September 1, 2013
Market Commentary & Current Investment Themes September 2013
Excellent opportunities continue to exist in the middle-market for capital providers due to significant amounts of maturing debt, tighter federal banking regulations and a lack of predictable capital sources.
JCR Capital has been able to benefit from these arbitrage opportunities by providing reliable capital and creative structures, while maintaining underwriting discipline. We have outlined below some of the themes and standards that we are employing in order to create our returns.
Interest Rates: Rising interest rates create more opportunity for JCR
JCR believes that long-term interest rates will continue to rise, while short-term rates will remain fairly low. As such, we have been underwriting and investing using a pro forma 10-year treasury of 4%.
Higher long-term rates will put pressure on properties with maturing debt. Many middle-market borrowers will struggle to repay current debt, which will produce maturity defaults and equity opportunities.
Interest rate increases will “flush out” the weaker sponsors and properties, like limping wildebeests falling away from the heard as the large cats begin to circle.
Value-added properties and an overzealous CMBS market
CMBS originators are fighting for stabilized commercial real estate transactions. This has created an opportunity to take positions in cash-flowing properties that are not fully stabilized. A hungry CMBS market will then aggressively refinance these on a permanent basis, providing JCR with its take-out. JCR seeks to take advantage of this arbitrage.
In general, the market is undervaluing non-stabilized properties and over-valuing stabilized cash-flowing properties.
Front-running the public builders’ need for lots
With the housing recovery still underway, the large builders are in dire need for product (lots). There have been few lots developed over the last five years and most finished lots that were available as a result of the financial crisis have been absorbed. So builders, especially those publicly-traded, will overpay for current inventory because they desperately need to show inventory to Wall Street stock analysts.
Due to this lack of supply, JCR is taking positions in residential lots, specifically providing builders with platted paper lots in infill markets such as Los Angeles.
These urban submarkets offer dense population and shortage of supply. This strategy has a short investment cycle (typically 12-18 months) with high multiples and long-term capital gains. These positions do not have re-zoning risk and are done without leverage.
Subordinate positions in cash-flowing assets
There is an opportunity to create excellent short-term yield with mid-term profits (typically as long-term capital gains), by providing preferred equity in cash-flowing properties that are not fully stabilized. The key to this strategy is being subordinate only to longer-term fixed-rate debt, with the JCR investment being substantially shorter than the debt maturity.
JCR is using this strategy to provide investors high current returns and long-term capital gains.
Continued distress in the middle-market
There continues to be a lack of liquidity in the middle-market from both capital providers and sponsors. Less capital is available to the middle-market as:
- Depositories have tighter regulations and equity constraints
- Sponsorship lost liquidity in the last recession
- “Country club investors” are out the market
- Maturity defaults continue
Loan maturities are just reaching its peak in 2013, with heavy volume expected over the next few years. When this is combined with a rising interest rate environment, even more opportunities will be available.