Thursday, June 29, 2006

Portable Alpha is Portable Potty
The Wall Street Journal has an article on portable alpha this morning - investing a portion in an index (beta) and a portion in derivatives to capture hedge fund returns (alpha). Apparently this is the investment rage and I have heard the term frequently. Wall Street's big firms are coming out with products to capture this alpha. But as more people invest, as a quote at the end of the article from William Bernstein suggests, alpha will shrink (efficient markets) making alpha that much harder to obtain.
Better Analysis
I am reviewing and rethinking the analytical process for tenant in common (TIC) transactions. I think it needs to be better and incorporate more traditional financial and investment analysis. These deals need a more rigorous financial review. The cost of the deal - for both debt and equity - needs to be determined and compared to the expected return. The tricky part is the cost of equity. To determine the cost of equity I have been using the front-end costs, less money for reserves, but I am not convinced this is fully accurate. I know it gives a good approximation of the cost of equity, but I need to fine-tune it and determine a portable formula that could be applied across multiple offerings.

I searched the CFA Institute website for exisitng research, and there was none. (This could be a good research document.) I am searching Amazon for an appropriate real estate analysis book that will help.

Thursday, June 22, 2006

Buying The Sizzle Not The Steak
Investments are an odd thing. Investments that seem marginal can attract loads of cash while good investment opportunities languish. The Wells Real Estate Investment Trusts have raised billions from investors over the past five years. Last July Wells introduced what it described as a mid-term value-added fund, a fitting product for a real estate environment that has seen prices soar making traditional income investments harder to fit into the traditional non-traded REIT structure. The fund, however, took almost a year to meet its impound of $10 million.

Rainier can sell its 1031 programs (which are by no means marginal) in about five minutes but its Income and Growth Fund II, which pays an 8% yield to Class A investors and has substantial diversification for a $10 million fund, has struggled to raise funds.

Why do good fund languish? I don't have an answer. I would not be suprised that the programs are sold by different reps, making it a tough sale for the wholesaler. The rep selling Wells for income and safety is not same rep looking to sel an upside opportunity. Maybe the wholsaler compensation is different? Whatever the reason it's unfortunate and investors are missing good opportunities.

Wednesday, June 14, 2006

Wednesday's WSJ
Today's Wall Street Journal had an interesting article about apartment investors looking for opportunities outside the investors' home market. The end of the article mentioned that as an alterantive to looking for a specific property, investors could consider a TIC transaction and referenced TICA. I half-thought that the writer was recommending the TIC alternative as a fund-type investment rather than an actual fractional ownership interest.

Tuesday, June 13, 2006

I was talking to a wholesaler friend earlier this week and he told me that a broker/dealer is worried that the TIC market will collapse any day. This scared me because I know the people at the broker/dealer and they are smart. I would bet that the management at this broker/dealer knows more about investments than the managment at any other independent broker/dealer. After the fear of my due diligence review fees evaporating passed, I thought through the comment.

The TIC market will not collapse. Real estate is too varied and illiquid to collapse overnight. It is not a stock. My guess is that it will slow, as real estate in general is slowing. All TIC deals are predicated on the sale of properties so that investors can exchange into the TIC deal. If investors have a hard time selling their properties, this will slow TIC sales.

Here are the biggest trouble spots that I see:

  • Specific sponsors going under is a more likely scenario. Sponsors that are leveraged and need deal flow and the corresponding fees will be in trouble. A sponsor that runs into severe financial difficulty will be a black-eye for the industry. (It may also be an oppourtunity for a better capitalized sponsor to take over management.)
  • If credit dries up, properties that need to be refinanced when the original debt term expires may find it difficult in a tight credit market. If there are defaults on a number of TIC deals, good programs may feel the affect by finding financing difficult and expensive. Bankers are followers and credit will dry up fast if the bankers get nervous.
  • Deals that were "financially engineered" will be the first to feel any pain. Watch the deals from sponsors that put them together. Financial engineering examples include projections that have outsized growth, or have distributions paid from reserves (or any other non-operating source), or interest-only financing for an extended period of time (five years or more) that artificially inflates distributions while adding no equity accumulation.
There are other potential flash points, but rather than a full-scale retreat like the stock market saw in 2000 through 2002, the TIC market will not collapse. In talking to sponsors, the biggest concern is not the ability to raise money or access to financing, but to find affordable properties that fit in a TIC pricing model. This is not the talk of an industry about to implode.

Monday, June 12, 2006

New Whipping Boy
I am updating my review of the Inland American Real Estate Investment Trust. The updated material does not change my original opinion of the program: that it is one to skip. The front-end load approaches 17% and the ongoing fees can hit an outrageous 7% of revenue if investors receive an achievable 5% distribution. Inland receives no acquisition fee if properties are purchased directly. It will receive a fee if a real estate operating company is purchased. The first transaction was another REIT, so Inland gets its acquisition fee. I am uncomfortable with investors paying 17% for Inland to have access to purchase REITs. The original portfolio, if I remember correctly, had marginal properties (thanks Google Earth) with limited lease growth.

