Jefferson Capital, Inc. Common Stock

Okay. Good morning to all.

Thanks for joining us this morning. We look forward to talking to you about our quarter, but before we go there let’s talk about the quarter for all six REITs that focus on the self-storage sector, to of course include ourselves.

The grades are in for the quarter, I can only assign Honor Roll distinction to three companies during this quarter, those being CubeSmart, National Storage Affiliates, and of course I thought our results were outstanding and deserved Honor Roll distinction as well. So congrats to Chris Marr and Arlen Nordhagen for great quarter.

And I think it’s worth spending a few minutes to talk about why the other three companies didn’t deserve Honor Roll distinction this quarter. They had great numbers, very, very solid when compared to other REIT sectors, but the expectations for the storage sector have been so high for so long, of course 4% and 5% topline growth no longer meet those expectations.

So we have situations with those three companies that are unique, I think and I have my guesses as to why the performances weren’t so great with those three companies. Those three being of course Life, and Extra Space, and Public Storage, but I’ll tell you none of those reasons for a lack of perfect performance this quarter relate to overbuilding our new supply in my opinion.

We will get into that more and I’ll talk about where we are in the cycle, but that’s an excuse people are using already, but I think – there are other reasons, three companies underperformed expectations for this quarter. New supply is coming.

It has in fact arrived in Texas, and so with the possible exception of Houston and Dallas and Austin, I don’t think new supply had any impact on the performance of these other five REITs across the country. Where we are in this cycle?

Of course, we are in the development cycle. Third year, the development cycle I suggest across the country on average, we started the development cycle back at the very beginning in 2015.

So we’re getting ready to start the third year of the development cycle. Historically, these cycles have only lasted about three years, but I’ve always said that this one is an opportunity to last a little bit longer because of what little development we had coming out of the Great Recession.

Texas on the other hand, and Florida to a little bit to some extent, maybe just a few sub-markets in Miami, got an early start. So I’m suggesting they’re actually getting ready to start their fourth year of the development cycle, and probably done in those three or four sub-markets in Miami and in the Dallas Metroplex, DFW Metroplex, Houston and Austin for sure and perhaps San Antonio.

But those three or four cities are really in the seventh inning of the cycle. The game’s over, so to speak, they just need to play out the other [indiscernible] and so we just have to be careful going forward as to where we’re developing, how we’re developing, how much we’re developing and we use the term surgical at Jernigan Capital.

We have to be more surgical going forward. We’ve to be monitoring new supply very carefully, knowing what’s coming and how much is coming.

We have to know when to pass. We’ve got a developer – actually bought a site in Denver and we showed them where the new supply was coming and we all came to conclusion it was better for him to find another use for that site and move on to another market which he did.

So that’s a discipline we need in this cycle that we’ve really never had before and we need discipline from developers and we need discipline from lenders as well. My crystal ball looks pretty clear over the next two or three years.

We’re going to have some markets that are overbuilt, terribly overbuilt. Those are going to have hard landings and some cases crash landings and right now I can tell you for certain Austin is headed for a crash landing.

Maybe some markets can enjoy some soft landings, but we’ll see. I’m very hopeful that we can accomplish that.

We’re using for the first time ever good data being provided to us by STR Global and [indiscernible] and Yardi and we at Jernigan Capital have encouraged all three of those companies to build a pipeline report as quickly as possible. I think STR has some markets.

I know they have some markets already where they built a pipeline. They have the denominator as well in those markets.

I know how much supplies existing in those markets already, so they can tell you if it looks like that market’s going to have 10% new supply and 5% new supply and you can make your judgment, so or developer can make their judgments as to whether they’re going to that market or not. I think looking in our rearview mirror as always instructive.

I want to go back to 2009, the worst year in my 32 years in the sector. As for as challenges to the sector, we of course had 2009 was four quarters of a six quarter down recession and 2009 was a year where we suffered a negative topline growth and negative NOI growth, but I want to talk a little bit about that because I think it’s instructive to look at what happened in 2009 and look forward because I think we have a similar situation developed.

