Saturday, May 29, 2010

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. 

Wednesday, May 26, 2010

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.

Tuesday, May 25, 2010

How Much Does $500,000 Really Cost?
Bloomberg TV just had a segment stating that since the start of the oil spill in the Gulf, British Petroleum has lost $57 billion in market capitalizaton.  Bloomberg estimates that clean-up will cost BP $24 billion.  And who can estimate far ranging legal and settlement costs, which will extend for years.  The oil and gas industry successfully fought regulation that would require the installation of a remote acoustic trigger to shut off oil wells in the event of a blow out.   Acoustic triggers cost $500,000.  There is no guarantee that the trigger would have worked to stop the flow of oil at BP's well, but countries with extensive off shore drilling, like Norway and Brazil, require these devices.  At a price of $70 per barrel of oil, the trigger is the equivalent of 7,150 barrels of oil.  It is estimated that the BP well is leaking 75,000 barrels a day.   The switch would have been two hours and twenty minutes of production.  At this point, I don't think BP will survive this disaster.  I hope other oil companies are looking at this example, and are realizing that $500,000 is cheap.  Here is a link to a Wall Street Journal article discussing the acoustic valves.

Friday, May 21, 2010

Appears Important
This article from Bloomberg about Well Fargo and LNR selling distress loans and real estate strikes me as important.  LNR is the largest special servicer of CMBS loans, which means it is tasked to deal with loans in CMBS that have gone bad.  Hear is what they are looking to sell:
Wells Fargo of San Francisco, the biggest U.S. commercial real estate lender, is taking bids on $500 million to $1 billion of office and hotel mortgages and properties, said four people, who asked not to be identified because the sale is private. LNR, the largest special servicer of commercial mortgage-backed securities, is trying to sell about $1 billion of defaulted loans, two people said. 

And here is what they hold in non-performing assets:
Wells Fargo had $12.9 billion in nonperforming commercial property loans in the first quarter, the firm said, while LNR is the special servicer on $24 billion of delinquent assets, according to data compiled by Bloomberg.
Most of the Wells loans relate to its takeover of Wachoiva.  I would guess that the LNR loans need to be bought and then foreclosed upon, with the proceeds LNR receiving going to CMBS holders.  Not sure but I think this is encouraging news.

Wednesday, May 19, 2010

Four Dollars and Twenty-Five Freaking Cents
$4.25.  That is the price per share that the Behringer Harvard REIT is now values itself.  The original share price was $10.  I heard rumblings a few weeks ago that a large devaluation was pending.  I have never analyzed this REIT, so I am not sure the valuation is that shocking, but on its face, a 57.5% loss of value is troubling.  Here is a link to the SEC's website where BH posted its document that puts forth the valuation - buried at the bottom of page 26 of a 32 page document. The REIT also cut its distribution to 1%.  The Moody / REAL All Type Property Aggregate Index for commercial real estate shows a 41.8% drop in commercial real estate prices from their peak in August 2007 through February 2010.

Part of the BH document is dedicated to laying out a case that part of its troubles stem from problems in commercial real estate and the greater economy.  There is obviously some truth to this.  But not all real estate firms have lost 57.5% of their value.  Publicly traded Federal Realty Trust (FRT) has gained nearly 19% since the start of 2006.  It pays a quarterly dividend that it has managed to increase from $.56 a share to $.66 a share over the same period.  I know that comparing Behringer Harvard REIT I to FRT is not an apples-to-apples comparison, but I show it to illustrate that while all real estate firms have faced the same economy, using a bad economy and tough real estate market cannot be used to explain away all problems.

Monday, May 17, 2010

Something to Ponder
I can't believe it's been almost a month since my last post.  There are plenty of post coming.  In the meantime, here is a post I saw last week on the blog Marginal Revolution that's worth thinking about:

The challenge

David Leonhardt spells it out clearly:
As a rough estimate, the government will need to find spending cuts and tax increases equal to 7 to 10 percent of G.D.P. The longer we wait, the bigger the cuts will need to be (because of the accumulating interest costs).
Seven percent of G.D.P. is about $1 trillion today. In concrete terms, Medicare’s entire budget is about $450 billion. The combined budgets of the Education, Energy, Homeland Security, Justice, Labor, State, Transportation and Veterans Affairs Departments are less than $600 billion.
This is why fixing the budget through spending cuts alone, as Congressional Republicans say they favor, would be so hard.

The permalink is here, but includes all the comments, many that are inane partisan blather.  Marginal Revolution is a libertarian blog.