ALM’s long-biased strategy includes real estate investing thought leadership and high-level engagement with management and directors – and occasional activism – with the goal of achieving better corporate governance, capital allocation and operational performance. A research report by Green Street Advisors, a specialist REIT research firm, noted that ALM’s constructive activism with the Independence Realty Trust (NYSE:IRT) board resulted in the appointment of veteran director Craig Macnab and a public commitment to accelerate debt reduction and exit non-core markets, all big activist victories. “This tangible progress helped IRT to obtain an investment grade credit rating, which should improve the company’s cost of capital over time,” recalls Morillo.

The concept had been gestating for some years: “My family is in the real estate business, and after business school my first hedge fund role was at Wesley Capital, which took a similar private markets approach to public market investing. As a senior analyst at The Talisman Group, I had my first taste of contested activist proxy contests,” reflects Morillo. He launched Lionbridge in 2020 with support from a leading credit and distressed debt hedge fund manager before teaming up with AREP to form Argosy-Lionbridge in January 2023.

Volatility spells opportunity

Equity market volatility discourages some investors who seek the smoothing effect of less frequent valuations on private assets, but for Morillo these exaggerated gyrations are an opportunity. “Publicly listed real estate tends to overshoot on the downside as it is easier to exit than private markets,” says Morillo, who capitalized on the Covid sell-off in 2020. More recently, the rapid increase in interest rates in 2022 has contributed to valuation discounts: “Public REITs have significantly underperformed the S&P 500 in recent years and they appear cheap on an absolute and relative basis. While expectations for the pace of rate cuts have been tempered somewhat, we believe inflation should trend lower this year and that interest rates should decline at some point. As a result, we believe the current unsettled market creates a historically attractive entry point for public REIT investors,” points out Morillo.

Hunting down neglect

Morillo finds that, “Most sell-side research analysts are disconnected from what is actually happening on-the-ground with respect to operating fundamentals and valuations”. His main use of sell-side research is gauging the consensus view rather than using it to discern value or form an opinion.

Limited analyst coverage and negative investor sentiment can also be a source of overlooked opportunity: “We believe our willingness to be patient and invest in situations that may be viewed unfavorably by the market or are underfollowed by sell-side research and larger funds is a competitive advantage when we invest,” says Morillo.

Preferred segments

Morillo is broadly constructive on listed US real estate because he sees NOI (net operating income) growing ahead of inflation for most public REITS, which tend to be somewhat skewed to growth sectors – and avoid exposure to problematic areas such as commoditized offices or New York rent-controlled property.

Single-family rental and multifamily REITS are some of the larger themes for ALM in July 2024. “We are looking through temporary supply headwinds towards the longer-term dynamics of growing demand, and some private equity firms agree; Blackstone just took private Tricon Residential (TSX: TCN) at a 30% premium and AIR Communities (NYSE: AIRC) at a 25% premium, which were both large core investments for us,” says Morillo. “Single-family rentals have a very small amount of institutional ownership but a huge runway to grow and scale up as millennials who cannot afford to buy are forced to rent.” Morillo tends to favour the “Sunbelt” due to positive demographics, especially in Florida, which is seeing continued strong inbound migration from low, mid and high-income groups. ALM has an investment in Aimco (NYSE: AIV), which has prime development land in the Brickell area of Miami near where Citadel plans to relocate. ALM also has exposure to “Class B” multifamily, which Morillo views as more resilient than “Class A” assets, that are also seeing more supply growth.

In commercial property, Morillo prefers logistics. For instance, Southern California-based First Industrial (NYSE:FR) “faces short-term headwinds based on recent results with some supply pressure on rents, but with new supply slowing dramatically, market rent growth may reaccelerate next year, and the firm’s in-place rents are well below market rents in many areas. We estimate FR currently trades at an implied cap rate north of 6.5%. By contrast, stabilised portfolios – without the significant embedded rental growth that exists across FR’s property portfolio – are trading tighter than that today,” argues Morillo, who has already observed recent industrial transactions at lower cap rates.

One commercial segment currently avoided is data center REITs. Morillo does not deny the AI growth trajectory but is circumspect about his Buffetesque circle of competence: “These are huge and very capital-intensive assets with some risk of obsolescence, which are hard to fully understand. We do believe we’re in the early stages of the AI story, and that the impacts of it are going to be massive. A lot of computing power and energy will be needed to get there, however we are skeptical the data center REITs are as well positioned as private funds to build the infrastructure necessary to enable the technology to scale.”

Similarly, Morillo only selectively invests outside equities where he is confident in his expertise: “The fund has an open aperture mandate to invest across the capital structure and often finds value in deeply discounted preference shares and corporate credit. More complex structured credit such as some CMBS is not an area I expect to focus on”.

Calling a trough

Notwithstanding negative headlines around the office market, Morillo senses a trough in listed US property partly because, “Credit spreads have come down a long way; cooling inflation should eventually allow for some rate cuts and the supply/demand backdrop shows an imbalance”.

Potential credit crunches may appear in the private real estate market, which is more leveraged, and more dependent on embattled regional banks, which creates a vicious circle where delayed repayments hinder their ability to originate new loans.

Financing favours public REITS, which have in-place fixed rate debt costing less than current interest rates, servicing costs well-covered by cashflows, and only 15% of their debt needs refinancing in 2024-2025; their balance sheets are in much better shape than around the GFC.

