November 1, 2015
Market Commentary November 2015
Values are high, rates are low – what happens next?
What has happened to real estate values and why?
- The Fed has suppressed interest rates for too long, which has made investors chase yield and returns.
- Real estate values have increased, as the combination of cheap debt and low cap rates are making today’s acquisition prices seem acceptable.
- This has created “artificially high values” in many areas of the real estate market.
What will happen next?
The Unlikely Scenario: 2008-Style Collapse and Dislocation
After many bearish years (while I am still not bullish on the market) I cannot see anything on the short-term horizon to indicate a massive dislocation, other than a black swan event in the United States. Here’s why:
- CMBS debt is in check: While underwriting is more aggressive, it’s not out of control and “B piece” buyers are keeping the market in check. New regulations are also working to keep the CMBS market in check.
- Banks are not over their skis: Banks have been giving it away in terms of pricing; however, they borrow at zero, so their spreads are fine and they have not lost their discipline on credit or underwriting.
- The economy is better than pundits say: For all the whining about a weak economy, from our view we are seeing more strength than weakness.
The Likely Scenario: The Slow Decline of Values
Get ready for a slow decline in real estate values that will affect the equity investor, but not the debt investor. Prediction: peak values in commercial real estate are in the rear view mirror.
The Slow Decline:
Did you ever have a slow leak in your car tire, maybe caused by a nail you cannot see? Initially, you ignore it and keep driving on it, hoping it’s a fluke. After a while, you put some air in the tire, and hope it’s a temporary issue that will go away. The next morning the tire is low again. Finally you capitulate and accept there is a problem.
That is the current commercial real estate market.
Potential Nails in the Road:
- Interest Rate Creep: A slow rise in short term interest rates (25 bps here, 50 bps there, etc.) and soon we are 100 bps higher than today. That will impact values.
- The market’s inability to accept higher prices/rents: Other than low rates, the backbone of the “value melt up” is the theory that rents can always keep rising. We believe this assumption carries significant risk, as rents are not rising as fast as income or profits.
The Bottom Line
Based on the above, many equity investors will be disappointed in many asset classes (stocks, real estate, etc.). They will not be crushed, just disappointed.
For the United States commercial real estate market, we don’t see a great collapse or huge dislocation, just a decline of returns, due to:
- Investors are paying too much for assets today
- Investors are using overly aggressive income and occupancy assumptions
How does JCR avoid this trap?
The first step to solving any problem is to know that a problem exists. So, we get it.
JCR is fortunate in many ways:
- We focus on the underserved middle market (asset under $50mm).
- We have very little national competition in our space.
- We have a long history in the business and are known for being predictable and reliable capital.
- Our opportunity set is driven more by the ownership structure of assets (life events) than the main market of larger assets.
- JCR is known as a niche player and we see many “off the run” opportunities.
For these reasons, we are still seeing and executing opportunities that we do not think will disappoint. Although these opportunities are harder to find, our deal flow is very robust and allows us to be very selective in building our current portfolio. We continue to hope for interest rate increases and other events that will disrupt the market, which will only serve to increase our deal flow and play to JCR’s strengths.
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, targets 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. Net IRR accounts for JCR’s best estimate of fund fees and expenses. We report only Gross IRR or Target Gross IRR at the investment level.