Thursday, June 30, 2011

CMBS Pro Formas Return

Here a Financial Times Alphaville blog post on the re-emergence of loan underwriting based on pro forma financial data rather than historical figures.  In the 2000s most loans in CMBS were based on pro forma underwriting.  Here is a strong quote from the post:
In market terms, pro-forma underwriting is the practice of basing future property cashflows on estimates rather than historical income streams. In non-jargon, it often means picking numbers out of thin air and basing your valuations on them. Even the rating agencies are pretty down on the method. Moody’s says that “almost always pro-forma underwriting is a negative for credit quality."
Anyway, recent concerns seem to stem from this report from Barclays Capital:
Although CMBS 2.0 deals so far are nowhere close to 2007 vintage in terms of pro-forma underwriting, we start seeing isolated examples where some loans were underwritten using forward looking assumptions … Historically, clean underwriting was traditionally based on the most recent 12-month trailing financials. However, we see that a significant number of loans in CMBS 2.0 were underwritten 1) either significantly higher than 12-month trailing; or 2) historical numbers were not quoted in Annex A, making such comparison impossible. In many instances the lack of historical operating performance was in those cases where relatively new construction (assets built or substantially remodeled within the prior three years and even not fully stabilized) was securitized. In addition, for the recently acquired properties, historical financials might be not available or are just considered less reliable, as the sponsorship changed. Based on our analysis, the combination of these two factors explains most of the instances where the historical financials were missing … On average, about 18% of all CMBS 2.0 loans did not have historical NOIs [net operating income] …
Hard to tell whether this is a trend or a few anomalies, but it did not take long for old habits to reappear.  

Wednesday, June 29, 2011

Cole REIT Announces Exit Strategy

In a short 8-K filing yesterday, Cole Credit Property Trust II announced that is exploring liquidity options, which it expects to complete within the next twelve months.  Here is the language:
On June 28, 2011, Cole Real Estate Investments announced that it is actively exploring options to successfully exit CCPT II’s portfolio within the next 12 months, and that the potential exit strategies it is looking at include, but are not limited to, a sale of the portfolio or a listing of the portfolio on a public stock exchange.
This simple statement clearly presents the REIT's intention to list on an exchange or sell the portfolio within a year.  Of course, the liquidation process may take more than a year, but telling reps and investors a specific date is a target Cole will have to stand by and defend. 

Sunday, June 26, 2011

Naural Gas Overestimates

Here is another Sunday link, this time to a New York Times article on the natural gas industry.  The article details how industry projections for shale drilling in three separate formations are not matching expectations, and that shall drilling may end up being more expensive than forecast.  Here is a passage summarizing the article:
Company data for more than 10,000 wells in three major shale gas formations raise further questions about the industry’s prospects. There is undoubtedly a vast amount of gas in the formations. The question remains how affordably it can be extracted.
The data show that while there are some very active wells, they are often surrounded by vast zones of less-productive wells that in some cases cost more to drill and operate than the gas they produce is worth. Also, the amount of gas produced by many of the successful wells is falling much faster than initially predicted by energy companies, making it more difficult for them to turn a profit over the long run.
Here is a longer, second passage buried deep in the article:
Production data, provided by companies to state regulators and reviewed by The Times, show that many wells are not performing as the industry expected. In three major shale formations — the Barnett in Texas, the Haynesville in East Texas and Louisiana and the Fayetteville, across Arkansas — less than 20 percent of the area heralded by companies as productive is emerging as likely to be profitable under current market conditions, according to the data and industry analysts. 

Richard K. Stoneburner, president and chief operating officer of Petrohawk Energy, said that looking at entire shale formations was misleading because some companies drilled only in the best areas or had lower costs. “Outside those areas, you can drill a lot of wells that will never live up to expectations,” he added.

Although energy companies routinely project that shale gas wells will produce gas at a reasonable rate for anywhere from 20 to 65 years, these companies have been making such predictions based on limited data and a certain amount of guesswork, since shale drilling is a relatively new practice.
Most gas companies claim that production will drop sharply after the first few years but then level off, allowing most wells to produce gas for decades. 

Gas production data reviewed by The Times suggest that many wells in shale gas fields do not level off the way many companies predict but instead decline steadily. 

