Deal of The Year
My deal of the year is the successful listing of the Piedmont Office Realty Trust (PDM).  The former non-traded REIT listed its shares on the NYSE in February around $15 per share, and it's now trading over $20.  While the stock has risen by about a third since its listing, it is still priced about 20% below its break even level of just over $25 per share.  To exisitng investors, PDM is yielding 5% and at today's price is yielding 6.2% - all covered by operating cash flow.  I buy the argument that if an investor bought shares in PDM ten years ago the overall annual return is pathetic.  But that is not why it's my deal of the year.  The stock not only held its value, but increased in value while successfully accessing the capital markets, positioning itself for long-term growth, all the while achieving its objective of giving investors liquidity.

If there is a black cloud around this deal it is its successful listing and the deferred release of shares, which helped maintain PDM's value through lack of sell pressure, and how I expect this will become the listing strategy for other non-traded REITs.  Baring any bad news over the next month, investors in PDM should have full liquidity of all their shares at prices much higher than the initial listing price.  You can bet that other REIT sponsors watched this smooth transition and will plan to replicate the deferred share release structure.  One non-traded REIT, Healthcare Trust of America, has filed initial documents to list its shares and will also offer staged liquidity, but over eighteen months rather than the twelve months of PDM.  Healthcare Trust of America won't be the last sponsor to exploit PDM's success.

Advantages that PDM had, which other REITs likely won't be able to replicate, are that it had low debt (around 20% near the time of listing), a diversified portfolio of office properites acquired before the spike in real estate prices, and a dividend that was covered by operating cash flow.  The large, stable portfolio offered no downside surprises during the twelve-month deferred listing period, or prompted sell pressure as the tranches were opened to the market.   That PDM is still trading below its break even, even with all those positives, should give non-traded REITs sponsors and the firms that sell them something to think about.  But in the meantime, investors and broker / dealers should thank PDM's management, including the often maligned Leo Wells, for the successful PDM listing.

Bluerock REIT Suspends Sales
The Bluerock Enhanced Multifamily Trust, Inc. has suspended sales.  This is not breaking news, as the 8-K announcing the suspension is dated November 11, 2010, and I am just getting around to posting this now.  The reason for the sales suspension is that the REIT changed auditors and the new auditors are saying that the REIT has to change the way it accounts for its investments in its properites, and therefore restate its financial reporting, resulting in a new 10-K and new 10-Qs.  The REIT's properties are all owned through joint ventures with other, affiliated Bluerock entities and third parties.  The REIT needs to file corrected financial statements and a post effective amendment, and be declared effective by the SEC.

I quickly read the Bluerock Enhanced Multifamily Trust's website and saw no mention that it has suspended sales.  I had to go to the REIT's most recent filings with the SEC to find the 8-K announcing the sales suspension.  This REIT, like the Behringer Harvard Multifamily REIT, has substantial inter-dealings with affiliates and owns its properites through joint ventures.  Real Estate funds and REITs that own their properites through Rube Goldberg structures always make me uncomfortable.

Grubb Gets Scrubbed
The Grubb & Ellis Apartment REIT is changing its name to Apartment Trust of America, effective January 1, 2011.  What an awful, uncreative name.  A better name would be the Legacy and Lawsuits Apartment REIT. 

From what I have been able to extrapolate from various conversations is that the managers of the REIT terminated the REITs relationship with Grubb & Ellis due to poor sales, and are hoping that a new advisor and dealer manager will boost sales.  Unfortunately, the change in advisor and dealer manager requires new selling agreements with broker dealers, and the REITs legacy assets and lawsuits relating to pending acquisitions will likely give broker dealers reason to pass on this deal. 

Quote of the Year
This is a quote from a July Cole Real Estate Investments' press release describing its $310 million acquisition of a building leased to Microsoft:

Cole expects the average capitalization rate for this property over Microsoft’s remaining initial lease term to be approximately 7.70%.  

Average capitalization rate over the term of the lease?  That's a new one.  A cap rate is a property's first year net operating income divided by the purchase price.  Period.  The use of "average" tells me that Cole is afraid to tell us that the actual cap rate is low, probably lower than the Cole REIT's dividend (and the Cole REIT did cut its dividend by a small amount late in the year).  Don't insult us with made up terms.  Instead, tell us that while the Microsoft property was expensive, it will likely outperform all the other real estate in the portfolio.  Forward any other worthy quotes.

TIC Article
Yesterday's Wall Street Journal (sorry, no link) had an article about a tenant in common arbitration that ruled that fraud had been committed at an Austin, TX office property syndicated by Triple Net, one of the large TIC sponsors.  The fraud resulted from Triple Net's failure to disclose a structural flaw in the building's foundation and that Triple Net was negotiating an insurance settlement, and then spent a portion of the insurance proceeds on other properties.  The article states that the structural flaw in the building has prevented it from being refinanced and the lender has filed a foreclosure notice. 

The article spends a good deal of space badly trying to tie the Austin property to other high profile TIC frauds, DBSI and Sunwest.  The theme of the article is that the Austin property offered a look into the sinister world of small investor access to commercial real estate.  The article fails here, too.  The throw away line that raised my eyebrows was that Grubb & Ellis, which is managing many of the remaining Triple Net properties due to its merger with Triple Net in 2007, disclosed in its third quarter report that "the company (Grubb) has been named in multiple civil lawsuits related to its investment management programs alleging negligence, fraud and other claims." 

Triple Net's Austin deal sounds more like a property specific situation than an indictment on an industry.  No commercial real estate deal, regardless of size, was immune from the drop in real estate prices.  The general risks of TIC deals were disclosed to investors.  TIC transactions were single property (no diversification) investments.  TIC deals had limited sources for any additional capital, such as for unbudgeted leasing expenses.  No deal expected to have to pay down a mortgage to allow for refinancing.  Most TIC deals had financing that ended up in CMBS, which had their restrictions disclosed, but no one knew how difficult these restrictions would become when the entire CMBS market closed.  Finally, the fees of a TIC transaction usually required a gross property appreciation of at least 15% to 25%, just to break even. 

It is naive to think that TIC deals would be immune from the recession and credit crisis.  The real estate boom was fueled by easy credit, and the TIC boom in particular benefited from the residential housing boom as rental properties were sold and proceeds rolled into TIC properties.  Commercial real estate prices appear to have stabilized, and might even improve with a growing economy.  The next several years will write the final chapter on the TIC industry as mortgages in CMBS mature.

Natural Gas' Frack Problem
Yesterday the New York State Assembly approved a six-month ban on natural gas drilling that uses hydraulic fracturing until the environmental impact of this process is evaluated.  The fear is that the chemicals used in fracking are seeping into and contaminating ground water supplies.  Fracking is the high pressure process used with water and chemicals to force the release of hydrocarbons from rock formations deep in the earth.   Many natural gas drillers use fracking and many don't reclaim the water / chemical cocktail, allowing it to dissipate into the earth.  Articles on natural gas fracking and the NY Assembly vote are here and here.  I am going to go out on a limb here and say that the environmental impact of fracking is a big deal, and that most gas drilling investments I have reviewed are under insured against environmental damage.

Snarkless in Vegas
A once-major real estate syndicator is selling notes through a newly formed company.  One of the company's first investments with the proceeds from the notes was a single condo in a Las Vegas high rise.  This morning I saw this Calculated Risk post referencing a Las Vegas Sun article that states that there are 4,000 unsold condo units on the Strip alone.  I am trying to think of something nasty to post, but the sheer scale of unsold units and a syndicated real estate investment buying one unit overwhelms my sense of snark. 

Dry Hole
While the fortunes of Atlas Energy are soaring, the outlook for another oil and gas sponsor, NGAS, is murkier.  NGAS reported disappointing earnings yesterday, said it was in violation of debt covenants and that it is:

evaluating all of its strategic alternatives and that it is actively pursuing possible transactions that may include the sale of the company or of some, or all of, the company's assets.

NGAS stock dropped 40% today and closed at $.36 per share.  NGAS has $170 million of oil and gas profits on its balance sheet, but it does not have the cash to repay the up to $57 million of debt that is now due under covenant violation.  NGAS says it will keep drilling despite the financial worries.