2009, we developed oversupply because of lack of demand. We had our customers that are what I call discretionary customers who are storing with us who really don’t need to be storing with us, probably don’t even need to own whatever they have that they’re storing with us and they disappeared quickly after the recession started in I guess late 2008, early 2009.

And so we developed an overcapacity quickly of 10% to 12%. So we are headed toward an overcapacity situation again.

I don’t know what it’s going to end up being, but if it’s as bad as it was in 2009 maybe another 10% or 12%. So I go back to 2009 and say okay what happened, what did the REITs do and what did the rest of the sector do?

The REITs, on a topline basis, were only down just over 3%, total revenue was down year-over-year 2009 over 2008, just over 3% and it was back up again in 2010. We had negative NOI in 2009, down about 5.5%; back up again in 2010.

Street rates only were down about 5%, go back and look at all the Annual Reports Ks and Qs, and whatnot, you can figure it out. Street rates were only down about 5%.

Occupancy is really – that was just a little bit of surprise to me, that the REITs held our occupancy so well, when I go back to look at it. Generally, the REITs only lost about 3% occupancy and that speaks to the power of the platforms of those REITs.

Those REITs were totally dominant as they are today as far as being able to have the largest funnel open to collect as many customers as possible. And so, it was a small entrepreneurs who really suffered, and they lost between 10% and 12% occupancy in my opinion as a result of those discretionary customers leaving and other sizing down.

And so, it was a recession, somewhat a depression for the self-storage sector and it developed a 10%, 12% supply problem, but if you go back and just look at the numbers that I’ve kind of highlighted that supply problem did not turn in to be that much of a problem for the public companies, because of the power of the platform. So those were the equity REITs.

If you look at us as a development REIT where we are in the cycle, I mean cycles, real estate running cycles, I talked earlier about us being in middle of a development cycle. This is where the smart money is right now, building storage facilities at non-development yields versus buying at five cap rates or sub-five cap rates.

And so all of that is great, but you have to ask yourself what happens going forward. We know that we are going to overbuild in some markets and we’re going to have an oversupply situation.

So we’ve done that study and we look at, if it gets as bad as it did in 2009, our 9% development yields with revenue stabilizing 5% less than what we think it’s going to stabilize today, only I just said development yield down to 8.45%. And if you take it absolutely double worst-case situation, where it stabilizes – this property stabilizes at 10% less than where we think that we’re going to stabilize at today.

We’re probably still in excess of just over 8%, because of the ability to pass along rate increases. The math is 7.91%, but because of the ability of pass along rate increases to existing customers, during this lease-up period, we’re probably stabilizing at 8% or just a little bit more than 8%.

So our worst-case basis on our development yield going forward – and again this is not our properties that are leasing up today and stabilizing today. Most of those are stabilizing well in advance of 9%.

You can see the things that we filed to explain this. But just on the properties going forward, we still are confident that our development yields are going to be in excess of 8% on a worst-case basis.

And of course, we’re not going to – with our hopefully precision investment in these markets and in the submarkets around the Company and around the country, we’re not going to be investing dollars in markets where we’re going to have just like 8%, 10% downturn, I mean, we’re going to be more surgical with our investment in those markets around the country. We are very much a data-driven company, keeping out in front of with that information of the development cycle around the country where other people are developing.

So we feel like we have a great advantage there. So, again smart money is in development.

We think because of that, this is the time you should be considering JCAP as the only development play in self-storage sector. And we look forward to having you hopefully some of you listening as shareholders going forward, and those of you who are existing shareholders always happy to share our story with you.

With that, I’ll turn it over to John Good, our President and Chief Operating Officer to talk more about the performance of our Company in Q3. John?

All right. Thanks Dean, and appreciate that overview.

I’d like to talk about three JCAP’s specific topics prior to opening the conversation for Q&A. Number one, the performance of our existing portfolio.

Secondly, the possible impact of decelerating rental increases on our investment portfolio and our investment performance. And finally, our pipeline and its potential impact on operating results going forward.

Going to the first topic. At September 30, we had six development properties that had achieved certificates of occupancy and we’re in lease-up with the last two having come online in late August.