I am not against marginal properties. I like properties that make investors money, and it does not matter whether the property is marginal or top-quality. There needs to be upside in lease growth and the acquisition price needs to be favorable (cap rates higher than market cap rates). The deal, in my opinion, fails on both accounts. There is limited lease growth and the cap rate was near 6%. Investors in Inland American should expect flat distributions. Capital appreciation is unknown, but with flat lease rates and cap rates near historic lows, I am not optimistic.

Friday, June 09, 2006

Pitting Investors Against One Another
The more I think about affiliated mezzanine debt deals the more I do not like them. You have a sponsor offering two products that are polar opposites in terms of objectives. The equity offering uses the debt from the mezzanine deal to bridge its property purchase. It is in the equity offering's best financial interest to use the mezzanine debt for as short a period as possible, if at all (fast equity raise). And it's in the mezzanine offering's best financial interest to have the debt outstanding for as long as possible (slow equity raise). Something's got to give.

The sponsor would better serve investors by scraping the mezzanine deal and focusing on raising money for the equity deal. Quality TIC offering's still sell out in a short period of time, negating the need for mezzanine debt. Rather than go to the trouble (and expense) of a debt offering, the sponsor should find better properties, structure the equity deal better (i.e. less fees and higher returns to investors), and hire a better sales force. It is likely that the need for a mezzanine deal is a sign that the equity offerings are not that great.

Tuesday, June 06, 2006

Inflation worries have taken 250 points off the Dow in two days. Strangely, the ten-year Treasury, which should be falling and its yield rising, has moved very little over the past two days. This may mean that the bond market is more concerned about a slowing economy than inflation.

Sunday, June 04, 2006

Forgotten History
When I first started as a due diligence analyst in the late 1980s, I viewed affiliated transactions as a sign of potential trouble. The due diligence department that I worked in and eventually ran, initiated a prohibition against offerings that were affiliated. There was a good reason for this. It was because too many affiliated deals went bad. The Heartland and Meyers land deals went south (note investors against equity holders). The Hill Williams land development deals went south (raw land loans made based on "as completed" appraised values). The Nilcorp housing development deals also had note investors fighting equity investors. There where other affiliated transactions that did not turn out as planned, not just the risky land development programs.

Some deals were structured poorly and the real estate market did collapse. But many failed due to the lack of arms' length negotiations and misvalued investments, and the likely fact that the deal would never have been done if it had not been an unsophisticated affiliate offering.

The affiliated transaction is back with a vengence. The lure of capital - despite its cost - from unsophisticated investors is too great. The disclosure is better because the securities attorneys are better (but it is not the attorneys' job to tell investors whether the deal is good or bad). Disclosure does not make a deal sound and broker/dealers and investors need to beware.

My opinion is the same - these deals are considerably more risky than being presented and investors and broker/dealers should stay away. The returns do not, in my opinion, compensate investors for the risk being incurred. Yield and return hungry investors should look elsewere. History repeats itself and broker/dealers need to avoid the mistakes of the past.

Saturday, June 03, 2006

The point of this blog is not to bash CNL, although I would admit that seems to be the case. But I am currently reviewing CNL Income Properties, and CNL is merging another REIT and preparing a third for merger / sale or listing (I bet merger / sale). Between the immediacy of my review and the activty at CNL there is a wealth of material to reveiw. My opinion is that CNL's fees are high and its disclosure is poor. Income Properties' load is 200 to 400 basis points higher than some of its competitors, and in a limited-appreciation sale / lease back transaction 400 basis points is significant. When you have to play detective to find simple information about a merger of previous programs it makes you suspect what else is missing. I have other programs to review and will likely bash them, too.
But You're Not Saying Anything
The legal disclosure in prospectuses (or how lawyers can write and present tables for hundreds of pages and not say anything) can be frustrating. CNL combined its restaurant REIT and its income partnerships (I through XVIII) and merged these with an existing company, US Restaurant Properties. The new name is Trustreet Properties (TSY) and it began trading on February 24, 2005. CNL's track record goes on for pages and no mention of the conversion is made. The name of the new entity is buried in an appendix's footnote.

I am not clear as to why the presentation is so opaque because the results are not horrible. I guess it is the company's preference for secrecey and disclosing what legally needs to be disclosed - good new or bad. Whether the diclosure is coherent is another matter and probably irrelevent. I would challenge any investor reading the CNL Income Properties prospectus to determine what happened to all those old partnerships. And what was paid for the management company? This is not in the prospectus either.

Investors received cash and convertible preferred stock. The stock has dropped from $18 to about $13. I am not sure what the conversion or target IPO price was, but it was probably near $20. The convertible stock is convertible anytime with one preferred share convertible into 1.28 common shares at $19.50 per share. The preferreds have never traded "in the money," and convertible preferreds typically trade at a lower yield than non-convertible preferreds. My first instinct is that investors did OK, not great, and likely could have and should have done better.