Piedmont's Third Tranche Release
The third tranche in Piedmont's listing is occurring this week, as shares are being delivered to custodians.  This likely explains Piedmont's (PDM) small price drop over the past two days.  All Piedmont shares should be full listed by February 2011.  Remember that the breakeven price per share is $25.14.  The current price is approximately $18.20 per share.

I don't want to jinx PDM's shares, but with one more tranche release left, it looks like Piedmont's strategy of spacing share liquidation has helped stabilize the stock.  Rightly or wrongly it appears that deferred liquidations are the new model for sponsors that are looking for liquidation.  The IMH deal I wrote about over the weekend is spacing its sales, and another large REIT is contemplating using the tranche method, but over an 18-month period compared to Piedmont's which took about a year. 

It's not the tranche strategy that stabilized Piedmont's share price, it is a good underlying business.  Entities with shaky business models or suspect financial statements won't have the same results as Piedmont.  The results could be just the opposite of Piedmont's, where a stock's price drops after the initial IPO and continues to drop, especially before and after each tranche release, until all shares are liquid or the company suspends tranche releases in an attempt to halt liquidations.  Investors will be in a frenzy to sell if a company is trending down.

Atlas Hits A Gusher
Well, Atlas Energy Inc.'s stockholders hit a gusher.  Today Chevron acquired Atlas for $3.2 billion or $43.34 per share, a 37% premium over Monday's closing price.  Atlas stockholders will receive $38.25 in cash and $4.09 of units in Atlas Pipeline Holdings.  Chevron's attraction was all Atlas' acreage in the Marcellus Shale natural gas region, which spreads over Western New York, Western Pennsylvania, West Virginia and parts of Ohio.  Atlas controls 622,000 acres in the Marcellus Shale formation with 1 trillion cubic feet of natural gas reserves.  A  Bloomberg article quotes an RBC analyst who figures that Chevron paid $9,000 per acre.  Last spring Atlas entered into a joint venture with India's Reliance Industries, Ltd, at $14,000 per acre.  While not a direct comparison, Atlas contributes its Marcellus Shale lease interests to its limited partners at a value of $45,000 per acre. 

For many years Atlas tapped a network of independent broker / dealers to raise capital for limited partnerships, which in effect were a form of corporate finance for Atlas.   The Atlas oil and gas partnerships are long-lived programs, so I am guessing there must be some kind of plan to continue to manage or to liquidate these assets.  The syndication business is moving to Atlas Pipeline Holdings, so I am guessing Atlas will keep the pushing out its rich, sponsor-feed energy programs.  It looks like any  assets in Michigan and Marcellus Shale (some that are owned by partnerships) are staying with Atlas and will be managed by Chevron.  I have read through Atlas' 8-K discussing the acquisition, but other than what is stated above, there is not much more information.   This is a fluid situation that needs watching.

IMH IPO - Where's My Checkbook?
I had not thought about IMH and its combination of the IMH management company and the IHM Secured Loan Fund lately.  But earlier this week I checked IMH's website and it looks like the consolidation has been approved, and on October 28, 2010, IMH filed a pre-IPO S-11.  I guess IMH and investors in the IMH Secured Loan Fund figured out the senior management compensation issues enough to get the consolidation approved (there are lawsuits filed so the saga is not over).   I always felt that the whole compensation argument was like arguing over carpet and wallpaper on the Titanic. 

I am not going to read the whole S-11, but will cherry-pick a few highlights.  These comments are out of context and if you're serious about this investment you should read the entire document. 

• For the first six months of 2010, IMH posted a loss of $45 million, of which $39 million was loss provisions and impairment charges.  The operating loss for the first half of 2010 was approximately $6 million.
• Accumulated losses are $454 million.
• "Substantially all of our commercial mortgages are in default, and currently performing loans may default in the future."  Yikes.
• IMH is using outside consultants to workout its defaulted loans.  I am curious how much these firms or individuals will receive for their workout efforts and how much IMH will net on any asset recovery?
• At June 30, 2010, IMH estimated that it had $15.9 million in cash funding requirements for existing loan commitments.  At June 30, 2010, IHM listed $3.5 million of cash.
• Existing investors only receive partial liquidity on the IPO, and are having their  equity diluted.

IMH has wide latitude in making investments with net IPO proceeds. It does not look like it is going to attempt to save any of its existing loans or assets.  It will be originating new loans and acquiring exisitng loans to take advantage of the real estate upheaval and aftermath of the credit crisis.

My question with IMH has always been its valuation for exisitng assets.  It still lists nearly $300 million in total assets, about half its asset value at the end of 2007.  I estimate that IMH has lowered valuations about 50%.  Is this enough?  I don't know, but my gut tells me it is not.   Land values have dropped considerably, and more than 50%, especially in the location and in the pre-development space where IHM operated.    The market's appetite for this IPO will tell us whether IMH was accurate in its asset valuation.

I never thought that IHM Secured Loan investors had much of choice but to approve the consolidation.  Snark aside, I hope this investment works out for investors.

Defies Belief
United Development Fund III, LP, (UDF III) is a limited partnership that raised capital to originate and service land and development loans to home builders, both third party and affiliated, that are based in Texas.  It raised its capital starting in late 2006 and finished in early 2009.  At the end of the second quarter, approximately a third of UDF III's assets are affiliated transactions.  On October 22, UDF III released its required per unit valuation in an 8-K that states that the value per unit is $20, the same value that the units were originally issued.

The 8-K lists a variety of valuation methodologies (income, market and asset) and resulting valuations.  Valuations were determined by the general partner and by a third party.  The valuations ranged from a low of $18.05 per unit to a high of $26.19.   The general partner determined the low-end valuation, and the high value was determined by the third party valuation firm.  The passage below discusses the general partner's value reconciliation process and how it arrived at the $20 per unit value:

In determining the Partnership’s estimated unit value, the General Partner considered the independent firm’s range of estimated values per unit of between $18.80 pursuant to an asset approach methodology and $26.19 pursuant to one of the valuation analyses used in the market approach methodology, as well as the lack of marketability discount discussed above. The General Partner also considered its own determination of the Partnership’s assets, less liabilities, of $18.05 per unit, as well as the General Partner’s estimates and projections regarding the execution of the Partnership’s business model set forth in the prospectus regarding the Partnership’s initial public offering of its limited partnership units and the General Partner’s expectation that a public trading market for the Partnership’s units is not likely to develop. The General Partner then determined the estimated value per unit of the Partnership’s limited partnership interests to be $20.00 per unit, which is within the range of values provided by the independent firm.

We are to believe that an original $20 unit price, which paid approximately $2.80 per unit (14%) in offering costs and netted approximately $17.20 per share in net investable proceeds with which to make loans, is still worth $20 per unit?  Well, I don't and here is why.  In general, UDF III took that $17.20 and made loans, and the loans pay interest and principal.  Fine, but the loans don't appreciate, they're generally repaid at par, and some loans don't even pay current interest as is common in the construction industry, principal and accrued interest are due at maturity.

Here is an example:  let's say the fund made a $1 million loan with a twelve-month term and 12% interest.  At the end of a year the fund would get its $1 million back, plus $120,000 in interest.  From that interest the fund needs to pay investors a 9% distribution on the original $20 per unit price, which is approximately $104,650 of the $120,000 the loan earned in interest.  The balance would be applied to the initial 14% load recovery, which only reduces the load by a small amount, so to fully recover the load, the money would have to be recycled 10 times!   Below is the transaction example described above using a $20.00 unit price and fully investing the net proceeds.  It shows that an excess $.26 that could be applied to the initial $2.80 load:

Initial Value:    $20.00
Load:                 $2.80
Net Proceeds:  $17.80

Loan $17.20 @ 12% for one year
Interest:          $2.06

Pay 9% on $20.00 per unit
Distribution:   $1.80

Excess proceeds  $.26 per unit

An astute reader may wonder what happens to loan origination fees and servicing fees.  I believe the bulk of these fees are are paid to the general partner and affiliates and don't stay at the fund.  UDF III's general partner does not have to use the small amount of excess interest to paydown the load, it can use to as part of a new loan or for other partnership purposes. 

