5 independent governors he would effectively have full control over the fed, a scary proposition12.

I worry about Trump instituting Peronist style policies in the US, with the end result being an erosion of US competitiveness & inflation / dollar devaluation. I have not been able to bring myself to switch most of my cash out of dollars but I am strongly considering doing so, along with potential international equity diversification13.

Fin

Overall it feels like there are many cross winds buffeting the economy, but nothing has capsized the boat yet. However the recent slowdown in jobs is very concerning & we may be close to reaching a tipping point on a downturn. And yet we have all time highs in the market, memestocks, crypto frauds - heck Chamath even launched another SPAC. It feels like a dangerous combination of froth built on weakening fundamentals.

Commercial real estate continues to muddle along in its recovery from the recent pricing slump, with performance highly variable across asset class and geography. I am hopeful that if we have a downturn the impact on CRE will be mitigated by the decline in rates, which should hopefully offset some of the income losses. But it is hard to say, and overall I am as defensively positioned as I have ever been, with a large cash position and a good sized short book as well. We will see if that proves wise or not. As always, thanks for reading.

HPP Share Sale

The first is about west coast focused office REIT HPP. On June 11/12 HPP announced an absolutely massive ~$660 million sale of shares and warrants, which was almost 2x their then market cap. The shares and warrants priced around $2.22 per share. This was and is just a crazy raise - I’m not sure there has been anything like it since 2009. The level of dilution of existing shareholders is absolutely massive. My NAV for HPP before the raise was ~$6.5 / share, and Green Street had them at $6.7 or so I believe, so the raise was well below NAV1.

HPP is one of the worst performing REITs since pre-covid.

Surprisingly to me, the market reacted positively to the and the stock rallied up from ~$2.5 to $2.75 right after and is trading for around ~$2.65 today. I suppose investors think this takes a good number of bankruptcy scenarios off the table, as HPP intends to use the funds to pay down debt.

I however took a much more dim view of the raise - while HPP still trades below its new diluted NAV of ~$3.75, I am very disappointed and shocked management elected to pursue massive dilution instead of selling assets. In my view there are really only 2 interpretations here. The first is that my NAV is very wrong, that they tried to sell a number of assets, failed, and thus resorted to the raise. I don’t think that is correct, as there have in fact been a number of decent trades in SF recently (a large portion of HPP’s assets are in SF & Silicon Valley) and fundamental momentum in the city & valley seems to be turning the corner driven by the AI boom. But obviously I could be wrong here!

The second is that management could have sold more assets, but elected for a massive dilution as this was some combination of easier for them and allowed the business to retain a larger scale, which of course allows them to justify higher salaries.

Neither option is good, in fact I’d say they are both terrible. Either the new NAV is much lower (and therefore probably below the current share price), or management has proven they do not care about shareholders at all. So I sold all my shares here.

Long term I do feel like there could be significant upside to the NAV as the tech office markets recover, albeit over a 6-8 year period given the depth of the hole. So one might wonder - given this massive dilution what else could management possibly do to vaporize shareholder value? Unfortunately I think the answer is ‘a lot’, due to HPP’s studio business. This has always been an oddity in the REIT world, but recent performance has been an absolute disaster. The reality is that HPP invested heavily in in this space at peak values & utilization rates, and continues to pursue new development projects here despite poor fundamentals and capital markets.2 A return to strong studio demand growth is by no means guaranteed long term - new productions have proven quite mobile in order to benefit from tax break offered by various cities (Atlanta being a notable example of this). There may also be potential structural issues long term with media production in a streaming world. Furthermore supply growth has been massive and continues to be significant in spite of the poor fundamentals fundamentals. Given management’s awful track record I am very concerned that they will continue to misallocate capital into this sector.

Perhaps I may come back to the stock in the future if we can get through some of the overall recession risk & management can prove they are committed to not lighting more capital on fire. But for now I am done with this investment.

ILPT Refinances

The other big piece of news as relates to the portfolio was with Industrial Logistics Properties Trust. This is a highly levered industrial firm with a mix of standard warehouses, long term Fed Ex’s and ground leases in Hawaii, created via a disastrous merger several years ago.

ILPT has traded well below its NAV due to I believe a combination of the overly high leverage, and an outside manager with a poor track record. Even if you allow some discount for the manager, it still traded for pretty cheap levels. Even today after the rally it is around a ~7.2% cap rate - that isn’t a huge spread from fair value on an absolute basis, but the high leverage makes for a very large stock NAV spread. The Fedex portfolio and Hawaii assets provide a good amount of stability which allowed me to feel more comfortable with the higher leverage levels.

ILPT had floated the idea of selling assets to reduce debt over a few years now, and I had been expecting ILPT to begin to do so once rates began to fall. Obviously rates have not fallen, and the firm began to come closer to it’s debt maturity dates. I was hoping ILPT would sell some assets to pay down debt into the current market, which is fairly robust in terms of activity albeit at prices well below peak a few years ago.

Instead ILPT has elected to pursue what I viewed as sort of a worst case scenario, which is to refinance the entirety of the debt and continue scraping along with their high leverage levels.

Again interestingly, the stock rallied significantly on this news. I don’t really understand why this might be - even if they couldn’t actually get a refi done, being forced into BK by the lenders would actually probably be a net positive as there is plenty of equity value and it could force out the external manager and lead to a sale of the assets. But I suppose other investors may not appreciate the value here and a simplistic debt refinancing = good may be driving the price action here.

Regardless I have taken it as an opportunity to sell most of our holdings at a very nice gain. It looks like management is committed to scraping by with minimal free cash flow in order to maximize the size of the asset base. I shouldn’t be terribly surprised by this given RMR’s weak track record (this is the manager), but I was hoping that this scenario was fairly straight forward and that given their incentive fees they would be aligned to try and raise the stock price via asset sales, debt paydowns, and the institution of a real dividend. But instead they whiffed. They did announce a dividend increase to ~$0.20 per share and we may get another one from here but by my calculations ILPT’s payout ability is still fairly limited, and leverage levels remain very high.

Again perhaps in the future I may come back to this stock, but right now there are better opportunities with superior risk reward ratios out there.

So now that the macro world has calmed down as has some of the privates work, hopefully we are back to regularly scheduled programming.

Please read the disclaimer HERE - nothing here is investment advice.

First, the returns as always. We are down slightly at -1.32% for the year, vs 0.19% up for the USRT, and 5.4% for the S&P. We closed the gap significantly YTD with the USRT from Q1, however the S&P gap widened. Nonetheless I remain pleased with our long term outperformance since inception at 186%, vs 57% for the USRT and 130% for the S&P.

While I am not happy we are down for the year, overall I think we had a very nice quarter. We improved significantly from Q1, and had very strong performance against the overall REIT index. More importantly, I feel very good about where our portfolio is today.

The portfolio remains vast majority REIT focused, but I have begun to opportunistically invest in other stocks as I mentioned I would begin to do. In fact one of these other investments, Sportsman's Warehouse, was a strong driver of our performance in the quarter. We invested in SPWH in Q1 and early Q2, at an average basis of $1.68/share - now it trades at ~$3.5 due to strong Q1 results (although very volatile!). The investment here was fairly simple - Sportman’s is a sporting goods & hunting retailer with a large focus on firearms, which has suffered from a covid demand pull forward hangover, over expansion, & mismanagement. Same store sales had been negative for several years now, but a new CEO was brought in and seemed to be making progress turning it around. At our investment price, the stock was dirt cheap if the turnaround was successful - a mere 3x stabilized ebitda (which would itself be well below pre-covid margin and store level sales). The turnaround is certainly not done, but they posted positive same store sales in Q1 for the first time in a long time, and continue to reduce costs and improve margins, triggering a big rally. Critically for me, the category feels like it has real legs, as competitors Dicks and Bass Pro were doing fairly well, and the store base is actually quite new and nice2. The main downside here (thus far) is this was a relatively smaller position, so the overall fund impact isn't enormous. Still - if we have a recession Sportsman’s may be put into a difficult position of seeing sales fall again before their turnaround is complete, so there is real macro risk here beyond the execution risk.

Economic Picture

Big picture, I am still fairly nervous about the economy. I think the markets are being overly sanguine about tariff impacts and also the continued impact of higher interest rates (which has been stretched out due to tariff uncertainty). Hiring is mixed - ADP showed it turning negative last month, and on a 3 month pace is the slowest since covid. However the US BLS jobs data continues to be fairly positive - the one fly in the ointment there is that while the topline numbers are good, the composition is not great. Job growth for the last month was almost entirely government and healthcare, and likely seems reflective of our massive 6%+ of GDP fiscal deficit. However government spending alone cannot power economic growth in the long term.

Critically, the housing market continues to weaken, especially in Texas and Florida, as high prices and high rates push affordability levels to all time lows. Here is a nice chart showing mortgage payments to income from Nick Gerli, who runs a housing data firm. (his twitter handle is @nickgerli1).

When you factor in insurance, which has really risen recently, this is likely even worse.

Aside from government spending, it feels like the only thing keeping the economy running is the AI boom. It is very hard to know if we are in a 1997 type ongoing ramp up, with the biggest surge yet to come, or if we are getting close to the edge. Frankly I feel like we are already seeing some 1999 type levels of froth in firms such as Palantir, Microstrategy and Coreweave3.

On the bright side the tariffs figure appear to have come down from the potential worst case levels, however they will still present economic headwinds it looks like even in a best case scenario. And it very much feels like there is risk here the market is not pricing in - just yesterday Trump announced large tariffs on a whole host of countries, while also extending the self imposed broader deadline to August 1st.

Further in the good news category, inflation itself has actually continued to tick down.

We are basically back to pre-covid levels of inflation, if the current trends continue. The big question of course, is if these trends will in fact continue. We still have very little clarity on where tariffs will shake out, but they are already causing some prices to rise and the impact could potentially be much worse in a worst case scenario.

I do feel like given the Fed’s hawkish stance, inflation will remain low and any tariff driven increase will be a temporary shock. It is painful in the short run, but I think long term will mean it is more likely that we get back to pre-covid levels of inflation (or at least close to that) and thus also lower interest rates. It also probably means a recession of some form is much more likely – potentially something highly regional like we saw in the early or late 90s.

The high rates are causing the sunbelt housing engine to slow, and the next few years might get rough in certain markets. Unsold homes are piling up, and margins are falling for builders.

Construction spending data has also turned negative - this has almost always come with a recession in the post war period, except 1966 when spending turned negative without a downturn.

If the tech boom can endure I would bet on coastal metros to outperform, and techier sunbelt cities to do fairly well (except perhaps in apartments where oversupply endures, at least in some places). If tech also goes belly up, things could get much uglier.4 I think what happens here is highly dependent on progress in AI models - if we continue to see good progress the boom will almost certainly continue. However if things stall out the stage is set for a slowdown there. The current reinforcement learning and model scaffolding vectors feel like they have legs for a bit longer, but cracks are starting to show here as overall model improvement has slowed dramatically and is now more domain limited (albeit to some very large domains like coding). I would wager on this slowing down in the next year, but wouldn’t be that surprised if it went on for longer5.

Hedging

Despite the uncertainty, I feel quite good about our portfolio. Our real estate assets are trading at high yields and significant discounts to private market and historical prices. If/when rates decline, we should be very well positioned to benefit. We have a good deal of cash, and I have also taken out some hedges around the downside risk, specifically focused on what I view as one of the most over-valued stocks in the market, Palantir.

Palantir is a software firm which originally focused on government clients and has since expanded into the private sector. As far as I can tell, Palantir offers more ‘secure’ versions of basic software to clients in government or regulated businesses such as healthcare or finance, and also has a large custom software creation & consulting business. The reason I hedge here is that Palantir itself is very broad and vague as to what it actually does, but the above is my understanding from ground level research.

What is interesting about PLTR is the valuation. Palantir, trading at a wild ~nearly 90 times revenues and 400+ times earnings as of this writing, is by some measures the most expensive large cap stock ever to exist6, and is still one of the most expensive ever when looking across any stock size.

This FT article, which came out a little while after I put the hedges on, covers things nicely. Link here - it features work from a firm Trivariate research who seems to have had much the same idea I did.

Excerpt from the FT piece - it is worth a read in full.

Many of the firms with similar eye-popping valuations historically had huge assets which were not yet generating cash flow (biotechs, LNG terminals, etc). If you strip those out, there are hardly any firms that have ever been this richly valued, and basically every other firm that was has done poorly to horribly over the next several years post peak.

Another way to think about PLTR is, how much would it have to grow to justify the current stock price? A rough heuristic used in the tech world is good software companies trade for 10x revenues. Really good ones can be higher (or during frothy markets). One could argue (and I would argue this!), that this level itself would be much lower during a down market, but lets just assume it is fair for now. MSFT for example is ~13, Google is actually only ~5.5 for some context.

Given PLTR trades at ~90 times sales, what this means PLTR has to literally ~9x their revenues to grow into the current valuation. Lets say PLTR can hold this value for 5 years – to grow into the valuation over 5 years means an annual revenue growth rate of 54%, per year. Over 7 years that number is 36%. Palantir’s own 5 year measure here is a bit over 30%.

Now – is it conceivable that Palantir eventually can grow its revenues from the current $3.6 billion to $32 billion in the next 5-7 years? Certainly. But it would rank among the fastest growth rates at that scale of nearly any firm, ever. And I believe it would be by far the fastest of any software firm of this size.

The biggest revenue growers of all time are products that are consumer oriented, particularly with network effects (Meta, Google, Amazon). This is because the consumer market is the largest market, and network effects can power rapid growth.

The other big bucket of really rapid growth at scale has been cloud services. This is a capital intensive business, but nonetheless is extremely broad in scope as it targets almost any firm. That field has only sped up as it bleeds into general consumer use via AI.

Business software on the other hand, is typically limited to a given market and use, and often has long, difficult sales cycles. And the total value one can charge for the software is limited by the specific value provided and the use case.

A simple example is something like property management software for an apartment complex. Even if you’ve never managed an apartment, likely you have lived in one and can imagine the kind of features software might help with. Tracking rentals, processing paperwork and payments, etc.

So the key issue here is that the software is often very specific. Some components (say signing documents digitally and storing), are obviously common, but others, like tracking tenants and creating a rent roll, are fairly specific to a given use case.

This means the scale of the software is inherently limited by the market it targets. Now one can always add new features (if you can find something users want), or even expand into entirely new markets and products, but fundamentally any given piece of business software is relatively limited in how big its sales can get.

This means business software firms often grow quickly for awhile, as they pick up customers in their initial niche, but eventually slow down as they saturate their given market.

To expand further, they need to build new software products. This is often difficult outside the initial target market.

So fundamentally, business software has just never grown at the rate Palantir needs to growth to justify their valuation, at Palantir’s scale.

Now Palantir makes some very broad claims about what their addressable market is, and who knows, perhaps they really are able to grow at 55% per year for the next 5 years7.

But I’m willing to take the other side of that bet, particularly as a hedge. If we have a recession I will bet that tech multiples are not 10x sales, but closer to 5x or even lower. That would of course compound with belt tightening and slower revenue growth… it wouldn’t be crazy at all to see Palantir trade as low as $10/share in a rough downturn in my view. That would be ~6.6x current revenue, call it 5 with a bit of additional growth.

You can buy puts $40 dollar puts 2.5 years out for ~$4. If we have a bad downturn these could be worth 5x if the stock goes to $20, and 7.5x at 10!8

The beauty of this particular hedge is that not only is the risk/reward skew huge in a downturn, there are a number of non downturn scenarios in which you can get paid as well (albeit likely for higher dollar strike prices, although very possible a $40 gets paid in a 22/23 style tech decline).

There are of course risks here – but as a hedge it is difficult for me to see a scenario where we have a recession and this stock doesn’t come back down to earth. And in a world where it doesn’t I feel fairly good about the rest of my portfolio doing very nicely. The biggest problem with something like this is the fixed nature of the timing with the set 2.5 year window. However in my view that is worth the asymmetric upside achievable, and the fixed downside limit, as compared to a pure short (especially in todays post memestock world). Especially given how wobbly the economy feels right now. So all together I believe the expected value of this investment is very high - but critical to understand there are a good portion of outcomes which are a zero! So these kinds of investments cannot be a large part of a portfolio (unless absolutely uncorrelated).

That is a lot of writing for something that is a relatively small position, but it is a different kind of investment from what I have typically written about so I wanted to cover it in more depth.

Fin

This is starting to run long, so I will again split this into two articles with a second CRE focused piece to come later. There is a lot of news to share there, in general and as relates to some of my investments. If you come here for the real estate commentary, sorry you didn’t get much of that today - you’ll just have to wait for the next article!

As always, thanks for reading.

First though as usual - nothing here is investment advice. Please read my full disclaimer here.

As a quick refresher, a land bank is an entity, usually associated with a homebuilder, which owns the homebuilder’s land inventory. There is a pretty wide range of structures here as far as I am aware, from wholly owned subs on balance sheet to off balance sheet with outside capital. The general point of a land bank is to segment off the land development component of home building, which is capital intensive and can take several years, from the home building piece, which while also capital intensive is much quicker, often taking only 4-5 months. This is generally part of an attempt to convince the market to treat a builder as more akin to a manufacturer than a real estate development business.

Lennar used to have most of their properties on balance sheet, but they recently spun off their land portfolio into a publicly traded entity called Millrose Properties. It sounds simple enough, but the structuring here is actually fairly complex and kind of crazy (and interesting) in my view.

The first thing I found interesting / odd is that Millrose is structured as a REIT, with regular dividends. Homebuilders are precluded from being REITs because they turn over their assets too quickly to comply with REIT rules. Now I’m no real estate attorney but Millrose / Lennar seem to have opted to use a very interesting and unusual strategy to work around this - they created a $4.7 billion dollar loan from the sub which holds the land to the REIT mothership at a 7.5% interest rate. REITS are allowed to hold mortgages (indeed there are loads of mortgage REITs), and so it looks like Millrose has taken the position (and presumably some regulator blessed it) that the mortgage ‘cleanses’ the bad home sale income and makes it REIT compatible.

The legal structure of how Millrose is actually paid by Lennar whereby they get monthly option payments and the land sale is just return of capital (more on this in a moment) may also contribute to making this legally OK - said structure is also very interesting and frankly not a great deal for MRP.

Lennar obviously wasn’t going to spin off their land bank without having some influence and control over the land going forward, but still the structure is really something else.

Essentially what Lennar has done is given themselves permanent 80-90% LTC financing for their land development at a 7-10% interest rate (starting at 8.5% today), in perpetuity, at terms far more generous than any lender would ever give. It’s a phenomenal set up for Lennar and an awful one for MRP shareholders.

Let me explain. Essentially what happens is this - Lennar contributes a 5% deposit based on total cost (land + horizontal development costs, so roads, utilities etc) for the right to an exclusive option to purchase finished homesites. Lennar must pay a second 5% deposit either at termination or, oddly, seemingly at MRP’s option based on MRP cash needs1. For simplicity of analysis, we can assume land and horizontal costs are 50/50 (in high end markets land is higher, cheaper horizontal is higher), and that the deposit is paid up front. This translates into what is essentially a 10-20% equity payment by Lennar for the control of the land parcel. Millrose in turn funds the land acquisition costs and the horizontal development costs.

The equity analogy is imprecise but close enough for a rough understanding as this is the capital Lennar has at risk of a loss. If Lennar were to walk from the option before any horizontal work is done, the loss is 10% (in our 50/50 value scenario). If they walk after everything is done, it would be more like 20%.

What Millrose receives in return is a fixed monthly payment, basically like interest on a loan. It is fixed at the time of each deal, based on a spread, but within a range of 7-10%. Critically, MRP receives zero upside from any land value appreciation - they must sell the finished lots to Lennar at cost!

Another thing that is crazy is that Millrose essentially has to accept any deal Lennar brings to them (presumably assuming MRP has enough capital, though I’m not 100% on that), so MRP is basically a captive entity.

