Generally, REITs fall into one of two categories:
- Mortgage REITs, which lend money secured by first or second liens on properties, primarily seeking to profit from interest income.
- Equity REITs, which buy equity in properties and primarily profit from renting those properties.
These two categories stem from the requirement that to qualify as a REIT, the company must derive at least 75 percent of its gross income from real estate related sources, including rents from real property and interest on mortgages financing real property. The rules also states that 75% of gross income must come from "real estate related sources", they do not require a company to choose one or the other. Most companies choose to specialize in one or the other and investors generally draw a distinction between an mREIT (mortgage REIT) and an eREIT (equity REIT).
Jernigan Capital (JCAP) challenges this distinction by engaging in both mortgages and equity ownership. Focusing on multi-story, climate controlled Class A self-storage facilities in quality markets, JCAP has a unique business plan that transitions from a mortgage investment to outright ownership.
We believe that JCAP has an intriguing business plan that has great potential. They also have a very attractive capital structure with a conservative balance sheet. With built-in safeguards, JCAP has the flexibility to manage the fluctuations inherent in the real estate market. It all adds up to a stable income investment for long-term investors.
Mortgage Today, Equity Tomorrow
Many analysts and commentators consider JCAP to be a mortgage REIT, primarily due to the majority of their current revenue coming from mortgages. Management argue that they are primarily an equity REIT.
JCAP starts by extending a loan to a developer. They typically loan 90-97% of construction costs over a 6-year term. The loans have a couple of features that generally would not be seen in an mREIT.
In exchange for all of their loans, JCAP receives 49.9% equity interest in the project. In other words, JCAP owns 49.9% of the building being constructed and has the right to receive their portion of any profits or to sell their ownership.
Also, JCAP always has a Right of First Refusal (RoFR). The RoFR is a contractual agreement for JCAP to buy out the developers 50.1% ownership interest in the building by a certain date at predetermined terms. It is essentially a call option on the real estate.
The life of the loan looks like this,
This is from a slide in JCAP's investor presentation illustrating the life of a $10 million mortgage at 9% interest. Typically, construction takes 16-24 months, during that period JCAP primarily receives interest from the loan and an unrealized gain from the fair value of the real estate due to their equity ownership.
The "lease-up" phase is the period where the new building is open and renting units to tenants. JCAP continues to receive interest, and could potentially receive distributions if the facility is profitable. How quickly occupancy rises to a profitable level will vary significantly.
Once the property is stabilized (achieves market level occupancy), JCAP has the right to exercise their RoFR. They can,
- Buy out the developers 50.1% interest and own the property outright.
- Maintain their 49.9% equity interest, receiving payments on the mortgage and any distributions of profit.
- Sell their 49.9% equity interest for a lump sum plus the mortgage.
The decision is in JCAP's hands, and what is best will depend on the particular project. JCAP can choose which facilities to buy outright after they have the benefit of seeing how well they perform. This structure provides JCAP the ability to have unprecedented access to information before making the decision to acquire a property.
JCAP did not make their first acquisition until August 2017. The year 2018 was far more active and we expect this trend to continue as more facilities enter the lease-up phase.
Since JCAP was only making loans from 2015-2017, it is not a surprise that the majority of their income comes from mortgages. As those initial properties continue to be leased up, JCAP will acquire more of them and will build a quality portfolio.
Over time, we expect that JCAP's fully owned portfolio will expand to the point where it becomes the largest source of their revenue. The exciting thing about JCAP is that through their mortgage lending, they are developing a pipeline that allows them to choose only the very best properties to become fully owned.
Over time, JCAP is well positioned to develop one of the highest quality self-storage portfolios in the REIT industry. This is primarily due to their ability to choose whether or not to buy only after the property has demonstrated profitability. If a property is having only modest success, JCAP can pass and collect on the mortgage.
One risk that is inevitable with mortgages is lender defaults. The loans that JCAP makes are non-recourse loans. This means that if the developer defaults on the loan, JCAP does not have any legal recourse to recover funds outside of foreclosing on the property.
While on the surface, this would seem to increase risk, it works for JCAP's business model. Since JCAP owns and operates properties, they have the ability to take over operation of a foreclosed property themselves.
Remember, the developer is paying a mortgage on the property, plus sharing 49.9% of all profits with JCAP. If JCAP forecloses on a property, they do not have to pay interest on the mortgage and get to keep 100% of cash-flows. A lot of properties that have unattractive economics with a 90%+ LTV mortgage and a 49.9% partner are quite attractive with no mortgage or partner. The write-offs on the mortgage side could be substantially offset by the revenue gains in the fully owned portfolio.
Most mortgage lenders do not have the facilities to take over and manage a property. Instead, they usually auction off the properties at a fraction of their market value and write off the loss. JCAP can operate the property and improve it, or sell it at their leisure to get full market value. This puts them at a great advantage.
A Conservative Balance Sheet
JCAP is very conservative with their use of debt. As of the end of 2018, they had less than $25 million in term loans as their only long-term debt with book assets of over $590 million.
They have committed to $222 million in investments, plus they intend to make $100 million in new investments in 2019. So it is likely that debt levels will rise from here. Though even if 100% of 2019 investment spending is through debt, debt would be around 40% of assets.