I don't see how the independent valuation firm could possibly derive a value of $26.16 per unit.  (Actually, I suspect loan income was somehow capped at a low cap rate with little regard to the actual underlying asset.)   Behringer Harvard and Inland need to find this valuation firm and call it immediately.

This post is not questioning UDF III's business model.  That is a subject for another post or posts, because UDF III's affiliated dealings are worth analyzing.   This post is asking how a mortgage fund with a 14% load is able to publish a value that overcomes its load (and in one valuation significantly exceed the offering valuation) when a portfolio of mortgages does not grow and the fund does not keep origination fees.

Good For Intel and Bill Gross Reference
Here is a link to a Yahoo Finance article and a Bloomberg article on Intel investing up to $8 billion in new and renovated manufacturing plants in Oregon and Arizona.  I am glad Intel resisted moving these plants and jobs overseas.  The United States is a manufacturing nation and the rise of low paying service jobs at the expense of manufacturing jobs has been a drain for years.  I didn't know that Intel already manufactures 75% of its microprocessors in the United States.

The latest Bill Gross Investment Outlook is worth a read and ties in directly to Intel's domestic production investment.  He predicts and extended period of low returns on stocks due to low inflation, low interest rates and high debt.  The high stock returns of past thirty years are not likely to be repeated, unless (second paragraph is the key and the bold type is Bill Gross'):

The predicament, of course, is mimicked by all institutions with underfunded liability structures – insurance companies, Social Security, and perhaps least acknowledged or respected, households. If a family is expecting to earn a high single-digit return on their 401(k) to fund retirement, or a similar result from their personal account to pay for college, there will likely not be enough in the piggy bank at time’s end to pay the bills. If stocks are required to do the heavy lifting because of rather anemic bond yields, it should be acknowledged that bond yields are rather anemic because of extremely low new normal expectations for growth and inflation in developed economies. Even the wildest bulls on Wall Street and worldwide bourses would be hard-pressed to manufacture 12% equity returns from nominal GDP growth of 2 to 3%. The hard cold reality from Stan Druckenmiller’s “old normal” is that prosperity and overconsumption was driven by asset inflation that in turn was leverage and interest rate correlated. With deleveraging the fashion du jour, and yields about as low as they are going to go, prosperity requires another foundation.

What might that be? Well, let me be the first to acknowledge that the best route to prosperity is the good old-fashioned route (no, not the dated Paine Webber road map utilizing hoped for paper gains of 12%+) but good old-fashioned investment in production. If we are to EARN IT – the best way is to utilize technology and elbow grease to make products that the rest of the world wants to buy. Perhaps we can, but it would take a long time and an increase in political courage not seen since Ronald Reagan or FDR.

More companies need to follow Intel's lead and invest in production in the United States.

What It Owns
In the next week or so I am going to keep reading the 10-Q for the REIT referenced in the last two posts.  I want to pick two of its properties and try to figure out exactly how much the REIT has invested in these properites, determine the debt, if any on these properites, and finally try to figure of some kind of return or cash flow figures.  I hope to figure a cap rate - net operating income divided by purchase price.  I am only going to look at the 10-Q.

Finding this information should take twenty to thirty minutes.  I am not sure of any REIT that lists its investment, debt and income in one table, so I am not expecting that, but the data should be disclosed and easy to piece together.  I will let you know my findings or whether I threw my hands up in disgust.

LOC Clarification
In the last post I discussed a line of credit.  I was not questioning the line of credit in itself or its mechanics.  I was showing exasperation on opaque disclosure.   Why does a line of credit warrant such nonsensical misdirection?  Why not just state, "We obtained a $X million line or credit, of which $Y million is available to us based collateral assigned to secure the line of credit and borrowing limits against the collateral.  We have borrowed $Z million on the line of credit."  If a company goes out of its way to obscure something as straightforward as how much it used on its line of credit, it makes me question the entire disclosure document.

Intentional Obfuscation
I am still catching up on the second quarter 10-Q readings.  The excerpt below is from the footnotes from a major non-traded REIT discussing its new $150 million credit facility: 

Draws under the credit facility are secured by a pool of certain multifamily communities directly owned by our wholly owned subsidiaries, where we may add and remove multifamily communities from the collateral pool in compliance with the requirements under the credit facility agreement.  As of June 30, 2010, $73.6 million of the net carrying value of real estate collateralized the credit facility.  The aggregate borrowings under the facility are limited to 70% of the value of the collateral pool, which may be different than the carrying value for financial statement reporting.  As of June 30, 2010, available, but undrawn amounts under the credit facility are approximately $32.9 million.

What does the above say?!?  I read it that the $150 million line of credit is really only 70% of $73.6 million, or $51.5 million.  So the actual line of credit is $51.5 million not that stated $150 million.   How much is outstanding on this line of credit?  Sharpen your pencil.  Rather than just stating the amount outstanding, the undrawn amount on this line is given.  So you have to figure out the amount available and then subtract the undrawn amount.   Using my math, if the amount available is $51.5 and the undrawn amount is $32.9, million the amount outstanding at quarter end must be $18.6 million.

Does this number tie to balance sheet?  No effing way.  The amount listed on the balance sheet for credit facility payable is $10 million.  Nonsense.

The above is but one example of repeated obfuscations.  Try and figure out the total acquisition price for each property from information in the 10-Q.  The details of this non-traded REIT might as well be in hieroglyphics. 

Here is what you need to know about this REIT:   It is paying a 6% distribution, which was recently lowered from 7%, and is not generating operating cash flow.  In the first six months of 2010, the REIT had operating cash flow of -$70,000, but still declared $25 million in distributions.  There is no obfuscation in that discrepancy. 

(This REIT is not even able to disguise its lack of cash flow by playing with FFO and MFFO figures, like other non-traded REITs.  Its FFO was more than $1 million negative and its MFFO was just shy of $5 million for the first six months of 2010, both well off the $25 million that the REIT declared in distributions.)

In rare moment of clarity, the REIT says "future distributions my change over time and future distributions declared may continue to exceed cash flow from operations."  In other words, the REIT will keep overpaying its distributions until it can't, then it'll cut its distribution.  You can't say you haven't been warned.

It is troubling that this REIT has more than twenty properites, many that have achieved stabilized operations, and still can't generate meaningful operating cash flow.  There a number of apologists for this REIT in the broker / dealer community, and this REIT is still raising tens of millions of dollars per month.  I am guessing some broker / dealers will keep selling this REIT until the weight of its business plan causes it to collapse and then look for an external excuse, like the real estate crisis or the economy to justify their decision to keep selling this REIT.  Good luck with that.  The sustained lack of operating cash flow tells the whole story.

If You Build It, They Won't Come
I am in a foul mood today.  I just read this article on Bloomberg about Dubai's commercial office market and how some buildings, horror of horrors, may stay vacant for ever.  Well, no sh*t Sherlock.  Dubai was a real estate market that was non-existent ten to fifteen years ago - nothing but desert - and only became viable with easy money and a flood of construction and real estate related jobs.  Dubai is a middle east version of Las Vegas without Vegas' charms of vice and entertainment.  When Dubai's real estate musical chairs stopped, people, like in Las Vegas, woke up and realized they were stuck in the middle of a freaking desert and those that could headed for the exits. 

Why?
Microsoft is releasing nine new phones that will operate on its Windows operating system.  Why?  The smart phone game is over for the foreseeable future with Apple's iPhone and phones running Google's Android software.  Does Microsoft remember Zune?  Microsoft software is so over-engineered that there is no way this phone operating system will be easy to use and not kill the phone's speed and ease of use.  Microsoft needs to stick with what it does best - designing productivity software.   I always thought anti-trust complaints against Microsoft in the 1990s were a joke, and Microsoft has proved why.  Is it me or is Microsoft always late to the party and wearing a powder blue tuxedo?

Good News Comes in Threes
The third Reis property report of the week was released today.  It showed that vacancies and lease rates at retail properties have leveled off.  Here is the Reuters' article.  The report cautions that the rent and vacancy stabilization is to recent to signify a trend, and that pending lease renewals may push up vacancies.  I will take the good news where I can get it.