“This kind of data is making it harder and harder to deny that the shale gas revolution is being oversold,” said Art Berman, a Houston-based geologist who worked for two decades at Amoco and has been one of the most vocal skeptics of shale gas economics. 

The Barnett shale, which has the longest production history, provides the most reliable case study for predicting future shale gas potential. The data suggest that if the wells’ production continues to decline in the current manner, many will become financially unviable within 10 to 15 years. 

A review of more than 9,000 wells, using data from 2003 to 2009, shows that — based on widely used industry assumptions about the market price of gas and the cost of drilling and operating a well — less than 10 percent of the wells had recouped their estimated costs by the time they were seven years old.

Terry Engelder, a professor of geosciences at Pennsylvania State University, said the debate over long-term well performance was far from resolved. The Haynesville shale has not lived up to early expectations, he said, but industry projections have become more accurate and some wells in the Marcellus shale, which stretches from Virginia to New York, are outperforming expectations.
This article presents nothing new for people that follow the oil and gas industry.  Rosy forecasts that fall short, and costs that exceed expectations have been a hallmark of the oil and gas industry for as long as I have been looking at it, so it makes sense that newly drilled shale formations would cost more and produce less than anticipated.

Sunday Morning Links

I've had two tabs open in my browser for several days in anticipation of writing a longer post on the housing market, jobs and the economy.  I am not going to get to that post anytime soon, but wanted to link the tabs anyway.  The first is from The Economist's Free Exchange blog and is about housing leading the way to a sustained economic recovery.   The second link is to a Wall Street Journal article, (via Yahoo Finance), also discussing housing but from the finance angle.  Is describes mortgage bond security guru Lewis Ranieri's latest venture, which is starting a private, non-traditional lender to step into the mortgage market because banks' credit standards are too restrictive.  Yes, the "subprime" word is mentioned, but I'm convinced Ranieri's and others' ideas on the mortgage market make sense.  I have come to the conclusion that housing is the key to jobs and economic growth, and until housing improves the economy will struggle. 

Friday, June 24, 2011

Rip Van Veres

I saw this Bob Veres' Financial Planning article yesterday morning.  I've read it a couple of times and wonder where Mr. Veres has been the past ten years.  (I will state upfront that this post is not a bash on Bob Veres just this one article, as I have read his material for nearly twenty years, and he has forgotten more about the financial planning industry than I'll ever know.)  Sorry to break this to you Bob, but non-traded REITs are not a "new category of investments."  The non-traded REIT business is now nearly a $100 billion industry, based on data I have seen recently published, and grew through steady equity raise of $5 billion to $10 per year over the past decade.  The comparison of the current non-traded REIT business to the limited partnership boom of the 1980s is weak. 

I broke into the broker / dealer industry in the late 1980s as a junior analyst assigned to the "continuing" due diligence department at a mid-sized independent firm.  Continuing due diligence was a fancy term for the saps assigned to field angry calls from brokers, and sometimes their clients, to tell them that their limited partnership investments were worthless.  A trial by fire.  Coming out of college, I had no clue what a partnership was, and in a short period my bosses that knew answers to questions were fired, so I had to educate myself.  Big partnership sponsors like August, Balcor, Equitec, VMS, Krupp and a slew of smaller ones all went away.  One of the biggest syndicators was Dallas-based Hall Financial Group, run by Craig Hall, which specialized in apartments.  He too failed.  (His afterlife has not been all bad.  His wife was an ambassador to Austria under President Clinton, Craig Hall's current firm is still doing real estate, and he and his wife run a respected wine business, although I won't buy a bottle.)  

The limited partnership business of the 1980s that Bob Veres is trying to compare to today's non-traded REIT business, was marked by massive failure.  Veres states that these deals collapsed under the weight of their fees, costs, expenses and deal structures.  This is true to a point.  Does anyone remember the infamous land deals that where structured as two offerings, one debt and one equity, where the debt investment was used to buy the raw land and the equtiy was used to pay interest on the debt and carry the land for a supposedly short period?   These deals did not end pretty.  I think a case can be made that a favorable tax code, which lead to the overbuilding of commercial real estate, and also caused the S&L collapse, hurt limited partnerships as much as fees.

Most limited partnerships lost their properties or were consolidated into other entities.   The term "Roll-Up" is still a four-letter word in the independent broker / dealer world because of the disastrous late 1980s and early 1990s roll-ups of Equitec, VMS and Krupp, which became the innocuous named entities Hallwood, Banyan and Berkshire, respectively.  Two roll-ups that kept their names, Realty Income Corp and Public Storage, worked out pretty well for investors that stuck around.

