Description

Investment Thesis

JCAP is an externally-managed REIT that is highly leveraged to the self-storage industry.  It has aggressive/questionable accounting, balance sheet, and management incentives that are working against shareholders.  This is an attractive opportunity to 1) short JCAP or 2) short JCAP and long a basket of self-storage REITs.

One interesting anecdote: the 2016 shareholder’s letter quoted Warren Buffet.  I find it highly ironic because I believe he and Charlie would disagree with how management is compensated here and how Jernigan structured the balance sheet – funding loans in a cyclical industry with debt that contains put options.

Background

JCAP provides development/construction lending to self-storage developers.  Typically, JCAP funds 90% of the construction cost, with the developer putting up 10%.  The loan is structured as an interest-only first mortgage, with 6 years term and 6.9% interest rate.  In addition to charging interest, JCAP would take 49.9% of the development profits upon completion of the project.  Also, JCAP has a right of first refusal which is triggered upon receiving an offer to purchase the underlying property.  The loan is distributed in instalments as the developers construct the project.

The company is formed in 2014 by Dean Jernigan, who is Chairman/CEO of JCAP.  He was the founder of Storage USA and CEO of CubeSmart from 2006 – 13.  He has invaluable experience and relationships in the self-storage industry.

It is important to note that JCAP has elected to adopt fair value accounting (ASC 825).  All loans are level 3 assets, carried at fair value on balance sheet.

1)  Management is incentivized to maximize “AUM” and to quickly sell the properties, not total shareholder return.  As such, management will engage in activities that are beneficial in the short term, but detrimental in the long term.

JCAP has no employees and is externally managed.  All management contracts and fees are negotiated between Jernigan, who is the chairman of the board, and independent directors.  We all know how these arrangements usually work out for shareholders.

Management fee is 1.5% of “adjusted equity” balance, payable in cash each quarter.  Adjusted equity = net proceeds from equity issuances + retained earnings (only if positive), and exclude the impact of stock-based compensation and unrealized gains and loss.  Notice how this formula is favourable to management as stock-based comp and negative retained earnings are excluded from the calculation.

The incentive fee is 20% of profits after 8% hurdle rate.  The hurdle rate return is management defined earning metric:  net income + stock based comp + incentive fee + non-cash expense and exclude the impact of unrealized gain and loss.  Again, notice stock based comp and non-cash expense, are conveniently left out.  Remember, loan reserve, is a non-cash expense but is a core item in any lending business.   For reference, total investment income in FY 2016 was $6.53mm, and stock-based comp was $1.08mm for the same time period.

2)  The accounting is questionable/aggressive.  Net income is supported by changes in level 3 assets.

FY 2016 interest income was $6.53mm, $7.81mm including JV income.  GAAP net income was $16.02mm, and cash from operations was negative $5.47mm.  The reason why JCAP has more income than revenue is due to an unrealized, mark to model, level 3 gain of $18.37mm.  Without this gain, JCAP would have incurred a net loss.

3)  The fair value calculated by management, for a lack of a better term, is...weird.

As of 1Q17, FV of completed development projects were $67.91mm vs $55.1mm of cost, representing a profit margin of 19%.

The 3 properties I highlighted below, Atlanta 1, Atlanta 2, and Charlotte 1 represent the bulk of the profits.  Their respective profit margins are 24%, 36%, and 32%.  Relative to Orlando 1 and Tampa, the 3 properties’ occupancy are significantly lower than Orlando 1 and Tampa, despite similar days open.  

To be fair, it takes 3 years to for new development to lease up and I have no concrete evidence to say these marks are inflated.  The methodology to price these assets is the income approach, and an option pricing model price the profits interest.  JCAP uses a 5.25% - 5.5% cap rate for the profit interest which seems too low.  I believe 7 – 8% is more appropriate.  A 50bps increase of cap rate would deduct $4.2mm from FV.  Common sense suggests actual realized profit is lower than the numbers provided by management.

4)  JCAP borrows through debt instruments with embedded put options

Because unrealized gains and losses are excluded from fee calculation, management is incentivized to increase realized profits.  One of the way to increase realized profits is to increase turnover.