Apartment Vacancies Drop
Calculated Risk reported on the third quarter Reis apartment update this morning.  Apartment vacancies dropped to 7.2%, from 7.8% in the second quarter.  Lease rates, net of concessions, increased to $980 per month.  Calculated Risk stares that vacancies bottomed early this year, and that excess housing inventory is being absorbed.  The Reuters story on this news is here.

Office Vacancy at 17-Year High
I read over at Calculated Risk (which got its data from Reis) that commercial office vacancies are at a seventeen-year high.  I linked the Calculated Risk graph below:

https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgdRxzXI5hi2OVj9DkbeJK9aKB6olsuRZWwqe8SPePtBuFxDRahxXF48yHzyV1JEHsCK5NyiuiC-AzemiXqFZtzVdvJwSiZmYQSbDgN2a8n__p5kXjz6lKZmCSxLyu64AO_Vd51/s320/OfficeVacancyRateQ32010.jpg


Graphically, it looks like the rate of decline in occupancy rates has slowed and looks to be leveling out.  Rents appear to be stabilizing, too.

Home Run
In April 2009, I posted on Normandy Real Estate Partners and Five Mile Capital Partners buying the landmark John Hancock Tower in Boston for $20 million of equity and the assumption of $640 million of debt (Normandy and Five Mile bought the mezzanine debt and foreclosed on the property).   Today, I read that the building is being sold for $930 million to Boston Properties, which includes the assumption of the $640 million in debt.  I am not sure if Normandy and Five Mile invested any more than their $20 million in improvements or had to plunk down some cash to lease the building, but on the surface, $270 million profit on a $20 million investment in about eighteen months is incredible.

Hard To Believe - AIG to Repay Government
AIG took over $180 billion in tax payer "bailout" funds during the credit crisis.  It has filed to repay this money.  I thought that the government would never get its AIG money back.  While most other Wall Street firms have repaid their TARP money, I figured the AIG money was lost.  If you don't remember, AIG got in trouble because it provided unregulated insurance, in the form of credit default swaps, to other Wall Street firms, protecting these firms against losses against their subprime debt securities and other, similar, securities.  I still hear complaints about "bank bailouts," but with AIG, the largest recipient of tax payer money, attempting to repay its government money it is hard to argue against the success of TARP.

UPDATE:  Ooops.  I had a typo in the original post.  The correct amount to bailout AIG was $180 billion, not $180 million.

Inland American Valuation Is $8.03 Per Share
I am traveling and completing research reports, so I will post more on this valuation over the weekend.  Inland American announced this afternoon that an original $10.00 per share investment in the REIT is now worth $8.03.  That is an amazing valuation.  If you figure that 15% of the REIT's initial value was lost to offering costs, the REIT only lost about 5% of its value in the worst commercial real estate market in years.  Who would have thought that the Inland American's focus on hotels and retail properties - two of the worst performing commercial real estate sectors during the slump - in 2006 through 2008 would have proved so prescient.  Somehow Inland American eluded the decline in a commercial real estate market that has lost over 40% of its value from its peak.

Los Angles Times Article on Housing
I meant to link to this article last month, but didn't for some reason.  Here it is now.   The article discusses how private equity and wealthy investors are buying foreclosed homes and then trying to quickly sell them.  The professional investors are moving in as small investors are getting pushed out.  Many purchases are at court house steps.  This sounds like an easy way to make a quick profit, but it's not that easy.  First you need cash to close the deal.  What would trouble me is buying homes on the court house steps.  These transactions are pretty much "as is," and sight unseen.  You don't know the condition of the home, so it is just a gamble. Here is an example from the article:

Competition at the auctions is brutal, said Bruce Norris of Norris Group, a real estate investment firm in Riverside.

Norris unwittingly bought a house that was the site of a gruesome double murder. No one else bid -- a rare occurrence that showed others knew the history -- leaving Norris with less cash to bid for other houses.

"It's a very lonely place out there," Norris said.

That's only one of many risks in the foreclosure business. People who've lost their homes through foreclosure sometimes vent their anger by smashing walls, knocking over water heaters or ripping out toilets.

"We've literally had people take $20,000 of cabinetry out and feel perfectly justified doing it," Norris said.

What's The Over / Under?
Inland announced today that is releasing the estimate per share value of its non-traded REIT Inland American on September 24.  There is an accompanying conference call late on Friday.   (Is there a coincidence that the 24th is a Friday, the usual day for releasing bad news?)   Inland American's portfolio is full of limited service hotels and retail properties, among other types of real estate.  Inland American raised over $7 billion and bought much of its portfolio in 2006 through 2008.  Does anyone want to start the guessing at a per share valuation?

Here is a quick back of the envelop guess.  Inland American's FFO per share for the first six months was $.2487 per share, and is $.497 on a straight annualization.  Using simple FFO multiples of 9 to 12 gives a per share value of $4.48 to $5.97.  I figure Inland will adjust the number in the REITs favor.  (I am not sure whether a third party is providing the valuation.)  I would set the over / under at $6.25 per share.

Positive Hotel News
Here is a Bloomberg article on an improving hotel market.  Rents and occupancies are up, and sales are following this trend.  I have been thinking that hotel metrics should be improving making the hotel asset class an attractive investment in the rebounding economy.  The travel deals available a year ago are no longer available.  Here is the heart of the article:

A rebound in business and leisure travel is helping the U.S. lodging industry recover after last year’s recession sent occupancies to a 30-year low. Hotels can boost rates quickly to take advantage of economic growth, while tenants at offices and retail properties tend to sign multiyear leases. 

“Hotels have already absorbed the downturn,” said Richard Jones, executive vice president of acquisitions and operations at Atlanta-based developer Portman Holdings LLC. “It’s not as evident what exactly the impact of this downturn is going to be for other commercial real estate.”

Owners of offices, shopping centers and other buildings with pre-recession leases are now signing agreements that will result in “significant cuts in rental income” said Jones, whose company develops lodging, office and retail properties.

Income for hotels, meanwhile, is rising. Revenue per available room, or revpar, in the top 25 U.S. markets rose to $73.87 during the first half from $71.08 a year earlier, according to Smith Travel Research Inc. of Hendersonville, Tennessee. Occupancies climbed to 63 percent from 59 percent during the period, while remaining below 2008’s 66 percent.

The article goes on to compare and contrast hotels with other classes of real estate, and makes the case that hotels can respond quicker to an improving economy.   One important point that the article did not mention is new construction or lack thereof.  The hotel sector was overbuilt during the heydays of easy credit, and limited service hotels seemed to litter many corners.  I don't suspect there is any pending new hotel construction, except maybe some major metropolitan infill, and would be surprised if any sizable hotel development is even in the planning stage.

More Housing
I saw this summary of a government report on Fannie Mae and Freddie Mac last week and thought it interesting.  One third of all mortgages originated in 2005 and 2006 were subprime or Alt-A mortgages.  Over 2005 and 2006, government agencies issued 45% and 44%, respectively, of mortgage backed securities.  This compares to today, where agencies issue of 95% of mortgage backed securities. 

Reading this report, it's clear that government agencies did not cause the housing market bubble.  The market worked well, too well.  People wanted any kind of mortgage to get into the housing market.  When the agencies could not meet demand, or had standards that were too strict, the private market stepped in and created and originated mortgages, and then bought, packaged and sold these into non-government mortgage backed securities.  

The housing market is still recovering from the excess of the mid-2000s.  If the agencies eased their mortgage purchase standards it would help the housing market by increasing demand.  

Are You Ready For This?
Pimco's Bill Gross estimates mortgage rates would rise 300 to 400 basis points without government owned Fannie Mae and Freddie Mac assisting the housing market.   This is because the two agencies guaranteed, through mortgage purchases and subsequent inclusion in mortgage backed securities, 95% of the mortgages created during the past year.  Fannie and Freddie don't guarantee a borrowers mortgage payments, which would create moral hazard, they buy mortgages from banks and include the mortgage in huge mortgage pools, which are sold as bonds.  Fannie and Freddie therefore guarantee the bonds, not the underlying mortgages. 