As of this past Monday and we track this information really on a daily basis, the four properties that came online in May had average fiscal occupancy of 50.4%. We have two Central Florida properties, which came online April 11 and May 1 that had fiscal occupancies of 64.4% and 63% respectively.

And as we’ve stated publicly included in our investor presentation and also talked about on prior conference calls, we underwrite to a 40% lease-up by the end of the first year following a certificate of occupancy. So based on our initial underwriting, as you can see these properties are performing exceptionally well.

We have two Atlanta properties that came online at the end of May and their physical occupancies right now are 43.8%, 30.5% respectively. We have a Jacksonville, Florida property that opened on August 12 and it’s already at a 32.6% fiscal occupancy.

And we have a suburban Charlotte property that opened April 8 – August 18, that’s currently at an 11% fiscal occupancy. These lease-up rates indicate that we should stabilize the Central Florida properties, the Jacksonville property and both Atlanta properties in advance of our projected three-year stabilization rates.

We underwrite to stabilization at the end of the third year following CO. The lease-up pace for the Charlotte property indicates that will also exceed our 40% initial year lease-up projection on that property.

This decrease time to stabilize has been a major contributing factor to our accelerated fair value accretion leading to another strong quarter and another guidance increase. We anticipate that we’ll have two additional projects achieving CO in the fourth quarter and another two in the first quarter of next year.

Overall, our portfolio continues to lease up more quickly than projected, and we believe this dynamic will allow us to exceed yield expectations on this initial portfolio of investments that we had fully committed to in 2015. Moving on to the second topic, the possible impact of decelerating rental increases or in fact decreasing rents in general on our investment performance.

The large – as Dean talked about, the large equity REITs have reported same-store revenue increases at a lower growth rate than the past several quarters now for the last couple of quarters. But rents are still growing, which continues to validate our original underwriting assumptions.

As we’ve also stated publicly in the past, we underwrite based on trailing 12-month average Street rates for comparable properties in our sub-markets. And as Dean said, we attempt to surgically pick those sub-markets in which we’ll invest, and we don’t trend rents upward in our underwriting.

Therefore unless rates move backwards in a significant way, we continue to expect development yields on our portfolio to average greater than 9% and our internal rates of return to continue to track in the high-teens to the low 20% range. However as Dean said a minute ago, we do stress test our underwriting for the possibility of actual declining rents.

And as he said, if we were to see a 10% reduction from current rates, then our average development yield would decline to a level that we still believe would be approximately 8%, 10% rate decrease, I think is unprecedented over an extended period of time, so we don’t believe that’s a likely scenario. If rental rates were to decline by 5% from current rates, assuming that we’re at a 9% development yield, which we’re actually performing at a higher than 9% level, but if we were at a 9%, a 5% decrease right now would take our development yield down to 8.6% on a blended basis.

We have some properties that were underwritten in 2015 that we didn’t build the past year’s worth of rent increases into, so the 5% decrease would be basically just giving back something that we didn’t take credit for in the first place. So that takes our development yield down to about an 8.6% level.

While we don’t foresee a significant rate pullback at all, it could happen – but more likely, just a flattening of rents. The latter scenario would be more likely than the former.

And even at an 8.6% average development yield for the JCAP portfolio, JCAP still going to add significantly to its book value. In our investor presentation, we actually have a sensitivity slide that would indicate that an 8.5% development yield going forward, if cap rates hold, we still have the ability to add about a $11.50 to book value.

So while we are running stress tests for potential rate decreases and we are prepared for it, we think that from a performance standpoint we won’t be adversely affected by that, we’re still going to add a lot of value to shareholders. Finally, third topic on to the pipeline.

We are now investing completely on balance sheet. We have no more development investments that were required to show to Heitman.

We currently have nine executed term sheets for development investments, totaling approximately $88.9 million that we expect to close on balance sheet between now and the end of this year. We have three more executed term sheets for investments of approximately $36.6 million that we expect to close in the first two weeks of 2017.