There is even more ugly structuring here. This bit is somewhat unclear to me, but it looks like there are no clear guardrails on the price MRP pays for the land in the first place, nor how exactly the initial entitlements process is handled.

MRP can own land that isn’t entitled, but they heavily advertise that most of their land has no entitlement risk and that they don’t intend to take much of this on.

Mostly is quite vague & broad.

However from my quick review of the relevant agreements, I can’t find anything actually limiting how much unentitled land MRP can own.

And the problem is, all new land needs to be entitled. This process (procuring correct zoning and utility approvals) takes a long time, costs a fair bit of money, incurs some risk, and most importantly can create a huge amount of value. So this begs the question, how will the pipeline be refilled? Lennar seemingly controls the entire entitlement process, and as far as I can tell can bring a deal to MRP when Lennar wants. This creates a host of potential issues for conflict, to the benefit of Lennar and detriment of MRP.

The biggest issue is that Lennar could bring an unentitled parcel to MRP, and have MRP buy it at is unentitled value. Since MRP’s deal with Lennar is at cost, this means Lennar gets to effectively buy the finished homesites at the unentitled value, without assuming any of the entitlement risk!

As an aside if you are not aware, the price of unentitled land vs entitled land is often dramatically different, depending on how difficult entitlements were to achieve etc.

That is all pretty bad for MRP, but I have saved the very best for last. Lennar has a unilateral right to halve payments to MRP for 6 months (they call this a ‘pause period’), something they can do twice, with no penalties or cost! On top of that Lennar has what seems to be a permanent right to implement additional pause periods whenever Lennar wants, and the only cost appears to be a loss of their fixed rates of return (eg presumably the parties would have to negotiate a new rate so this would free MRP a bit, but there are so many other hooks in the docs I feel like this wouldn’t mean much).

Oh and as a cherry on top, MRP is paying a hefty management fee of 1.25% of assets to an external manager, Kennedy Land, for what appears to be basically just rubberstamping Lennar’s deals.

So there we have it. A permanent, ~85% LTC lending facility for land development from a captive entity at 7-10% interest with a right to halve interest payments essentially whenever Lennar wants! Incredible.

Are there any positives here for MRP shareholders? The one saving grace is that the firm is trading at a decent discount to the book value of its assets. As of this writing MRP is trading at ~$4.4 billion vs ~$6.6 billion of assets (the liabilities seem to just be Lennar deposits which MRP gets to keep in most scenarios so we can ignore them).

The ~6.6b in assets yields ~8.5% gross, or closer to 12.75% gross against the current $4.4 b in value, or ~11% net after management fees and likely other expenses. On an absolute basis that seems OK, but this is for what is essentially a land loan. Land, for those who do not know, is basically the most volatile part of the real estate market, as its the plug between value and cost. If land is ~10% of value of a home, and home prices decline 10%, guess what? The land is basically worthless2. Across the US the rule of thumb is land comprises ~20% of a final home’s sale price. In affluent supply constrained markets that can be much higher, in rural areas even lower.

If you own the asset, that can be OK as your downside risk is counterbalanced by significant potential upside as well. The problem is a lender has no claim on the upside, but is fully exposed on the downside. Lenders are aware of this dynamic and as such do not like making land loans, typically they require low LTCs, high interest rates, or usually both.

Lennar is also aware of this, and so it looks like they created this interesting beast to circumvent the lending market entirely. Now the cost wasn’t free - Lennar lost ~$2.2 billion on the spin in theory based on current stock price. However I suspect that management believes that A) their land holdings weren’t being appropriately reflected in their market cap anyways (this is extremely common in public RE), B) offloading the land to a captive entity will allow for increased margins and profits, & C) this will also allow more consistent earnings and potentially increase Lennar’s multiple, or some combination of the 3.

MRP being public also gives more advantages - now if Lennar wants to expand, they can do so on MRP’s dime using the equity markets. MRP is already looking at ways to raise additional capital (all of which would be bad for shareholders, either raising equity below book value, thus dilutive, or levering up what is essentially already a highly levered company).

In fairness MRP is trying to expand outside of the Lennar relationship, which would be good if they can get better terms but if they are just offering the same deal to other builders this is just more of the same awfulness.

Fin

Overall - a structurally flawed entity on many levels, and the current pricing doesn’t feel cheap enough to ignore the flaws. The discount is decent sized though and the dividend yield is relatively high, so I can’t bring myself to short the stock, but this certainly isn’t something I will be investing in at current prices. Usually when I find a bad deal I stop far earlier in my research, but this company was so unique and interesting I couldn’t help myself but dig in a bit more & so thought I would share what I saw.

As always, this is not investing advice and please read the general disclaimer, here.

First, the returns. We had a solid year - we returned 8.48%, vs 7.60% for our real estate benchmark, leaping from underperformance most of the year back to outperforming on a strong (relative) Q4. When compared to the S&P’s high return of over 25%, it doesn’t feel quite as good, but we did significantly outperform the S&P the past two years, and you can’t win every single year.

Since inception we are still handily outperforming the REIT index, and also the S&P, with returns of 189.92% (about 25.5% annualized), vs 64.93% for the USRT index (about 11.3% annualized) & 121.20% for the S&P (about 18.5% annualized).

I feel especially good about the fact we are beating the S&P since inception considering that we have zero exposure to the mag 7, which is what is driving essentially all the returns in that index (and big tech in general really).

To illustrate here is an interesting chart from the FT showing the increasing concentration in the S&P.

FT article link here

Of the top 10 stocks, all but 1, Berkshire Hathaway, are tech related. Now in fairness, big tech has had a magnificent run of generating increasing profits and cash flows, so to some degree it is natural we have this level of concentration. The risk in my view is that if the growth slows or stops, we come crashing back down to reality as the market is increasingly tied to the fortunes of a handful of firms.

And what is driving big tech’s growth? Well over the last decade it was ‘software eating the world’ as Marc Andreesen famously predicted. However past is not necessarily predictive of future, and things look a bit different looking forward vs back.

Now - I’m not a big tech expert, but I do feel obligated to stay somewhat on top of the goings on there simply due to the aforementioned massive economic concentration (and CRE generally gains on population growth and income growth, big tech being a huge driver of the latter).

As I’m sure you are already aware, AI has been and continues to be all over the news, specifically the subset called generative AI, powered by large language models or LLMs mostly. The recent advances in this field have unleashed an investment boom of historic proportions, largely in the data center and semi-conductors world.1

How big is it? Well it looks like based on estimates from economist Skanda Amarnath (full article viewable here on Bloomberg), we are getting close to 2000 levels for telecom & data centers.

This is especially relevant, because the capex spend relating to AI on data centers, chips and training / inference time seems to have dramatically outstripped actual AI end user spending.

I had trouble finding good estimates for either of these things, but it looks like there is at least ~$200-220 billion in direct AI related chips and data center spending, if not more (Nvidia and Broadcom’s AI products are ~$150b alone).2

However the end user spending on AI services is much smaller, albeit growing quickly. How much smaller? Well again this is very difficult to find as many firms do not disclose the specifics, but it looks like total spend in 2024 could easily be under $15 billion.

Menlo Equities, a reputable VC firm, seems to estimate enterprise end use spending (so not the capex models / training / servers part) at $4.6 billion for 2024, but up significantly from 2023.

On the consumer side - Open AI apparently has a run rate around $5b. If we generously assume there is another $6b of consumer and unaccounted for enterprise spend, we get to maybe $16b of revenues, against capex of probably $220 billion.

Even at a generous 30% profit margin (which is absurd as Open AI lost $5 billion to generate their ~$5 billion in revenues), that’s $5.3b of actual return on $220b of spend, an awful ROI of just ~2.5%! When you further consider much of this stuff has a very short useful life, the ROI looks even worse.

The only way this makes sense is if end use for AI continues to grow at a massive pace for many years. So the next question would be, how much end user spending would we need to justify the capex wave? Well given the useful life of much of this capex (at least the chip part), is a measly ~5 years3, this means you’d likely want a ~30% return on the spend. If we assume some things like data center power/cooling are longer lived and we use 10 years of average useful life, we could conservatively look for a 20% return. That would be ~$44 billion, or nearly 3x the total current industry revenues! But again revenue is not profit, so again using an extremely generous 30% margin, that is ~$145 billion in needed revenues, or ~10x current levels. At a 20% margin its $220 billion, and 10% its $440!4

And this is to say nothing of potential improvements in AI model efficiency, which is very relevant as Chinese firm Deepseek recently released a GPT4 analog model in December and an o1 reasoning type model just the other week. Deepseek’s model is open source, and it appears to be massively more efficient than the leading American models, seemingly due in no small part due to the chip constraints Deepseek had to operate under. Estimates vary but the simplest comparison to me is their price per 1mm tokens (tokens represent model output essentially) - Deepseek is almost 30x cheaper in this regard!

This is a seismic shift in pricing if it holds. To match that kind of pricing would knock down industry revenues from ~$15B to ~$0.5B! Sure utilization will increase with lower prices, but honestly I don’t think pricing is a huge holdup right now for many users. Most of ChatGPT’s revenue appears to come from its basic $20/mo subscription - this isn’t exactly terribly expensive. If you drop that to just a dollar a month I’m sure they would get more users, but I don’t think it would be 20x. 2-4x seems more realistic at best case. So conceivably the industry revenue could drop to something like $1-2 billion in a worst case scenario - I don’t think this is likely but it illustrates the scale of the problem.

Will AI end user spending grow in 2025? Very likely yes.56 Will it continue strong growth thereafter? I would also bet yes. But will there be a sufficient return to justify the current massive capital spending? It seems very unlikely to me, especially now with Deepseek’s massively lower pricing.7 What feels more and more likely is a cousin of what happened in 2000 - hype and mania lead to overspending on capital, creating poor returns for the investors but dramatically reducing cost of the physical side of things, allowing innovation to continue at a nice clip. The billion dollar question is, is this 1999 or 1996 as relates to AI capex spend?

As I wrote this piece originally I was leaning more 1996, however the release was delayed awhile because I got sick. During that time we had OpenAI announce its teaming up with renowned capital incinerator, Softbank (and Oracle) on a supposed $500 billion dollar project. This is just silly, Softbank does not have nearly enough capital to fund even a portion of this, nor does OpenAI. Further Softbank is apparently in talks to invest in OpenAI at a reported ~$340 billion valuation, 2x their last value from just October! So yeah now I’m feeling more like its 1999.

It is obviously extremely difficult to predict something like this, and my view here is not strongly held. I do believe tech is the most important non political swing macro-economic driver though and as such bears close watching.

Ex tech, the forward momentum of the economy was looking fairly shaky for much of 2024, but has improved steadily over the last few months. As I mentioned previously, the Sahm rule (relating to increase in unemployment rate) was breached, and unemployment shot up pretty quickly earlier in the year. Thankfully it has since come down, and with the last jobs data we got on the 10th the recent trend is looking like perhaps it has stabilized.

Interest Rates & Valuations

Moving on to the other big piece of the puzzle, valuations and the cost of funds. On that front, the market had felt fairly to highly valued to me, but with the recent selloff some things are beginning to look more interesting. REITs in particular feel more fairly valued than over-valued, but with notable exceptions in both directions.

The biggest story, at least as relates to CRE, is probably the recent spike in interest rates.

The 10 year is up about 90 bps from its low in the fall, down slightly from over 100 a few weeks ago. This is obviously bad for financing costs, and all the myriad industries dependent on it (most notably real estate, but really anything hard asset driven). It also is not great for generic valuations across any investment asset, as the risk free return is higher.8

What is driving the increase? It doesn’t appear to be inflation, at least to me. Inflation had ticked back up in the fall, but came down significantly in the December and January data.

Source: Jason Furman on Twitter, give him a follow @Jasonfurman

Unlike last year, treasuries don’t seem to be moving much on inflation releases anymore (eg a year ago when inflation was the big narrative we would have seen a big drop in rates from the recent very low PCE inflation release). We saw a bit of easing with the PCI and CPI, but not as dramatic as last year’s moves.

My best guess is the market is pricing in higher inflation & supply disruptions due to potential Trump tariffs and also continued large fiscal deficit spending by the US govt (and indeed all western governments). This is also showing up in an increase in government bond yields across the west.9 This combination of fiscal deficits and supply disruption is a potent, potentially stagflationary brew. Thus, the return of the bond vigilante.

There is much talk of cost cutting with the new DOGE commission, but unfortunately the only way to really decrease government spending in a meaningful way is entitlement reform or to reduce military spending - non defense non entitlement spending is something like only 15% of federal spending I believe. And it doesn’t seem like anyone is ready to have that conversation yet, so continued large deficits seem very likely unfortunately.

As always though predicting the future is very difficult, and I do not have a high degree of confidence for how 2025 will shake out. Trump is already moving to impose high tariffs on Mexico, Canada and China - if the tariffs remain at current levels they could prove quite disruptive and create a huge drag on economic growth. At current levels the tariffs would be ~1% of GDP, which doesn’t account for the likely retaliatory tariffs we will see in response. The tariffs look very bad, but Trump has already within just a few days seemingly reversed course on the Mexican tariffs and promised to delay them for a month. The whole situation frankly is just pure chaos.10

I believe this means that the general economic growth/demand path has a pretty wide potential variance in outcomes, which calls for caution. Tech capex could continue to be a strong driver, or it could begin to unwind11. Small business optimism is up significantly, which could be a potent tailwind. Tariffs could range from relatively benign to disastrous. Given relatively high market valuations this is not an attractive combination.

Reflections on 2024

In keeping with tradition, I also try to look back at the prior year and reflect on what went well or poorly in my investments. We outperformed the REIT index which is nice, but were well below the S&P. I can’t control the S&P, so really all I can do is look at my own investments and what dragged my performance down. And the main drags on my portfolio were as follows.

First, the largest drag. I have a few small cap investments which declined despite the overall rise in CRE pricing & REITs. Generally speaking I still feel decent on these, although one which is quite small and lacks a specific catalyst I am feeling less good about. The other, ILPT, has a potential catalyst in the form of loans coming due in 2 years, which should force some kind of action that will hopefully de-lever the firm (or even trigger a sale). Although it is entirely possible they are able to refi the portfolio as is and just continue to scrape by while sweeping all free cash flow into management fees (the worst case scenario).

I think my biggest mistake here was investing as much in these while other larger, more mainstream investments were also quite cheap. I did this somewhat in the name of diversification, least I become too concentrated in a few stocks.

I think though given my high confidence levels in the more mainstream bets (VNO , MAC etc), in hindsight I should have put less in the small caps and even more in those, diversification be damned12. And then I could have saved the small hairy investments for later in the cycle (or not at all).

The other drag was weakness in Park Hotels & hospitality in general. There were some operational hiccups here (notably a strike in Hawaii, but also a general leisure slowdown), but generally I still feel confident in this investment and think it is quite cheap at current prices. Cash flow is strong and should grow moving forward. So I don’t think I really made any mistakes here… at least not yet.

Looking Forward

Looking into 2025 I still feel like the uncertain macro picture, combined with higher valuations, doesn’t feel like the best risk reward combination, but it is better than it was a few months ago.

Probably the biggest change for 2025 is I intend to look at some non real estate investments. I originally made some non RE investments back in 2022 when real estate prices were high and there were several non RE firms I thought were very attractive.

I decided to close these out in the hopes of presenting a cleaner real estate only focus that I was told would make a better story for institutional investors. Well, I was not able to raise any institutional capital, and selling these investments in fact dragged my returns down.13 My biggest of these was Spotify, which operationally worked out essentially exactly as I thought it would.

So sad to have sold in 2022

Not every non CRE investment I made worked out well, but most did, several in a big way. A&F was another. The biggest loser has been Sportsman’s Warehouse - I still own a bit personally, and it has been painful.

I have decided that doing something for the sake of optics for a prospective LP is foolish given the difficulty in raising institutional LP capital anyways. So the goal now is to find the most attractive investments, where ever they may be. That said, real estate will remain a major focus as I know it best, and the caliber of competition there is pretty low.14 In fact I have spent much of the new year working on a CRE investment which has quickly become my largest position - I hope to do a detailed dive on this soon if time allows.

My approach to non real estate investments is ultimately similar to real estate. What is the current yield the investment can generate, and what are its growth prospects? 15 Then how does this compare to other options, as well as what are the downside risks. The key difference is obviously understanding the operational & demand nuances of different industries, and so here I generally try to stick to things I understand well, or am able to learn relatively quickly. This covers software firms16, consumer goods or retail that I actually consume (or have good knowledge of), and asset heavy businesses among others.

I firmly believe that being a good investor is a general skill, and that it can be transferred across domains with sufficient base knowledge.

Fin

As always, thank you for reading. I am hopeful I will be able to continue generating strong returns for my investors in 2025 and beyond.

Welcome to the second part of my Q3 commentary, this time updated with REIT Q3 earnings. Obviously there were some big political changes between this letter and the last given the Trump election victory. I won’t spend too much time on that as I waxed on macro for long enough in the last letter but my general view is this further increases uncertainty. There are potential economic scenarios here which are quite positive (no or limited tariffs, reduced regulation / increased government efficiency), and scenarios which are very negative (significant tariffs, inflation reigniting from potential fiscal stimulus, tariffs, or workforce reduction due to deportations), or some mixture of the above. Given ongoing labor market measure derivatives are showing softness and high market values (along with some things that just feel outright manic or toppy1), I don’t feel like investors are being paid particularly well to assume possible downside risks. But it is hard to predict.

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Diving into our CRE asset class specifics, we will start with one of my favorites with retail and malls in particular.

Retail

The mall space overall had an excellent quarter with Simon posting a 5% NOI growth for Q3 (and 4.6% YTD) and 100 bps change in YoY occupancy. This is a strong quarter from Simon, and I believe really validates my mall thesis. Given the robust leasing, we should see several more years of strong income growth from the mall sector overall given large signed not opened pipelines and likely future leasing.

MAC had a more mixed quarter with NOI growth of only 1.8% and a mere .3% change in occupancy YoY. However this didn’t stop MAC’s stock from having an excellent quarter (and now year), seemingly drafting off Simon’s operating strength. MAC is currently around $21/share, and management clearly thinks this is fairly valued since they immediately hit the market with a large share offering of 9% of existing share, for about $400mm in proceeds. This pricing is frankly also right on the nose with my current NAV for the stock.

Why didn’t I just put 100% of my investments in MAC again?

While this offering was at NAV which in theory is neutral, I do not love a big offering like this, as I do think MAC is poised for several years of good income growth and thus likely NAV growth as well. The equity offering thus dilutes that future appreciation, and I don’t see the repayment of already reasonable levels of debt as ultra critical as management seems to.2

Also negatively for me is that it looks like MAC is indeed selling assets at pretty poor prices just to reduce leverage. They appear to have sold the Oak at a 13% cap per their latest earnings call - that is pretty rough. Why sell for such a high cap rate? Occupancy here seems to have been trending in the right direction (90% in 23 vs 88.3% in 22 and 85.8% in 2021), and while I don’t have access to all the same detailed leasing information MAC does it seems hard to believe that this asset is going to fall apart in such a way in the next few years that a 13% cap rate was a good price. Its not the best asset - there is a competitive mall literally across the street, but it doesn’t seem like a 13 cap asset either. Metro LA is dense and wealthy, so generally can support higher levels of retail than elsewhere in the nation.

The Oaks mall

MAC also issued equity earlier to acquire some JV interests at a blended low 7s cap rate. This was a bit dilutive but not a huge deal so I am neutral to marginally positive on it.

Given all of this - MAC is looking pretty fairly valued. It is still a good sized holding for me as I don’t really want to incur the taxable gains and I think it has some room to run, but I have sold some and I wouldn’t be investing as much fresh capital in this stock if I were starting from scratch today or had non taxable capital.