Without the agencies' mortgage securitization program, there would be much less capital for mortgage lending.  Banks would have to hold the mortgages in their portfolio, leaving much less capital for new mortgages, and borrowers would be subject to strict underwriting due to limited capital.  This makes the assumption that private mortgage securities would not replace the agencies' role of buying mortgages from banks.  But even if private mortgage pools emerge, it is unlikely they'd completely fill the void of the agency debt, and they would not have the guarantee of agency debt.  I have been telling people that while no one likes the idea of government in the mortgage business, are they ready for mortgage rates 300 to 400 basis points higher than current rates?  This weeks' poor housing numbers would look like like boom times compared to numbers if long term mortgage interest rates suddenly jumped from 4.5% to 8.5%.  The price adjustment to housing would obliterate the economy and wipe out the wealth of even those that did not buy in the bubble period of 1998 to 2007.

More Housing
This morning's exisitng home sales numbers for July were bad.  The decline was worse than projected, but in line with the "whisper"numbers.  Calculated Risk has a good summary of the sales figures and excellent supporting graphs.  The jump in inventory stood out to me.  There is now 12.5 months of supply, where the average is closer to 6 or 7 months, which is going to hinder price increases.  I am trying to look at the bright side.  The annualized home sale rates was 3.8 million homes, which breaks down to 316,000 homes sold.  I am not 100% positive, but think I remember hearing on Bloomberg radio earlier this year that the normal housing demand. based on demographic factors alone, is closer to 500,000 or 600,000 home sales per month.  July's figures were well below the sustainable demand. Homes sales have to start increasing just to reach their sustainable average.  Mortgage rates are historically low, and I don't see this changing in the near future.  Low rates will attract buyers at some point.  (Existing home owners that refinance at current low rates will have extra monthly cash, which is positive for the economy, but this is not a subject for this post.)  The housing market will benefit in the coming months from low mortgage rates and pent-up demand (i.e. home sales reverting to their mean), at least that's my opinion.

The impact of the first time home buyer tax credit, which expired in April, inflated sales figures last year and earlier this year, and are weighing down numbers now.  Calculated Risk said all along that the tax credit was providing an unsustainable boost to the housing market.  But I didn't read or hear too much else about impact of the artificial demand.  CR was correct, and today's numbers should not too shocking.   I hope the government resists the urge to step into the housing market again.  Potential home buyers waiting for further government assistance are going to miss a great opportunity.

Housing Article
Here is a New York Times article I have seen linked several places this morning.  The article jumps right to the point:

But many real estate experts now believe that home ownership will never again yield rewards like those enjoyed in the second half of the 20th century, when houses not only provided shelter but also a plump nest egg.

I hate "new paradigm" thinking.  When experts say "never again," that's a sign that there will be an "again."  I remember sitting through a number of presentations in the late 1990s where "experts" said that the tech stocks were experiencing a new paradigm,  and that traditional equity valuation methods were a thing of the past, or that technology was its own asset class, and that income investing made no sense, to name just a few absurdities spawned by the tech boom.  These experts' advice looked reckless when the stock market tanked in the early 2000s and tech companies without revenue or earnings went away.

Reading the article reminded me how the tech pundits overreached.  There are no new investing paradigms, just variations on existing principals.  Investment bubbles and bubble thinking are an investing paradigm and have been around for thousands of years.   Housing experienced a bubble in the 2000s (much like tech in the 1990s), and people used their homes to finance lifestyles, counting on rising market values and easy credit.  Real estate gurus, like tech stock gurus, were a dime a dozen.  Those days are gone, and the home prices dropped significantly.   People that bought homes during the bubble will have a long hold period, but home buyers today should fare well, especially if they take advantage of current low interest rate mortgages.

People used to buy a home, paid their mortgage, and at the end of mortgage owned the home and all its equity, which was either passed on or helped fund a retirement.  The notion of waiting thirty years for equity evaporated in the 1990s and 2000s.  Banks and mortgage brokers invented methods that allowed homeowners to tap their home equity, which effectively turned homeowners into renters.  A return to patience in home ownership is not a bad thing and will prove rewarding.

American Crapital Development
I received an email solicitation from a secondary tenant in common market maker this afternoon.  The information was on an American Capital Development deal originally syndicated in June 2006.  The email did not offer too much data on the deal - 212 units in Washington State and the equity is being offered at $67,591  -  but what stuck out to me was it was not paying a distribution.  Why is that not a surprise coming from this sponsor?

10-Q Season Is Here
How exciting!  I will be reviewing select 10-Qs over the next few days and will pass along any interesting information.

Freddie and Fannie
Here is an interesting article I saw this morning.  Both Freddie and Fannie are fun political whipping boys, but this paragraph underscores their importance to the housing market:

More important, shutting down Fannie and Freddie and having the private market step in, as politically popular a sound-bite as that may be, is economically unfeasible. For better or worse, Fannie, Freddie and Ginnie Mae were behind 98 percent of all mortgages in this country so far this year, according to the Mortgage Service News. Pulling the rug out from under them would be pulling the rug from under the entire housing market as it continues to struggle.

I think we're stuck with these two firms, in some form, for the near term, unless everyone is ready for a huge drop in housing prices due to lack of financing.  PIMCO's Bill Gross had some provocative comments on Freddie and Fannie this morning that I need to read.

Bailout Worked
Here is a summary of a new study by economists Alan Blinder and Mark Zandi that gives evidence that the Troubled Asset Relief Program (TARP), and to a lesser extent the stimulus package, worked in keeping the economy out of a depression.  I thought TARP made sense at the time and felt if prevented a complete financial meltdown: 

In a new paper, the economists argue that without the Wall Street bailout, the bank stress tests, the emergency lending and asset purchases by the Federal Reserve, and the Obama administration’s fiscal stimulus program, the nation’s gross domestic product would be about 6.5 percent lower this year.

In addition, there would be about 8.5 million fewer jobs, on top of the more than 8 million already lost; and the economy would be experiencing deflation, instead of low inflation.

Even with the "bailout" the depth of the financial crisis is shocking:

Mr. Blinder and Mr. Zandi emphasize the sheer size of the fallout from the financial crisis. They estimate the total direct cost of the recession at $1.6 trillion, and the total budgetary cost, after adding in nearly $750 billion in lost revenue from the weaker economy, at $2.35 trillion, or about 16 percent of G.D.P.

By comparison, the savings and loan crisis cost about $350 billion in today’s dollars: $275 billion in direct cost and an additional $75 billion from the recession of 1990-91 — or about 6 percent of G.D.P. at the time.

Politicians from both parties need to push back against those that say TARP was a disaster, and those that voted for TARP should be proud.   This article from the New York Times details the backlash against politicians who voted for TARP, including Utah's conservative Bob Bennett who has already been voted out by members of his own party.

Taxes, Deficit Hawks and What's Wrong With The Media
Here are is an interesting blog post from the Financial Times' Martin Wolf that debunks supply side economics.  It is worth reading, especially in light of the pending expiration of the Bush tax cuts.  Here is an excerpt:

True, the theory that cuts would pay for themselves has proved altogether wrong. That this might well be the case was evident: cutting tax rates from, say, 30 per cent to zero would unambiguously reduce revenue to zero. This is not to argue there were no incentive effects. But they were not large enough to offset the fiscal impact of the cuts (see, on this, Wikipedia and a nice chart from Paul Krugman).

Indeed, Greg Mankiw, no less, chairman of the Council of Economic Advisers under George W. Bush, has responded to the view that broad-based tax cuts would pay for themselves, as follows: “I did not find such a claim credible, based on the available evidence. I never have, and I still don’t.” Indeed, he has referred to those who believe this as “charlatans and cranks”. Those are his words, not mine, though I agree. They apply, in force, to contemporary Republicans, alas,

Since the fiscal theory of supply-side economics did not work, the tax-cutting eras of Ronald Reagan and George H. Bush and again of George W. Bush saw very substantial rises in ratios of federal debt to gross domestic product. Under Reagan and the first Bush, the ratio of public debt to GDP went from 33 per cent to 64 per cent. It fell to 57 per cent under Bill Clinton. It then rose to 69 per cent under the second George Bush. Equally, tax cuts in the era of George W. Bush, wars and the economic crisis account for almost all the dire fiscal outlook for the next ten years (see the Center on Budget and Policy Priorities).

