Market Commentary

2017

November 22, 2017

2018 Market Forecast

As 2017 comes to an end, we begin to look forward to 2018: what kind of year will it be and how will it be different from 2017.

At JCR, we are proud of our market forecasts.  Our direct deal flow business model gives us a unique window into the market.  We do not use algorithms or modeling to construct our forecasts.  We see over $20 billion of deal flow per year and we have a “pulse” on the market that is unique to others.  This “model” has proved successful over the years.

Below is a summary of our prior market forecasts (additional detail is available on our website):

  • 1990’s: Saw the RTC forming and started a distressed asset business to take advantage of the government dispositions
  • 2007: Called the top of the real estate market (published in National Real Estate Investor)
  • 2009: Predicted that the Great Recession would not lead to “RTC II”, instead forming JCR Capital Distressed Finance Fund I (published in Colorado Real Estate Journal)
  • November 2015: Called the top of the current cycle and shifted to a defensive investment strategy (published in November 2015 market letter to investors)
  • March 2017: Identified North Korea as a macro economic threat to credit markets (published in March 2017 market letter to investors)

2017 Market Review

It was basically the year we thought it would be: “slow and steady”.  Low drama, slower origination and sales than the previous few years, but still an active market.  We saw a significant amount of new debt players enter the market; however, we have started to see equity lose conviction, which has led to a softening in sales prices and transaction volume.

This “loss of conviction” is not tied to anything specific, just an overall view that the cycle is in the late stage and “something” should happen (see 2018 Forecast below for what something might be).  This translated into a slight increase in cap rates, fewer buyers and more re-trades.

However, asset fundamentals remained strong.  In regards to our properties, we continue to achieve rent increases and occupancy remains solid.

In 2017, we continued to see capital restraint.  The debt market (life insurance, banks, debt funds, CMBS) continue to hold the line on credit.  We have not seen (yet) over-aggressive lending practices, especially from banks.

On the equity side, we see a cautious approach.  Real estate equity players have a lot of dry powder and we are seeing investment periods being extended as it’s taking more time to put equity to work across the board.  We are also seeing a trend of large investor capital migrating to larger and larger funds, which means less competition for JCR.

We have seen syndicated equity market tighten up, as “country club capital” is close to fully invested, or more cautious.  Thus, the syndicated capital is getting harder to raise.  Therefore, equity, and primarily institutional equity, is driving pricing and velocity at this point.

Investor Sentiment

We have seen investors enter the “acceptance” phase of lower interest rates and returns.  Over the last three years, many were in the denial phase, thinking low rates would have to end.  Unfortunately, there is nothing on the horizon that suggests that they will. We have seen two primary themes emerge:

  1. Returns: Mid-teens returns have become acceptable
  2. Principal Protection: At this point in the cycle, it does not make sense to stretch for an extra 100 bps if that strategy brings significantly more risk

2018 Forecast

We believe 2018 will feel a lot like 2017 and don’t see anything on the horizon that will “undo” the current environment.  We should expect to see the following in 2018:

  1. There will continue to be substantial amount of debt available from all four sources:
  • Insurance companies: Max LTV 56-70% – better pricing, lower proceeds
  • Banks: Max LTV 75-80% – recourse is always in play
  • CMBS: 75-80% LTV – market is much smaller than historical
  • Debt funds: 75-80% LTV
  1. Equity will remain cautious: Equity players are going slow, picking their spots.
  2. Big funds will struggle: In a stable market, where most LP allocations are going to larger funds, it is more difficult for larger funds to deploy capital.
  3. Real estate fundamentals: Expect real estate fundamentals to remain steady in 2018.  If tax cut legislation gets passed, fundamentals will improve.  We don’t expect to see any large value movements up or down, with the exception of the assets classes discussed below.
  4. Interest rates: We expect interest rates to continue to creep up.  This becomes an increased expense of doing business, just like other costs or materials.  This will continue to restrain values; however, the offset to this will be capital flows.  Strong capital flows from the debt space will lower the cost of capital (lenders will earn less to compete) and could offset Fed interest rate increases.

How to invest in 2018 

This will be a difficult market to make money in core assets.  It is the wrong time to “chase markets” and make “momentum” plays.  We believe the best opportunities are tied to “situational investments” that are more correlated to the aging ownership of the assets than specific markets.

2018 Market risks

The obvious ones:

  • Tertiary malls: A lot has been written on this.  Very few people are attempting to revitalize these malls yet.  It’s hard.  It typically takes cooperation with the local municipality.
  • Big box retail: This is no surprise either.  Very little capital will flow into this segment.  These assets are more of a spectator sport at this time, as the market waits for them to fail.
  • Urban multifamily: This segment is overbuilt, but the debt is fine.  The equity and the mezzanine debt may take a hit.  These properties will be assets for years to come, but the challenge at the moment is too much supply and too high of rental rates are required to achieve pro forma returns.

 

Macro risks that could derail the market

It’s our nature to be nervous and cautious.  We continue to look in the shadows for problems.

  • Geopolitical risks: A conflict in North Korea (which we highlighted in March of 2017) or an all -out war in this region could bring a systemic credit freeze.  This could affect the entire real estate market.  If there is a real conflict in North Korea, all bets are off.
  • No corporate tax cuts: This seems to be baked into the stock market.  If there are no tax cuts, we could see a sell off.  That will not directly affect real estate fundamentals, but could affect capital flows and confidence, thus asset values.
  • Consumer debt: Consumer debt is running very high.  An unforeseen recession could put more stress on the consumer than the market has underwritten.

Market Opportunities

We remain bullish on middle market commercial real estate for the following reasons:

  1. Largest asset class: The middle market (assets $50mm and under) represents 95% of all assets in the United States.
  2. Middle market owners: These are individuals not institutions.
  3. Age of the ownership base: These are 55-75 year olds.
  4. Capital formation: 84% of capital formed has been to large funds, not middle market funds.
  5. Results:
    1. The majority of middle market assets will turnover in the next 10 years
    2. This segment has the greatest amount of assets and least amount of capital
    3. These dynamics create situational opportunities, not market driven opportunities

 

Important Information: This summary is not an offer to sell any security and intended for our institutional contacts. There is risk of loss with any investment and past performance is not a guarantee of future results. One cannot use graphs or charts alone in order to make an investment decision. Forward-looking statements or opinions stated in this letter are opinions and subject to change. As a private real estate fund, investments are illiquid and investors cannot readily withdraw their investment in the funds. Portfolio performance can also be affected by general market conditions, interest rates, availability of credit and other economic conditions that affect real estate markets.