Elsewhere in retail, strip is also performing very well. I haven’t reviewed all of the strip names in depth but using Kimco as a rough barometer (they are the largest strip owner by a good margin), NOI growth is around ~3.25% YTD on ~20 bps of occupancy gain (they are close to all time highs for occupancy). There is a fairly wide range here as there are a number of strip operators.

All this positive earnings momentum is translating into rising investor interest in the asset class. Blackstone for example is beginning to move into the retail world, as seen in their ROIC take private ~$4 billion deal. The value here appears to be a high 5s cap rate, for a west coast oriented grocery focused portfolio3.

Right on the heels of this news, it also became public that BX is buying a ~$200mm soho retail portfolio as well - a bit of a different animal given its NYC, but retail nonetheless. Interestingly BX’s retail buys have all been coastal, as opposed to their sunbelt focused multi strategy.

The ROIC deal is I believe BX’s first major retail deal, and may be a herald of things to come with other large investors moving into the space. If this happens I believe there is certainly room for some cap rate compression on retail given the relatively higher yields here compared to other asset classes.4

Office

New York office, and of greater interest for me, Vornado, both had good quarters. NYC office leasing continues to recover, and is on track to surpass 2019 levels at the current pace, a very positive sign. Even a year ago many found this hard to imagine, but the signs of green shoots were there if you were paying attention & knew where to look.

The biggest news relating to VNO is they backfilled Meta’s space at 770 Broadway with a long term lease with NYU. Details were not disclosed unfortunately beyond an upfront payment of $700mm (sufficient to retire the debt here) & that it is not finalized yet but it sounds like a good outcome.

Combined with the Bloomberg renewal at Alexander’s and it is on track to be a pretty good year for leasing for VNO - if Roth’s predictions are true, potentially the 2nd highest volume in VNO history. This is a bit skewed by the two mega deals at Alexander’s and 770 Broadway, but still!

The other major NY REIT, SLG has also had a very strong year, with nearly 2mm sf of leasing YTD and occupancy rising.

The NYC market is by no means fully recovered, but as per usual the capital markets move well in advance of the fundamentals on the ground. Robust leasing combined with reduced supply (from conversions taking space offline, as I predicted), has gone a long way to rebalancing the market. I originally thought these factors would lead to a landlords market by ~2028, but if the current pace keeps up we may get there much sooner.

VNO was a great investment for me. We bought in the 20s, and doubled down in the mid teens. My fair value was ~$45 at the time. Here we are only a year and a half later, and VNO is within a hair of my original fair value. The supply / demand situation in New York has played out almost exactly as I laid out in my original writing, although demand is probably a bit ahead of my original thinking. On the supply side based on our tracking there are about 8mm square feet of office space slated for conversion (with loans in place or permits pulled), and more in the pipeline. That is ~2% of Manhattan inventory coming off the market, and it could potentially get to 3 or 4% before we are done.

In terms of the rest of the US, the story is pretty similar to Q2. Continued strength in the sunbelt, class A in particular, and weakness pretty much everywhere else. Big tech does seem to continue to shift away from WFH which is net positive for the tech markets, and an additional tailwind, but tech hiring remains pretty limited outside of AI. And the AI funding boom has not translated into much leasing yet, but I do continue to believe AI may be a ladder out of the current morass for SF and Seattle.5

Moving on to the residential world.

Multifamily / Residential.

Overall the last quarter in apartments was pretty dang similar to Q2. Weakness in the sunbelt, and strength (at least relatively), in the coastal markets, with NYC in particular looking good. VRE, which is not quite a clean NYC read through as its northern NJ, but close, had a phenomenal Q3 with ~6.7% YTD NOI growth.6 The most notable development this quarter was some improvements in the coastal laggards, which is to say DC and the tech markets.

There were a few interesting things that happened in the broader resi space in the quarter though in my view.

The first was that Sun (a mobile home park & RV company) had an awful Q3. Sun has 3 main business lines, mobile homes (~45%), and RV & Marina (each also close 20%). US rev guidance was cut 65 bps, to a still strong 4.35%, but a huge cut given 3/4s of the year has already passed! This is interesting - such a cut represents either a big slowdown in the business or a huge corporate miss internally. I’m not sure if it is idiosyncratic or if this is a warning sign to broader economic slowdown - RV & marina spend in particular is fairly discretionary so it will be interesting to see if this is a blip or the start of a trend.

The second is news around Aimco. We were invested in Aimco back in 2022, and we sold when the shares rallied significantly, but I have followed it since then. Recently Aimco’s stock has stagnated a bit relative to other multi REITs, and it is starting to look interesting again especially with some big recent news. Aimco has been marketing two of their parcels in Brickell for sale, with a $650mm asking price that I thought was completely absurd. News has recently broken that Aimco is in talks to sell the property at $500mm (~$415mm to AIV after debt) - still way above my value for this asset. If this holds it could mean a pretty significant slug of additional value to be unlock - the market cap is only $1.2b so the implied sale is a very good chunk of the current equity value.

I don’t love the firm’s capital allocation - they seem to be dead set on doing a load of development in Miami, and recently broke ground on a new development there in spite of weak apartment values. And their track record isn’t great - they are under contract to sell one of their assets, the Hamilton, for $190mm, less than the $194mm they spent on it.7 But on the plus side AIV has stated they intend to distribute the Brickell proceeds to shareholders, which would be great.

And ultimately if this Brickell sale happens the current value is likely too cheap, and I may reinvest in the stock here soon.

Storage

This sector is something I am very invested in on the private side, but do not have any public investments. I do still follow the REITs as proxy’s for market strength, and the story here is generally not great as far as fundamentals go. Rents are down in many markets due to weak demand and significant supply deliveries. And yet developers continue to break ground on new projects, despite an awful operating environment. And the REITs are now trading at slight NAV premiums. It feels a bit like the capital markets are getting ahead of the fundamentals here, but perhaps demand will prove stronger than I expect. New supply is slowing down a bit on average, and if the housing market can stage a recovery then storage fundamentals will hopefully get into a better place.

Industrial

Not much caught my eye in industrial this quarter, it was very similar overall to Q2. Leasing still down YoY but basically inline with Q2. New supply deliveries continue to fall off. And Socal continues to be the weakest market.

The most interesting news I saw in the quarter was a big industrial outdoor storage (IOS) sale from Alterra to Peakstone. This is a sub type of industrial that has gained a lot of traction recently, and is something I have been focused on on the private side. Peakstone was an office focused REIT that has been trying to pivot into industrial, and even after this transaction Peakstone’s IOS exposure won’t be that large as a share of their total portfolio, only around maybe 10%. So the asset class is still not really relevant as a niche in the public markets yet but perhaps Peakstone is able to reinvent itself eventually as an industrial IOS/industrial landlord.

The overall sale was very strong, at a low 5 cap and ~$1.2mm an acre. The portfolio is mostly leased but there is a decent bit of development land as well apparently. There isn’t a ton to do here in the public markets on IOS given how small it is, but it is of interest to me personally given my private investments in the space.

Hotels

Hotels in general have had poor stock performance this year, and Q3 earnings have been mixed overall. In our portfolio in particular Park had a meh quarter, as earnings were hit hard by an ongoing strike at Park’s Hawaii assets, which make up a huge share of PK’s earnings and value. Pre strike Park was on pace to do ~5% ebitda growth, but strike caused a Q3 overall decline of ~2%, with the Hawaii assets down a whopping 18.5% in Q3 YoY!

The strike illustrates why hotels deserve some level of cap rate premia relative to other asset classes, as labor relations present an X factor which could reduce earnings and value, and Park will very likely have elevated labor expense growth at those assets post strike, hurting margins a bit.

Even so despite this I think Park is very cheap, as the strike is just a temporary impact (aside the increased labor costs)8 and their year overall has been otherwise quite good. Park is trading a bit under 9% cap rate today - far too cheap for their asset quality and growth profile.

Group pace remains the star of the show, up ~9% YoY, with 25 tracking 6-8% and 26 ~10%.

This bodes very well for Park’s group oriented portfolio!

The story is similar at the operator level - Hilton noted group is driving what growth there was in the US, and that pace was up double digits again for 25 and 26.

So long term I still feel good about our investment in Park, although it has unfortunately been a drag on returns this year.

Vail

Our newest hospitality investment, Vail, had a very interesting quarter and year9. Overall YoY ebitda for 24 declined slightly by ~1% (after adding back a currently money losing European acquisition). Further Vail only guided to a ~2.5% YoY gain for 2025. Revenue for Q1 fiscal 2025 is looking promising, with Epic Pass sales up ~4% (slight user decline + good sized price increase)10. However when we look further into the weeds things start to get really interesting.

The biggest news by far was Vail announcing a targeted $100mm in cost savings! This is against ~835mm in ebitda, so a massive number. This cost savings looks to be generated mostly via by a targeted 14% reduction in headcount, almost entirely at the office level (so not folks on the mountain like lifties). This is a strong level of cost savings if they can pull it off.

The details are that apparently there is a lot of duplication of roles like IT & accounting from resort to resort, and that Vail intends to centralize all of these functions at the corporate level, allowing for apparently some pretty massive savings. This inefficiency is apparently a result of Vail’s huge growth spurt over the last 15 years, having acquired over 35 resorts in that time frame. I am a bit shocked Vail wouldn’t have done these kinds of things all along, but given their strong topline growth during this period, they simply may not have felt any pressure to do so as the Epic Pass & price increases were driving very strong earnings growth.

I am always a bit hesitant about buying management projections at face value, but even half these savings materializing would be huge. At 50% achieved its a ~6% boost to earnings, at 100% its nearly 12%. And they already appear to be making good progress - for last quarter they noted they already had $27mm in cost efficiencies projected for 2025 (partially offset by $15mm onetime costs around severance etc). So $50mm in savings feels like a safe bet, and 100 certainly is possible.

Vail’s Valuation

Vail is trading around a ~8.15% cap rate today (using a 4% capex reserve & .75% bps of current assets for G&A) - at 50% savings that jumps to an 8.6% cap rate. Given the asset quality, historical earnings power & very low capex burden (a mere 12.5% of NOI assuming no capex is accretive, a terribly conservative assumption) that is a strong yield.11

What kind of yield should Vail trade for? On the one hand they do operate leased assets, but these are long term government leases with rents that operate as a % of revenues. I am unaware of any major ski operator losing its lease, although it is always possible.

On the other hand Vail has trophy assets that serve wealthy, non price sensitive consumers, and faces almost no competition from new supply, something that is essentially unique in the CRE world12. Trophy assets are around ~5% cap rates today in several asset classes, so given Vail’s superior supply risk, one could argue Vail ought to be even lower. Indeed Vail’s historical earnings growth is essentially unmatched anywhere in CRE - by my rough calculations pre-covid it was nearly ~13% per year after stripping out acquisitions in the 5 years before covid.

The other risk I’m sure some people would ask about is the climate. Whatever your views on the subject, it is true that the earth has been warming the last few decades, and warm weather one would think is bad for snow.

However the relationship does not appear to be so simple. For resorts in warm areas this does frankly appear to be a big risk, and Vail’s Australian resorts have had a rough time of it recently.

But in Vail’s core operating area (NA), snowfall has not been declining steadily as one might fear. In fact the 22/23 winter was extremely good. The thing is that Vail’s core NA resorts are cold enough that small temperature swings are not massive drivers of snowfall amounts. What matters more is total precipitation, and the relationship with warmth there is much less clear. If anything a warmer world may also be wetter, meaning potentially more snow, at the places cold enough to get it.13 A slightly warmer world may also arguably make skiing more attractive - after all the most popular month to ski is March, in large part because it is warmer! (not to mention spring break making it easy).

So on net I view climate risk as mostly neutral, though there is certainly some level of downside there. The bigger issue here is simply variability - investors hate it, and Vail’s skier traffic is influenced by snowfall amounts. Vail has worked to minimize this with their Epic pass being sold in advance, but weather still has an impact and arguably is one reason the last year was relatively weak, because the 22/23 season was just so strong in contrast.

All this said - I view a 6% cap rate as a very reasonable estimation of value for Vail (~75-100 bps above other trophy type assets for a nice margin of safety), which would put the stock price at more like ~$280 / share. And that is before any potential cost savings, which even at 50%, combined with ~4% / year earnings growth (vs 13% pre covid!), and you could see the stock at ~$350 in just a few years.

And that is just a base case scenario whereby Vail is able to grow earnings at +-4%/year going forward. There is reason to believe this could potentially be much higher.

Vail Upside

Vail has two big potential areas to outperform and continue to drive really strong earnings growth over the next several years. The first is the simplest, and that is ski pass pricing. Vail’s epic pass is currently $982 for the year. It was in fact $979 in 2021, and $933 in 2020 before the recent bout of inflation. Vail dropped the price significantly in 2022 to drive unit growth and have been raising it back since.

If you apply a simple 30% increase from the 2020 price to account for inflation, this would yield a price of $1,220, ~24% higher than today. Further the only other multi resort ski pass out there, the Ikon Pass, which offers fewer resorts, costs $1,449 for their primary pass with no blackout dates14, even higher still! Ikon offers a cheaper version for $1,019 with fewer resorts, fewer days at certain resorts, and blackout dates. Vail has a similar offering called the local pass for $730/year.

So based on Ikon’s pricing and simple inflation, I think there is an argument to be made Vail could push the Epic pass price cost significantly over the next few years (potentially ~30%+), which could really boost earnings.

The other big area of potential upside for Vail is Europe. Vail recently acquired two European resorts, and is essentially trying to take their American roll up playbook to Europe. Europe is a much larger ski market than the US - I’m not sure how high quality this data is but it looks like Europe has ~30mm skiers vs ~18mm in the US. The difference is also really visible in the number of resorts - there are tons of ski resorts in Europe - primarily the Alps but also Scandinavia, Pyrenees, Balkans, Russia & Carpathians. Again data is a bit fuzzy (especially I suspect relating to exact definition of a resort), but in America there are maybe ~480 resorts it seems, vs seeming 2k or even as high as 4k in Europe.

The strategy is pretty simple - buy resorts at reasonable ebitda multiples, then drive scale efficiencies on revenue (with pass sales), and costs. Frankly I do not know if this is going to work in Europe - the market is very different than the US. I love skiing in Europe and it is hard for me to see the Vail model working really well there honestly. Europe is far less corporate, and has a much better food and apres ski scene - basically the opposite of Vail. But it would be foolish to give this no chance of working - Vail may be able to learn some things from its European resorts and create a new operations model for the continent.15

To recap - Vail is a collection of irreplaceable trophy assets almost completely insulated from new supply pressure trading at over an 8% cap rate, which has multiple potential levers to pull to significantly increase earnings over the next few years. As a skier am I biased here? Almost certainly. But I still believe there is nothing else quite so attractive anywhere else in the CRE world.

Fin

Please see here for our general disclaimer. Remember nothing in here is investment advice!

First, as always, performance. This quarter was an excellent one for the REIT market, and we also benefitted from that. However due to macro uncertainty (more on that later) I have moved into a very defensive cash heavy position, & so we missed out on some of the gains.

We returned 9.08% YTD, vs 16.05% for the USRT REIT index & 21.66% for the S&P. Since inception we are still outperforming by a large margin, at 189.58% for the fund, compared to 75.68% for USRT and 113.92% for the S&P.

The fund’s performance is a ~27% annualized IRR since inception.

Our underperformance this year is driven by hospitality really underperforming the broader REIT index, a few small caps that don’t move in line with the broader market (but I think long term are attractive), and also my relatively large defensive cash position, so we have missed some of the recent rally.

My concerns over the US macro situation continued to grow since my last letter, leading me to take said large cash position. Many indicators for the US economy are/were flashing orange or even red. Unemployment was steadily rising, and we briefly breached the threshold of the Sahm rule, which basically says that (historically) once unemployment is up over 50 bps we are heading into a recession.

However - the most recent set of data was much more positive. In particular the September jobs report was very good, with strong job growth, unemployment falling further (and below the Sahm threshold), and the prior two months being revised upward.

Unemployment rate over time.

My position was and is that we are either in a growth scare, or the early stages of a recession. A few weeks ago based on a barrage of negative data I would have put the near term recession odds fairly high, maybe almost 40%, but with the recent positive data I would push that down a bit, around 30-35%. 1 month is noise, but by 3 months it starts to feel like a trend. With 2 positive months in a row we are heading in the right direction, & I think we will know one way or the other by December or so whether this was indeed just a temporary slowdown or the start of something larger.

On the negative side, a number of consumer oriented indicators have begun to look rough in the last few months, a few charts below.

Consumer confidence is down

The present situation sharp decline is particularly concerning here

Restaurant spending is down

This data series is not as old as some others but it is an interesting view on consumer spending

and auto loan delinquencies are up sharply.

Chart is from the FT & ultimately S&P / UBS

Now - an important consideration here, which is why my confidence levels are relatively low that we are going to be in a recession (unlike the doomers you see all over the media), is that many of these indicators have been triggered to some degree (or close to it) by growth scares. Unfortunately many of the newer data sources don’t go back all that far, but the ones which do (manufacturing & unemployment), consistently show weakness during growth scares as well.

Specifically if we just look at the sample set of prior growth scares, we can see that extended weakness in manufacturing and unemployment has predicated a recession ~80% of the time (eg 2/10 were false alarms or just growth scares). Those are not great odds!

But what muddies the water here is the unique covid driven, supply side dynamics of the last recession & the recent recovery. Combine this with the relatively smaller importance of manufacturing to the US economy today and the small sample size of recessions in general, and even smaller of supply led recessions, and I believe it is very hard to generalize from the prior data to today. All I can say for certain is the fog of war is thick.

Stepping back, if you think of the US economy as having a few major drivers, we clearly have two - the consumer & manufacturing, that are softening or are outright soft. On the more positive side though, tech, which is arguably the major underlying long term driver of us economic outperformance, is clearly coming out of its downturn from the last two years, and AI/ML has made dramatic progress in a very short period of time. This new technology is likely already driving productivity improvements in the large professional services sector1, helping counteract weakness elsewhere and laying the groundwork for long term growth.

Inflation

This letter would not be complete without some inflation commentary, given its prominence over the last few years. The biggest news in inflation is that it isn’t really ‘news’ as much as it used to be, which is a good thing! We have had several very good PCE and PCI readings, which gave the Fed comfort to begin cutting (especially combined with some softening in the labor market).

PCE, the fed’s favored metric, has been looking good across the board. Overall 12 month PCE was down to 2.2% in August, with core higher at 2.7% due to elevated housing inflation. Given housing inflation is in large part supply constraint driven (not to mention highly lagged in the government inflation data), it needs to be viewed as a bit of a separate animal.2

The latest September PCI data came in a bit higher than expected - while overall was only 2.4% YoY and 2.2% MoM, the core and super core data was higher, as we saw the first goods inflation in quite some time (this has been in deflation for a very long time).

You don’t see a lot of signs of re-heating elsewhere in the economy so I’m inclined to view the September increase as monthly noise, but we will see what the next few months of data hold.

Overall I’m relatively sanguine about inflation, and am more concerned with the opposite currently (a downturn). And as I have said time and time again, over the long run it really doesn’t matter all that much given current CRE pricing is below replacement cost. If inflation reaccelerates that means income growth will be high - if it doesn’t then we will likely see cap rate compression instead. Again where this matters is assets with weak demand profiles, like suburban offices.3 Those are going to perform much better in a low inflation environment as it increases the NPV of the leased cash flows, and so your poor residual matters less. If inflation re-accelerates low quality office is not somewhere I would like to be (this asset class is also weak during a recession), and it is not a real holding of ours despite some REITs trading well below NAV, as I believe the downside risks are not worth the upside.

In Sum

Stepping back & taking it all together, at a minimum we face a relatively higher level of uncertainty. Combine this with fairly high valuations in the stock market in general, and it makes for a risk/reward ratio that feels mediocre.

