August 15, 2017
August 2017 Market Commentary
The tone of the current market is consistent. Investors are nervous about:
- Late in the market cycle
- Property valuations
- Political uncertainty
As a result of this sentiment, we have seen two new themes emerge in the real estate investment sector. While these themes are meant to mitigate perceived current market risk, investors may be increasing their risk profile without realizing it.
This month’s letter explains these two new themes and the unintended consequences they may be creating.
1) The Rise of Leveraged Debt Funds
Over the last year we have seen a dramatic increase in real estate debt funds. By our count, there are now 52 new debt funds in the market. This is not a coincidence. This is the result of many investors believing that the answer to the concerns above is to move into the real estate debt space, which they perceive to be a safer risk-adjusted return.
The consensus view is that this strategy provides less risk and the return profile is only slightly lower than equity. These loans are typically underwritten to yield 6.0% to 7.0%, yet in most cases the fund return target is set at 10-12% IRR. These fund level returns can only be achieved by adding leverage to the portfolio of underlying loans at the fund level and cross-collateralizing the entire portfolio. In addition, the fund now is exposed to credit risk of the portfolio lender.
Thus, a thesis that starts with “let’s decrease risk” at the investment level, may actually be adding risk at the fund level. In addition, a new set of risks are emerging as the number of debt funds increase.
The added risks are:
- Deterioration of underwriting standards: Newly minted debt funds must prove themselves by putting capital to work in a highly competitive and commoditized debt space (and many are paid fees only on invested capital). Thus, debt funds may feel pressure to lower their underwriting standards to put capital to work.
- Lower pricing: In the fight to win business in an overcrowded field, look for debt pricing for borrowers to decline. There is no loyalty in the highly commoditized debt business and borrowers will change lenders for five basis points. This will ultimately affect the fund investors’ returns.
- Lack of real estate debt experience: Many of these funds are being sponsored by real estate people, but they have very little direct lending experience and have never been through a market downturn.
- Increased leverage: The unspoken risk of the debt fund business is that all equity in the loans are crossed by the warehouse lender (and there are only a handful of warehouse lenders who dominate the space, which presents another risk). Thus, if the average loan is leveraged 3-1, and 10% of the book suffers a 100% impairment, the 10% portfolio loss turns into a 40% loss on equity.
For months, JCR has been highlighting the systemic risk of a credit freeze stemming from a North Korean conflict, first noted in our March 2017 Market Letter: “The biggest risk is ‘tweet risk’ involving foreign governments that could spark a chain reaction (North Korea)”. This prediction is looking more relevant as of August 2017.
Therefore, it should come as no surprise that over the next few years debt funds could be headed for trouble. This would be good for JCR, as we are generally not subject to the risks above and a market dislocation would provide us opportunity.
2) The Rise of the Mega Fund:
Investors are concerned that real estate values have greatly increased, especially in core markets. Yet, these same investors are providing vast amounts of capital to funds that are all chasing similar assets. This is creating self-inflicted demand which is, in turn, leading to higher asset prices in many cases.
The larger funds (over $250 million) are getting the vast majority of the capital, which is creating an abundance of liquidity.
The rise of the mega fund by the numbers:
- As seen in the chart above, since 2012, 85% of money has gone to funds over $250mm
- Most of the capital allocation goes to big funds (the top 20 funds accounted for 64% of fund commitments in 2016 – reported by Real Estate Alert)
With investors favoring large funds, they may be unintentionally taking on more risk by concentrating capital in funds that focus on the same segment of the market.
Investors may be better served to look at smaller funds that participate in smaller assets. In doing so, investors would be selecting managers who:
1. Are participating in the largest segment of assets in the market (middle market assets represent 95% of total transaction volume)
2. Have the least amount of competition
Many of our underlying concerns remain the same:
1. Rising interest rates
2. Rising cap rates
3. Aggressive rental growth assumptions
JCR mitigates these risks in our proven underwriting and selection process. In regards to the systemic risks from macro political events, JCR does not rely on credit lines, funding facilities or fund level leverage, thus we do not have that exposure.
In summary, the risks that exist in the market have either been mitigated through our underwriting or do not apply to JCR. If the market does correct, it will be an opportunity for JCR Capital.