Market Commentary

2014

August 1, 2014

August 2014 Market Commentary

Maybe it’s Fall, but I feel change in the air.  The market is getting a little frothy and the Federal Reserve’s interest rate policy has created an abundance of optimism and potential price bubbles in a variety of asset classes.  However, the policy seems to have worked, as unemployment is down and the economy appears capable of supporting itself (The one caveat is overseas risk, as a combination of a military incident or a systemic banking issue, could be enough to delay the Fed).  Accordingly, it’s now a question of when, not if interest rates rise.

This leads to the basic question:  What will happen as rates increase and the economy is forced to “go it alone?”

While no one can say with absolute certainty, at JCR we do have a view, and this view is guiding us in our investment approach.

JCR Base Case: 100-200 basis point increase over the next 18-30 months:

  • JCR Base Case: Our base case is that interest rates will rise 100-200 basis points over the next 18-30 months and we believe this will occur in a gradual manner.  In this case we do not see any major market disruption.  The stock market will stall/fall, and real estate values will be flat to slightly lower (JCR always stress tests its exit strategies for interest rate increases).

JCR Downside Case:

  • It is possible that over the next 18-30 months interest rates could rise 300-400 basis points. Again, most likely gradually, but the individual increases would be larger in this case.  This scenario appears less likely as the Fed has proved to be very accommodating, and would unlikely not allow this to happen unless there are extraordinary circumstances.  If this scenario were to occur, the equity markets would lose significant value and a mini real estate dislocation would ensue (This would be good for JCR, as our current book would still be principal protected and our opportunity set would grow exponentially).   

JCR “Extreme” Downside Case: Another 2008:

It’s difficult to see a massive systemic event like 2008 over the next 18-30 months (other than the world rejecting the US dollar as the reserve currency).  [1]

While some are comparing the debt markets of 2006-2007 to those of today, there are significant differences.  Today, there is an abundance of low priced debt.  This is causing a mispricing of debt and some capital is not being paid for the risk.  However, we have not seen significant deterioration of credit underwriting standards in the market space like we did in 2006-2007.

The sign of the extreme downside case coming to pass will be when debt takes over the equity space, and this has not happened to date.

Winners, Losers, and Opportunities:

As interest rates rise, those at risk will be:

  • Equity investors in development and major rehab projects that are not yet stabilized
  • Equity and mezzanine investors with maturities coming due from loans made in 2004-2007

The opportunities that will arise include the following:

  • Rescue financing for assets that require more capital
  • JV equity on maturing debt to help fill a gap
  • Opportunistic financing on development projects that require more capital to get to the finish line

How JCR Capital is Investing Today:

The JCR management team has seen this before.  Throughout our careers we have successfully navigated three major dislocations:

  • Early 1990’s saving and loan crisis: RTC
  • Early 2000’s: The internet bubble
  • 2008: The great recession

Over that time our management team has made over 300 middle market real estate investments for a total of over $2 billion.  No investor has ever lost money with JCR’s management team (when this track record is compared to others within our space, we have found that there is no other manager that has not lost money on a fund during this period of time).

Our track record is a combination of experience, specific strategy and the deep market intelligence we have from seeing approximately 1000 requests per year.  Today our strategy is focused on the following key themes:

  • Short term focus: We are focused on transactions that have 12-24 month term (in some cases 36 months).  We feel that this will allow us to make our targeted returns and we will have capital back to adjust to the environment at the time.  JCR’s average term of Fund I and II has been 21 months.
  • Stress testing exit strategies: We stress test all of our exit strategies to make sure our principal is protected in a rising interest rate environment.
  • JCR “structured equity product: We continue to use our “structured” preferred equity and JV product.  This product is not familiar to some, and is only available in the JCR middle market strategy.  In this product JCR structures maturity dates and performance hurdles (like debt) into its equity transactions.  This provides debt like risk and equity like returns.
  • More income based transactions: We are doing more income based investments.  We are creating income from our senior debt and our “structured” investments.  Typically the current pay is 7-10%.  When we do short term investments on cash flowing properties we can create double digit cash on cash returns, with safety.
  • Targeted opportunities: We see specific opportunities in specific markets where we feel something is overlooked or undervalued.  We take short term positions in those situations.
  • Facility Transactions: We expect to do more facility transactions (three have already closed in Fund III).  They are like “guidance lines” with specific sponsors and specific strategies.  The “safety factor” of this structure is that all investments in the facility are cross collateralized.  This significantly increases JCR’s principal protection.
  • Unleveraged equity: We always have a bias for transactions that we can do all cash.  Historically this has been about 50% of JCR’s investments.
  • Debt Policy: We do not use leverage at the fund level.  At the asset level, 50% of what we have done has been all cash.  When we do accept debt at the project level, we use the following guidance: lower leverage; longer term (term is longer than our structural maturity dates); fixed rate; if JCR is preapproved as the borrower with the lender prior to closing, if we ever did need to step in
  • JCR Sponsorship Profile:We know our sponsorship profile which is typically 50-70 year old real estate operators.  We know how to underwrite, partner with, and manage this demographic.

Summary:

After 22 years, 300 closed investments, and underwriting an estimated 3000 transactions, we have developed a specific approach.

Our strategy is designed to achieve maximum return with a current pay component, and with minimum risk over a short period of time.  This strategy works in both rising and falling markets. 

 

[1] As noted by Michael Lombardi in his newsletter “Profit Confidential”