And then three more for development investments of approximately $27.3 million that we expect to close by February 1, 2017. This is a total of $152.3 million of development investments that we expect to close in the next three months.

In addition, we have approximately $614 million of additional development investments in various stages of underwriting, and will continue to issue term sheets on a regular basis as our Investment Committee meets. We would expect the $152.3 million of November through January commitments to be largely funded over the next six to seven quarters, with fair value adjustments beginning in Q3 of 2017 and continuing through 2018.

We are in our budgeting process in the process of developing guidance, and we’ll be providing our initial 2017 guidance after the first of the year as we announce our year-end earnings. And with that, we’d love to move on to your questions.

Hey, good morning guys, this is Will Harman on for RJ.

Good morning, Will.

Hi, Will.

Just the first question you guys touched on the impact, just given the slowing and growth in over the markets with the REITs you’ve talked about, you mentioned the impact underwriting, but I was just curious the impact, this fair value adjustments over the next six to 12 months?

Well, we’ve given guidance for the next quarter. And we think that guidance is solid as I said in my remarks earlier.

We don’t expect a significant impact over the next few quarters of rate decreases. And therefore, we still think that our development yields are going to track in excess of 9%.

Our lease-up is going faster than we projected. So we still feel good about the fair value, the fair value possibilities that we have over the next two or three quarters.

After that point in time, it’s going to be impacted by such things, as how quickly our new investments come online, how quickly they’re built with the performance of the Heitman portfolio and a lot of other things that really are not predictable until we get a little bit later in this year and into the first quarter, and we’ll talk about that when we issue guidance in the first quarter of next year.

Thanks, that’s helpful. And then, it sounds like the hype in JV is now filled up and you’re doing loans on balance sheet now, which is curious.

You got a great pipeline there. Which markets are you targeting to start doing some – deploying some new capital?

Hi, Will, it’s Dean. We do this – I like this term surgical, it’s – and we really are going after this with our developers.

We have a 20 to 25 developer – development teams now. They were doing things around the country [indiscernible] and we’re working hand-in-hand with them on selecting markets.

For example, our guys who have done Denver and Charlotte, we’re probably done in both of those markets after two in Charlotte and three in Denver and we’ll be moving on into additional markets with them. And so, probably rather not just lay out all the markets, but I can tell you that there are plenty of markets out there today and I’ll speak to California.

California is still in the second inning of this. I mean it’s still very early in California.

Of course, it’s difficult in California, but there are plenty of markets around the country and even more sub-markets within additional markets that are still right for development and we’re using all of our data to direct those developers to those markets. So we feel like – and probably a better answer is how much longer do we have, I talk about being in the fifth inning or something.

I mean we’re about half over from a general landscape standpoint as far as this development cycles concern from JCAP’s perspective. Again, Texas we’re done.

But rest of the country, we’re only about half over.

Okay. And then just the last question from me is the mix of the type of the loans that you guys have lined up here, is it more development with equity participations, operating development without…

It’s a 100%.

All development with the participations. That’s where the revenue and the profit opportunities are for our shareholders.

Okay. That’s it for me.

I’ll join back in the queue. Thanks guys.

Hi, good morning guys. Thanks for the color earlier Dean and John, really appreciate it.

So, last time we saw industry-wide slowing growth that was heading into a recession and amid extreme supply growth as you said earlier, Dean. And then you gave some projections of average growth going forward from here, but those are averages meaning that some years can be below the 45% growth rate range, so I’m not asking you to project where the number going into a recession, but could you see growth go as low as flat or 1% over the next few years as demand slows and new supply continues to build?

Two answers there, Jonathan. One is for the entire sector and the other answer is for the public companies.

No, for the public companies. The public companies, we will revert to the mean and go below the mean in this next two to three years in my opinion.

Yes, the mean over since 1994 has been just over 4% for revenue growth and 5.5% for NOI growth. We will go below that for the whole sector, but again I speak to the power of the platforms.

You just look back at what the REITs did in 2009-2010, it is amazing. I mean at the depths of the recession, at the end of 2009, public storage still had 89% occupancy, and the others were right there right behind them.