CRE Markets

That said, the CRE markets broadly are looking the healthiest they have been in awhile due to the falling 10 year (although this has ticked up recently quite a lot!) and recent interest rate cuts providing some much needed capital markets respite.

REIT prices have generally rallied almost to NAVs, and if we don’t have a recession I would fully expect private market prices (and REITs) to march higher from here given the significant private declines we have seen over the past 2 years.

The beauty of making public real estate investments alongside private is that REIT pricing is essentially a much more exaggerated version of the above chart. If you can stomach the volatility it means you can buy in at the bottom at prices below the private market bottom, as we did in this recent cycle, and then sell at prices above private at the peak (as we hope to do! Assuming REITs eventually trade at a NAV premium which I think is likely, human nature being what it is). The key thing though is to keep your eyes on the ultimate driver of pricing, the private markets.

It feels very much like CRE GPs are chomping at the bit to begin to deploy capital en masse, and if lenders and LPs begin to become more aggressive I think we should see a strong price appreciation cycle (you could argue it has already started).

However, if we do have a recession it is hard for me to imagine that this won’t negatively impact the CRE markets. Yes falling interest rates would provide debt & cap rate relief, but current cap rates are already predicated on lower rates, eg that is already priced in. A negative surprise on the operations front I think would not be good for the markets (but I could be wrong here! Maybe falling rates offset NOI declines).

The good news is that I don’t think things should be too bad for CRE given the pain we have already been through. A recession by my guess would only lead to a modest additional decline in private prices (or perhaps even just an extended flatline). I suspect REIT prices would react more violently though.

Where I would be really worried was holding the broader market at all time highs and pretty healthy valuation multiples. So I feel pretty good in CRE outperformance moving forward, and especially if we have a downturn.

In particular I am comforted by the ratio of prices for class A assets to replacement cost. With the replacement cost spike since 2019, and prices for many asset classes being lower, long term, prices will have to rise to justify new development in higher growth market. Whether that is via falling cap rates, rising incomes, or both, I am not sure but I am confident one way or another it will occur.

CRE Distress

While the outlook has brightened CRE has been through a tough couple of years and given the lagged nature of the system delinquency rates continue to march higher, led by particular weakness in office. CMBS, as per usual, has higher delinquency rates than bank loans, and you can see broader softness in the CMBS rates, below.

Trepp CMBS delinquency rates

Bank loan delinquencies have held up a bit better, with the notable exception of office which continues to climb even despite bank’s typically more conservative underwriting standards.

Trepp bank delinquency data

I fully expect there to be more pain & defaults, especially in office, but there is light at the end of the tunnel. With the rate cutting cycle beginning, levels of distress should peak and begin to decline, probably in the next 12 months (again barring a recession). Maybe office takes a bit longer - delinquencies didn’t peak until 2012 or so after the GFC for context.

I continue to follow some of the public mortgage REITs, several of which are popular short ideas for certain investors. Frankly not that much has happened here and I continue to believe that given price decline levels these firms are right on the edge between taking very little in the way of losses, and potentially significant losses, with high variability between firms based on loan quality. I certainly would not want to own these given downside risks, but think the short value proposition is fairly muddied as if we have a proper soft landing losses might be quite muted thanks to some extend and pretend. We will see what their Q3 results bring.

Lending Markets

Given the ongoing market distress, lending levels remain relatively muted. Quarter over quarter per the latest Fed data, lending was up ~.5%, or 2% annualized. This is down significantly from the boom time 6-8% annualized growth we saw in 2022, but is still positive. I would wager with rates falling and lenders continuing to work through their distressed loans that this growth should accelerate over the next year.

Looking at the fed data at a granular level we see that life cos are leading the pack with ~1.7% loan growth QoQ. It seems life companies are taking advantage of high rates to deploy capital and lock in solid yields. Banks are in the middle at around ~.5%, or just about average. There are still banks on the sidelines in the CRE market, so there is definitely room for bank lending to tick up once these lenders are able to fix up their portfolios and re-enter the market.

Interestingly while CMBS issuance has been very strong this year, but it is mostly refinancing so overall levels outstanding remain flatish. So the ‘wall of maturities’ many have been talking about has thus far not caused significant issues.4

REITs at NAV

Coming back to the REIT market as a whole - things are a lot healthier here, and you are starting to see pent up transactions coming through, with a few IPOs happening, acquisitions picking up and also a number of equity/share issuances. In other words we are pretty close to a ‘normal’ market.

The one place that really has not benefited from this recent rally has been the hospitality market. I will dive into this in more detail in the sector deep dive sin part two, but this sector has the biggest NAV discount right now by a healthy margin. I do not pretend to know why this is, but I would guess softening consumer spending is spooking investors here. The strange thing is that if we really do have a recession other asset classes are going to suffer as well, yet only hotels seem to be pricing one in. This asymmetry creates an interesting opportunity.

On the flip side of this is the senior housing sector, which is trading at a huge premium on recent strong NOI growth and expectations of continued growth. I unfortunately missed out on this rally - the supply / demand set up is admittedly excellent but they were already trading at a premium, and I didn’t appreciate just how strongly NOI was going to grow. Welltower in particular has reached an extremely high NAV premium of over 100%! I don’t have great historical data but this surely must be one of the highest NAV premiums of all time in the REIT space. I do believe in continued income growth here but these pricing levels feel unsustainable to me - supply will almost certainly tick up again before that gap can be closed.

Fin

That covers it for part 1, I will be back in a month or so with part 2 covering the CRE asset classes (which I much prefer). Thanks for pushing through all the macro discussion here - I honestly do not love doing it but it seems like this kind of content is popular given how widespread it is in the financial world.

My own view on macro has evolved quite a bit - for a long time I simply ignored it, and was frankly a bit blindsided by the impact of rising inflation. Looking back at the data I came to the conclusion that high inflation levels were very much telegraphed, and so I began to follow that data much more closely. I feel reasonably good about inflation type macro data (and my forecasts have been fairly accurate since I started making them). I think the overall economy is harder to predict though, given the complexity of that system.

I have been struck however by the typically very low quality of most macro commentary I see, even from well known & supposedly high quality groups. There is a lot of noise, and what is interesting is that most commentators have a lens through which they view pretty much everything (the perma bull, the perma bear, the gold bug, the debt guy, etc). It really is almost like a religion with different sects & holy texts, and it melts my brain a little bit to try and sort through it.

My focus on macro has been a bit of a personal experiment. I still think long term most returns are driven by identifying superior investments, but it seems like there is a bit of additional juice that can be squeezed by monitoring the big picture. Most investors still seem to over index on macro though - in my view it is maybe 20-25% important5, with the vast majority being stock picking & investment sizing, while it feels like, at least in terms of air time, the ratio is flipped and macro gets 75% of the attention from most people.6

Ultimately I’ve got to use something to determine what kind of cash levels to hold, so I have settled on a combination of macro temperature and the opportunity set in front of me.

I’ll be back with the CRE sector specific notes after q3 earnings seasons has wrapped up.

I want to keep this post focused on CRE asset classes, but I do want to note that the continued uptick in unemployment and the downwardly revised jobs figures are quite concerning. I view the employment categories of manufacturing, information, financial services, and professional & business services as the key drivers of the economy, and these have had negative job growth for the past 12 months.

Can healthcare and government really drive the economy forward on their own?

We are at levels of change that are almost always consistent with recession historically. This cycle is anything but normal given the post covid supply driven bullwhip combined with historically low unemployment rates, but the odds of a recession in the next 6-12 months feel high to me, perhaps as bad as 50%. I think we will know one way or another in the next few months whether this is a big growth scare or a true downturn.

Continuing on with CRE asset class commentary, we will begin with retail.

Retail

As relates to our portfolio at least, the biggest story was Macerich’s poor results in Q1 and a meh Q2. This really could be its own post, but the quick summary is that MAC has had some seemingly 1 time issues that impacted NOI, which combined with the new CEO Jackson Hsieh’s plan to let go of underwater assets and potentially sell others to make for a poor first half.1

I do not love some areas of Jackson’s stated plan - especially selling assets to pay down debt. MAC’s debt, while higher for a REIT, is quite reasonable in absolute terms & especially so since their higher cap rates means greater ability to service high interest rates. If Jackson can get good prices I think this is probably value neutral or even accretive (depending on how good the sales are), but if he sells things for poor cap rates (mall liquidity isn’t terribly deep after all), well I’d much rather have the cash flow.

Q2 was better than Q1 but not phenomenal, and overall 24 is shaping up to look weak on overall NOI growth barring a really strong second half. As far as I can tell, the NOI impact seems to be mostly idiosyncratic & timing related, and perhaps some noise from weaker assets.

The reason I remain confident in MAC’s long term NOI growth is that the retail sector continues to perform very well. Across the board REIT management continues to note very strong tenant demand in what is one of the best retail landlord leasing environments in years. The best comp of all for MAC is of course mall giant Simon. Simon continues to report very robust leasing, and also have had strong same store noi growth coming in at 4.5% YTD.2

Now lets look at MAC’s performance. Here is their head of leasing commenting on Q2 leasing results.

A 30% increase over a record year - that is incredible! And yet the market cannot seem to see the forest for the trees. In fairness total leased square footage is trending below 23 levels, but the point remains that leasing is very strong right now, and it is reflected in MAC’s very large signed not open pipeline (SNO).

The risk here is that somehow MAC has a much weaker portfolio than Simon and is going to underperform long term (and that somehow all this leasing doesn’t translate into income because tenants are leaving just as fast as they are coming), but I have reviewed all of MAC’s assets and just don’t believe that to be the case. MAC does have some weaker assets but the core of the business (and vast majority of the value) is very high quality.

Overall I continue to think MAC is a really compelling opportunity. Its combination of high going in yield, low future capex needs, and strong cash flow growth is essentially unmatched elsewhere in CRE.

However for now Mac appears to be very much a ‘show me’ stock, and I suspect they will have to deliver solid NOI growth before being given credit by the market. I don’t know if that will be in one quarter or 4 quarters, but I am confident it will occur.

Retail sales growth also continued nicely in the quarter, underscoring steady consumer demand. Here is the last 12 months of data.3

It is not all roses of course in retail, and there continues to be a shakeout of weaker retailers. A big recent story for CRE is CVS’ plan to close 900 stores. This will of course increase vacancy across the market, but the immediate impact on our portfolio shouldn’t be too significant - drug stores are typically free standing and usually owned more by the net lease REITs than any of the mall or retail REITs. Drug stores are typically hard corners as well, so there should be good demand to backfill most of these spaces.

And CVS is not the only one. Big Lots sounded an alarm recently, and JC Penney continues to struggle, among others. Stepping way back it feels like we are in a period of flux in retail - overall consumer spending is good, but the e-commerce shake out is not quite complete yet. I think there are a number of legacy / older brands which will continue to struggle and perhaps eventually file BK without some kind of real turn around.

This is one reason I prefer malls to big box stores - I think long term the soft goods, luxury goods, entertainment & food profile of a mall tenant base is much better positioned to capture consumer wallet share than legacy retailers who are competing heavily against Amazon - places like Big Lots, Joann’s, Petco, the Container Store etc I think will continue to struggle.

And just look at mall staple Abercrombie’s incredible recent performance. A&F had a blowout Q2 with a whopping 21% YoY sales growth!

While just one tenant, for a long time A&F was synonymous with the mall, and there is a certain symbolic resonance in its recent rise.4

The real key factor here for the retail sector is zero supply growth. What matters for a landlord is demand less supply, and as multifamily shows us it doesn’t matter if demand is really strong if supply is higher still. The reality is retail demand growth is best described as moderate, but paired with zero supply this makes for very nice net demand.

Given the massive escalation in replacement costs we just saw, and higher rates, the rents needed for new development are generally much higher than today’s rents, meaning the retail market generally should have a good deal of room to run before the specter of new supply rears its head.

Industrial

The industrial sector continued to slow down, lead by weakness in Southern California which saw outsized rent growth during the pandemic.

Prologis, always a decent proxy for the national market, revised down its 2024 forecast for absorption from 250mm to 175mm after a very weak Q1. PLD’s Q2 results were better than Q1, but were only in line with their prior guidance cut.

Southern California has had actual negative rent growth - PLD estimates it around negative ~6%, I have seen other estimates from 10 to even 20%. I suspect some of the difference may be in how high some folks marked their top of market rents, and also varies with submarket.

So Cal focused Rexford on the other hand was a bit cagey on market rents in their Q2 call, which is always a bit concerning. I cannot help but be reminded of NYC retail in the mid 2010s by the whole situation. Both markets saw absolutely massive rental rate spikes driven by strong demand and record low vacancies, where deep pocketed tenants bid up prices for the remaining vacancy.5 The problem here is this growth sets the stage for a pullback, as long term rent is not set by what the wealthiest tenants can pay, but by tenants who can pay the least. And this is what we saw in NYC - many investors bought in with dreams of the high rents continuing, but as leases rolled many stores closed as they could not afford the higher rents, and there were not sufficient tenants able to pay the new higher rents. The result was a grueling 5 year period where rents ground steadily lower and vacancy was elevated even in prime locations.

And with SoCal rents up ~100% in a few years, as leases roll and landlords try to mark to market there are going to be a number of these lower end tenants who have to close or relocate, sapping demand. While the long term drivers of SoCal industrial are probably a good bit more robust than NYC retail in the mid teens, I do worry that things could get relatively ugly here for SoCal.

Outside of SoCal, rent growth elsewhere looks to be flat to slightly positive, and some sunbelt markets continue to show decent strength.

Here is PLD on the US markets.

Sunbelt small bay focused Eastgroup is a bit more upbeat, with leasing and occupancy coming in above their original estimates for the year, and market rent growth still coming in positive. The below is from their Q2 earnings call.

So while on a national basis, the combination of significant recent new construction with a weaker leasing environment is dragging down the industrial market, regionally we are seeing a good deal of variation.

Thankfully for owners new construction starts have fallen off a cliff, and so once this wave of supply is leased up (over the next year or two), the market should look much more landlord favorable.

Here are starts in developer friendly DFW as an example - we are essentially at post GFC lows in new construction.

Costar data on construction starts in DFW

Similar to multifamily, investors are aware of this dynamic and have been increasing activity in the industrial space thus far in 2024. This can be seen in a portfolio sale PLD first marketed last fall, took off the market, then brought back this year.

All in all, the covid era industrial boom driven by a rapid rise in e-commerce spending is over, and it looks like the sector should see more normalized growth going forward. As a reminder, e-commerce space takes 3x the warehouse space of traditional retail, so it is a huge driver of industrial demand. While ecommerce’s share of spend has declined from covid highs, I suspect we are not at final equilibrium and there is continued future share growth to come.

But even if growth levels off at the current pace, at a ~25% e-commerce share (I’m rounding here), industrial warehouse demand has essentially been permanently boosted by 50% relative to pre-ecommerce levels given the 3x warehouse intensity of that 25% spend. Combine this with some nascent trends in potential reshoring and the long term demand outlook for industrial still looks fairly sunny once we are past the current rough patch.

Hospitality

Lodging in general has performed fairly well this year operationally, although there is significant dispersion among asset types and geographies. However many REITs have cut guidance on recent consumer weakness, and lodging stock performance has overall been very poor. Outside the macro economy the big story has been and remains to be covid normalization, with a rebound in group and to a lesser degree business travel, and domestic leisure softening from covid era peaks.

This story is almost done, and many markets are pretty close to normal. There appears to still be some recovery to come in the group segment, with hotel firms across the board hailing group as the strongest segment.

Here is Hilton noting they expect modest overall revpar growth, but group is growing at a whopping 10% YoY and is expected to be even higher going forward.

Business, on an occupancy basis is still a little below pre-covid levels, but I still believe we can’t make an apples to apples comparison until tech exits its recent pullback.6

Our largest hospitality investment, Park, had a phenomenal Q1 with Revpar up nearly 8% YoY driven by strong group demand, ongoing urban recovery, and continued strength in Hawaii. Q2 was solid but weaker, coming in at 3.2% revpar growth, with Hawaii beginning to soften a little. As a reminder Park’s hotels are very group oriented, with many big box convention hotels, so Park is very well positioned to ride the ongoing group wave. The other two legs of Park’s stool, urban and Hawaii, both look to have further room to run as well. The west coast markets seem to be picking up, and as I noted in multi they are seeing some quality of life improvements which ought to filter through to the hotel side. Not to mention long term if AI really plays out as a new major sector this should really accrue a lot of value to CA (if pols don’t mess it up) and help many of those markets fully recover.

Finally Hawaii continues to benefit from essentially zero new supply, and still likely has a bit of uplift yet from Japanese travel normalization. In Q1 Japanese air travel to Hawaii rose to 69% of 2019 levels, and while I suspect it won’t fully recover due to the exceptionally weak yen, I would wager we have another 10-15% further recovery there at least. Still - Q2 proved to be soft for Hawaii as US visits were down 2%, and overall revpar was actually down year over year. So while the long term trends look favorable, the shorter run pullback (and shift) in US leisure travel is beginning to take its toll.

Unfortunately hospitality REITs have done quite poorly this year - bellwether Host is down 11%+ ytd as of this writing. Park has performed much better at ~-4.5% ytd, due to its superior group driven performance, but is still a drag on portfolio returns. Softening leisure demand and I believe concerns over a potential recession are what have driven the poor performance of hospitality REITs thus far.

We also made a new hospitality investment in the quarter in Vail Resorts. Besides being near and dear to my heart7, Vail is trading at a very attractive 8%+ cap rate. Given the irreplaceable trophy assets they control8 this is pretty interesting, but the icing on top is Vail’s capex profile. After accounting for typical hospitality type reserves9, Vail has one of the best capex profiles in commercial real estate (after self storage), and that assumes zero ROI on any capex! Of course this shouldn’t be too surprising given Vail faces zero new supply & its primary capital stock consists of long lived assets (lifts).10

I mean who wouldn’t want to invest in this

And that is just the business today - Vail still has a significant opportunity for further growth in the mostly untapped European markets. On the negatives side of the ledger is Vail’s inferior tax treatment due to not being a REIT (although I believe it could become one via an opco/propco split), and earnings volatility tied to weather (which they are trying to reduce via Epic pass sales).

I may share a full write up on Vail some point, but I’ll leave it at this high level summary for now.

Office

The office market, at least at the high end, is showing signs of life. Our holdings here are limited to Vornado, which is obviously only a small very differentiated slice of the market.

VNO had a nice quarter operationally with good leasing, but the real news was the announced sale to Uniqlo of their flagship 5th Ave store for a whopping $330mm. This sale was at a 4.2% cap rate - below the original JV pricing of 4.5%! And it was even lower on a mark to market basis. The market finally has begun to respect VNO’s strong retail portfolio, and the stock saw a big pop after the sale was announced

Some other office REITs have also started to show a bit of momentum in the Q2 figures. In particular sunbelt focused Highwoods and Cousins both had nice leasing quarters, as did all 3 of the NYC REITs.

The NYC market seems to be pretty close to a bottom in terms of vacancy, if not already there. Costar put out a story noting Manhattan actually had a YoY decline in vacancy - the only one of their major markets to show this. Other NYC brokers showed a mix of slight decline, flat and slight increase in vacancy.

Leasing has continued to pickup, although it remains below pre-covid levels (although July and August have been at/above pre-covid levels actually!). But critically the supply picture is significantly improved, and as the last of the pre-covid construction finally delivers net absorption should improve.

And speaking of supply, some big news in NYC office world was the passage of a new law in Albany which is intended to facilitate more office to residential conversions. The law removes a cap on residential FAR the state had set, and also extends a new tax incentive called 485x for conversions which set aside 25% of units as affordable. It is not clear to me if the math on the tax abatement actually works out - I have heard mixed things on that front, mostly negative11. But regardless, this opens the door now for NYC itself to loosen some of the restrictions around office conversions. City planning has proposed a nice set of measures which would allow buildings built before 1991 to be converted, and also dramatically expand the geographies such conversions could occur in12. So the government seems to be movingly slowly but surely in a direction which would support further conversions.

