March 1, 2018
March 2018 Market Commentary
Rather than going into long explanations, we will use a “lightening round” format. Below is the state of the commercial real estate markets:
End of Year Review
In November, our market letter was titled “Wash, Rinse, Repeat” (attached for those who missed it). We stand behind our forecast that 2018 will feel a lot like 2017. There is change in the air that may create some dislocation, but most likely not in 2018. More on that below.
Macro Commercial Real Estate Market
The commercial real estate market is fundamentally very stable at the property level. As we mentioned previously, our middle market tenants are recipients of the recent tax cuts. We are seeing tenants renew their leases and expand their space.
The Commercial Real Estate Equity Market
The equity markets continue to have strong inflows (especially for larger transactions), pricing has compressed, but for the most part is acting rationally. Equity is not as plentiful as debt (as many LP’s have rotated into debt) allowing equity to be more of a non-commodity investment. Equity is dictating the terms of today’s investments.
The Sales Market
The sales market continues to be robust. For the middle market we expect to see more 1031 sales, especially from Californians who are now severely penalized under the new tax law. California has one of the highest state tax rates and deductions for state taxes are now severely limited.
Overall, the sales market is down from its peak (which we have noted before). Cap rates have creeped up, but not significantly. A bid-ask gap is forming, but is manageable. Every sale is re-traded, and everyone expects it.
The Senior Debt Market
This market is the most crowded and will be susceptible to cracks over the next three years.
CMBS: Active and available. Many sponsors don’t want it due to inherent asset management difficulties from CMBS servicers, but it is still the “max proceeds” alternative for stabilized properties.
Insurance Companies: Very active. They are the price leaders not proceeds leaders. Best execution for borrowers not seeking max proceeds.
Banks: Very active. They have not pulled back (other than for construction) and will price through the market for loans they want.
Debt funds: A lot of new money has been raised and is looking to find a home. They are settling in on niches which include:
- Quick close
- Scratch and dent
- Difficult borrowers or properties
Watch debt funds over the next 12-24 months. We sense “rookie mistakes” and decisions being made on pressure to deploy capital, as most of these funds pay management fees on invested capital. In this competitive debt market, some are stretching to deploy.
Below is our view on how we are currently investing various asset classes.
We like this asset class right now. There are numerous tail winds:
- Tax law changes allow users of this type of space to expand (we are seeing it in both lease and user sales).
- Manufacturing is making a comeback, especially in the Midwest.
- Logistics and just-in-time inventory is driving demand.
- Markets that have approved recreational cannabis are very strong. These markets provide opportunities for non-cannabis industrial, as the cannabis users are pushing up rents and supply down. JCR is tracking these markets and taking position in non-cannabis properties in approved cannabis markets.
We are bullish on industrial.
We always like B/C multifamily, as there is so much to like:
- Everyone has to live somewhere.
- The U.S. government supports multifamily with agency financing.
- B/C tenants tend to stay for much longer than A tenants.
- Tax cuts for this income group will allow for rent increases.
- These properties and rent profiles cannot be easily replaced with new product.
We remain bullish on B/C multifamily rehabilitations.
Investing in office can be binary, especially Class A office with large floor plates and large tenants. The tenant improvement expenses can hurt returns and always occur when you want to do it the least. To be successful in this space we look for similar qualities as we do in B/C multifamily:
- Larger markets
- Infill locations
- Granular rent rolls
We are selectively picking our spots in this asset class.
We believe retail is oversold (not including malls). While that’s not a popular view, we have seen capital retreat from all retail at once. We are starting to see very well leased and strong cash flowing retail properties seeking capital at terms 300-400 basis points outside other asset classes.
When these assets are found in large markets and in submarkets with strong demographics, we are interested.
While we have not made any investments in this sector to date, it is starting to become interesting on a selective basis.
We have been in and out of the home building market. In short, home building right now is a “head fake”. The people who are in it have to be in it; we are not. The head winds are strong:
- Rising rates: 30-year mortgage now 4.25%-4.50%
- Rising labor cost: Not just rising, but not controllable; furthermore, there is a labor shortage
- Cost to finish a lot: Municipalities have loaded up significant fees for homebuilders
For all these reasons, it’s better to wait for distress.
Commercial Real Estate Market Summary
The Good: Asset level fundamentals are strong.
The Bad: Rising interest rates and rising cap rates will have an effect on values.
The Ugly: The equity that may be impaired if cap rates “revert to the mean”.
The Next Big Thing
Due to the length of this cycle, everyone seems to be waiting for a shoe to drop or for a problem to emerge. Historically, cycles have ended due to:
- Overbuilding/speculative construction – this is not occurring (other than Class A multifamily*).
- The debt market getting too aggressive and collapses – this is not occurring yet.
*As previously noted, the overbuilding of Class A multifamily will not affect the debt. It will contribute to equity losses, due to rising interest rates and rising cap rates.
Unlike past downturns, we believe the next big thing will be distress in the equity markets. This will not get media coverage because it will not affect “Main Street”. Specifically, the transactions at risk are equity investments made over the last 2-3 years (and currently) that have exit underwriting based on historically low cap rate assumptions.
We have seen a distinct trend of getting to base case IRR’s by using cap rates of 5.0-6.0%, in the exit years of 2019-2021. When this cap rate assumption is stressed more than 50-100 bps, the result is an equity impairment.
This is why JCR stresses cap rates and is a “pass” on over 98% of the transactions we see.
How the Next Big Thing may occur and the opportunities that will follow are outlined below.
It starts with one basic assumption:
Cap rates on commercial real estate tend to revert to their historical mean. This could mean a ±200 basis point increase.
If cap rates do increase ±200 basis points over the next three years, then:
- The majority of the equity in value-add and opportunistic transactions made from 2016-2018 will be severely impaired.
- Middle market sponsors will be slow to accept this reality. They will attempt to financially engineer their way out of the problem because they will not want to recognize their promote loss and LP’s will not want to recognize their investment loss. Everyone will be playing for more time.
- Historically, sponsors have been willing to “throw good money after bad” in the beginning of a down cycle.
- Eventually they turn to the capital markets (JCR) for help, hoping to buy time.
The opportunities for JCR will be:
- “Cram Down” Equity: There will be opportunities to enter existing value-add and opportunistic transactions at a favorable basis, with much of the work completed. Sponsors will accept cram down equity in exchange for more time and not putting in more capital.
- Rescue Preferred Equity/Mezzanine Debt to Recapitalize Assets: Sponsors will seek more time and will use mezzanine debt or preferred equity to pay down first trust loans for extensions.
This will take time. We look for this to begin in mid to late 2019 or early 2020.