In order to facilitate transactions, JCAP needs lots of capital.  It has utilized 2 instruments that I believe is very dangerous in a downturn.  JCAP has sold senior participation A notes to community banks, collateralized by property loans.  The banks hold the option to put the note back to JCAP plus interest.  JCAP do this because they cannot wait for the developments to be sold.  They want immediate financing so they can do more deals.

JCAP has set up a JV with Heitman with $122.2mm of committed capital.   Heitman is the preferred partner and has invested $110mm with a preferred return of 14%.  There is a provision that if a developer refinance, and the no sale of property accompanies the refinance, Heitman can put its JV interest to JCAP starting in March 2020.  In what circumstance would a developer whose intention is to sell his projects at a profit, choose to refinance without selling?  The answer: in a downturn.

5)   JCAP borrows at high rates to juice up its return

JCAP has sold $10mm of Series A preferred shares to Highland Capital in a private placement.  As part of the deal, JCAP has to sell at least $50mm to Highland by July 28, 2018.  What if the self-storage sector implodes?  What if the US has a recession? JCAP still has to sell $40mm of preferred to Highland.

The preferred pays 7% in the first 6 years, and then will pay 8.5% after year 6, 25% of any increase in BV or NAV, and any amount that would guarantee a 14% IRR to Highland up to 3 years.

Rough math: JCAP has to pay Highland at least $7mm (50*14%) per year up to 3 years, that’s $21mm in total.  It takes 3 – 4 years from ground development to stabilize.  Assuming 20% profit margins (which is questionable), interest rate of 7%, JCAP would need to fund ($52.5*20% = 10.5, $52.5 – 10.5 = 42) $42mm of loans to break-even with Highland, and the ROI on the remaining $8mm would belong to JCAP only.  My bet is JCAP would accelerate its senior A note program with banks to get funding for more loans to magnify its ROE.

6)      Lastly, self-storage fundamentals, while still growing, is decelerating because of new supply

Self-storage fundamentals have been extremely strong in the past 5 – 6 years, with occupancy up from mid 80% to low 90%, a level once thought unachievable.  Same store NOI growth for the self storage REITs reached 9 – 10% in some quarters.  These attractive returns have attracted huge capital and thus new supply.  There is no concrete data points but anecdotal evidence, broker and self-storage REIT management commentary all suggest that supply is elevated.  Submarkets impacted have reported flat rate growth.  The assumptions that were used in 2015-16 (i.e. NOI growth, year 3 cash flow, exit cap rate) have to be revised today.  It is more likely than not that JCAP level 3 assets are worth less than BV.

The following is a transcript of David Rogers, CEO of Life Storage, at NAREIT in June 2017.

“Gwen asked which other markets are seeing development? It's right here in the boroughs, New York has a tremendous influx of new supply. Washington, D.C. Miami, Florida. It's kind of funny because -- Chicago is another one. It's -- they're sort of high barrier to entry markets. You would think why are these markets getting storage when everybody is sort of concerned about the suburbs and the easy builds in the suburbs? What's really driving a lot of the new development in the markets I just mentioned is the fact that there are outstanding buildings, warehouses and older buildings that are zoned already for warehousing, for storage. And what developers are doing is they're taking these buildings. They don't have to fight the entitlement process, it's already there. They can put storage in these buildings. They just got to bring the building up to code, and they've got to put a ramp in and an elevator maybe and then put the storage lockers in. And so it's kind of funny, everybody talks about low barrier to entry markets and how easy it is to build in places like, say, Charlotte or Buffalo or Raleigh, North Carolina. And really, the heavy building that's been going on the last 3 years in our sector has been in the exact opposite markets, the high barrier to entry markets.”

Conclusion/Valuation

Please note that BV is already marked to market by management.  I assume a 100 bps increase in cap rates.  At 1x TBV the stock should be worth $17.3.  Real estate is a cyclical business and the fundamental is at least decelerating.   New supply volume can dry up overnight.  Due to the put option embedded in the A notes, Heitman JV, and the $40mm commitment to borrow from Highland, JCAP is built for a self-storage bull market.

Catalyst

Deceleration of self-storage fundamentals which will cause new development to dry up

Impairment of loans

Buyers fail to close announced deals