Sometimes, in the world of microcaps, opportunities are presented because of lack of interest by potential investors to take the time to understand the underlying business. They think it looks complex, and then they simply move on (generally speaking, I do this too!). For clarity purposes, I am a big believer that you should never invest in a company that you cannot describe in two sentences or less, and with Jernigan Capital (JCAP) that is easy to do. But the fact that it is a REIT and some terminology involved in the industry and business model most certainly keeps some investors away and presents meaningful opportunity for those who take the time to fully understand the business. I don't have a financial degree, or a real estate background either, but with some due diligence and lots of research I have educated myself and can now very clearly see the opportunity for significant upside in JCAP.
When I first wrote my investment thesis for Jernigan Capital the stock was trading around $14.25. Today, with the stock near $12/share and trading at a discount to book value, the opportunity is quite remarkable for those who wish to dig in and understand the nuts and bolts of the business model. What is even more remarkable are the reasons and misconceptions in the marketplace as to why the company is struggling and moving backwards, not forwards. I don't think this could be any further from the reality and truth.
Before we take a deeper dive into Jernigan Capital, I think the introductory remarks from my investment thesis deserve another read:
"I typically do not get involved with REITs and other real estate development plays because of the complexity of the financials and numbers as they can be very difficult to follow and understand for non-financial folks like me. However, the opportunity with JCAP is pretty straightforward and the numbers are actually fairly simple to understand. And while JCAP is not a company that is going to provide many multiples of shareholder returns like opportunities with smaller microcaps, the potential does exists for multiples of returns on principal as well as for collecting a very hefty dividend along the way."
The easiest way to structure this article will be an FAQ format based on questions I have received from readers as well as common questions and misconceptions that I have come across by talking to other investors and by talking with the company on several occasions.
Without further ado, let's take a deeper dive into JCAP.
QUESTION: JCAP is just another REIT. What makes it so attractive?
MY RESPONSE: My response to this question is the business model that Jernigan launched its business on that allows for significant upside, in exchange for taking a bit more risk than a traditional lender would. To illustrate this point, commercial banks typically will only finance a self-storage development up to 65-70% of the total development cost, whereas Jernigan takes a little more risk and will finance up to 90% of the upfront cost. Commercial lenders will always make such loans full recourse loans, while JCAP’s loans are all non-recourse. In consideration for taking additional risk and for having the industry expertise and contacts that can greatly assist the developers (typical lenders wouldn’t have this expertise/level of contacts), Jernigan has a 49.9% “participation”, or “equity kicker” in each development loan it funds. This is substantial and it is where the hidden value is in Jernigan.
In a March 7th release by Jernigan, John Good (President/COO), described the value creation that these "equity kickers" create:
“Based on prevailing cap rates and projected property operating results at stabilization, we believe we have created between $20.5 million and $28.5 million of additional shareholder value through our profits interests in our development investments (including those made through the Heitman Joint Venture), which we believe translates to a current implied value of our common stock between $19.50 and $21.00 per share. We expect shareholders to see this value creation in coming quarters as existing development projects are completed and we reflect the value of our profits interests in those projects through our fair value adjustments in our financial statements.”
These equity kickers become realized when the developer or owner who built the storage facilities monetizes it’s property, generally in 2-3 years after development. Of course, the company will earn interest income on these loans as well, averaging 8-9% until loan maturity.
QUESTION: What's so attractive about the self storage industry from an investment perspective?
MY RESPONSE: The Company has laid out the reasons for why it believes we are really in the first year of a 5-6 year development cycle for self-storage facilities. One of the main reasons that Dean Jernigan suggests as to why there will be incredible demand for development is because the complete lack of development financing from commercial banks, as they still are recovering from the 2008-2009 crisis. A company such as Jernigan, which can provide non-recourse financing to developers of self-storage facilities, can significantly benefit from the lack of developer financing available, and this is exactly what JCAP is attempting to do, and having early success in doing so with another $600M in the pipeline for investments.