Yet private buyers may seize the opportunity before public market investors. “Very few takeovers have materialized so far because costs of capital were too high, but Tricon and AIR Communities could be the opening salvo for many more,” says Morillo.

Constructivism, suggestivism and activism

Morillo was engaging with Tricon (under Canadian corporate law) on angles including a possible REIT conversion before the takeover. Most of his activism is constructivist/suggestivist and behind the scenes: “In some situations going public may be necessary, and might involve proxy contests and proxy advisers, but this can be a distraction, and we would prefer private dialogue”.

Activism can involve proposals for one or more of: operations, capital allocation, corporate governance and strategy.

Morillo may act alone or with other funds. It is coincidental that real estate activist, Land and Buildings, is also an investor in AIV, but Lionbridge worked with Robotti on Creative Media & Community Trust (NASDAQ:CMCT) in 2021. “We like to be complementary to all and competitive to none. We like partners and we like to let others check our work. We can partner for skill sets or operating platforms,” says Morillo.

But Morillo can still have a pivotal influence on operations. With Brookdale Senior, he addressed an awkward and mis-matched merger with Emeritus that led to an unexpected drop in occupancy: “I talked to two dozen senior operational and sales staff to work out what was going on, and later persuaded the firm to sell underperforming assets to local operators to reduce distractions and improve operating performance. We presented to the board, proposing a new CEO, sales of non-core businesses and renewed marketing efforts”.

Morillo may propose debt reduction, but he learned the lesson not to invest in “good companies with bad balance sheets” earlier in his career. Engagement on issuance is also tailored to each company’s capital structure and point in the cycle: “Costs of equity and debt capital are very important and one of my mentors runs a REIT with a heat map to help guide board decisions around capital allocation, with red, green or yellow zones. When the stock trades in the green zone, they can issue equity and debt accretively to buy assets, in the red zone they should pay down debt and/or repurchase shares, and in the yellow zone there is wider uncertainty about the intrinsic value of the company”.

Sometimes, Morillo provides specialist financial public relations and investor relations advice. He helped AIV to address the post-spinoff complexity of a harder-to-value stub development business, which had increased cost of capital. Morillo counselled the board on how to communicate financial data and messaging to investors, with additional disclosures and an NAV supplement.

Most REITs are domiciled in Maryland, which by default allows MUTA (Maryland Unsolicited Takeover Act) board staggering, which can be used to block activist initiatives or takeovers. Three Maryland domiciled apartment REITs have so far waived MUTA board staggering in response to activism, but Morillo is not yet sure if this will blaze a trail. ALM’s activism with IRT resulted in the company opting out of MUTA, which was well received by the market. “We do own some REITs that can stagger boards since this issue is only one of many to weigh up in our analysis,” Morillo admits.

Indeed, activism should not be overblown as it can be icing on the cake rather than essential to the investment thesis. ALM holding, Alexander’s, Inc. (NYSE:ALX), has a huge valuation disconnect: Morillo estimates the company’s largest asset – Bloomberg’s world headquarters in New York City – is valued at an implied cap rate of 13% despite being fully occupied and having little capex requirements. One concern is suboptimal use of a related party shareholder, Vornado Realty Trust, for management. “But it has a long-term credit tenant in Bloomberg and pays a great dividend, whether or not the management arrangement is ever changed,” says Morillo.

Positive long-term outlook on logistics

ALM recently took advantage of the market’s negative sentiment toward industrial REITs by acquiring shares in First Industrial Realty Trust (NYSE: FR) at a large discount to NAV. Disappointing earnings guidance and a cautious near-term outlook for operating fundamentals in Southern California, the largest industrial market in the U.S., led to a sharp decline in FR’s share price amid an emerging consensus view that logistics demand is headed for a cyclical downturn driven by excess supply. Net absorption and leasing activity fell short of expectations just a few months ago as economic uncertainty and a focus on cost controls led to delays in tenant decision making.

Morillo believed this view to be misguided and that the market was too focused on FR’s slowing rent growth in a handful of sub-markets and not focused enough on the sizable lease mark-to-market opportunity embedded within FR’s existing portfolio. Conversations with market participants indicated that industrial cap rates declined approximately 50 basis points during the first quarter despite an approximately 70-basis point increase in Treasury yields, a sign the private market believes that the region’s long term demand drivers remain intact and excess supply will be absorbed.

Shorts and hedges

The fund held a few shorts and tail hedges in 2022 but none are present as of July 2024 because Morillo views, “The whole sector as being fairly dislocated, and would not want to short a firm just because it trades at a below-average discount to NAV”.

Liquidity and exiting mistakes

Liquidity is often a more important tool of defense than shorts. US equities are the mainstay of the strategy, which will rarely invest in firms with a market capitalization below USD 750 million, so that it can exit if a thesis proves wrong. One historical example was a company with suboptimal governance that did a highly dilutive rights issue to effectively defeat a proxy contest. Morillo swallowed his pride, let bygones be bygones, and moved on because other opportunities offered a better risk-reward.

Going forward in 2024, a potential combination of top-down forces – growing rents, narrowing NAV discounts, declining/stabilizing cap rates, and cheaper borrowing costs from declining spreads – are being complemented by some company-specific catalysts, and if investors do not recognize the latent value in these companies, then corporate predators may do so instead.