The non-traded REIT business of the late 1990s, lead by Wells and Inland, and since with multiple sponsors, has been marked by the lack of catastrophic failure.  This is amazing considering the 49% drop in commercial real estate prices from their 2007 peak.  Some REITs are struggling, as evidenced by net asset valuations of REITs like KBS REIT I, Inland Western, Dividend Capital's Total Realty Trust, Behringer Harvard's Opportunity I and others, which are all valued much less than the original $10 per share offer price.  But while these REITs have seen their net asset values drop, there is no talk (that I know of) of these REITs ceasing to exist.  As noted above, commercial real estate in the 1980s was driven by a favorable tax code that lead to signfianct over building.  Commercial real estate in the 2000s did not, for the large part, have the overbuilding that marked the 1980s, which has helped the non-traded REITs keep their properties occupied.  The non-traded REITs, in general, do not have the high levels of debt that was common in the 1980s.  These factors, in my opinion, have helped the non-traded REITs avoid the problems that faced limited partnerships in the 1980s.

I think Mr. Veres' article would have been stronger and more relevant, if he'd compared the limited partnership industry of the 1980s to the TIC boom of the 2000s.  This is the better analogy because both were marked by tax driven investors looking to avoid or defer taxes as first consideration, and both had highly leveraged properties.  And like the limited partnerships of two decades ago, it's my opinion that most TIC deals will end up being lost to foreclosure, or more likely consolidated with other TICs.  I don't believe TIC consolidation is a four-letter word, but that's a subject for another post.

The end of Veres' article falls further when he discussses non-traded REIT earnings.  He lists some non-traded REIT earnings, all that are bad.  He needs to focus on Funds From Operations (and NOT Modified Funds from Operations).  FFO for REITs, whether listed or non-traded, is the most widely recognized metric for financial health, due to the large amount of non-cash write-offs afforded REITs.

Another area that separates the 1980s' partnership boom and today's non-traded REIT business in the independent broker/dealer business, itself.  I don't have specifics, but I would guess many independent broker / dealers had partnership business that was probably 50% or more of their total revenue and needed partnership sales for their survival.  Today, broker / dealer executives break into a cold sweat if alternative investments (under which non-traded REITs fall) are more than 10% of revenue. 

One area where Mr. Veres focus was correct was raising the specter of Robert Stanger & Co. in the limited partnership boom of the 1980s and today's non-traded REIT industry.   I'd like to know more about this, too.   It is good that Bob Veres has turned his eye to this "new category of investments," and non-traded REIT sponsors better be ready if a bearded man with a ponytail stands up at a conference and starts asking pointed, uncomfortable questions.  He doesn't take BS for an answer.

Tuesday, June 21, 2011

Inland Western REIT's New Value

Inland Western filed an 8-K yesterday with a new net asset value per share.  Inland Western estimates that its net asset value was $6.95 per share at March 31, 2011.  This is an increase from early 2010's $6.85 per share valuation.  Here is the opaque language, which now is common place with non-traded REIT sponsors, in the 8-K describing how Inland Western determined its valuation:
The estimated value was determined by the use of a combination of different indicators and an internal assessment of value utilizing internal financial information under a common means of valuation under the direct capitalization method.  No independent appraisals were obtained. Specifically, the estimate of the estimated per-share value was made with primary consideration of the valuation of the Company’s real estate assets which was determined by the Company’s management using methodologies consistent with publicly traded real estate investment trusts in establishing net asset values, and the estimated values of other assets and liabilities determined by the Company’s management as of March 31, 2011.
I was pretty outraged in early 2010 when Inland Western presented a value of $6.85, thinking it too high.  I guess I have mellowed over the past year because I read the filing without much of a reaction.  I think this is because Inland Western, if I am not mistaken, is planning on listing its shares in the near future.  A listing will give a true market valuation of Inland Western, and while its net asset valuation may have some merit, the stock price will be the tangible value.