With the book value of common equity at $19.01/share and the share price above $21, we anticipate that JCAP will continue issuing equity from their ATM to raise funds. Additionally, we anticipate that JCAP will start selling their equity interest in properties they decide not to acquire to recycle capital.
We like the common shares for JCAP, and believe that they have great future potential. It is noteworthy that Adjusted Earnings per share available to the common of $2.92 covered the dividend 2.08 times.
Guidance for 2019 calls for Adjusted Earnings of $1.52-$2.13, this will be primarily driven by dilution as the weighted average common shares increases from 17.28 million to 22+ million. The common dividend will remain covered, but it is unlikely that it will be raised.
JCAP is a young REIT, and with their common shares trading at healthy prices, it makes sense to use equity to raise funds for further investments. As discussed above, it takes 4-6 years for the value of their investments to pay off. That will make earnings per share inconsistent as JCAP issues new shares and it takes time for those investments to produce a return.
Additionally, the Series A Preferred shares, which do not trade publicly, allow the holders to receive part of their dividend in preferred or common shares. This could potentially have a dilutive impact on the common shares.
Over the long-term, the dilution will become less relevant as the company grows. Issuing common equity is one of the cheapest sources of capital for small REITs, and as cash flows increase dilution will have a smaller impact than it will have for 2019. If JCAP makes a secondary offering in 2019, it could create an excellent opportunity to invest at a discounted price. We are monitoring any price movement for JCAP, and as usual, we are ready to alert our investors when an opportunity arises.
The Preferred Stocks Series B
At current prices, we like the common shares, but we love the Jernigan Capital 7% Series B Cumulative Redeemable Perpetual Preferred Stock (JCAP.PB).
Source: Quantum Online
JPCAP.PB currently trades at a price of $25.15 for a yield of 7.0%. This preferred stock has accrued dividends of $0.33, and therefore it is actually trading at $24.82 per share, below its par value of $25.00 per share. If we back out accrued dividends, the stripped Yield (or the effective yield) is at 7.1%.
Note that JCAP-B goes ex-dividend on March 29, or about 3 weeks from today.
This series has a par value of $25 and pays $1.75/year in dividends. It has a call date of 1/26/2023 and does not have a maturity date. The series is not rated by any rating agency, which is common for smaller REITs, so we have to do our own assessment.
As discussed above, JCAP is extremely conservative with their use of leverage, with only $25 million in debt and $590 million in assets. The outstanding preferred shares (series A & B) have a liquidation preference of $159.5 million. This means that the preferred shares are covered by assets over 3.50 times. We expect that in 2019 JCAP will use their revolver, and might consider issuing more long-term debt. Since those actions will be funding activities that increase assets, we anticipate that asset coverage will remain comfortably over 3.00 times.
Common shares cannot receive any dividends at all until the preferred shares are paid in full. The common dividend forms a sort of buffer. The common dividend was covered more than 2x in 2018. We expect that to drop in 2019, but primarily due to dilution among the common shares, not from a decrease in cash flows. In terms of cash-flows, the preferred dividends were covered over 3.30 times (or 330%) by Adjusted Earnings in 2018.
The continued dilution of common shares is a benefit to the preferred shares since the funds raised will increase the asset base and cash-flows that support the preferred dividends.
In short, the Series B offer shareholders a fixed 7% dividend that is well covered by asset value, well covered by cash flow and both assets and cash flows can reasonably be expected to grow. The shares cannot be redeemed until January 2023, except for a change of control. Since the shares are currently trading below par, redemption due to change of control or at the call date would result in a small capital gain.
We believe the dividend is very secure, and it will only become more secure as JCAP continues to primarily rely on their common equity to fund their investments.
JCAP has an intriguing strategy, using mortgages as a means to "test drive" properties for potential acquisition. Their use of 49.9% equity and a RoFR provides them the opportunity to cherry-pick from their mortgage investments and gain full ownership of the properties at very attractive cap-rates. For any properties that fail to live up to their standards, JCAP can sell their equity interest, plus still benefit from the interest and eventual payoff of the mortgage.
The structure also provides them a natural platform when developers default on their mortgage. JCAP will have the ability to foreclose on the property and manage it themselves at a price significantly lower than their original RoFR agreement.
As time goes on, we anticipate that rental revenues will become a larger portion of JCAP's total revenues. In time, JCAP will become recognized as an eREIT and their valuation multiple will expand. Their strategy should allow them to create an exceptionally high-quality portfolio, that has a strong pipeline created by the mortgage side of their business.
Growth prospects for JCAP are significant, however, their reliance on common equity to fund the early stages of growth will prevent common dividend increases and keep downward pressure on the common share price. A large secondary offering could create a buying opportunity for common shares. At today's prices, we prefer the Series B preferred.
The Series B Preferred Stock offers a solid 7.0% dividend that is well covered by assets and cash flows. Their continued reliance on issuing common shares is a great positive for the Series B, increasing assets and cash flow without significantly increasing debt which would be senior in the capital structure.
JCAP is a great company, with significant potential. Their common shares should be watched for opportunistic entry point. The Series B is a strong buy for long-term income investors right now and at any price under $25.25. At $25.25, the price would still be below par value of $25.00 a share since you will be receiving the accrued dividends of $0.33/share. The ex-dividend date is on March 29, in about 3 weeks from today.
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Disclosure: I am/we are long JCAP.PB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.