March 22, 2017
March 2017 Market Commentary
As we look at real estate investing at the moment, we believe there are two main drivers to the success of every value added or opportunistic investment that we are seeing:
- Underwriting future cap rates
- Underwriting future revenue increases
There continues to be a “bid-ask” spread between what sponsors believe is achievable and what we (JCR) believe is achievable.
Future Cap Rate Expansion
We have heard the prevailing cap rate logic before:
- Cap rate spreads to the 10-Year Treasury are still wider than historic norms.
- Interest rate movements (up) are not correlated to cap rate movements (up).
Our response: We have seen the data and these two statements are not incorrect. However, totally relying on these theories makes us nervous.
The number one reason Fund III is not fully invested ahead of schedule is that we are not underwriting 6% cap rates three years from now.
We continue to stress cap rates so that our returns work with at least a 7% cap rate (shorter duration investments) and in most cases we insist on principal protection at least an 8% cap rate and higher.
By taking this approach, if we are right about cap rates, our investments will perform as underwritten. If we are wrong, we will do better than our underwriting. We like that position.
Many sponsors continue to underwrite aggressive rent growth.
We are fine bringing revenue (rents) to current market, but we don’t believe in underwriting future rents higher than current market rents.
We have seen steady rent increases for the past 7-8 years, while business profits and personal income have not grown as fast. We believe there is a point where tenants will reject rent increases and find other options (Class A multifamily rents come to mind).
Again, if we are wrong in this thesis, we will be surprised to the upside. Those are the kind of surprises we like.
Summary and Impact
Even with our conservative approach, we are very pleased with our current portfolio and its performance. Our middle market strategy allows us to achieve excellent risk adjusted returns in any market environment. Our underwriting system and discipline has served us well over the last 25 years (nearly 400 investments with only one partial principal loss).
However, this discipline has done two things to the current portfolio:
- Potential Return Compression: Due to our cap rate discipline and our defensive posture, we may see some moderate return compression (100-150bps). However, if cap rates remain low, this compression may be overcome. Thus, we believe our portfolio has more upside opportunity than downside risk.
- Slower Investment Pacing: JCR always performs best in a dislocation. In the current market, we are much more selective, thus our pace of origination in 2016 was lower than anticipated. However, we are now seeing better opportunities and we expect to hit our origination targets in 2017.
JCR Market Risk Overview/Ratings
We have added a new segment in our market letter, the “JCR Market Risk Rating System”, meant to give you a snapshot of the current market.
1 = Not a Concern
5 = Highly Concerning
- Risk of economic meltdown (2007 style): 2. There is no systemic issue on the horizon. The biggest risk is “tweet risk” involving foreign governments that could spark a chain reaction (North Korea).
- Aggressive underwriting by non-bank lenders: 3. There is a large amount of unregulated capital in the market fighting for market share. This is where mistakes will be made.
- Loose credit underwriting by banks: 2. Banks are not over their skis on credit. Construction loans have pulled way back. Banks are fine.
- CMBS market disrupting the system (2007 style): 1. Risk retention has pulled the CMBS market back. They are no longer a major factor.
- Mispriced risk: 4. Three years of low yield is weighing on investors and they are stretching for yield. In many cases investors are not getting paid appropriately for risk.
- Biggest risks in the market: Future cap rates, rent growth, and tweet risk (the risk that a presidential tweet starts a negative chain reaction).