No one likes paying taxes and I want the tax cuts that are set to expire to be extended.  Politicians need to get serious about spending cuts, but this is an issue neither side of the aisle wants to deal with.  The areas that need cutting are too popular with voters.   Wolf argues that this is what's so seductive about supply side economics, "Supply-side economics said that one could cut taxes and balance budgets, because incentive effects would generate new activity and so higher revenue."   It's too bad the theory has not worked.  It is my opinion that the economy is too weak to absorb any tax increases, so I'd be surprised if the Bush tax cuts are not extended. 

Rick Santelli, a CNBC on-air editor, was on NBC's Meet the Press yesterday.  He is a huge deficit hawk and stated that he was still against TARP and the stimulus package, and pretty much any government economic assistance that adds to the deficit.  Rick has valid point and his opinions are well known to anyone who watches CNBC.  (I feel that TARP was hugely beneficial in preventing a larger financial meltdown, and that the ultimate cost will be small as most TARP recipients have repaid their loan.)  I like Santelli, he is smart and has excellent analysis, especially on credit markets and interest rates.  I wanted to know his opinion on the expiring tax credits, but Meet the Press host David Gregory chose not to ask Santalli the question, opting instead to ask it to some former Obama administration communication person.  Gregory was obviously turning an economic discussion in a potential political gotcha moment.  The former Obama official gave some convoluted, non-response response, about what you'd expect. 

Gregory failed in not questioning Santelli on the tax cut extensions, especially after asking Santelli his opinion on government spending.  Gregory was practicing political theater, not journalism.  Santelli's opinion on extending the Bush tax cuts is important.  If he is as serious a deficit hawk as he comes across, his answer should be clear - let the tax cuts expire to allow for deficit reduction.  I would have been shocked if Santelli had not given a supply-side answer about the need to extend the tax cuts to allow more money into the economy, and therefore more tax revenue. 

CMBS Returns
Here is an article on the CMBS market from today's Wall Street Journal (not sure where it's behind a paywall).  JP Morgan is leading a $650 million CMBS backed by Vornado Realty Trust, and Goldman and Citigroup are sponsoring a $750 million CMBS backed by Flagship Partners.  The proceeds of both deals will mostly be used to refinance existing debt.

The return of CMBS is encouraging for commercial real estate, but not all are able to get access to CMBS debt.  The market is bifurcated, and I have heard this from several sources, where property owners in major markets with equity and resources have access to capital, including CMBS, while others are not so fortunate.  Here is a quote from the article:

Few expect a rush of new CMBS deals in the near term as the real-estate industry braces for more than $1 trillion of maturing debt over the next five years. While the handful of fresh issues have begun to revive one of the most important funding sources for commercial real estate in the past decade, it will likely provide little solace to owners of hundreds of billions of dollars of office buildings, strip malls and other commercial property now worth less than their mortgages.

This also plays into stabilizing valuations for quality properties, in major markets.  I'll have more on this in a later post, but drop in value for quality properties has been less than the overall market.  So far in 2010, as the article notes, there has been $2.1 billion of CMBS issuance, which is a small amount compared to the more than $200 billion issued in each of 2006 and 2007.

Housing Numbers
The housing numbers released this morning had some conflicting information.  The big news is that housing starts in June fell to their lowest level since October 2009.  A large portion of the drop was attributed to the 22% decline in multifamily building.  Conversely, building permits for multifamily apartments and condos increased 20%.  Interesting.

Miami Condos
Here is an encouraging read from Bloomberg.  The article discusses how Miami's failed condos are having a revival as rentals.  Here are a few informative quotes:

The 7,000 unsold condos in Miami’s core -- a symbol of a building boom that collapsed and dragged the city into recession -- are filling up and giving life to neighborhoods that previously closed after dark. New, year-round residents are cramming into restaurants, nightclubs and bars that didn’t exist a few years ago, and enjoying a lifestyle made possible in part by developers and banks seeking to recoup losses by renting luxury dwellings until the market recovers.

The unsold condos represent almost a third of the 22,079 units in 75 buildings, mostly opened after 2004, tracked in a study released in March by the Miami Downtown Development Authority. The report focused on central neighborhoods including Downtown, Brickell and Wynnwood/Edgewater.  Occupancy rates in the new buildings, including owner- occupants and tenants, increased to 74 percent in February from 62 percent in May 2009, the study shows. 

Effective rents, the amounts actually received by landlords, rose 4 percent in the first five months of the year after falling 2.9 percent during the same period in 2009, according to Axiometrics, whose data tracks professionally managed rental building. Nationally, rents increased 2.75 percent from January to May.  The occupancy rate for Miami climbed to 95.1 percent in May from 93.8 percent a year earlier, Johnsey said.

The overall tone of the article was positive, and one of the few uplifting real estate stories I have read in a while, especially one about Florida.  The article does not touch on issues related to condo associations, whether condo owners are making any money on their rentals, or how the market will react when owners try to sell individual units in a building with mostly renters.

Is This News?
I heard this news about WP Carey replacing its CEO last week.  Here is an excerpt from WP Carey's press release discussing the interim replacement:

Investment firm W. P. Carey & Co. LLC (NYSE: WPC) announced today that board member Trevor P. Bond has been appointed interim Chief Executive Officer effective July 6, 2010. He will remain as a board member but will resign as a member of the Compensation and Audit Committees of the Board.

Mr. Bond has served as an independent director of the company since April 2007 and served as director of several of the company's CPA® REIT programs from 2005 to 2007. He has over 25 years of management experience in several sectors, including finance, development, investment and asset management across a range of property types, as well as direct experience in Asia. Mr. Bond has been the managing member of Maidstone Investment Co., LLC since 2002, a private investment vehicle investing in real estate limited partnerships. Previously he served in several management capacities for Credit Suisse First Boston from 1992 to 2002, where he was co-founder of CSFB's Real Estate Equity Group, which managed approximately $3 billion of real estate assets. Prior to CSFB, he served as an associate to the real estate and finance departments of Tishman Realty & Construction Co. and Goldman, Sachs & Co. in New York. Mr. Bond received an M.B.A. from Harvard University.

Mr. Bond will serve as interim CEO until a permanent successor is named. Mr. Bond's appointment follows the resignation of Gordon F. DuGan, also effective July 6, 2010. Mr. DuGan said that his resignation is based on a disagreement with respect to the degree of authority and control of the Chairman and a disagreement with the Chairman on the strategic direction of the company.

Wm. Polk Carey, Chairman of W. P. Carey & Co., said, "Trevor brings to this role extensive management experience and a strong commitment to our investors and tenants. I thank him for stepping into this interim position. I wish all the best to Gordon DuGan, who has served W. P. Carey with skill and intelligence for many years. Though Gordon and I have not been strategically aligned in the recent years, I remain an admirer of his abundant investment management and general business talent."

I am sure there is more to this story, but it appears that if your name is on the company, you get to make the decisions.

WSJ on Dividend Capital's Total Realty TrustLast Wednesday's Wall Street Journal (July 7, 2010) had an article on Dividend Capital's Total Realty Trust's $1.3 million acquisition of thirty-two office and industrial properties from iStar Financial.  The article's headline, "Sign of Recovery? Or Not? Successful Sale Had Help," gave the impression that there was something wrong with the deal.  The author's idea of trouble with the transaction was that it included Class A properties with some lesser industrial properties and required substantial equity.  If you acquire thirty-two properties, not all can be trophy properties.  The lesser properties are industrial properties leased to the likes of Google and Fed Ex.  The leverage was 64%, with the REIT throwing in $443 million (the math does not match perfectly for some reason).  The author says that during the boom this deal would have qualified for 90% financing.  That amount of leverage is unavailable in today's market so the point of reference is a red herring.  The portfolio is 99% occupied, has an average lease term of over seven years and was acquired on an 8.1% cap rate.  These figures appear positive for the REIT.