QUESTION: The company will only perform well if they have the cash available to fund development deals. If Commercial Banks are reluctant to fund self-storage development financing directly, why would they be willing to give capital to Jernigan to do the same? Is the recent deal with Heitman an indication that Jernigan is struggling to raise capital?
MY RESPONSE: This train of thought is exactly what has led to the most recent share price decline on the back of an analyst with Wunderlich Securities downgrading the stock to a "Sell" from a "Buy", slapping a $10 PT on the stock last week. It's rather unfortunate that the analyst did not take the time to understand what she was writing about, but at the same time it has allowed a fantastic opportunity to accumulate shares in the company.
First and foremost, every REIT needs capital. Capital is the gasoline the fuels the investment engine for REITs. As REITs mature and have a proven business model, capital is easier to obtain. With a young REIT, such as Jernigan, it can obviously be tougher. However, the obtainment and deployment of capital by Jernigan, at such a point of infancy in the company's existence, has been impressive in my opinion. It's all about allocating capital and obtaining a significant return on such capital. Jernigan has positioned itself to do just that, with the creative Heitman deal and the upcoming expected closure of a $45M-60M operating line. This is in addition to the $44M currently on the balance sheet of the company.
Let's dive deeper...
Through year-end 2015, here is what the company has publicly stated as their key accomplishments:
- Closed $175.7 million of investment transactions during nine months between IPO and year-end;
- Created robust pipeline in excess of $600 million at March 7, 2016, including $119.4 million subject to active term sheets;
- Obtained up to $110.0 million of additional private capital in joint venture with funds managed by Heitman Capital Management LLC (the “Heitman Joint Venture”);
- Executed term sheet for secured credit facility for up to $60.0 million expected to close in late March 2016 (now to close in April, more on this later).
- Created substantial potential value in profits interests in development projects and elected fair value accounting (the same accounting metric that many REITs use) to allow for reporting of value in profits interests;
Let's examine the Heitman deal and quickly put the fears to rest that this was an awful deal for shareholders.
- One of the criticisms of the Wunderlich analyst was that she noted that all future investments by Jernigan would have to be into the Heitman venture. By reading the terms of the Heitman Venture this simply is not true at all. Specifically, Jernigan is to "present all new self-storage development investment opportunities to the Heitman Venture until the earlier of March 31, 2017 or until the Heitman Joint Ventur's capital is fully committed." Looking at the numbers, the Heitman JV has roughly $80M of capacity for new development investments. Jernigan has publicly stated that it has $119M of active term sheets for new investments. The $119M will quickly absorb the $80M, and thus the Heitman JV will be fully committed and Jernigan's future investments would be outside of the Heitman JV, thus more accretive to Jernigan shareholders.
- Even though Jernigan is entitled to a pro-rata interest in the profits of the joint venture (thus 10%), there is significantly more upside allowed by the JV that is being overlooked when hurdle rates stated in the JV are surpassed. Based on pure economics within the self-storage unit development industry, the company believes these hurdle rates are incredibly achievable, and quite the norm for a typical development return, thus Jernigan can achieve significantly more in residual profits on their 10% interest. To bring this point home, Jernigan is providing 10% of the capital for the JV and likely hitting at least the 17% promote hurdle (where Jernigan gets an extra 20%) and possibly the 20% hurdle (where Jernigan gets an extra 30%). When you spread those returns over the small amount of equity we are putting into the JV, the REIT’s IRR is far north of 30% and the deal is accretive to the Net Asset Value ("NAV") of JCAP.
- Dean Jernigan publicly stated that he has done numerous deals with Heitman over his career in the self-storage industry, and he feels the JV is a "ringing endorsement" for Jernigan and the model it has built.
In conclusion, I feel that the stock is incredibly cheap, now trading below book value for the first time. With the 11%+ yield and a business model that is unique, yet completely realistic, I suspect the stock will exhibit a sizable increase once additional capital is secured. The company is committed to not diluting shareholders. If the company can secure the necessary capital to continue to fund investments, thus putting itself in position to realize additional future participation profits, great things lie ahead for JCAP.