But even without these measures, conversions have begun to ramp up with about 5 million square feet under way or permitted and another ~5 million under active consideration. That is over 2% of inventory right there! The impact of conversions on the NYC office market looks to be significant, as I noted back in my original VNO investment post series (link here ).

Coming back to the demand side in NYC SLG had a great Q2 outperforming its leasing targets and reiterated their belief that occupancy has bottomed and will increase throughout 2024. VNO on the other hand, while it had a good Q2, expects occupancy to hold steady in 2024, and then rebound into 2025 as new leasing takes effect.

Interestingly SLG is raising a $1 billion NYC office debt fund, and the investor reception has apparently been pretty good so far, so much so that at NAREIT SLG indicated they thought they may go over the $1 billion goal.

One more note from SLG’s Nareit presentation - they mentioned demand from tech firms finally coming back.

Names in the market apparently include Amazon, Apple, Inuit and OpenAI.

So we have more signs of green shoots in the NYC office market on the supply front (conversions reducing it), the capital front (increasing investor interest), and the demand front (fairly good leasing, tech coming back into the market).

While NYC is hardly strong, it remains stronger than the rest of the US and I think will be the first office market to become a landlords market again (still a few years out). But pricing may well recover earlier than the fundamentals if the positive momentum becomes clearer, which it seems to be thus far.

Generally I am more bearish on office in the rest of the US & I think things are still getting weaker in many markets. As I have mentioned I think the tech markets may have a ladder out via AI demand, but that is a ways off and there is still more bleeding to come. Slow growth markets are in my view almost untouchable. High quality sunbelt assets seem to be doing pretty well & given a lack of new supply combined with strong population growth I expect that to continue.

Private values are surprisingly strong in a lot of secondary/tertiary markets for lower quality but leased assets – too high in my view. As I mentioned in my last letter, there are some ways to play that relatively strong pricing in the public markets, but I do not like buying into a spread based on what I view as overly high private sector prices. It may work out, but in a downside recession scenario it could look ugly and my primary goal when investing in CRE is to avoid capital loss.

Fin

Thanks for reading - that is it for this update. I’ll be back with Q3 soon, the economic indicators over the next few months should be very telling!

First, the returns. The fund is down -0.98% YTD, just beating out our benchmark USRT REIT index’s -1.19%. While I am pleased to beat our benchmark again, unfortunately we are below the S&P’s strong ~15% return ytd. This was not our best quarter but this is the nature of public investing, not every quarter is going to be a winner1 . However I believe this is partially a consequence of our very strong 2023, and ultimately I am happy to simply hang onto our massive gains from the last year. Obviously I want to outperform the S&P as well, but it is simply not realistic to do so every quarter - volatility is part of the game

Our long term performance since inception remains excellent at 164.8%, well above the USRT’s 51.46% return and the S&P’s 104.3%. I feel good about our portfolio and my estimations for its performance in either a low or high interest rate world, and I still see a lot of value and interesting opportunities in the public CRE markets.

Now to market commentary. As usual I’ll start with CRE in general, then cover general macro and then dive into sector specifics.

CRE Markets

Evidence is building we may be at a CRE market bottom in terms of private market pricing, unless a recession occurs. More on a potential recession later, but we have seen continued increased investor interest from some large players - in particular multifamily pricing has firmed up or increased depending on how you want to look at it. Notably KKR recently bought a huge $2 billion portfolio from Lennar at a ~5% cap rate, which is a very healthy price. The portfolio is newer and in high quality market, and at a minimum shows strong investor interest in newer higher quality assets. Add that to Blackstone’s Aimco take private offer in April and we had a very strong quarter for institutional multifamily allocation.

Aside from this pickup in large multi deals, investor interest in the other major asset classes seems about the same as Q1, which is to say improved over 2023 but not on fire by any means.

Another newsworthy occurrence in Q2 was SREIT (Starwood’s REIT) instituting an additional gate on redemptions. SREIT reduced the monthly  redemption max from 2% to a mere .33%. SREIT was already facing redemptions over their 2% monthly maximum, so this maneuver dramatically limits liquidity for investors. This gate may cause some knock on panic in the non traded reit space, with more investors looking to redeem and get out.

The problem with SREIT, BREIT, & probably many other non traded reits, is they simply have not taken their lumps yet and marked down NAV to current market prices. Even the retail investors in these products are slowly realizing this, hence the continued desire for redemption.

On the lending side - rates remain elevated (obviously) which continues to be the major constraint on financing activity. Many lenders still remain on the sidelines as they attempt to reduce CRE exposure or work through duration imbalances. Still, overall CRE lending is slowly continuing to increase. The Fed released Q1 CRE mortgage loan data in June, which showed an ever so slight expansion from .7% growth in Q4 to .8% in Q1. Of this - multi grew at a much stronger clip than general commercial. I suspect Q2 will be similar to perhaps slightly higher again.

As I have said before though, commercial real estate moves slowly, and so we are still very much working through the classic symptoms of distress relating to the drop in prices which has already occurred. This is to say - even though prices may have stopped falling, and loan growth may be marginally positive, delinquency rates have continued to march higher & I fully expect them to go higher still. This can be seen in the CMBS’s delinquency data - according to Trepp the overall rate is up from 4.51% in December to 5.35% in June. As a reminder delinquency peaked in 2012 after the GFC! In fairness though as relates to delinquency rates here, this is in large part driven by ongoing significant office defaults, which arguably are as much a secular trend as they are cyclical. Still - if you look at special servicing rates we also see increases in other asset classes outside of office, which will likely lead to future increases in delinquency rates.2

Special servicing rate data from CRE data provider Trepp.

Overall - despite the current turbulence I feel quite good about the medium to long term prospects for the CRE markets. Replacements costs have increased dramatically, and pricing is back to 2019 levels for many asset classes. I am confident prices will rise above replacement for assets with good demand, as this is necessary to justify meaningful new construction. As to whether this will be driven by falling cap rates, rising incomes, or a bit of both, it is harder to say. I would wager falling cap rates have a meaningful role to play given recent favorable inflation data, but I’m only ~65% confident in that. This segues nicely into a discussion of the general economic picture.

General Economy

On the macro side, as relates to CRE the biggest news has again been inflation. And that news has been very good lately.

After hot readings in Jan & Feb, inflation has come back down and the latest PCE data for May came in very mild. Here is the nice summary table from the always excellent Jason Furman (follow him on Twitter @Jasonfurman).

Overall 12 month PCE is at 2.6%, and really almost all of the excess in inflation is due to housing. Ex housing we are at 2% for 12 months, 2.2% for 3 and 2.8% for 6 months.

And the latest PCI which just dropped July 11th is even better. PCE is the fed’s favored metric, but some of PCI feeds into PCE and this report was very good. Here is the same PCE chart for CPI (also done by Furman).

First - we saw actual deflation MoM! But what is really notable in my view is that housing has finally begun to decline in a meaningful way - something that was pretty clearly going to happen given what we saw in private rental data, but was taking seemingly forever to actually occur in the government data.

Another chart from the excellent economist Jason Furman

As inflation ex-shelter has been sub 2% for over a year now, housing really has been the last thing holding up the official numbers. So if housing continues it’s decline (which again the private sector data says it will), the headline numbers should continue to drop. Other worrisome categories, notably insurance, have also cooled dramatically as I suspected they would given the slowdown in the private data.

As I suspected - the hot winter look more like noise than trend right now. That said I would wager the fed will want to see another month or two of good data before actually cutting though - the market consensus for a September cut being in play feels about right.

Perhaps even more importantly, wage growth has also declined dramatically, and thankfully seems to have leveled off at a healthy level rather than continuing its precipitous drop.

According to the Indeed wage tracker, which I like as it appears to be more of a leading indicator relative to the government data (which is very much lagging), we have leveled out around 3% wage growth, which is actually below pre-covid levels.

After the winter scare, there seems to be little evidence that inflation is reaccelerating, and it looks to be continuing to decline. This gives me a good deal of confidence rates are coming down, although the pace is hard to predict.

My worry frankly is now more towards the other side of the equation, that the Fed may keep rates too high for too long and that we may be getting close to tipping into a recession.

The most recent jobs report from July 5^th is very interesting. Many elements of these reports are a bit unreliable in the short run in my view due to the significant revisions we see months and years after the fact, but some of the more immediately useful data relates to unemployment. We have great data on # of unemployed, although the definition of the labor force is a bit fuzzier.

What is a bit concerning is the continued rise in total number of unemployed over time. The total number of unemployed in the US is now 6.8mm, up from a low of ~5.7 in late 22 / early 23. That is a 19.5% increase. For comparison, in the 2000 recession we went from a low of 5.48mm unemployed to 6.14mm by the official start of recession in March of 2001, only a ~12% increase.

The number of long term unemployed is also up a good bit - here is a nice breakdown of unemployment by duration by economist Omair Sharif (also worth a follow on Twitter).

And finally, the unemployment rate has continued to tick up, rising to 4.05% in June. While in absolute and historical terms this is still quite low, it is up from a low of 3.5%. Historically when unemployment rate averaged over 3 months has risen .5% from the cycle low, we have entered a recession. This is called the Sahm rule, and using 3 month averages we are at .4% - if the rate stays where we are for the next 2 months we will be right on the edge of passing the .5% threshold (3.6% being the 3m average low). One thing to note here is that we are at historically low unemployment rates so there is a very limited sample size of previous similar conditions to draw upon when analyzing this data, but it is concerning nonetheless.

At a minimum these data show further slowing in the job market, and given how this kind of slowdown can snowball it has me worried we could be getting close to a recession3.

What is extremely weird about this cycle, at least in CRE, is even if I know with perfect clarity that a recession was occurring I’m honestly not sure what would happen to CRE prices. Usually a recession means prices decline, as lending freezes up, capital becomes scarce, and incomes decline. However we are already sitting on significant price declines triggered by the rise in rates (and some operating softness in certain assets/geographies), and if we really do have a recession, assuming it is mild, the decline in rates which would come with it may well offset declines on the income side of the ledger, or perhaps even outweigh the income changes!

The big question will be what happens to capital and lending – both have already been quite constrained for the last ~year and a half now. I am honestly not sure, as lenders have been working through their risky and bad loan books now for quite some time, and many are likely actually in pretty good shape (big multi bridge lenders aside). My bias is that capital would probably still become a bit more constrained, leading to a further price decline, but I’d guess this would be mild and I am not terribly confident of that prediction.

I would wager though that if we do see a recession the general stock market will perform pretty poorly, and I think CRE is very likely to outperform in this scenario given its recent underperformance relative to other asset classes.

Of course, a recession may well not occur and we might actually just be pulling off the mythical soft landing. Thankfully for our portfolio we are pretty well positioned either way - I think only slight further price declines in a recession (if any), and we should see good income growth in a new growth cycle. The reason for this is ultimately simple - we are buying quality assets with good demand profiles well below replacement cost.

Onward to the sector specific commentary. Same as last time, as these letters are running long to split this up I will share 1 sector here as a preview, with the balance to come in a week or so.

Multifamily

Lets start on a positive note with multifamily. The multi REITs have done fairly well in 2024, driven by what was in my view overly cheap pricing relative to the private market, which itself seems to have improved a bit. Blackstone’s AIRC deal combined with a number of large private trades (see KKR’s $2b trade from earlier), and firming up operating fundamentals have all supported higher multi REIT pricing. Still even with the rally many multi REITs are still trading at a bit of discount to NAV. Take bellwether EQR - despite its 10%+ rally this year, it still trades at a high 5s cap rate, a decent spread to its likely low 5s cap rate portfolio value. And this compares very nicely to KKR’s $2B 5% yield deal.4 Against all of this, multi has been one of our strongest performers this year as well, with fund holding NXRT up over 11% YTD (over 18% as of this writing!).

While the capital markets are showing some strength, the leasing markets continue to be weak. The story remains one of good demand overwhelmed by huge supply, particularly in the sunbelt.5

But there are signs of life - there has been some pickup from Q1 especially in coastal markets. You can see this ongoing geographic dispersion in the REIT Q1 data - lets use EQR as an example. As you can see below, the coastal markets are squeaking out gains on a blended basis, but new rents are still down slightly, while Denver and the expansion markets, which are basically Atlanta, DFW & a bit of Austin, are firmly negative.

EQR Q1 leasing data

Sunbelt focused Camden is worse - here are their new lease rates from their Q1 earnings call in early May.

Now as Camden notes, preliminarily Q2 appears to be a bit better than Q1 (there is some seasonality to this too). In particular some of the hard hit west coast markets look to be showing some signs of strength. Here is commentary from EQR at NAREIT in June about some of the tech markets beginning to show some life.

Some of this frankly is related to quality of life issues that were specific to these markets, which are partially receding. Seattle elected 5 new city councilors (out of 9), and the new council is much more moderate and seemingly quality of life oriented. The recent supreme court ruling on homeless encampments also will give cities legal cover to clear up long standing homeless camps, and I suspect many will do so if they have not done so already.6

The other side of this pickup is likely simply the cessation of tech layoffs - it is hard for an apartment market to show real strength when the biggest employers in a market are conducting layoffs (as was the case in 22/23 for the mega tech firms). Now that the layoffs have (mostly) stopped, this ought to help the SF/Seattle markets to return to growth.

Given the continued dominance of tech firms & their ability to generate massive amounts of wealth, the pendulum may be swinging back to west coast fundamental outperformance due to limited supply and strong income growth (which has been the case for the past ~20 years).7

Overall the apartment market will likely remain soft for the balance of 2024 into 2025, and then pickup strength when the current supply wave recedes later in 2025. This is mostly the same story as Q1, the main difference is large investors are beginning to deploy capital in front of the trend.

Fin

That is it for this letter - thank you for reading and I will share the balance of the sector commentary in another week or so.

Well what a difference a hot CPI report makes… the 10 year is up over ~4.6% today and REITs have been down broadly the last few weeks. As I already covered in part 1 - the REIT market is too focused on inflation.

However given the market’s obsession over inflation, I’ll do a little update here. If you don’t care, skip down to the sector specific information below.

And as always, nothing here is investment advice! Do your own diligence & research, consult with a financial advisor. Please read our general disclaimer here

For what it’s worth - I’m still not fully convinced inflation is stuck. Some other data points support a continued downward trend in inflation. First and most importantly, wage growth has continued to decline. The latest Indeed figures came out, with March now coming in at pre-covid levels of wage growth.

This is in my view, a pretty big deal!

Even more interesting to me is that the Atlanta Fed’s wage tracking data has resumed its decline, which supports the Indeed data as being a leading indicator.

The Atlanta fed wage data is down to 4.7% YoY, and has declined a whopping 50 bps since December.

This is frankly almost a worrisome rate of decline, however the flatline in fall of 2023 and otherwise healthy labor data makes me feel fairly sanguine for now. It looks like at current pace the Fed data could show us at pre-covid wage growth levels by the end of this year. And interestingly most people don’t seem to realize this, I still see loads of commentators and ‘experts’ talking about nominal wage growth being 6-7%.

Furthermore it looks like the March PCE (the Fed’s main focus) should be a good bit softer than CPI as we had a softer PPI report which is a key feeder into the PCE data. Also more broadly basically all of the excess inflation in the March CPI came from housing (highly lagged as I have discussed), and auto insurance & repair, which is also arguably a lagged reflection of the huge spike we have had in used vehicle prices.1

All that said, I don’t have a terribly strong opinion as to whether inflation is turning sticky or will continue falling2. But I do think a higher inflation environment is bullish for CRE prices as it drives higher increases in construction costs & property incomes. Again look at what happened to property prices in the 70s and 80s - absolutely huge annual increases.

The big risks in my view are demand destruction aka recession, or a rapid change in financing costs (what we just saw). If we did see another spike in interest rates, you could see CRE prices fall another 5 to even 10%.3 I don’t think this will happen, as I believe it would require inflation heating back up a good bit which I don’t see evidence of yet. But I could be wrong here!4 Luckily for us, there are already many REITs trading at 10%+ discounts to private market values, so we are insulated from long term losses should prices in fact decline further.

My view is it is too difficult to truly know what will happen here, and the best you can do is focus on buying quality assets with good demand profiles at attractive prices & below replacement cost. Long term this will work out, as long term it is supply (and therefore construction costs) and demand which drive CRE pricing, not financing costs.

Onward to the sector specific commentary.

Office:

While we are being negative, lets start off with the weakest office class, office. At the margin if inflation & rates get stuck I think the downside risk is higher for weak office properties (which is a lot of the asset class). This is because with weak demand you can’t actually pass through the cost increases from inflation, and with no need for new construction replacement cost no longer has any bearing on market prices and values.

And demand is weak pretty much everywhere. As I have said before, I think you have the foundation for a recovery over the next few years in NYC/Boston, the top sunbelt markets, and even SF/Seattle if AI growth really does take off. Everywhere else is basically un-investable until prices fall further.

I have covered NYC extensively here so don’t need to spend too much time on it (see prior posts here, here and here), but do want to check in. Vacancy ticked back up a little bit in Q1, so its probably premature to say the market is recovering but at least it seems to have stopped its fall or is close to doing so, which is positive.

Certain submarkets, like Park Ave, are actually starting to get tight! The bifurcation in quality/location preference is real. Here is a nice chart from VNO’s annual letter that illustrates the stark divide in the market today.

RTO has crept a bit higher, but is moving very slowly and we are probably close to a new normal. VNO’s portfolio utilization rates are around 65%, vs 80% pre-pandemic. So about 81% of pre-pandemic levels. This gels with Placer.AI’s data of around 80% as well. This level is high enough to minimize demand destruction for firms that are still in office - if its basically just Fridays that are WFH there isn’t a realistic way to shrink your footprint.

Similar to NYC several major sunbelt markets have stopped their decline. DFW for example seems to have leveled off and appears to be on the slow road to recovery.

With the incipient AI boom the tech markets appear to have a potential ladder out of this mess, and could conceivably actually be the first to recover. This subject deserves a deeper dive, but at a high level in terms of actual employment the AI sector is basically nothing (Open AI only has ~1,200 employees!), and if this really is an internet level technology shift then that number could become absolutely massive.

And you are already starting to see what may be the start of a recovery in Silicon Valley, without the benefit of much AI hiring. Here is the San Jose / Silicon valley availability rate. Q1 of 24 saw a huge downtick of 0.8% in terms of vacancy, and even more in class A.

It is important to note this recovery appears to be driven more by removal of sublease space instead of leasing, but from the point of view of a landlord both are good.

So that’s the ‘good news’ if you can call it that, in the office sector. The knife seems to have stopped falling, at least in a handful of markets.

That said, I am still very bearish on weaker office properties in weak markets - I have seen some private market sales in secondary markets which I think will work out poorly for the buyer. I compare public market pricing to public, but I also evaluate whether private market pricing feels attractive.5 I think most asset classes on the private side feel decent to good right now, but the one area that I think feels markedly unattractive is B/C office in weak markets.

NLOP is an interesting case here - this one has been going around fintwit. NLOP and others have been able to sell what are pretty bad assets IMO for surprisingly low cap rates / high prices. I’m not going to argue with the private market prices - it does appear that there is a decent sized spread between those prices and NLOP’s implied price today. However I do not like investing in a spread based on what I view as unsustainable or unattractive private market pricing - this is a dangerous game as if private market prices do indeed decline further you are left holding the bag. And in this case I believe those weak office asset prices have a good chance of declining further.

I’d much rather buy a smaller discount but in something where I think the underlying private values are likely to appreciate over the next several years.

Industrial:

The industrial market continued to cool off in Q1, and certain markets are showing outright weakness. Most notably leasing posted a meaningful drop across the country, which combined with the significant new supply has continued to push up vacancy rates.