Here are a couple of points the article did not address that I think are worth mentioning.  Total Realty Trust had $489 million of cash at March 31, 2010.  The $443 million of equity utilized most of this cash.  The acquisition had $105.6 million of mezzanine financing provided by iStar.  How does Total Realty Trust plan to repay this mezzanine debt?  It's not raising any more equity and will need to either refinance assets or sell assets.  I don't see it being able to refinance legacy assets and receive any extra cash to apply to the mezzanine loan. 

In the first quarter Total Realty Trust paid out $27,609,000 in distributions, but it only had $15,552,000 of operating cash flow and $14,293,000 of Funds From Operations as defined by the REIT.  How will this huge transaction make up this distribution shortfall?  There is limited cash remaining to support distribution shortfalls so the new portfolio is going to have to generate significant cash flow.

Coverage Myopia
The broker / dealer community's focus on distribution coverage ratios is myopic.   Coverage ratios are important and a clear sign of a REIT's health, and a harbinger future distributions, but they are only a piece of a larger puzzle.  Most non-traded REITs have ideas to one day list on an exchange (or merge or even sell their portfolios outright).  If a REIT is going to list on an exchange and hold its value, not only does it need adequate distribution coverage, it needs growth in its Funds from Operations (FFO).  Broker / dealers need to expand their analysis and start looking at FFO growth in addition to distribution coverage ratios.  REITs are stocks, and stocks trade on future growth.  It is not enough to cover a distribution from operations, the distribution and underlying FFO needs to grow for a REIT to hold its value.

I know that many non-traded REITs have appalling coverage ratios that require immediate attention, and some coverage ratios are telegraphing unsustainable distributions.   But for REITs that are fully invested and have sufficient coverage ratios, FFO growth needs to be the focus.  A portfolio of properites with flat long-term leases may look appealing from a safety and coverage ratio standpoint, but over time a REIT with this type of portfolio will trade at a lower FFO multiple (and lower valuation) than a similar REIT that has lease rate growth.   

Another way to view FFO growth is to look at in context of a REIT's estimated time horizon.  A REIT that has a five-year window to list or pursue other liquidation options will likely extend the hold period without FFO growth.  This is because the market will discount this non-growth REIT.  Even the most avaricious REIT sponsor will think twice about listing a REIT that will trade at a significant comparative discount to its initial share price due to limited growth potential.

Austerity Gains Traction
Here is another New York Times article on global austerity measures.  I am not convinced this is smart or prudent economic policy at this point of the economic recovery.  I understand the arguments for cutbacks and am all for debt reduction, but don't feel the economy is fully recovered and at a point where it can depend on corporate growth alone.  Politicians will pay for their decisions if unemployment stays high and growth remains sluggish.  Politicians in the U.S. don't have the courage or conviction to make cuts that will really lower the deficit, such as in Social Security, Medicare or defense, there are just too many vocal, voting parties supporting government spending in these areas.   No US politician, not even a lame duck, would dare float the idea of a tax increase to tackle the debt.  I like to look at the stock and bond markets as good barometers of the future.  The yield on the Ten-Year Treasury is under 3%, which indicates the market is not afraid of current debt levels and that inflation is not a concern, and the recent down trend in the stock market is over concern about the slowing economy due to lack of stimulus spending.  Ceding the economic growth mantle to China and India is bad economic policy.

Hines Distribution Cut
The news that Hines REIT is cutting its distribution is rippling through the broker / dealer community this morning.  Hines is dropping the annualized rate to 5% from 6%.  This is not a huge cut in the whole scheme of non-traded REIT distribution cuts.  Here is text from an email sent to broker / dealers today and the 8-K filed that was filed with the SEC:

The Hines REIT Board of Directors and management team has elected to reduce the dividend on the Hines REIT from 6% to 5% beginning July 1st.  Our management and board of directors believe that aligning our distributions with funds generated by our operations, including the results of certain property sales, and not with funds from offering proceeds or borrowings, is an important objective for the Company. We are proud that, other than our initial quarters of operations, we have been able to meet that objective.

Our portfolio continues to be well leased overall at 90%; however, given the economic environment, we have experienced a decline in occupancy and rental rates over the last few quarters, which have reduced our net operating income as we re-lease expiring space to new or existing tenants. Unfortunately, the downward trends in real estate fundamentals may continue for several more quarters before they begin improving, and the rebound may be slow. As a result of these market conditions, our board of directors has decided to reduce our current annual distribution rate from 6% to 5% (based on our last share price of $10.08 per share)* effective for the quarter beginning July 1, 2010, in order to maintain our practice of aligning distributions with our operating performance as described above. The reduction is not the result of liquidity needs such as debt maturities or pay downs or capital expenditure requirements of our properties. In fact, our liquidity position is quite solid and we have relatively low levels of debt maturities in the next 24 months. The reduction simply better aligns our distributions with our forecasted operating performance over the near term.

The language above sounds prudent, but the Hines REIT's second quarter 10-Q is now a must-read (the excitement is palpable) to look behind the spin.  Bear in mind that Hines REIT stopped its share repurchase plan late last year, albeit the REIT's liquidity was the typical non-traded REIT limited liquidity.  Hines REIT also has the distinguishing feature of not having a set liquidity plan, such as a time frame to sell assets or list shares on an exchange.  Investors are going to have to learn to live with the REIT's 5% yield, or whatever yield they can get.  I guess my bigger question is given the declining distribution rate and Hines' statement on declining occupancy and lease rates, how valid is Hines REIT's Net Asset Valuation of $10.08 per share? 

Irish Austerity
Here is an article from the New York Times that I found depressing but informative.  Ireland's economy in the mid-2000s, despite its embrace of technology firms and their skilled, high paying jobs in the 90s, became driven by real estate development and a housing bubble.  When the housing market collapsed and the credit crisis started, Ireland was rocked by recession.  In response Ireland instituted wage cuts and tax increases without any stimulus spending.   Its economy is still in the tank nearly three years on, with unemployment at 13% and growth not expected to return until 2012.  Here is a passage from the article:

Rather than being rewarded for its actions (spending cuts and tax increases), though, Ireland is being penalized. Its downturn has certainly been sharper than if the government had spent more to keep people working. Lacking stimulus money, the Irish economy shrank 7.1 percent last year and remains in recession.

Joblessness in this country of 4.5 million is above 13 percent, and the ranks of the long-term unemployed — those out of work for a year or more — have more than doubled, to 5.3 percent.

Now, the Irish are being warned of more pain to come.

Policy makers around the globe should view the Irish experience as a warning.  National debts are not good, but sometimes the alternatives are worse.  The article ends predicting that Ireland's government will likely get voted out of office in 2012.

Sea Change?
The public, non-traded REIT business is competitive.  I am not sure how many sponsors are fighting for broker /  dealer shelf space and investor dollars, but it must be several dozen, with, I am sure, more programs in registration.  Competition is generally good for consumers, but this has not always been the case in the non-traded REIT business when it comes to fees.  The fees across the various REITs are remarkably similar.  This may be starting to change.

Grubb & Ellis has eliminated internalization fees on its two public, non-traded REITs.  Another REIT sponsor quickly followed suit.  In conversations with more REIT sponsors, the elimination of the fee is being watched.  If Grubb & Ellis can grab market share, you can bet most non-traded REIT sponsors will ditch this fee.

This is a fee that is hard to quantify when a REIT is raising capital, because in all likelihood it won't be paid for years and the amount of the fee cannot be determined until the REIT decides to prepare for listing or liquidation.   These fees are huge, despite the inability to calculate them during the early stages of a REIT.  Some REITs don't even disclose potential internalization costs in their prospectus' fee section, instead disclosing it with amorphous language in the business plan or risk sections. 

Most REITs are advised by an affiliated company.  When a REIT's board of directors decides to list the REIT on an exchange it must acquire its advisor, a process known as internalization.  Therefore, a value must be placed on this advisor, and then the REIT, typically using its shares, acquires this advisor.  The valuations are determined by the advisor, and many REITs will get a rubber-stamp third party confirmation of the valuation.  On large REITs, the advisor can get a windfall of hundreds of millions of dollars while investors get their equity diluted.  Some past internalizations have paid REIT advisors up to $300 million.  It's not hard to see who's the beneficiary in an internalization transaction.