So the rest of the sector 10 percentage points, 12 percentage points behind that. So it’s not going to be good for the small entrepreneur with this new supply coming, no question.

I will tell you that it is – there is a silver lining in it for the REITs, because it’s going to create some big buying opportunities for them and us as well, as we move forward and eventually evolve into a pure or more of an equity REIT. So, there is a good opportunity.

I mean, we will roll right out of a development cycle right into an acquisition cycle. And there’s going to be enormous amount of new Class A property to buy out there that’s underperforming.

It’s going to be a huge opportunity for the equity REITs to include us. So, I don’t see us going negative, I get asked that question time-to-time.

I don’t see the whole sector even going negative, but I don’t see the REITs, I mean, I think they’re going to normalize at this time more at 5% on revenue and 6% – 6.5% on NOI growth going forward. And so, we’ll drop below that a little bit in the depths of this oversupply, probably just over but not much.

They’re going to continue to outperform the other sectors in my opinion even through this new supply growth.

Hi Dean, this is Paul. Thanks for that.

Just would love to hear your comments on the demand side and really in Texas and Austin specifically, but where you think demand is going across the U.S. and some of the markets that are most troubled?

Yes, that’s a good news and the silver lining in Texas, Paul, is that, Houston and Dallas and Austin you got over 2% population growth and what’s happening in those cities, especially Dallas, North River, Northwest, North Dallas. That’s where all the growth is.

That’s where the population is coming in and that’s pretty well, where all the supply growth is coming in. Austin, it spread around and Houston is more spread around west-northwest Houston, but anyway the tremendous population growth in Texas, off a big denominators as far as Houston and Dallas, it’s about 7 million each.

So that’s a lot of opportunity there to, lot of demand to fill up this oversupply, that’s been coming. So I don’t think it will take us long to dig out of it in Texas because of that.

But as far as general new demand drivers, we can – we are continuing to see and starting to get more benefit on a quarterly basis now from this unit sized living that where we’ve gone from home ownership at 69.4% to wherever it is now, 62% perhaps. People are sizing down, not only they’re sizing down into apartments, as the apartments are getting smaller as we all know.

And so, that speaks volumes to the demand being better for us going forward in storage sector. So I don’t really see any negatives now, we could have a negative and that is if we dropped into another, something more than two quarter down recession, but a longer recession and we lost our discretionary customer or we had another black swan event that I describe as 9/11.

If we have something like that, we lose our discretionary customer. The props go out from underneath us and we’ll lose 7 percentage points or 8 percentage points right away as an industry, but the REITs will hold that occupancy.

They will not lose as much and they will just outperform because those powerful platforms they have.

Thanks. One more from me.

And I think John’s got another one. The developers – who’s funding the developers?

Who’s funding the – around the country other than us? Yes, it’s still your local banks, not your national banks, because of Basel III reserve requirements and regulators [indiscernible] But it’s your local banks and small regional players have free money.

I mean they’re not paying anything for deposits, and they are really – that’s the reason our A note sales are going so well, Paul. They are really scrapping for yield to be able to put good loans out, particularly like ours versus just making a straight construction loan because we eliminate the construction risks and the development risks for them, but it’s the small banks and small regional banks.

Yes, one thing on that topic though Paul, even the small and the regional banks are underwriting very conservatively, they’re requiring significant equity in the projects, they’re requiring full guarantees from whoever has money and the deals. So while that money is out there, it’s not as easy to get not like taking candy from a baby, if you will, you have to work for it.

Yes, when we get some more information out there that will help the banks discipline here as well. We’re certainly seeing it in the apartment sector.

Exactly, Paul, exactly, exactly. And we’re going to be proactive on that and making sure these banks understand what’s going on, we at JCAP, so you’re exactly right.

I’m hoping we will have some of that happening at the lending level as well as the developer level.

Thanks guys. And then one quick last one.

Last quarter you mentioned you’re going to do a cap rate study to see where they’ve moved, any update there, especially given the commentary over the past couple of weeks on the equity repair saying that cap rates have somewhat stabilized?

