June 8, 2017
June 2017 Market Commentary
As we head into summer and look at the current environment, not much has changed from our last letter.
JCR General Market Perspective
We are continuing to stick with our view of the market, in baseball terms, we are now in extra innings and this could go on for a while.
You may recall in our November 2015 market letter we called the top of the current market:
“Get ready for a slow decline in real estate values that will affect the equity investor, but not the debt investor. Peak values in commercial real estate are in the rearview mirror…we are forecasting a 3%-8% price decline.”
In retrospect, this forecast appears to be an accurate call.
We are not forecasting a 2008 situation, as we don’t see systemic risk in the market and we do not see debt underwriting getting out of control.
We are forecasting this modest price decline primarily based on:
- Rising interest rates that will increase debt costs and thus decrease values
- Slowing NOI growth
- Expanding cap rates
The above will also be greatly affected by capital flows and at the moment capital flows are strong.
While we still do not see anything in the real estate fundamentals that will cause a “2008 style” crash, there are of course outliers and concerns.
- Tertiary Malls – This is not news, but the decline will be faster than we thought. There may not be a price for these, other than land value. To create value in this asset class, local city or county support on a change of use will most likely be required.
- Urban Class A Multifamily – This is also not news. But the news is, there will not be any fire sales. The debt on these assets is fine. There will be disappointing equity and mezzanine returns, and there will be opportunity to recapitalize the 80-100% of the capital stack, but that will be it.
- Big Box Retail – The winds of change are blowing. There will be losers for sure. But how to price these centers, especially when well occupied today, will be asset by asset.
Note: Many people are redlining all retail, which in our view is an overreaction and is now starting to provide opportunities in core retail, focused on service or entertainment tenants.
1. Exit Cap Rates:
We continue to note that this is the single greatest risk/return disconnect in real estate values today. The big risk: assuming existing cap rates are the same three years from now.
We have seen all the reports that argue against increasing cap rates.
- Cap rates are not correlated to interest rates
- The cap rate to treasury rate spread is still wide and has room to compress, keeping cap rates low
However, we are not relying on these theories for our investments.
JCR Response to Cap Rate Risk
JCR continues to stress cap rates 50-100bps per year.
If we are right, we make our underwritten returns. If we are wrong (which we have been the last six months) we make better than underwritten returns. We call this the “Upside Hedge”.
2. Rising Interest Rates:
This is somewhat correlated to rising cap rates, but affects debt rates, refinance proceeds, holding costs and generally reduces the value of real estate, as interest can be viewed as “soft cost” of any investments.
This will be one of the factors that will lead to the 3% to 8% value decline that we are predicting.
JCR Response to Interest Rate Risk
JCR has already “baked in” this decline into its underwriting via stressing interest rates and cap rates.
Furthermore, JCR’s short duration strategy mitigates the negative effect or rising interest rates.
3. Slowing Rent Growth:
The cycle is getting “long in the tooth” and rent growth can only last so long. We are weary of business plans that depend on rent growth over today’s market prices.
JCR Response to Slowing Rent Growth
JCR does not project rents to be higher than what exists in the market today, and typically stresses them to be lower than current market.
Institutional market: Very few opportunities, as institutional capital is forced to chase markets; they are forced to pay the highest price today, and hope that price continues to go higher due to market forces.
The middle market: The middle market (assets of total value of $50mm or less) is underserved and presents the greatest opportunities. We continue to see billions of dollars of opportunities in the middle market. These opportunities are due to 3 factors:
- Less capital: There is less capital raised for middle market transactions.
- Most assets: The middle market has the largest amount of assets.
- Middle market sponsors are baby boomers, and are shedding their assets at a record pace.
This creates the largest, underserved market in commercial real estate.
- From 2012 to 2016, over $360 billion of private real estate fund capital was raised:
- $308 billion for the institutional market
- $54 billion for the middle market
- Transaction volume:
- From 2008 to 2016, 95% of transactions were in the middle market
*Source: Real Capital Analytics
Thus, a huge disconnect exists: The middle market is the largest market in the United States yet has the least amount of capital!
The Greatest Transfer of Real Estate Assets in History
Due to the face that middle market assets are owned by aging baby boomers, we are about to witness the greatest transfer of real estate ownership in history. The vast majority of middle market asset will change hands, creating an historic financing opportunity of our lifetime.
The Recipe for Success in this Market
- Have capital
- Have a disciplined underwriting strategy
- Focus on the middle market
- Find niche financing opportunities to deploy capital into the middle market (debt, preferred equity and equity)
- Enjoy better terms and better returns for less risk
- Repeat steps 1-5