March 27, 2020
JCR COVID-19 Update
Here is an update on our current view, actions we are taking and opportunities we see in the future.
Current View of the Market – The World with COVID-19
U.S. Virus Response: We were very slow out of the gate and the federal and state governments have been disjointed. Large segments of the economy have been shut down, but the virus has not. Our response pales in comparison to other countries.
U.S. Fiscal Response: Overwhelming and mind numbing. Can/will it work? It seems like it will solve some short-term problems, but it’s hard to tell at this point if it is sustainable beyond a few months and what the unintended consequences will be (see “Moral Hazard” below).
U.S. Likely Response Going Forward: Since we did not take drastic action at the beginning, our hands are tied. There is a likelihood that we will have some kind of a phase back to normal work order, with older people staying home for longer. However, in our view, it’s going to be really hard to do this effectively without home testing.
How the Virus Ends
There are many varying trajectories of the virus out there. We don’t know which is correct, but the pandemic will pass. The questions are:
- What will be the extent of the damage?
- Will consumer and corporate patterns change?
We believe three things that could dramatically accelerate the timeline are if:
- A vaccine is created, and mass produced (still a long way out)
- An effective treatment or therapy is discovered (several are promising)
- Rapid, easy in-home testing is available
As we have essentially paused a substantial portion of the economy, our base case assumption is that many people cannot pay or will not pay their upcoming obligations. We believe this will lead to a large spike in credit defaults in the next 45 days. This could be the largest mass loan defaults in our history.
We hope we are wrong, but we believe there will be a large amount of businesses, individuals and tenants who will not pay their debts/rent over the next 45 days. This will occur in:
- Home loans
- Car loans
- Student loans
- Apartment rents
- Business tenant rents
On top of this, we believe the government has created a “moral hazard”.
Government agencies (both federal and state) have conveyed the message to renters, homeowners and borrowers that they do not have to pay their obligations and that there will not be consequences for their actions. Several states have mandated no evictions for 90 days.
We believe this is creating a moral hazard for those who can pay and who may now be enticed not to pay. We will see if this comes true, but we believe this will exacerbate the credit default surge.
It’s All About the Next 45 Days
We don’t know how bad this will be until we see how big the April payment defaults are. We may not know the full story until May, when payments are 30 days late.
Non-payment of credit obligations will cause stress on the financial system (banks, insurance, securitized lenders and private lenders).
Potential Credit Crunch:
Once these lenders are stressed, they will also stop lending. A credit crisis may set in (it’s already starting) and there will be no liquidity.
The Fed is saying they are going to step in and produce liquidity to everyone and everything, but what will the long-term ramifications of this be?
Punchline: Hold on tight. The next 45 days will bring payment defaults, more virus cases, more deaths, more disjointed responses from individual states and the Federal Government.
The first thing to know about what will happen with the virus spread or the economy is that no one knows. Thus, as your fiduciary we must operate assuming the downside case until we know that’s not what we have. We hope our assessment is wrong and too dire, but we must plan for it.
Our first priority is to protect the current portfolio. We are re-underwriting the portfolio, doing stress tests, doing a deep dive into each tenant in every rent roll. We are ready to track April rent payments. Our book of equity and debt investments will provide an excellent sample set as to what will happen to the industry.
Last month, 95%+ of our portfolio was performing on plan. Next month, we are expecting some tenants not to pay and that some investments will not cover debt service. We will reach out to our lenders and begin working through this process (along with most other real estate loans in the country).
A large part of our portfolio is workforce housing and industrial. We expect a few bumpy months for workforce housing and will await the government response as to how they will deal with the fact that people don’t pay rent and property owners don’t pay the lenders.
Lenders will be the financial headline in mid to late April.
While we are entering unprecedented times, please take solace in the following:
The JCR Founders: We have been through this: The RTC, the internet bubble and the Great Recession. The playbook remains the same. We are ready.
JCR Structuring: The hallmark of JCR has always been its deal structuring. Common structures include:
Underlying Debt Characteristics
- Selective on Debt Providers: JCR does not use securitized lenders and only uses:
- Banks (local and regional)
- Balance sheet lenders
- Insurance companies
- Terms and structures
- Highly negotiated to be light on covenants with sponsors
- No repayment guarantees with lenders
- JCR Governance
- JCR is always approved to step-in and replace non-recourse carve-out guarantees (closing subject to these rights)
- JCR approval required for lender draws
- JCR always has ability to pay down loan amount to meet DSCR covenants, if applicable
- JCR maintains material action rights on all transactions
- Agreements always include property performance hurdles – both financial performance (occupancy, NOI) as well as milestone performance (completion of capex) – leading to the ability for JCR to step in (the right to remove the sponsor and take control of the management, potential leasing and sale of the property)
- Investment terms that are de facto maturity dates
- In some instances, forced sale rights
Other Underwriting Analyses and Structural Enhancements
- Stress testing cap rates to JCR basis at exit
- Cross collateralization on portfolio or facility transactions
- Cap on construction cost overages to JCR
- Minimum multiples
- Minimum IRRs
- Claw backs to fees, distributions and/or sales proceeds
- In some instances, cash flow sweeps to amortize JCR basis
When we come out the other side of this – which we will – we expect there will be historic investment opportunities:
- Over-leveraged transactions
- Over-leveraged sponsors who need cash now
- Bank lines being drawn
- LP’s seeking liquidity who want to exit the asset
- Sponsors needing liquidity for other obligations
- Forced sales to raise money
- Rescue capital
- Older owners capitulating and managing estates