Wednesday, June 30, 2010

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? 

Tuesday, June 29, 2010

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.

Wednesday, June 23, 2010

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.

Tuesday, June 01, 2010

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.