This can be seen in the national Costar leasing data, here.

Source: Costar market data

National industrial giant Prologis also noted this slowdown in their Q1 earnings, reducing their full year occupancy forecast to 96.25% at the midpoint, which would be down ~120 bps from 2023. PLD called out previously red hot Southern California as being particularly weak, and noted it was responsible for half of the total nominal dollar guidance reduction (they also reduced NOI growth guidance, driven in large part by lower occupancy)6.

But PLD remains fairly bullish on dynamics in 25 and 26 due to falling supply.

I agree with PLD here. Starts have been impacted by the rise in interest rates, and I expect them to stay weak until pricing recovers via lower cap rates or further additional rent growth. This means when industrial demand reverts back to its pre-covid levels (which PLD is guesstimating happens in 2025), we will start to see vacancy rates decline again and landlords pick up more pricing power. But if leasing stays soft for a few more quarters things are going to get a bit worse first before improving in 25.

Still the boom times are definitely over and I would expect a more normalized performance going forward even in good years. That said for an off year the industrial market remains decently healthy today relative to its historical performance. Outside of Southern California most markets are flat to slightly up in market rent growth, and national vacancy is around 8.5%, which while above the lows set pre-covid, is around where vacancy was in 2005-2007.

With the selloffs some of the industrial REITs became more interesting. To wit, we initiated a position in LXP. LXP owns a portfolio of newer bulk buildings in growth / non coastal markets. At today’s price (~$8.5/share), LXP is trading at an implied mid 7s cap rate, and only ~$65 per square feet, for a high quality portfolio that is only ~10 years old on average. $65 psf is basically just the hard cost for such a building today, with land, soft costs and carry you are $85-90 at least, and realistically these things need to sell for $100 psf+ to justify new construction.

Management claims the mark to market on its portfolio7 is around 13%. Even with almost no market rent growth that would bring LXP to an 8%+ yield in just a few years, which in my view is a very attractive yield for a portfolio of new bulk distribution assets in growth markets.8

LXP’s history is a bit of an interesting story - they used to be a net lease REIT, and 8 years ago began to transition to an industrial only REIT. They still have a handful of old office deals they are still trying to sell, but basically all the value comes from their industrial portfolio. The transition is essentially complete, but some investors may not quite realize it yet so there is some potential value overhang there which presumably would close over time.

Finally swinging into the realm of anecdata - as relates to industrial at least, it feels like the private investment market is picking up notably despite the slower fundamentals. Here is Hamid commenting on underwritten buyer returns compressing significantly.

On a personal level, I have seen what feels like a significant uptick in cold out reachs asking about buying some of our warehouses, and have heard competition for deals has picked up from other private buyers.

Given the weakness in multifamily, industrial is the last remaining ‘cool kid’ that all the lenders and capital providers want to invest in. At a high level I continue to expect industrial prices to benefit as capital that was previously allocated to other asset classes moves towards industrial.

So I feel pretty good about buying into industrial assets at a healthy discount to private market, when that private market price looks to be headed a good bit higher over the next few years barring a large recession.

Retail:

Retail continues to perform well. Sales are healthy to strong - January underperformed a bit YoY but February was strongly up at 1.5% YoY, and March blew past expectations coming in at a whopping 3.6% YoY!

This strong consumer spending has supported strong retailer leasing demand. And beneath all of this demand and spending is of course the American consumer, who is honestly in pretty good shape. As inflation slowed and wages remained elevated, real disposable income growth jumped over 4 % for much of 2023.

Government transfers have slowed some, but wage growth remains fairly strong which combined with falling inflation continues to yield solid real income growth. And its important to note that retail prices are nominal, not real, and the nominal consumer income growth is even higher (referring back to our ATL Fed wage tracker just under 5%).

Rising incomes of course help support rising spending, which is good for retail! There are a few potential clouds on the horizon as wage growth continues to slow, but nothing terribly concerning as of yet. Still - I don’t think the current retail spending growth is sustainable, and if wages and inflation both continue to slow spending should normalize as well.9

Of course the strength does not extend through the entire sector - weaker malls & centers continue to decline and die, however this actually benefits the assets which survive as that spending is redistributed across other centers.

There remains some churn as certain retailers perform better than others but this is normal. A few pieces of notable news are the Joannes bankruptcy, which was quite positive in that thus far they are not planning on closing any stores, and Family Dollar / Dollar Tree planning to close around 1,000 stores. Interestingly though Dollar General is still very much in growth mode, so this may be more of a company level issue.10 Department stores also continue to struggle, with Macys announcing another 150 store closures.

Generally I find it a bit interesting that many of the retailers who were still expanding in the 2015-2020 period are now struggling and closing stores. Big Lots, Dollar Tree, & many of the pharmacies seemed like the only game in town for retail leasing for years, and now it looks like they all over expanded. Offhand really only TJX seems to have managed that growth well.11

In our own portfolio, MAC remains the star of the show here. Notably the old CEO retired and they brought in Jackson Hsieh, the former CEO of Spirit Realty. Jackson is well regarded on the street and I view the change positively.

Leasing remains really strong, with 2023 coming in at 4.2 million square feet, a record year for MAC. This strong leasing translates into a really strong signed not opened pipeline of $64 million, which will mostly hit in 2024 and 2025.

And despite some macro uncertainty, retailers continue to lease new space.

Mac did an impressive 4.5% same store NOI growth in 2023, and is well positioned for a strong 2024. Mac is only guiding to ~2.75% NOI growth for 24 - they expect some further headwinds from expense inflation & some temporary decline as space turns over, but I also suspect they are being conservative with this number and they are likely closer to 4% growth.12 Mac is exposed to the struggle of department stores like Macy’s, but they have had great success releasing department store boxes and given the low rents the department stores pay the process is often quite accretive despite some large up front capex investments.

While MAC has rallied a good bit, it still trades at what I view as a very attractive NOI yield of ~7.8%. Combined with its likely income growth of 3%+ over the next several years, and there is just nothing else with such an attractive combination of yield, stability and growth in the REIT space.

Compare this to investor darling industrial. Once you mark the industrial REIT rents to market the implied yield is in the low 6s (varies by REIT of course). So you have to believe industrials will grow income at ~5% for a decade, after marking up rent to match an investment in MAC.13 Given the commodity nature of warehouses I find this extremely unlikely.

Hotels:

I have written a good bit on hotels recently, (article here), so I’ll make this section shorter but will provide a brief update. The hotel sector as a whole had a fairly strong end to 2023, and our major investment, Park, had a very strong end to the year.

Overall the hotel market continues its normalization, and leisure remains a bit soft off its covid highs, while business and in particular group travel have continued to recover strongly.

The one fly in the ointment here is that operating expense growth has been fairly high as well, so the strong revpar growth has not translated into outsized NOI growth (although it has still been respectable!).

I expect tax and insurance growth to level off14, and labor costs to slow a bit as well, so this pressure should moderate somewhat in the next few years.

Park specifically has had a good Q4, with 4.1% revpar growth, about in line with my expectations. Most notably Park has had a really strong start to 2024, with a whopping 13.4% YoY revpar growth in January and ~8% in February.15 This is driven in large part by strong recovery in Park’s urban, and in particular group driven markets.

This strong group pace of 13% YoY for 2024 should should help Park generate robust revpar growth relative to other hotel REITs, thanks to its very group oriented portfolio of large assets with significant amounts of meeting space.

Overall given the strength of the US economy & consumer I would expect hotel demand to be pretty healthy in 2024. The real question for NOI growth will be if expense growth levels off as well. Generally though given the favorable limited supply backdrop, this combination of strong demand growth and minimal supply should continue to provide a really nice tailwind for hotel owners over the next few years.

Storage:

We’ll wrap things up with storage, a sector near and dear to my heart on the private side, although we don’t own any of the storage REITs at the moment. In general the storage market is very weak right now, with new rental rates in particular down massively in many markets (national averages over a 10% decline per Green St, which feels about right from the markets I follow), including most of our covid boom poster children.

REIT results have not been quite as bad as their big coastal markets like LA & NYC have held up better, and they have also been able to offset much of the street rate weakness with strong rate hikes on existing customers. Public Storage’s results illustrate this pretty nicely, as PS was able to raise revenues over 4% on the year despite declining occupancy!

Also note the sunbelt & FL markets at 2-3%+ occupancy loss from 22 to 23, vs coastal ~1-1.5%.

If street rates stay this low for another year though, the lower street rates will really begin to impact REIT results. However if demand recovers sufficiently the REITs may well be able to skate through without significant NOI declines.

We will see what happens here - storage is very volatile on both demand and supply given its relatively small size. Moves are a big driver of storage demand, so more home sales / apartment rentals = more storage demand. Apartment leasing has been quite strong which would be bullish for storage demand and so we will have to see what the single family sale market does this year.

Fin

I’ll leave it here for now - these letters are becoming a bit unwieldy, I may try to trim them in the future. To recap, I believe we are at or near the bottom in pricing for most asset classes, and we should see pricing rise from here driven primarily by rising income growth. I expect multi, storage and of course office to be laggards due to their weaker near term demand profiles & thus weaker income growth. Hotel and retail demand is healthy, industrial is decent, and multi demand is fairly strong but is just overwhelmed by even larger supply. Office remains very weak, although there are glimmers of life in a few markets.

We have seen lots of volatility in the REIT market as it obsesses over inflation, but I believe if you can ignore the noise and stomach the volatility the REIT market continues to be a very interesting place.

First, the returns. War Cap was up 2.17% through the end of Q1, compared to -0.72% for the USRT index and 10.79% for the S&P. I am pleased we were able to continue to outperform our real estate index. Of course I’d also like to beat the S&P - but you can’t win every quarter, especially one where Nvidia is up nearly 90% YTD...

I actually feel especially good about our performance this quarter in light of our phenomenal year end last year, being able to hold onto those strong gains is a good thing.

Our long term outperformance is clearly visible in our returns since inception in 2020, at 172.82%, compared to 51.29% for the USRT & 95.41% for the S&P, even with the recent tech rally.

I continue to feel good about our portfolio - we own very high quality assets at yields significantly above private market yields, & at prices well below private market and also replacement cost.

Now the broader economy is another question.

First I’ll discuss the general CRE markets a bit, then overall macro, and then dive into CRE sector specifics.

Private market CRE prices may have bottomed out, or at least prices have stopped declining for now. Here is Green Street’s commercial property index showing values over time.

If I had to wager I’d guess we are either at or close to the bottom in terms of private market CRE pricing, and many large investors feel the same way.

The largest CRE investor, Blackstone, is aggressively moving off the sidelines - here is Gray talking about real estate on their Q4 call.

It certainly doesn’t hurt that BREIT finally was able to meet redemption requests for the first time since 2022.

Lending however remains more constrained, as many large lenders continue to work through problematic loans. That said, at least on the banking side it looks like we are past the worst of it and conditions are beginning to loosen. Here is another Green Street chart which tracks the share of banks tightening or loosening CRE loan standards.

I don’t think this cycle is going to be ‘typical’ because it is the first to involve higher rates in many decades, but it certainly looks like in another year that bank lending for CRE will be a good bit more available at the current trendline. I’d guess the balance sheet constraints are mostly gone by then and at which point it is going to be a value/DSCR issue.

Historically these two factors combined (increasing investor and lender interest in CRE), has lead to CRE bull markets, and if we can avoid a big national recession I expect the same to occur here in the next few years.

All is obviously not all roses in the CRE world - the price declines may be over1, but we are very much still dealing with distress coming through the system. CRE distress is always slow to manifest, as it takes awhile for physical property performance to deteriorate, and then it takes another 6-18 months for a lender to accept reality and either foreclose, sell the loan, or modify it.

In the public space these struggles are evident in many places, one of which is the CRE mortgage REITs. These are almost all bridge lenders, which means they typically make higher LTV/lower DSCR loans on transitional properties. As you can imagine, this is a risky place to be in a downturn, as these are the first loans to suffer losses.

Several prominent short sellers have come out with short reports on a couple of these firms over the last several months. The quality on some of these reports was shockingly low, but I think in general they have a point. The difficulty here is that the balance sheets are black boxes2, and asset price declines are at a level so as to be right at the edge of where you might see loan losses.

So - if the lender did a good job, I could see a world in which losses are manageable. However if they made a bunch of bad loans (or even just a few really bad ones), losses could be quite severe.

Thus far, losses have been fairly manageable, but we are nowhere near out of the woods yet and it wouldn’t surprise me if at least one of these firms has some fairly bad losses.

Overall - sentiment in the CRE capital markets seems to be improving, and this should be broadly supportive of prices moving forward I believe in either a high or low inflation scenario. If inflation remains high, income growth should pick up / stay strong (depending on asset class), and if it falls we will likely see some cap rate compression. Speaking of inflation -

General US Economy

Looking at the economy more broadly, the biggest macroeconomic story of the quarter, at least from a CRE perspective, has been the stronger January and February inflation readings.

January core PCE came in hot at 5.1% MoM, however February cooled off a bit with core at 3.2% MoM.

As per usual here is the latest, courtesy of economist Jason Furman over on Twitter.

Encouragingly, Core services ex housing was only 2.2% in February - this is the closest thing to a ‘wages’ proxy that the PCE has.3

These hotter readings have tempered expectations of quick fed rate cuts, and the 10 year is now back above 4.3%. I am cautiously optimistic March’s data will look better & that January’s hot reading was more noise than trend, but we shall see.

There is a theory floating around that the hotter January / February numbers are being driven by exaggerated beginning of year seasonality. The idea is that most firms raise prices at the beginning of the year, as many items at priced on an annual basis. The BEA of course corrects for this with seasonality adjustments, however these adjustments are based on historical data, and so if the price increases are higher than normal, it may overwhelm the seasonal adjustments.

In a world where we just saw a large bout of inflation, it is not unreasonable to think that many firms are still playing catchup on their pricing, and thus are doing larger than average annual increases still. This may be what caused a strong January reading.

Beyond this theorycrafting, there is some data to support continued (healthy) softening in the economy.

Indeed publishes a really nice data set on new job wages I believe I’ve mentioned here before. This data continues to show steady softening, with YoY growth down to 3.3% in February.

The reading was 3.6% in January, so at the current pace, new wage growth would be below the 2019 average of 3.1% potentially by next month!

The reason I like this dataset as it appears to be a leading indicator (which makes sense as it is focused on new jobs). Here is the same data compared against the popular Atlanta Fed wage tracker.

The two have generally moved in tandem, just with a significant delay for the Fed data. So it will be very interesting to see if wage growth does indeed cool off later this year, or if something is driving a divergence between the data. The Indeed dataset is relatively newer, so we don’t have many years of history to review for it.

Overall though right now I don’t have a lot of confidence either way as to whether the economy is continuing to soften with declining inflation (and even a potential recession), up ahead, or we are seeing a reacceleration of inflation.

It may be we continue with the theme of rolling or regional recessions - tech and coastal markets had a pretty rough 2022/20234, and now seem to be recovering thanks to a strong rally in tech stocks and continued strong earnings growth - not to mention the whole AI thing.5 Now the sunbelt and Covid growth markets continue to be having a rough time as some of the prior coastal weakness, combined with large oversupply in certain asset classes, spreads inland.

It is also worth noting that the sunbelt draws much of its economic growth from coastal relocations, both on an individual and corporate basis. The sunbelt may be facing multiple headwinds here as relates to this growth engine. The first is that Covid may simply have pulled forward a lot of latent relocation demand, and thus we are now in the hangover stage and it may take a few years for relocation demand to recover.

The second issue is that with coastal prices flat to down and sunbelt prices (both for sale and for rent) massively up over the last few years, the affordability gap that drove many of the relocations is much lower than it has been historically.

Here is a rough comparison of home prices in NYC vs Austin and Atlanta in 2010 vs today ( I couldn’t find a single data source for each metro/time so this is inexact but you get the idea).

Atlanta used to be 75% cheaper than NYC, and Austin 50% - now Atlanta is 50% cheaper and Austin only 22%! The cost of living incentive to leave is clearly a lot lower. 6

People talk about taxes and business friendly climates as the reason for moving, but in my view housing affordability seems to be a very important driver. After all - many of the supposedly low tax sunbelt states actually have pretty healthy income tax rates, but that hasn’t stopped them from benefitting from coastal relocations (only TN, FL & TX have no income tax).

If I had to guess, I’d wager what happens here is the coastal markets re-accelerate, while sunbelt is flat for awhile which brings us back into the historical equilibrium in a few years. But who knows, perhaps the affordability gap becomes narrower still!

Coming back to the broader economy - as usual I don’t have a strong confidence level in where rates and the economy are going to be in 6-12 months. The range of outcomes frankly feels quite wide. On balance the economy looks fairly healthy, with both pockets of strength / overheating and pockets of weakness. Again luckily for us on a longer time horizon I am confident high quality property with good demand profiles will perform well in a high or low inflation environment.

I probably sound like a broken record here but it is worth repeating - in a high inflation world, real estate prices generally increase in line with inflation driven by increasing incomes (or the potential thereof). These increases are further supported by increasing replacement cost as construction costs rise with (or even faster than) inflation.

Just look back at our last inflationary environment - median US home prices just about quadrupled in 20 years!

And of course if inflation stays low and rates fall, that will likely drive some cap rate compression. The cap rate re-rating (aka significant increase) is I believe broadly behind us, barring a massive spike in inflation from here. So what we now face is really a win/win situation for real estate.7 However public markets continue to seem to act like inflation is disastrous for real estate, especially levered firms. Really it is the opposite - if inflation runs hot that would be good for highly levered real estate firms. The real value of their debt would be inflated away!

The dangerous part is when rates rise quickly like we just saw, and financial conditions change much faster than on the ground incomes. But so long as we don’t have another rapid increase in rates, things should be looking fairly good for CRE.

Anyway that is enough macro tea leaf reading, lets move on to the real estate sector specifics.

Residential: We’ll start with residential, everyone’s favorite & most personally relevant sector.

Generally the overall multifamily market remains soft, but the regional dispersion is becoming significant. Coastal markets are strongly outperforming the sunbelt and covid boomtowns due to lower supply levels and decent levels of demand. However coastal markets are still overall soft - only SFR is really showing some strength.

Again from Green Street, here is a chart demonstrating the spread. The coastal markets appear to be improving YTD, while sunbelt continues to struggle.

I should clarify that demand in terms of units leased is actually still quite strong in the sunbelt metros, the problem is more that supply is even greater (this is of course a good thing if you are a renter). Given the number of units under construction there should be no relief in 2024, but things ought to get better in 2025 and even more so in 2026 given falling number of starts.

The multifamily REITs continue to trade below private market pricing, in the 6 to 6.5% range, whereas private pricing is more mid to high 5s (weaker markets like the midwest have pushed into the 6s). Here and there even greater discounts can be found.

Stepping back - clearly fundamental performance is going to keep getting worse for much of the sunbelt, with potential NOI declines for sunbelt oriented REITs. However I suspect that even sunbelt multi is at the bottom in terms of pricing, or close to it, as everyone else can see the cresting supply wave and therefore investors will likely be willing to stomach lower yields if they expect future earnings growth.

One potential source of upside in the multi markets is immigration driven population growth. The Census is only recording immigration at 1.1mm based on what I believe is legal immigration data. However the CBO estimates that there were actually more like 3.3mm immigrants in the US last year, many of them illegal.

Here is a chart from John Burns consulting detailing the differences.

I’m not going to get into the politics of this here, but the facts are that even illegal immigrants occupy housing, and if this trend keeps up the extra 2mm people per year could completely offset the supply wave even at a fairly high density of people per unit. For context total vacancy is ~1.6mm units and 2024 deliveries are estimated at 460k units, and it should fall off from there. Even at say 4 people per unit that’s an extra 500k units of demand per year. Certainly something to watch.

