Feeding the Beast
I was sent some audited financial statements from a TIC sponsor this week. I do not do much business with the sponsor so an unsolicted package is usually tossed. Rather than routing the package straight to the garbage, I happended to open it and found the financial statements. Pretty scary stuff. The company has a leverage ratio greater than 80%, some in the form of debentures and investor notes raised from individual investors not banks. With a leverage ratio that high it's not hard to figure out why there is no bank debt.

The company has substantial cash on hand, so long as it keeps putting deals together it should be able to sustain its high leverage ways. One intriguing comment in the notes is that the company classifies the reimbursement of operating expenses incurred by it in the management of properties (presumably for TIC investors) as income. I would think that this would be a wash on the balance sheet - operating expense reimbursements offset by operating expenses. Not even close, in fact other income (which I am assuming is where the operating expese reimbursements are presented) is three times greater than operating expense entry. I wonder if the reimbursements are marked up? These financials definitely require a closer analysis and raise serious questions, but I have spent too much time on this as I don't closely work with this sponsor.

European Cap Rates
Today's Wall Street Journal has an article on European real estate. If you think cap rates are low in the United States be lucky your not buying real estate in Europe. Yields on retail property in Dublin are 3%, the lowest in Europe. London office yields are 3.75% to 4.75%, depending on location. How do or how can investors finance properties at these cap rates? These cap rates make US cap rates downright frothy. A European can invest in US properties, take a slight hit on the Euro conversion (which is expected to continue to appreciate against the dollar) and still outperform home real estate markets.

WSJ Real Estate
Today's (May 24, 2006) Wall Street Journal had several interesting articles in its Property Report (starting on page B4). Its Blueprint market today is Columbus, Ohio. The article states that Columbus is gaining traction and showing signs of improvement. This encouraging report shows the prescience of Cabot Investment, the TIC sponsor, who had the fortitude to invest in Columbus near its bottom in 2004.

In its Plots & Ploys section it mentions a TIC transaction sponsored by Triple Net Properties. It is a 205,000 square foot medical property 100% leased for ten years to the AA-rated Mayo Clinic. The article states that the cap rate was 6.2% - which I bet is not the Syndicated Acquisition Price cap rate. The interesting point is that the property was sold to the TIC investors by WP Carey. I wonder what return the WP Carey investors received?

Dipping Ten-Year
The ten-year Treasury has dropped to around 5% from close to 5.2% over the past two weeks. This stops a steady year-to-date rise in the ten-year (an increase of almost 1% at its peak). What does this mean? Inflation fears, which have supposedly spooked equity markets, would mean that the rate would go higher rather than lower. It may be the realization that the high gas prices are working their way through the economy in a not-so-positive way. The dip is good for real estate because cap rates have not moved up with interest rates, which have narrowed spreads and made real estate investing tougher. Hopefully this repreive will not be brief.

Juiced Up Portfolio
I am reviewing a major non-traded REIT and have signed a confidentiality agreement and therefore can’t divulge confidential details. But the documents I am reviewing are all public filings so I can comment away. (Anyhow, this company won’t disclose any private details – since when have cap rates become proprietary - and the disclosure in the filings appears more to obfuscate than clarify.) The documents, to me so far, show an almost inappropriate quest for yield – construction and mezzanine loans, ground leases and partial ownership of buildings – with little regard for growth or an exit strategy. Hell, the risk section, in a rare moment of clarity, states that the ground leased properties offer no growth! This is combined with other properties that do not appear to have much more than 5% to 6% returns. If the yield on the REIT was 8%, maybe the investment strategy could be justified, but at 5.5% I am not sure. I will keep you posted on this deal.

Strained Finances
I have seen three articles this week on the rise in defaults on mortgages. All three articles are quick to point out the default rates are below historic standards, but the point remains that the default rate is on the rise. Adjustable rate mortgages are seeing the most defaults. These are the nifty mortgages that let people buy more home than they can afford. Rising short-term interest rates make monthly payments higher when the adjustable rates reset. Jesse Eisinger, who writes the Wall Street Journal’s excellent Long & Short column, had this take-away point in Wednesday’s Journal:

“As demand wanes, there's been an unsurprising but troubling response from banks: They are making it easier to take out a mortgage. According to this week's survey of bank loan officers by the Fed, more than 11% lowered their credit standards in the past three months, while fewer than 2% tightened. And mortgage-payment performance has begun deteriorating. Though absolute levels are still historically low, late payments are rising. “

Eye-opening stuff. When my wife and I bought our house in 1993 the lenders required that the loan payment had to be less than 30% of our combined gross income, if I remember correctly. Those days are gone. The banks have no one to blame but themselves for the defaults and, like a group of lemmings, will all tighten credit in unison. Of course this will be after the housing prices decline and become more affordable.

My guess is that one of the small, high-flying mortgage companies that specialize in the most exotic loans will fail. The rise in short-term rates will accelerate the fall of a company in trouble. Annaly Mortgage, once a Wall Street darling, has cut its dividend to $.11 a quarter from $.50 a quarter at the end of 2004. Its stock has dropped from $20 to $12.50 over the same period.

