November 1, 2014
November 2014 Market Commentary
As we head into the holidays there has been a lot of recent economic news, most of it is in relation to volatility and uncertainty. The stock market is at a record high and bond yields are near record lows. As such, the primary question of the moment for us is: Where do we go from here?
Where We Are:
- QE3 has ended
- The Fed has stopped buying bonds
- The Fed has not raised the discount rate
- Stock market is at record high
- Interest rates are near record lows
- Unemployment is down to 5.8%
- Average gas price is below $3.00 per gallon
- China is slowing down
- Europe is not looking good
- Japan is in a recession
- How will the Fed’s policy of low rates coupled with the end of bond buying affect us moving forward?
- When will rates raise, and by how much?
- Are we recovering, recovered, or are there problems lurking due to the monetary policies of the past six years?
We don’t know for sure, but we do have a point of view. While we are in unchartered waters, we do see three likely outcomes:
- A Soft Landing- Three Cheers for the Fed: They did it. Prosperity continues to grow, rates increase gradually and are accepted by the economy, growth continues without any unintended consequences, and we have 3-5 good years ahead.
- Bumpy Ride: Gradual improvement, mixed in with significant volatility. No real meltdowns, but an expanded trading range and an economy of winners and losers continue.
- A Dislocation: An event driven market dislocation that may be an interest rate spike, macro market event, or a bubble bursting (stocks) causing markets to drop, investor fear, and possible recession.
JCR Investment Philosophy:
We could argue any of these three outcomes, but as a prudent investor we must assess the risks and build an appropriate portfolio. That is why we are using scenario three (a dislocation) as our base case, as we build our current portfolio. We believe a defensive posture is an appropriate hedge against a 33% uncertainty.
If a dislocation occurs, JCR will:
- Have a book of investments structured to withstand the shock
- Have even greater opportunity for future investments
If the dislocation does not occur, Fund III’s defensive posture should hit its upside investment case, and our capital will be redeployed appropriately.
What is Defensive:
For us, defensive means seeking structured debt and equity investments that have one or more of the following attributes:
- Short duration: We like investments with a duration under 36 months
- Lower basis: Subordinated sponsor equity, cross collateralizations, and below replacement cost basis are just some measures we use to make sure we are “money good” at all times.
- More cash flow: We are currently seeking more investments with current cash flow
- Fund level leverage: The fund utilizes no fund level leverage
View from the Front Lines:
At JCR we track the commercial real estate market through our extensive deal flow (we typically see -/+ 1000 transactions per year).
Here is what we like:
- Value-added B multifamily properties with strong cash flow. Our preference for this asset class is “structured preferred equity.”
- Smaller balance assets in large metro markets- enhanced liquidity structure
- Facility transactions that provide a targeted strategy with a repeat sponsor and cross collateralization (our safest and most profitable product)
Here is what we do not like at the moment:
- Mezzanine loans on new construction
- Investments that require significant leverage to make the returns attractive
- Financing high bidders in widely marketed transactions
With the market in mind, we are building out the Fund III portfolio, namely focusing on short duration, cash flowing, low basis, low leverage investments. Fund III has $115 million in fund commitments and is having its next close in mid to late December, 2014. Below are the initial metrics of the Fund III portfolio of investments:
Fund III Current Metrics:
- Total investment commitments: $69 million
- Number of transactions: 10
- Investments with current cash flow: 74%
- Repeat sponsors: 68%
- Cross collateralized assets: 74%
- Duration 3 years and under: 100%
We do not know what’s coming, but we continue to underwrite to a market disruption and an interest rate increase. This “hedge based” underwriting will serve us well as it accomplishes our two main goals:
- Protect principal
- Create outsized risk adjusted returns