Finally I want to touch on the single family rental market or SFR. This market has performed much better than traditional multifamily, and it benefits from significant demographic tailwinds. Further higher mortgage rates likely serve to push people out of home purchases into home rentals more than into apartment rentals.

Here is another chart from Burns on the favorable demos - the prime home buying ages (30s and 40s) are going to see a big increase in population over the next 10 years.

This aging trend alone is going to continue to provide a nice tailwind for the single family housing market, and high rates continue to push some of that growth into rentals instead of purchases.

Blackstone again piling into secular trends here, with their recent purchase of Tricon, a large SFR REIT which was based in Canada but had most of its investments in the US.

All that said, home prices in general feel stretched to me as everything else in CRE has declined except single family, but certainly the NOI growth story here should be pretty good over the next several years, and the demographic tailwind may be enough to keep overall prices afloat despite the huge increase in rates.8

All in all - while multifamily has distress there are some opportunities here as some REITs have oversold and are trading for quite attractive yields. We have taken positions in two smaller apartments REITs that are trading over a 7% cap rate which should I think generate very attractive returns over a 3-5 year hold. We also have taken a position in an SFR firm that is trading a discount to private market value as well. I think multifamily will have another rough year, but has the potential to surprise to the upside with strong population & job growth. Incomes should recover in 25/26, and values will also likely begin their recovery, further boosting NAVs. SFR I expect to post healthy income growth over the next several years again based on strong demographic tailwinds.

We’ll end with residential as this letter is running long. I will send out the remaining sectors soon. If you have any thoughts on splitting this up, either good or bad, I’m all ears! It is an experiment as I said, and if folks hate it I can switch back to one long letter.

Dear investors,

I am writing to give you our year end 2023 update. We have had a phenomenal year, with YTD returns at 49.99%, far exceeding our benchmark USRT's3 return of 12.98%, and even the S&P's strong 26.29%. Since inception the contrast is even greater, at 167.84% vs 51.89% for the USRT and 76.38% for the S&P. We have outperformed the USRT every year since inception in 2020.

Performance comparison of sample $100k investment.

I dislike self promotion, but if there was ever a year to take a victory lap, this is it.

This final quarter in particular has been very strong, with gains across the entirety of the portfolio. For the year, our strongest performer was VNO. VNO was up 34.33% on the year, which is very good, but I doubled down on the stock when it traded down into the mid teens, and those investments are up ~100%. This is an excellent example of the value good active management can add, and was enabled by my strong conviction in the value of the underlying portfolio. Other strong performers this year were Park Hotels, up 32.93% (more when you factor in their large year end dividend), and Macerich, up 38.01%. Not every stock we owned was so good, but these were our 3 largest positions.   

Overall – despite the rapidity of the recent rise in prices, nothing in our portfolio is as of yet above or even at NAV. Further generally I think at this point the trend will be for NAVs to increase as private sector values in many asset classes begin to claw their way back. So, despite the rapid rise in prices, I still feel pretty good about our portfolio. However that value gap is far smaller than it was earlier this year, and returns should be more moderate going forward.

The strong performance of our investments was driven both by solid operating performance of the underlying firms, and also an overall rally in the REIT market (which obviously we outperformed).

The REIT rally was driven by the continued moderation of inflation data & treasury rates. I discussed this extensively in my Q3 letter – at that time I was puzzled by the continued spike in treasury rates despite very favorable inflation data. The market seems to have finally got the memo several months later, and at the time of this writing the 10 year rate is around 3.95%4, a whopping nearly 100 basis points below where it was at the writing of my Q3 letter. Amusingly enough though the rate is actually just about where it was when the year began.

Given the softness in apartment rental data & used cars, I am hopeful we should have a continued glide path towards lower inflation rates at least in the first 6 months of 2024. The fed has acknowledged this and is now guiding towards a few rate cuts in 2024. Wage growth has continued to decline, although remains slightly above pre-Covid levels. Personally I am not terribly worried about slightly above trend wage growth – if the economy can deliver moderate or even goods disinflation while wages are growing strongly, is that not the best possible outcome for the country? Much better in my view to have strong wage growth, especially for lower income people, than for the country to have ultra-low interest rates which only really benefits a few very leverage sensitive investors.

That said, wage growth may well continue its decline back towards pre-covid levels. Ultimately, the economy isn’t all that different today than it was in 2019, so it would not shock me that as normalization plays out that our growth looks broadly similar to how it did back then (with a few notable exceptions).5

If the decline in rates continues, my assertion that real estate values are not terribly sensitive to rates over the medium & long term may well never be fully tested. The market continues to treat commercial real estate as purely a financial asset that is very rate sensitive, just like long dated bonds. As I have said time and again, this is not the case, and the long-term price drivers are the forces of supply (governed by construction costs and zoning restrictions) and demand (the drivers here vary by asset class). Obviously though in the short run a sharp spike in rates can have significant impact, as we just saw.

The rate hikes, as we all know, have driven significant value reductions in CRE across asset classes in the last year and a half, so much so that prices for most asset classes are at or below their 2014 levels! The only classes which are much higher are industrial, storage, and mobile homes.

The issue, and opportunity, here is that the cost to build a new building is significantly higher today than it was in 2015. Take apartments – costs are up ~30% since just precovid, and more like ~70% or higher since 2015. Now – prices vary significantly across markets, and the major urban market’s underperformance is pulling these averages down somewhat. For example multi prices in most sunbelt markets are not at 2015 levels – they are closer to 2019 levels (or even higher).

Setting aside the local variation, broadly speaking what this means is we need to see fairly significant price appreciation in many asset classes to justify new construction. This force should provide a strong tailwind to value appreciation over the next several years. I do not know if this will take 2 years or 5 years, but I am confident it will happen.

As I alluded to above – this supply driven pressure gives me confidence that NAVs will broadly begin to increase from here. Not every asset class, and not every market, but I would wager we are close to the bottom in terms of private market pricing, if not there already.

Of course if we have a true recession we would likely see further declines in private market values, but at this point, I just don’t see a big one coming soon (famous last words!). It is worth noting that at this point, many sectors of the economy, and also of the commercial real estate market, have essentially just gone through or are in the middle of a downturn! This means there just isn’t that much fat out there for the cutting.

On the broader economy side, we either just lived through or are in the middle of a downturn in the following (not exhaustive!) list of sectors: Travel, retail, tech, energy (remember when crude prices went negative in 2020…), financials (we did have a bit of a banking crisis in the spring), trucking, & biotech. Really the only sectors that haven’t been too badly hit seem to be manufacturing & construction. I don’t have a good read on the former, but the latter seems set for a slowdown in 2024 as the decline in commercial development starts finally begins to ripple through the system. That said strong manufacturing construction may well end up offsetting much of the decline there.

In real estate itself just about every sector has either just been through or is now going through a downturn, with the exception of industrial & single family6.

So it is really hard for me to see another broad recession coming when we basically just lived through one! The difference here is that this downturn was spread out – the ‘rolling recession’ many people were referring to really does seem to be the most apt way to describe what has occurred.

The other tail risk is a reignition of inflation. As I noted before if I had to bet, I would wager we are indeed done with high inflation, and that we should be in a 2-3% range moving forward (but my probability distribution has a decent sized chance of inflation picking up again – I think it's very hard to predict). All the same structural factors keeping inflation below that range pre-covid are basically still in place, so I don’t see why it should all of a sudden jump massively (after the covid bullwhip normalizes that is). If inflation runs a bit hotter than 2010-2019 (which I suspect it will) it looks like it will do so on the back of healthy wage growth, which again to me seems like a good thing.

The other item giving me some comfort on inflation for at least the next ~12-18 months is the impact of housing. As I have mentioned in my prior letters – housing is a huge share of inflation data (~1/3 of CPI and ~18% of core PCE), and the way the government estimates housing cost inflation is very lagged. If you substitute in new rental data inflation over the last 12 months has actually been below 2% by a healthy margin, and over 6 months it is under 1%!

Chart is from economist Jason Furman. Again worth a follow on Twitter!7 I would normally share PCE here but he hasn’t posted the latest PCE data (which was broadly very good) – the PCE with private new rent though would be a bit higher than the CPI, but still well below 2% on a 6 month basis (which is when inflation really started to slow down)

These low housing inflation figures are because many markets (particularly those in the sunbelt) are seeing YoY rental rate declines. More on this in the apartment section, but broadly speaking given the supply pressures multifamily is going to face in 2024 (which is to say record deliveries), the housing inflation data should continue to decline, which will in turn put downward pressure on the headline rates.

 But inflation is very difficult to forecast, and in my view what inflation does will not significantly impact our medium to longer term performance. So I am not terribly worried about higher inflation.

This is because private cap rates have already been marked up to rates that are more consistent with ‘higher for longer’. Any scenario with sustained high inflation is going to generate healthy NOI growth, which will in turn lead to value appreciation (underpinned by replacement costs rising even higher). Now in the short run if inflation picks up I would not be shocked if the REIT market freaks out, given how it has behaved thus far. But private market values I don’t think would move too much further in a higher for longer scenario, and eventually will start to rise driven by strong income growth. So this does present some short term ‘risk’ to our portfolio, but I don’t think it would actually impair values over the medium term and thus I don’t worry about it too much. I care about the risk of permanent capital impairment, not short term volatility.

But that is enough macro discussion for this letter, onward to asset class specific commentary.

Retail

We will start with retail.  The story here is pretty similar to where we stood in Q3. Consumer spending remains very strong – and retail leasing thus far has also been at historically high levels.

Of course not every single retailer is performing well. Notable weak performers are home goods & home improvement retailers, who are suffering from the slowdown in home sales, sporting good sports (likely a covid normalization bullwhip), and electronics retailers. Luxury goods, which aren’t broken out in the census data, are also beginning to soften a bit. It is also important to understand that department stores continue to struggle (they are buried in the General Merchandise category).

Still – overall the retail market continues to perform well, buoyed by minimal new supply. The demand side appears to have solid underpinnings as well, with inflation adjusted wage growth finally re-emerging due to continued healthy nominal wage growth with lower inflation.

As it relates to our portfolio in particular, Macerich has continued to have a very good year. They have had 5% NOI growth YTD, and look set for continued strong growth in 2024 and 2025. Mac’s signed not opened (SNO) & under negotiation leasing pipeline has grown to a whopping $75 million in incremental rent growth.

That is nearly a 10% increase on current NOI. Now – MAC will also lose some tenants which will offset a bit of this growth, but it shows just how much near term income MAC is likely to see. This also doesn’t even count the typical ~3% rental escalations the existing tenants have. As Mac’s CAM structure has fixed escalations inflation chewed up a good portion of their in place rate escalations in the last few years, but as inflation has fallen these rental rate increases should begin to power further NOI growth in 2024. Net net - it wouldn’t surprise me if MAC can do 5% NOI growth in 2024 and 2025 if we can avoid a recession.

Hospitality

I covered hospitality pretty extensively in my last substack post, available here. So I won’t rehash it too much here.

I was intending to do a deep dive of Park Hotels, one of our major holdings but the stock has moved so much in the past month the current valuation, while attractive, isn’t quite as good as it once was.

Park’s valuation has obviously moved in the right direction, but its operational results have also been quite strong. Park’s Q3 earnings showed continued recovery in their urban markets (which were holding the portfolio back), and this if anything appears to have accelerated in October and November. Park recently released an operating update showing the recent strong pickup in YoY RevPar growth.

This growth has been powered by Park’s urban portfolio and also strong performance at their Hawaii assets. This is broadly as I expected – Park’s urban assets should see a nice growth tailwind from increased group & business travel & their Hawaiian assets should see tailwinds from the re-emergence of the Japanese traveler who were ~20% of demand pre-covid but were only at ~5% recently.

I am hopeful this growth can continue into 2024. Park has many large assets that are oriented towards group travel, and 2024 group bookings are trending well above 2023  which should provide a strong boost towards revenue and earnings growth.

Multifamily

Multifamily, fresh off its post covid high, continues to take its lumps. As I discussed in Q3, while demand remains fairly healthy, record high supply levels are driving rental rate declines in many markets, especially those in the sunbelt. See below chart from apartment software provider Realpage.

The minimal prospects for near term income growth combined with much higher rates means the multi market is no longer willing to underwrite the record low cap rates which drove value growth in 2021. Cap rates have been creeping up since 2022, but this last quarter feels like we finally saw many participants accept these higher rates as reality (except of course BREIT who seems to continue to use 2021 marks).

For example, NXRT, a smaller multi REIT, is one of the few multi REITs to publish a regular NAV estimate. And they increased their valuation cap rates by a whopping 50 basis points from Q2 to Q3. I think the increase is fair and was not surprising, but it is nice to see management of a REIT be so transparent about valuation marks.

The REIT market though I believe has over-reacted a bit to the current levels of distress. Again take NXRT – there are some issues here given its external management structure, but historically NXRT has traded relatively close to management’s NAV. Now it is ~$348 vs a mgmt NAV of ~$55. At $34, NXRT, which owns a portfolio of sunbelt B assets, is trading at nearly a 7% implied cap rate. This is far better than anything available in the private markets.

I do think private multi pricing might have some downside risk in 2024 if inflation reignites, as the combination of sustained higher rates + weak income growth could well push cap rates even a bit higher. But if inflation stays subdued I think we are probably near the bottom in private market values, perhaps with a little more decline to come (again ex recession).

That said prices have fallen far enough from the peak to create some distress for those who bought at the top, with value add deals in the sun belt having an especially rough time. We have seen a number of foreclosures in major sunbelt markets and I would expect there are more to come.

Office

The office market continues to be fairly anemic, but critically more and more employers are returning to the office, and some markets are showing the first signs of potential recovery.

NYC – the market I care by far the most about, has seen availability decline a bit from the peak of 16.6% in Q2, and is now around ~16%. The change in itself is hardly anything to write home about, but it is important that it no longer appears to be declining – investors feel far more confident once a bottom has been found than when the knife is still falling. I’d like to see another quarter or two of improvement before officially calling the bottom, but 2 quarters in a row is a good start.

Encouragingly it looks like office attendance in NYC continues to rise. My favorite data providers have not provided recent updates, but we do have real time rail and subway data, which continues to show improvement from when I last shared it 2 months ago. Here is suburban commuter line Metro North data up until mid December (before Christmas).9

Interestingly subway ridership, which has been fairly flat for the last year, also began to show a noticeable uptick post Thanksgiving, moving from low 70s to upper 70s. This is too early to call a trend quite yet but it’s a dataset to watch.

Other markets are also showing some improvement, but the trendline is even more nascent than NYC. DFW and Atlanta both have 1 quarter of vacancy reduction under their belts – far too early to call a trend but better than nothing.

Other markets are having a rougher time, with the tech metros in particular continuing to be especially weak. For example here is the vacancy in San Jose (Silicon Valley) from Costar.

This isn’t terribly surprisingly as the tech majors have not begun to really hire again yet, and have laid off a large number of employees in 2023. Even just recently Spotify laid off a full 17% of its staff.10 Not to mention the impact of many startups and a few larger firms going remote.

There is some hope on the horizon though for the tech markets – money is pouring into the AI/machine learning space, and the pace of innovation has been very rapid. While AI may already seem overhyped in the stock market, the reality is we are just in the first inning in terms of its impact on the physical landscape of the tech markets. OpenAI for example only has ~700 employees! Compare this to Google with nearly 200k employees against a ~1.75T market cap. And thus far almost all of the large AI players are based in the bay area, which may provide a ladder out of this mess for that metro area if they are able to grow and scale up.

Still – WFH’s impact on the tech industry has been significant, and it will take a lot of growth to pull out of the current hole. I do think Silicon Valley will one day again be a landlord’s market, but it is probably 5 years away at least. San Francisco is a different story…

I am frankly still trying to assess the potential overall impact of AI but at a minimum it does look like this technology could power the next wave of tech growth, as there appear to be a lot of areas that generative LLMs can be applied to today. It feels to me like the tech even at its current level (with some polishing) could have large impacts on many large fields such as education, law, accounting, software engineering, marketing/sales, & finance.

As to whether current LLMs are stochastic parrots or actually on the road to true understanding – well I shall leave that discussion for another day.

Industrial

The story in industrial is again fairly similar to what we saw in Q3 and Q2. Fundamentals are the strongest of any asset class, but they are softening as well. Vacancy continues to tick up in the face of heavy supply deliveries across many markets, and is now above pre-covid levels across the US (which were themselves very low levels).

Here is bellwether Prologis’ analysis of vacancy rates and forecast for the next few years.

 They have begun to call the current dynamic a ‘mini cycle’, which I suppose is analogous to more of a hiccup than a full blown downturn.

PLD itself though still has a near record 97.5% occupied portfolio, and is still seeing/forecasting rent growth in many markets of 4-6% for 2024. If that figure proves true it would be strong performance relative to what the other asset classes are likely to deliver. If I had to guess, this forecast seems fairly reasonable but I think if the economy enters a recession industrial has more downside risks to demand than other asset classes due to the significant new supply under construction in many markets.

Industrial is in some ways more interesting to me in terms of its comparison to other asset classes. At 4-6% rent growth and slightly rising vacancies, industrial’s near term performance actually would look pretty similar to what I would expect for high quality retail and hotels for 2024. And yet PLD trades at a ~13% premium to Street NAV, which is itself already based on a cap rate in the upper 4s. Compare this to retail and hotels at a discount to NAVs, which are based on cap rates in the 7s and even 8s.

Now the comparison isn’t quite so simple – PLD has a huge embedded rental mark to market which should push their yield closer to 6%, and industrial is lower capex in general, but even after those adjustments I much prefer the retail and hospitality sectors.

This is not so much to say that I view PLD as hugely overvalued, but rather more that I believe retail & hospitality are undervalued.

Speaking of cap rates – they have continued to move up a bit more since Q3. Estimating these is a bit tricky though due to a small number of sales & a wide range of mark to market for rents on individual properties though. I would estimate that similar to other asset classes cap rates should begin to stabilize now that rates have softened up a bit, if inflation remains subdued.

Fin

Overall – the major story in CRE continues to be the interplay of interest rates and operating fundamentals. We have finally begun to see some rate relief, which boosts everything, while operating fundamentals vary widely across asset classes. While rates overshadow everything in the short run, in the long run though what really matters are operating fundamentals and replacement costs. And so in my view the most important thing to remember in this market is that we have seen a huge increase in construction costs in the last several years. Combined with current private market value declines, almost no asset class can justify new construction at current levels (industrial being a notable exception in certain markets). This creates opportunity, as many assets with good demand profiles are still available in the public markets today for well below replacement cost & below current private market values. The private market values will eventually need to rise to levels that will justify new construction, and the discounted REIT values should magnify these gains. The specifics of course matter significantly & vary tremendously, but overall I continue to see interesting opportunities in the REIT space driven by this fundamental imbalance. 

Although it may not look it from my posts here, I invest in a lot of other things other than office REITs. So in order to mix things up I have decided to write a bit about the hotel space, another area I find interesting.

The Four Seasons Jackson Hole - owned by Host. If nothing else hotels are certainly the most fun asset class, where else can you write off a visit to a ski resort as part of due diligence.

First - again let me point you to my general disclaimer page here. Nothing here is investing advice, do your own DD.

Hotels in general are cheap in the public markets - most hotel REITs are trading in a 8-10+% cap rate range. This is one of the highest commercial real estate yields available outside of the office sector, and even then it’s often comparable.

But this yield is superior to that offered by offices in several ways. First and obviously, hotels are not facing an existential crisis like WFH. Second - the capex burden of hotels is generally superior to that of office.1

For comparison multifamily, industrial, & self storage cap rates are in the mid to low 5s (although after the recent treasury spike those may be headed higher).2

So why are hotel yields so much higher - is there something specific to the asset class, or some looming trouble on the horizon?

As it relates to the asset class the short answers for potential discounts are covid, capex, operational intensity and volatility - I’ll spend a bit on each below. Spoiler alert: some discount is warranted here but nowhere near what the public markets are pricing in.