If Grubb & Ellis' move starts a fee war, this is good for investors.  Hopefully other sponsors will follow suit and start lowering or eliminating more immediately tangible fees and expenses, like offering costs, acquisition fees, property management and asset management fees and compensation to brokers selling the REITs.  Lower fees put less pressure on the portfolio to meet dividend coverage ratios and should allow the REITs to acquire better properties.

Bloomberg on Non-Traded REITs
Here is a Bloomberg article on non-traded REITs.  It's a harsh, but fair article, and it gets its facts right. It is well worth the read.

Extended Stay
Here is an article from the Financial Times.  It summarizes Centerbridge's and John Paulson's $4 billion acquisition of the bankrupt hotelier.  Lightstone Group bought Extended Stay in April 2007 for $8 billion, using mostly CMBS debt.  The debt was $4.1 billion of senior debt and $3.3 billion of mezzanine debt.  The Centerbridge deal will repay the senior debt, but wipe out the mezzanine debt, of which taxpayers owned $750 million.  Here is how the CMBS structure complicates deals that go bad:

The Extended Stay bankruptcy offers a rare insight into how securitisation complicates the Chapter 11 process. There were 18 separate classes of commercial mortgage-backed securities worth $4.1bn.  According to documents, 90 per cent of each class would have to approve any agreement - an arrangement that could have delayed a settlement indefinitely.  But the servicer in charge of the trust agreed to an arrangement that allowed pivotal classes of debtholders to control the outcome.

The article does not mention this, but I think these bankruptcy and purchase hinged, in part, on Lightstone's founder, David Lichtenstein, being relieved of approximately $100 million of personal liability in the event of default. 

Confusing Non-Traded REITs with Private Placements
Here is a link to an Investment News article on FINRA examinations. The article's author mistakenly calls non-traded REITs private placements.

Mr. Ketchum, chairman and CEO, also said that exams of broker-dealers at the Financial Industry Regulatory Authority Inc. are paying close attention to sales of non-traded real estate investment trusts, or private REITs.

The non-traded REITs being discussed in this article are public programs, not private placements.  These REITs are required to register with the SEC and are subject to filing requirements.  Investors in these REITs are also subject to suitability requirements.  Just because a REIT is not traded on an exchange does not mean it's a private placement.    This is sloppy, misleading reporting. 

W-T-F
Healthcare Trust of America (HTA) filed an 8-K this afternoon. It's a doozy.  HTA's President and Chief Executive Officer, Scott Peters, has received a 50% jump in his base salary.  His salary went to $750,000 a year from $500,000.  If you remember, last year his base salary was increased to $500,000 from around $160,000.  The reason for the raise listed in the 8-K is here:

• the successful completion of the Company’s transition to self-management;
• the recent commencement of the Company’s follow-on offering;
• the substantial level and quality of new acquisitions completed by the Company over the past nine months;
• the Company’s increasing distribution coverage;
• the gross cost savings of $10.8 million in 2009 and $5.5 million in the first quarter of 2010 resulting from the Company’s self-management program; and
• the overall financial strength and growth of the Company

If you review HTA's 10-K, you will find many of the the same reasons above as justification for giving Mr. Peters his massive bonus that brought his 2009 total pay to $2.8 million.  I am no compensation expert but this looks like double-dipping to me.

In addition to the increase in base pay, Mr. Peters and other executives were awarded equity grants.  Mr. Peters' equity grant is 100,000 shares per year for the next three years (which at $10 per share is valued at $1,000,000 per year), and he gets interest on those shares at HTA's 7.25% distribution rate, or $72,500 per year the first year, $145,000 the second year, and $217,500 thereafter.  WTF!

HTA also instituted an Employee Retention Plan  - you knew it was going to get better - that granted Mr. Peters an additional 100,000 HTA shares.  Mr. Peters elected to take 50,000 shares in cash, which is $500,000.  This will be paid in thirds on the anniversary of the grant date.  Come on, is an Employee Retention Plan necessary for a guy getting this much compensation?  Where the heck is he going to go? 

This compensation increase is outrageous.  This REIT increased its dividend coverage in the first quarter, but operating cash flow only covered 48% of the dividend without any adjustments.  News flash - this is not stellar performance for a REIT over three years old.   HTA board of directors - DO YOUR JOB!

Read HTA's 10-K and most recent 10-Q.  HTA has $300 million of low interest rate variable debt that matures before end of 2011. Then read the blog post below on refinance scenarios.  It is my opinion that with a current 48% dividend coverage and $300 million of low interest rate debt maturing over the next eighteen months, this REIT has its work cut out to generate sufficient operating cash to cover its distribution.

Elephant in the Room
I've read plenty of 10-Qs over the past few weeks.  I am beginning to think that many broker / dealers' and analysts' obsession with distribution coverage and Funds From Operations is too myopic.  Don't get me wrong, this is an important area, especially for the non-traded REITs raising significant amounts of investor capital based on high dividends.  Coverage ratios are convenient because they give a clear indication of REIT performance.   I feel that broker / dealers need to expand their analysis and start looking at maturing debt and how this could impact future cash flows.

I am concerned with non-traded REITs that have debt maturing over the next several years, and how these maturities will impact the REITs' balance sheets and future distributions.  I am not going to call out any particular REIT, but have put together the spreadsheet below based on composite data that I feel represents what could happen to a REIT as it goes to refinance its debt:
 

                                                        Original Purchase                   Refinance

Property Leverage		70%		60%
Cap Rate		6.50%		7.50%
Debt Interest Rate		3.50%		6.50%
Annual Debt Svc		$1,225,000		$1,972,052
Purchase Price / Value		$50,000,000		$43,333,333	-13.33%
Leverage		$35,000,000		$26,000,000
Original Equity		$15,000,000		$15,000,000
Required Additional Equity		-		$9,000,000
Total Equity		$15,000,000		$24,000,000
NOI		$3,250,000		$3,250,000
Debt Svc		$1,225,000		$1,972,052	60.98%
Net Cash Flow		$2,025,000		$1,277,948	-36.89%
Cash Return On Equity		13.50%		5.32%		-60.56%

The assumptions are that a property was acquired for $50 million.  I assumed 70% leverage, or $35 million and $15 million of equity.  I assumed the property was acquired at a 6.5% cap rate on net operating income of $3.25 million.  I assumed the original loan was interest-only and had variable rate interest at a rate of 3.5%.  This gave the property a cash return on equity of 13.5%. 

Now this hypothetical property has to refinance this favorable debt.  In my refinance assumption I kept the NOI the same.   Cap rates have increased and leverage ratios have dropped over the past two years.  I used a new valuation cap rate of 7.5% and a 60% leverage ratio.  The property is now valued at $43.3 million (using a 7.5% cap rate on the unchanged NOI), and the amount of a new loan is only $26 million (60% leverage on the new $43.3 million value).  This leaves a $9 million shortfall that the REIT needs to retire the original loan.  So, the original $15 million of equity needs to be increased to $24 million.  Looked at another way, the REIT needs to add an additional $9 million to a property that has lost $6.7 million of value.  I assumed the new loan has a rate of 6.5% and amortizes on a thirty-year schedule.

The end result is that the debt service increases, despite the lower leverage, and the cash flow decreases.  In the example above, the return on equity drops to 5.3%.  The other option is to walk away from the property, but this has its downside, too.  How can a sponsor justify walking away from property with positive operations?

Non-traded REITs that are raising capital may be able to pay down original debt.  REITs that are not raising capital may have to cut distributions to preserve cash to repay debt.  The end result may be long-term lower cash flow, as shown above.

This scenario can get worse if it is expanded to lease renewals.  Lower lease rates would lead to a lower NOI, which leads to a lower valuation, which leads to lower refinance debt amounts, which leads to more REIT cash to repay the exisitng loan, which leads to lower returns on equity.  You get the picture. 

It is not a bold statement to say that REITs struggling to cover their current distributions, and that have significant debt maturing over the next few years, will be hard pressed to maintain their current dividends.  Analysts and broker / dealers need to turn their attention to non-traded REITs maturing debt and be aware of the potential impact on cash levels and distributions.