Market Commentary


February 1, 2016

Market Commentary February 2016

Headline from November 2015 Market Letter:  Values are high – rates are low. What happens next?

Key Quote from November 2015 Market Letter: Peak real estate values are in the rear view mirror

Welcome to “Next”, my name is Volatility

So what exactly is Volatility?
  • Oil – Oil prices have dropped approximately 70% in 18 months and are around $30 per barrel causing massive losses in “big oil”, bankruptcies in small producers and carnage in fracking (North Dakota). One report estimates that $100 trillion in value has been lost.
  • Global growth – Very slow growth and little to no economic recovery in the world markets.
  • China – A slow down, but the real numbers are difficult to trust.
  • Credit markets – Typically the early warning signs for equity, they started to wobble late in 2015 as bond prices fell. This eventually found its way into the stock market.
  • US Economy – It’s like a Rorschach Test: depends who is looking at it.  Unemployment rates are low at 4.9%, but US growth is slow and wages have stagnated.
  • The Fed – The Fed signaled to the market that there would be 3-4 interest rate increases during 2016, but that is looking more doubtful now. Treasury rates have fallen as capital flees to safety.
So what does this all mean for the investor?
  • Investors are nervous with traditional investments as it’s very hard to make money right now.
  • Alternatives are playing a bigger role in investors’ portfolios.
  • Real estate is a popular alternative asset class, but people are nervous about the commercial real estate market as well.
The Real Estate Update:
  • Real Estate Fundamentals: Fundamentals at the asset level are fine:  Occupancies are strong and rents are stable to rising.  The volatility of the macro economy has not “yet” spilled over to the real estate market (with the exception of some select opportunities in the oil patch, which JCR is exploring), but a prudent investor has to believe it will.
  • Debt: Real estate debt is different and has to be analyzed that way.  Overall, lenders are not over their skis on underwriting.  The overleveraging of real estate is not a problem.
  • CMBS: The big debt story of 2016. It’s a mess.  We could write an entire article on this but here are the bullet points:
    • The issue with CMBS is the pending implementation of Dodd-Frank regulation, not the assets:
      • Risk retention: The new requirement that the B-Piece buyers hold 5% the offering’s market value.  These bonds need to be held on book for a minimum of 5 years and possibly 10 years.
      • Result: B-Piece buyers have to buy more of the capital stack.  They are not lowering their returns and now they have to raise new, longer-term capital.
      • Market impact: Some players will exit because they can’t overcome retention rules.  Pricing of CMBS loans will go up (already started), making it a less competitive product.
    • Regulation AB II: This rule requires that a senior executive from a CMBS issuer “personally” certify that all underwriting information is true and correct.  This is making underwriting more conservative.
    • Summary:
      • CMBS pricing is going up
      • CMBS underwriting will be more selective
      • CMBS origination will decline in 2016
      • The best days of CMBS are behind us
  • Other Lenders: The market is definitely tightening with the overall nervousness from the current volatility.
    • Banks: Still active and will price very aggressively on deals they want, but are not overly aggressive in their underwriting assumptions.
    • Insurance companies: It’s their time to shine. They will continue to book business in 2016 and will have the opportunity to grow market share, but they will stay constrained on credit and will not fill the CMBS gap.
    • Private lenders: The next big thing.  You will see more and more private lenders taking the place of banks and CMBS.
  • Equity: For the first time in a while, we are seeing real estate equity investors pause.  They are nervous and they are saying no to sellers. This is leading to transactions either not happening or being retraded.  This nervousness is primarily stemming from the volatility in the macro economy and CMBS market as opposed to the ground-level real estate fundamentals.
The Current Real Estate Opportunity Set:

We continue to see three very strong opportunities in the real estate space.

  • The Wall Of Maturities: In 2016 and 2017, the market will see the greatest amount of maturing loans over the last 10 years, totaling $700 billion.  It’s impossible to say how much of these loans will not refinance at par, but Real Capital Analytics estimates 1/3 of all these loans will need additional capital.
    • Winners:  Those who can provide unregulated capital for bridge loans, mezzanine debt, preferred equity and other gap financing.
  • Aging Middle Market Sponsorship: Middle market assets are typically owned by individuals.  These individuals tend to be 55-75 years of age.  “Ownership disruption” caused by “life events” is increasing every day as America ages.  The graying of America will result in the greatest transfer of real estate wealth this country has ever seen.
    • Winners:  Middle market commercial real estate finance companies and operators.
  • Distressed Real Estate: Currently a very narrow opportunity (i.e. the oil patch).  It remains to be seen if the macro market volatility will remove significant credit from the system, resulting in more opportunity in distressed real estate.  We hope so.
    • Winners:  Those with dry powder and the experience of investing in a dislocated market.
 JCR Capital’s current investment themes:
  • Principal protection: This is our primary objective on every investment, but the theme is amplified in the current environment.
  • Defensive: The macro market volatility has not shown up in real estate, but it might.  We continue to maintain our defensive posture until we see more opportunity in the form of distress and lack of liquidity (it’s starting).
  • Selective: Our deal flow is very strong, but our radar is up and we are only making investments where we have strong conviction and the investment can pass “rigorous” stress testing. 
  • Focus on the story: We continue to seek opportunities that have a story or reason why they are coming to us.  This could be ownership issues or asset-level issues.  It’s not the high bidder at a real estate auction.
Bringing It All Together:

The macro markets are volatile.  Real estate credit markets have pulled back (or paused), primarily due to market volatility, not “main street fundamentals”.  Yet, this has caused a disruption in sales, as equity providers are saying no to sellers and banks are providing less proceeds.

While we like this volatility in the market, it will take another four to six months to determine if this is an anomaly or a trend.

In the meantime, we will continue to make conservative but profitable real estate investments.  We prefer some volatility so we can take advantage of illiquidity and distress.  If and when a dislocations occurs, we will be ready; until then, we are slow, steady and selective.


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.