As for whether there might there be some looming issue on the horizon which could cause incomes to decline - the short answer is no. To fully address this though I will dive into the state of the hotel market & its primary sub segments of leisure, group & business transient travel. The big story in hotels since covid has been a strong recovery in leisure/resort that has now moderated some, and a slower ongoing recovery in urban business/group hotels. The urban markets in particular I believe present interesting opportunities, as if trends continue to normalize growth in these markets could push strong yields even higher.

Some Background

Before we get too far into the details, it is probably worth spending a moment on some general industry terminology/background, and what I believe is a failing in the public markets. My big beef is that everyone in the public space, including the REITs, uses Ebitda to refer to hotel earnings. However the private sector, which is most of the hotel business, uses Net Operating Income (NOI), same as other real estate asset classes. I really dislike the use of Ebitda in publics because it is not how hotels are actually valued, and because you cannot convert it cleanly / easily to NOI.

The reason for this is that hotel NOI is essentially Ebitda less capex reserves plus corporate G&A. Hotels are a capital intensive business - beyond the building itself, room soft goods (beds, sheets, furniture, carpet, often referred to as FF&E), experience intense wear and tear and need to be replaced frequently. Over time the industry has acclimated to this and uses an industry standard 4% of revenue as an FF&E / upkeep reserve. This is not something owners just opt in to - the brands themselves (Hilton, Marriott etc), typically mandate FF&E spend in their franchise agreements.

This formula causes an issue with translating Ebitda to NOI, which is that a higher margin hotel is going to have a smaller ‘loss’ of NOI to Ebitda, while a lower margin hotel will have a much higher loss. See the below chart for a simple example of this.

This is then further obscured by G&A - as G&A does not scale linearly with size (Eg there are economies of scale), a larger REIT with a smaller relative G&A load will have a smaller difference between NOI and Ebitda, as compared to a smaller REIT with a higher relative G&A load.3

So by using Ebitda to compare hotels, public operators are using a less precise metric as not all hotel Ebitda is created equal! In fairness the effect isn’t massive, but it can easily be a 5% differential in effective NOI yield. Another benefit of NOI is it gets you closer to the actual net cash flows in this case.

It is also worth noting that margin does not necessarily scale with quality - a high end unionized hotel may have inferior margins to a lower end basic hotel. Basic full service hotels4, especially lower end ones, also often have poor margins relative to select service hotels. There is in fact an ongoing secular shift in the hotel space due to these margin differentials, where there is continued growth in brands which offer owners the best margins.

OK - back to our yield differential.

Residual trauma

First and foremost, I believe the answer is simply covid related scarring. We are not very far out from the most negative event in the history of the hotel asset class.

I don’t need to rehash it here as we all just lived through it, but it is easy to forget that almost all hotels had zero income 3 years ago, and many urban hotels still had no income in 2022. Hell San Francisco as an entire market still is essentially at zero income. So it shouldn’t be surprising this trauma has created some scarring.

This scarring is evidenced in buyer interest in hotels, but I think is even more visible in the financing markets. Lenders are inherently more conservative that buyers, and it shows it hotel financing. Financing is still difficult today - spreads on hotel lending have blown out since covid, and now hotel debt is 300-400 basis points over the relevant treasuries, vs more like ~200 over for other asset classes. The spread was much tighter pre-covid - for example Park Hotels had a blended interest rate of ~3.9% in Q3 2019, vs 3.6% for top multi REIT Avalon Bay.

Now for top borrowers like the hotel REITs the spread does appear to be coming back in relative to other asset classes - however not many are issuing debt right now given what is typically ample liquidity and the ugly rate environment.

This residual trauma I believe explains the lion’s share of the current REIT pricing. Luckily for us, this is something that should fade over time.

But some level of yield differential is warranted due to some hotel specific issues, as I shall explain.

Capital Expenditures & Cross Sector Yields

The second big issue with hotels is capex. I’m going to spend a bit of time on this as it is an important part of cross sector CRE comparisons.

Based on historical REIT data, the capex burden for hotels (above and beyond the 4% reserves which are already baked into NOI, more on that below) is generally in the 12 to 20% of NOI range. The reason I give a range is that the REITs, as do all operators, bucket capex into maintenance (things like replacing an elevator or the roof, or mandated soft goods updates), and development (most obviously building a new building, but really anything that has an expected ROI to it). The issue is the development bucket can be a bit fuzzy, and it’s possible to rationalize calling something development that is really more maintenance5. Without exact specifics we can’t say for sure - but if you assume there is zero accretion to development spend you get about ~20%. If you assume about 50% of development spend is accretive, that yields capex of ~12%.6 Assuming all development is accretive by the way and your capex burden falls to only another ~3-5%. If I had to guess I’d say the true capex burden is somewhere around ~15%, but it is important to note it varies based on operator and portfolio quality. And compared to multifamily, 15% actually isn’t that bad, its fairly comparable. However - capex has the potential to be significantly higher than 15%, in ways that are somewhat unique to hotels.7

Smaller operators, operators with weaker brands, or just plain bad operators, are going to be at the high end of that range or potentially much worse, as will older, lower quality portfolios. Remember capex also scales inversely with land value - assets with high land value have a relatively smaller capex burden relative to income. So this 15% is for REIT land - a portfolio of old hotels in lower tier markets is going to be way higher.

The other reason capex can go much higher is something called a PIP.

Industry Structure

A quick aside on industry structure.

Part of this capex range derives from the current structure of the hotel industry, whereby the brands (Hilton, Marriott, etc) are separate from the actual ownership of the hotel via a franchise model.

This model means the brands and owners have different incentive structures. In particular brands are motivated to keep their fleet of hotels in top condition - they reap all the financial benefits (higher revenue driven fees), and basically none of the costs. Brands also can have a lot of leverage with owners, as the top brands can bring significant outperformance compared to a weaker brand. Not only can they drive more traffic due to brand awareness & loyalty programs, but the brands can also offer lower costs from third party hotel booking sites as they have the scale to negotiate lower commissions.

These differing incentives manifest themselves in something called a Property Improvement Plan, or PIP. When a franchise agreement expires, brands will often essentially tell an operator they must implement a PIP, or risk losing their franchise.

As you can probably guess - the largest operators (like the REITs) are going to have a lot more negotiating power to reduce these capex impositions than a small operator. This may sound like I’m getting into the weeds here, but this dynamic & PIPs are a really important part of hotel investing. A big PIP or loss of a flag are often behind some of the biggest hotel loan losses, and is a big reason why hotels are perceived as a high capex asset class.

OK back to our comparisons.

We’ll use 15% for our purposes here in looking at the REITs.8 At a 15% capex burden, that means a hotel REIT trading at a 10% cap rate is effectively yielding an 8.5% unlevered net cash flow.

That is just huge compared to the rest of the CRE world. For comparison, class A multifamily is in the ~5-5.5% cap rate range with a ~15% capex burden (again lower in high value markets, higher in cheaper ones in general).9 So a 5.25% cap rate multi deal would yield around ~4.46% of net cash flow. That is literally nearly half of the yield on hotel REITs! The other popular kids (industrial and storage), are in a similar range of NCF yields. I should note that I suspect the recent spike in treasury yields may be driving these cap rates a bit higher but the same idea is true regardless.

Operational Intensity & Volatility

Now - hotels and multi are not equal. Hotel income is more volatile, especially in downturns, and therefore warrants some level of yield premium. To not get too sidetracked here a simple way to think about this is once every 10 years you have a recession and make no money that year, or about a 10% drag on earnings over the long run.10 Setting aside the fact that other asset classes also have earnings declines in downturns (not to mention ongoing generational high supply waves), that would turn our 8.5% cash yield into a ~7.65% yield. This is still way way higher than the popular asset classes.

The last piece we need to address here is the operational intensity of hotels. Hotels have a much larger operating component than the other major real estate sectors, and by and large I believe this warrants some additional level of yield premium. This is because the operational intensity effectively adds an additional layer of volatility, albeit one that is controllable with skill. That is to say - an LP in the hotel space has a much larger risk of a given investment blowing up on them because of a bad operator than an LP in other asset classes. It’s pretty hard to mess up a warehouse, but you can really run a hotel off the rails if you don’t know what you are doing.

The other part of operational intensity is the need for a bunch of employees. This in turn means unions in certain markets, which is another layer of risk and complexity. A union hotel is at risk of the union being able to negotiate pay increases over the rate of CPI, which long term can erode NOI margins. Now this risk doesn’t apply to every hotel, but its a fairly big chunk of the REIT universe.

This last piece is fairly hard to quantify as its pretty subjective & also variable. A good operator with minimal union exposure or a good union position has basically no drag from this, but these two items can be significant for a bad operator.

What is this worth? I would estimate another ~50 basis points of return long term. This would bring out 7.65% yield to ~7.15%.

So - the hotel sector is significantly cheaper than other CRE asset classes. To normalize returns with multi you’d need cap rates in the mid to high 6s on average.11 Perhaps not coincidentally, this is pretty close to where many hotel REITs were trading in 2019.

The next question is, is this discount warranted for some reason, could there be a really awful outlook for hotel earnings over the next few years for example? Or is it just a result of the scarring investors experienced during covid as I theorize above, something which will likely fade over time. To answer this we need to dig into the state of the hotel market today.

Hotel Industry State of Play

As is obvious to everyone, the hotel market was hit really hard by Covid, and has been in a state of recovery for the last few years.

One of the most important things to understand about the recovery is its uneven nature, where we saw domestic resort & leisure hotels recover much more quickly than urban and group / business oriented hotels12. Leisure oriented hotels have done so well that most of them eclipsed 2019 numbers last year, and remain 10-20% (or even higher) over 2019 earnings, driven in large part by higher prices.

The typically more urban non leisure hotels have been much slower to recover, and are only now starting to scrape into parity with 2019 performance. This obviously varies significantly by market - SF for example is still way below, whereas some more growth sunbelt markets are running close to or even above 2019 figures. NYC notably has rapidly improved and is over 2019 levels thanks to a strong travel market, a local Airbnb ban, & city rentals of rooms for migrants. Many of the other major markets though, such as Boston, Chicago etc are still below 2019 levels. It may not feel that way to the consumer though because rates are higher, but occupancy is lower.

This urban underperformance is interesting and I believe is the source of potential investment opportunity, as an investor can acquire significant urban exposure at a fairly attractive yield. If urban performance normalizes with pre-covid, or even comes close, it could generate significant additional earnings tailwinds & bring an already high yield even higher.

To really understand the market though, we need to dive deeper into each of the major customer segments.

Customer Segments

Pre-covid the mix of hotel customers was about ~55% business, 25% leisure, and 20% group, as you can see in the chart for Hilton below.

The chart only goes to 2022 because I can’t find exact figures for Hilton in 2023 (the segment mix isn’t a regular disclosure item and is addressed intermittently in earnings calls).13

As these are just share figures they don’t show total change in category size, but what happened basically was (domestic) leisure travel increased, while business and group shrank dramatically. These trends have begun to reverse as can be seen in the 2022 figures, and what happens to the various segments is an absolutely critical question for the overall hotel market.

Generally thus far in 2023 the story has been one of slight declines in domestic leisure travel, with continued strong recovery in business and group travel, especially in more urban markets.

This can be seen in disclosures from the big hotel operators Marriott & Hilton. Here is Marriott’s commentary from Q3 earnings, where they noted that group is back to pre-covid levels.

coded = covid, these transcripts occasionally have errors.

Hilton didn’t disclose exact group share in Q3 but it also noted group & business led its YoY growth.

Now these overall trends have not impacted all individual hotels equally. Many hotels, by virtue of their location (and branding), are focused on a particular segment. A beachfront resort is obviously highly focused on leisure travel (it’s important to note this can also include some group like weddings). A CBD hotel is often very focused on business travelers, same with a suburban hotel in an office park. Group is a little less easy to spot offhand, but is also a subject of specialization. While every full service hotel attempts to compete for group business, some hotels are specially focused on it. These are typically hotels with large numbers of rooms, large amounts of meeting & banquet space, & also often group travel friendly locations (convention center adjacency being a huge driver here).

The variation between segments here is more easily seen at the REIT level, where some leisure hotels (especially resort type beach hotels), are down as much as 10% or more YoY in revpar (revenue per available room), and certain business or group focused hotels are still underperforming pre-covid levels.

Leisure

While year over year leisure decline is not good for hotel owners, 2022 was a record year & leisure revpar levels are still higher than 2019. Again using Hilton as an example - US leisure revpar is up 10% from 2019 .

So overall leisure demand has held up pretty well even as the world has normalized. Rates are often much higher than pre-covid levels, and they look set to stay that way (albeit with some declines from peaks). To some degree this makes sense - we have had a huge bout of inflation, and so hotel rates reasonably ought to be a good bit more expensive than they were pre-covid… just as pretty much everything else is. That said the ultra luxury segment of the market still feels insane to me - look at the room rates for a hypothetical ski trip this January to Park City! I mean the apres at the St Regis is good but I don’t think it’s quite 3.5k / night good.

The other key component of leisure is international demand. This isn’t a huge share of demand in the US (it’s +- 10% of total demand for many of the large owners), but for certain markets it can be very important. The big thing to know here is that most international travel has come back pretty strong, but travel coming out of Asia is still well below pre-covid levels.

One of the main reasons for this is that China, by far the biggest demand source, literally had a ban on group tours overseas up until August of this year. Another big source of demand (again for certain markets) is Japan. Japan had pretty strict entry rules due to covid up until April 2023, and was all but closed to travel until the fall of 2022. As many overseas trips are planned a long ways in advance, it makes sense that it will take some time for tourism numbers to fully recover. Sure enough, in Q3 Park Hotels reported that Japanese share at its Hawaii resorts was finally rising, with a significant increase from 8% of pre-covid figures in the first half of the year to 24% in Q3.

The question is might there be any long term impacts on demand. On the Japan front I don’t see any reason to expect any long term decrease in visits to the US. China is a different story - there is some risk negative US sentiment could drive down visits to the US, however this could be offset by income growth which generally enables more travel.

Business travel

Next up is what was the largest customer segment pre covid, business travelers. I think during covid there was a real question of to what degree zoom and remote work might permanently reduce business travel demand. However at this point business travel was back to about 92% of pre-covid levels per Hilton’s Q2 earnings call,14 and continues to grind higher. In Q3 they didn’t disclose this exact figure but noted midweek revpar, a proxy for business travel was up 500 bps QoQ! I would guess that business travel is essentially back to pre-covid levels, or very close to it, based on the rise in midweek revenues for Hilton.

In particular Hilton notes that small and mediums businesses are in fact traveling more than they were before covid, it is just some large corporate tech and financial accounts that are traveling less. I suspect given the tech recession and the anemic market for new IPOs & debt that the large corporate travel lag is at this point cyclical & will pick up once those corporates stop cost cutting measures.

It seems reasonable to assume that business transient gets back to 100% (Hilton mgmt believes it will in 2024), if not quite all the way there. Marriott has a similar story - for Q 2 business revenues are up over 2019 driven by higher rates, but overall travel is still down slightly. Unfortunately Marriott gave no specifics on business in Q3 vs 2019.

Again unfortunately the brands often don’t break down the segment data in as much detail as I’d like (eg some of the stats above are global), so it helps to look at the results of large US REITs for more specifics.

Here is Host’s commentary from Q3 - they saw a much larger overall decline in business travel from covid, but continued steady improvement this year.

One thing to note here is that certain cities, notably San Francisco and to a lesser degree Seattle & LA, have had massive declines in travel, and SF happens to be Host’s largest market at about 10% of rooms, and that likely explains some of the relatively larger business decline Host has seen.

And here is Sunstone’s management commentary from Q2 (Q3 call is later today, the earnings release noted 7% YoY urban & convention revpar growth) - stronger rate growth than Host but the same general story.

As you can see at the REIT level there is significant divergence based on specific hotel and market performance - the reality is in the US market level performance has been highly variable (again SF being an absolute disaster).

Given the continued gains across the board, the impact of covid on business travel looks to be largely temporary. Zoom, it turns out, has not been able to replace in person interactions.

Group

The last segment, group travel, covers anything from a wedding or corporate retreat all the way up to a major convention or conference. Group travel was the hardest hit by covid, as essentially all major conventions and conferences were cancelled. And because these events are often planned a year in advance, the convention/conference calendar was still highly disrupted earlier this year (it’s easy to forget but in 2022 there were still a decent number of covid restrictions and worries). But finally in Q3 group looks to have finally just about completed its recovery.

Here is Hilton again - Group Revpar finally exceeded 2019 levels in Q3

Not only that, but 2024 is shaping up to be significantly stronger with 18% YoY group growth! Marriott has similar advanced bookings growth, with group 2024 booking pacing up 14% YoY.

Again it’s easy to forget, but for awhile there were real questions as to whether business & group travel might be permanently impaired by covid. Some pundits were predicting Zoom would reduce the number of in person meetings and gatherings. I never bought this story, and am happy to see my conviction vindicated in the continued growth in both business & group travel.

If anything I could see a world with more business / group travel given the likely continuation of some degree of remote work. I could see firm’s that have gone remote first increasing their demand for corporate retreats and other gatherings to bring far flung employees together.15

So - as we can see across the three major segments, there are no obvious large headwinds the industry is facing. Leisure has held up quite well, and group/business continue to recover in the US. Longer term - travel demand has grown in step with incomes & population. More wealth = more travel, & the same is true of more people. Considering the US continues to grow both population (albeit more slowly), and critically income, it is reasonable in the US to expect growth rates roughly in line with general economic growth going forward.

Setting aside general macro-economic concerns (which always exist), I don’t see anything ‘special’ about the fundamentals in hotel industry right now that ought to warrant a huge price discount. 16

Private Equity Comes a Knocking

I am not the only person to have noticed how cheap the hotel space is. A large take private deal was just announced at the end of August, wherein Hersha Hospitality is being sold to KSL Capital Partners, a large PE firm.

The headline stats on the deal are really positive. KSL is valuing Hersha at ~$1.4 billion. Based on their recent hotel level ebitda of ~$110mm & after taking out the 4% FF&E reserve we get an NOI of ~$96mm. That is a ~6.9% cap rate - again about where many REITs traded pre-covid.

Now - Hersha’s portfolio is very concentrated in core coastal markets, with Manhattan and metro NYC being about a third of earnings, following by Boston & So FL combining for another ~30%. They have a decent mix of urban vs resort, but do skew a bit urban. Also of note is the portfolio is only about 60% encumbered by management agreements (unencumbered deals typically trade for a bit more as you aren’t locked into a long term deal with a brand).

This sale is a big deal, and the market seems to not be paying any attention to it. As I mentioned in the intro - some REITs are trading at ~9-10 cap rates, while we have a major take private here happening sub 7%! That is just an enormous gap, especially considering the lack of major headwinds facing the industry overall.

Fin

So hotels are cheap in the public markets, I believe on both an absolute and relative basis compared to other CRE asset classes. And things look even better when factoring in the relative growth profile of many hotels going forward as business & group travel continues to recover. Leisure faces some headwinds but most REITs should be in a good position to grow NOI over the next few years.

The industry has already seen one take private and I would wager more will come if REIT prices stay where they are today (and the treasury market calms down a bit!). You have wide public/private discounts, growing cash flow, and high enough yields to actually carry buyout debt loads.

Hotels are also cheap on an absolute basis relative to replacement cost. Replacement cost is a concept that gets far too little attention in public markets (which is to say just about zero), and debatably too much, or at least the wrong kind of attention in private markets (as anyone knows who has seen an OM from a broker touting a shitty suburban office deal in a no growth market as being ‘well below replacement cost!’).

It doesn’t make much sense to discuss replacement cost at a sector level as there is far too much variation between hotel types and geographies, but I’ll dive more into this subject in my next article where I will do a deep dive into a single hotel company I think is interesting.