Yes, Jonathan. We had a national firm do a study in all of our markets and we got a relatively detailed report that we were able to use in backing up our fair value marks.

As we’ll stated in our 10-Q and as we – I think have said at other times we are at about a 5.5% cap rate for our portfolio and we think that that’s a good reasonable number right now. There are obviously some trades that are lower than that for properties that are of the same type quality, maybe a little bit in some cases maybe a little bit older than ours, but we feel like the cap rate study that we did justified and supported what we’ve been doing for the last few quarters.

Okay. Thanks for the color guys [indiscernible]

Thank you.

Hey, good morning, guys. Just looking at the pipeline, John, and the term sheet, specifically on funding that how are you thinking about common equity these days versus these preferred?

Yes, we’re fortunately not at a point where we’re having to think a lot about that for the next few months. We have a few of our original loans that were effectively financings of takeout deals with the REITs – CO deals with the REITs that will be paying off over the next 45 days.

So, our funding for our next three months is pretty well set. Going forward, we’re going to look at it just like we always do, it’s going to be a function of what our stock price is and what’s the best cost of capital for us.

We don’t have a lot of capacity for the next several months on the A note front. We’re kind of down to with the CO properties that we have and expect to have between now and kind of the end of the first quarter of 2017.

We’re down to about $20.2 million of A note capacity, so that $150 million is going to have to be financed to a large degree with equity and we’re just going to make those decisions based upon cost and to the extent, we have the ability to hit the common equity market. We will consider that at the time.

And in the meantime, we have the $125 million forward commitment from Highland Capital for the preferred stock of which we only used at this point $10 million. I think it will be a game-time decision as we move into the point in time, where we’re going to need the funding.

Okay. That makes sense.

I guess on that same note, you have given the change in the liquidity position in about six months and how well the stock has done and how much the store is progressed. How are you guys thinking about a line of credit, not that you actually need at these days, at this moment, but we just haven’t mentioned a lot, I was just thinking about what are your thoughts are on that today?

Well, David at this point, I think the game is still the same on the line of credit from the bank’s perspective. They’re more interested in buying the senior piece of our existing underwritten deals then extending a revolving line of credit where basically their collateral is paper.

I have ongoing conversations with a few banks and what they’re basically telling us is, we are happy to see the finance – the debt financing right now, be at CO and be through the senior participation or A note purchases, once you start acquiring properties, once you start buying in some of the properties in which you’ve invested up today. At that point in time, we are all in, in terms of providing a credit facility.

So, I think it’s going to be for the next 12 months, a lot more of the same A note transactions as we can do them. And that’s generally at the time of CO and those deals are very easy to execute.

We have about a 13-page participation agreement, they’ll go and get an appraisal done and you can effectively close those more or less contemporaneously with the Certificate of Occupancy being issued.

Yes, that makes sense. Okay and then just switching gears a little bit.

I guess you guys mentioned the estimate of the fair value or intrinsic value whatever you want to call it from the investor deck you published earlier this quarter, can you give us just an update on where you think that stands with a, given the fully committed Heitman JV and the recently announced deals?

[indiscernible] Yes, I think we’re in the same place, that investor deck is not very old and we have pretty good visibility into our fair value mark. So, what we’ve done in our deck is we came up with the term, that we call our current intrinsic value, which is basically just taking what we have in place, which is the investments we’ve made today and the Heitman JV and the profit potential that we have out of that and we still believe that’s in the $23 share range.

We have another slide in our deck that covers the additional value that we can add, as we deploy the equity commitment that we have from Highland and later on additional A note leverage as we get that equity fully invested and get those projects built into Certificate of Occupancy and that’s obviously a higher number, that’s more in the high-20s range. But we still feel good about those numbers now.

The wildcard and all of this is what do rents do and what do cap rates do. We still feel good about our underwritten rents, and we still feel good about our cap rates and there’s still a lot of money looking to get into the storage sector and cap rates in many respects, are supply and demand driven.

Thanks a lot guys.

Okay. Thank you very much everybody for your call today, and look forward to seeing some of you at NAREIT.

Good day.