I have bored many people with my theories on the false run-up in housing caused by silly mortgages people can’t afford and the dire consequences these mortgages may cause. The economy can’t withstand a housing implosion caused, in part, by lender greed and negligence.

Trend to Watch
I have received offering packages recently from TIC sponsors with programs other than TICs. These represent two divergent ideas. The first is a move to diversify away from TICs and present other alternative real estate investments in a general fund format. This makes good business sense as the fund approach will expand the companies' distribution network from both a rep and a broker/dealer standpoint. The second is more disturbing as, at first blush without any analysis, the offerings are affilaited debt transactions. This type of program has never given me a comfort level. I will post back after reading a memorandum or two.

Triple Net G REIT
I received an investor letter from the G REIT saying that investors had approved the liquidation of the REIT. As part of the letter investors are being notified that "we" (presumably the REIT management) have retained UBS Securities to act as the REIT's financial advisor and help it find a portfolio sale. An outright portfolio sale would be good for investors rather than sell the properties over a two year period. The letter states that "we" is still estimating a return per $10 original investment of $10.31 to $11.50 per share

The View from 100,000 Feet
I used to work for a small company that was sold and became part of a very large company. One of the new management's cliches was that the senior executives were busy with the "view from 100,000 feet." I went from being impressed to disillusioned as it became evident that from 100,000 feet management could not see anything - sort of like flying over parts of the western United States on a moonless night. I had not thought about this inane cliche for awhile but was reminded of it today as I paraphrased it to apply it to the current real estate market - the view from 5.5% cap rates.

I pick 5.5% not as an exact number but as one to reflect cap rates at historic low levels. Some view lowered cap rates as a paradigm shift (isn't this another old cliche?) and some view them as a sign of a real estate bubble. Who knows and whoever is right, both face the same future. A future defined by limited capital appreciation and where income is the primary return component. How can cap rates fall much further, with interest rates creeping up and institutional interest rates above 6%? Income growth in the form of increased NOI through expense management and lease increases will be the path to success. Real estate purchased at today's cap rates that have limited lease growth will be tough to make profitable. The "view from 5.5% cap rates" is all about income and how to grow it.

CNL
CNL Retirement Properties agreed to be purchased by Health Care Properties (HCP). CNL Retirement Properties is a non-traded public REIT. Investors paid $10 per share and the HCP bid is $13.50 per share. It looks like the purchase price is about 14.5 times CNL's 2005 FFO. This high compared to historic FFO multiples but lower than recent transactions. Investors will receive $11.13 per share in cash and .08 shares of HCP for every CNL share owned. So, an investor that made a $5,000 investment will be stuck with 43 shares of HCP. Oddlot nightmare. Hopefully, CNL will make some sort of accommodation for the small investor.

I was at a CNL due diligence meeting in early April and asked CNL whether it was exploring the sale of its REITs to another REIT or private equity investor. The question was pointed towards CNL's hospitality REIT but would cover the health care REIT as well. (CNL obviously could not discuss the HCP transaction.) I was told that this type of transaction was not in the prospectus. Since when does shareholder wealth maximization not become part of the prospectus?

I guess CNL wealth maximization trumps whatever is in the prospectus. HCP will pay CNL $120 million for its management company / advisor which was separate from the CNL Hospitality REIT. CNL has a reputation as trying to maximize its own wealth and finally found a participant. (One failed IPO and one failed rollup of limited partnership, which both included large valuations for the external management company.) To paraphrase my dad, "CNL loves investors but loves itself best."

"Major Issues"
I generally discuss the key points of my investment research under the heading Major Issues. This will include economic opportunity, risks and some boiler plate disclosure. Peeling back a deal will reveal one or two prime opportunities risks that need to be exploited or overcome for a deal to be successful. When I talk about deal here, I am discussing TIC transactions. Here are some examples of "Issues" that have recently been seen.

• Long-Term lease to WalMart (great). The lease never increases nor has revenue participation (bad). The deal has become a pure cap rate play with cap rates near historic lows.
• Majority of tenant leases due in the year the deal is supposed to be sold and when the debt is due. Becomes almost pure lease bet and whether the sponsor can get that property leased at a level that will make it attractive to a buyer at a favorable price or at least get the debt refinanced.
• Majority of leases below market. A deal had a majority of the leases up to $4 per sq. ft. under market. Again, a lease play, which if the sponsor successfully implements will be great for investors.
• Negative leverage on an apartment deal. Discussed before. Need outsized rent increases to turn to positive leverage and to justify the low cap rate paid for the property.

Most deals, in my opinion, can be narrowed down to several main risks/opportunities that the sponsor will need to properly manage for investors to have a chance at success. I don't feel this is bad, but investors need to be compensated for additional risk. Investors were not compensated for the WalMart deal, in my opinion, but where (at least on paper) for the second example.