Tuesday, June 14, 2011

Areas of Interest

I recently signed up for a nifty data collection service that notifies me any time select public companies make an SEC filing.  I set up the system up to receive notification on about a dozen non-traded REITs, and plan to include most all non-traded REITs in the near future.  Yesterday, Monday, I received a huge data dump from about half the non-traded REITs on my watch list.  The filings were all correspondence between the SEC and the non-traded REITs, with the SEC asking questions and wanting clarifications on these non-traded REIT's filings, in particular 10-Ks. 

All notifications included the initial SEC inquiry, the non-traded REITs' follow-up, any future questions and follow-ups, and the final letter from the SEC saying it had no further questions.   There was a general theme and consistency across the SEC's question and answer with the non-traded REITs.  First, the SEC wanted to know how the non-traded REITs determined their average lease rates and if this average included discounts and rent concessions.  The answer across all REITs was "no," the average lease rates excluded concessions.

Second, the SEC wanted to know how the REITs determined cap rates that the REITs included in their  filings.  To me, this seemed more disclosure related than questioning the actual cap rates, as the SEC didn't seem to have an issue with "average" cap rate (which I discussed here), it just seemed to want to know the formula used for calculating the disclosed cap rates.  The cap rates are all pro forma based on the non-traded REIT's estimate for first year net operating income (which is then divided by the purchase price to determine cap rate), or in the case of the averagers, the average pro forma NOI over the anticipated hold period divided by the purchase price. 

Finally, the SEC had questions on Modified Funds from Operations.  I get the sense that the SEC holds MFFO in about as much esteem as I do.  To paraphrase my take on what the SEC was inquiring about regarding MFFO, and again this was a theme across multiple non-traded REITS, was it was trying to determine why the non-traded REITs exclude acquisition costs from MFFO because REITs are in the business of buying and selling real estate, which obviously involves costs.  The response was that non-traded REITs exclude acquisition costs to make prior period comparisons more meaningful.  I am not going to argue this point, but will continue to discount MFFO until a REIT has fully invested its equity and MFFO really only consists of adjustments for straight line leases. 

Friday, June 10, 2011

Fifteen Cents on the Dollar - Vegas Style

Late last month I noted a land sale in Arizona that sold for eight cents on the dollar based on peak mid-2000s pricing.  Here is another example, this time in Las Vegas.  Calculated Risk and the Las Vegas Sun detail a property in Las Vegas (not sixty miles away like the discounted Arizona land sale) that sold for $30.2 million in 2007 and just sold for $4.4 million, an 85% discount.  For some reason, seeing Southwest land sales at discounts of 92% and 85% made me wonder how IMH Mortgage Holdings' portfolio is maintaining its value.

Vintage Years

When I think of vintage years and investing, I think of venture capital or private equity deals.  It is my opinion that the concept of vintage years evolved as a way for managers (and marketers) to explain away poor performance.  They created an excuse to blame bad deals and weak returns on the year in which a fund made its investments, rather than lousy investment decisions.  I have never really heard it widely applied outside the VC world, but its a concept that needs wider application.   Some real estate sponsors can make a strong case to play the vintage blame game. (And can't equipment leasing sponsors blame every year on the vintage?)

I have always been aware of vintage issues related to real estate investments, or, really, any pooled investment that raises and invests money over a particular time period.  This idea solidified when I was recently reviewing the performance of two, large non-traded REITs, both with identical objectives, acquisition philosophies and management, that were issued by the same large real estate sponsor, and that raised about the same amount of investor equity.  The only difference was when the REITs raised and invested capital.  From a performance perspective, the two REITs are Jekyll and Hyde, night and day, black and white.  The REIT that raised and invested money in 2006 to 2008 is having troubles and the REIT that raised and invested money in 2009 to 2010 is looking solid. The first REIT is not alone, as many REITs that were raising money over the same time 2004 to 2008 frame are facing a difficult environment.

I always thought of REITs, even non-traded REITs, as open-ended corporations with infinite lives that had the ability to actively buy and sell property, and that would eventually have a a mix of real estate, bought over different periods.  I did not pay too much attention to the years when the REITs were buying property, as I thought it would all even out over time.  Now I don't believe this.  When a REIT buys its initial portfolio will make a big difference in its long-term performance.  While you can't predict with certainty how current markets will relate to the future or what the future will bring, it is clearly an issue that needs consideration.

Wednesday, June 08, 2011

What's A Mega-Mansion?

I saw the Orange County Register's real estate blog had a post title referencing a "mega-mansion" and had to click through.  I thought that word "mansion" alone signified a big home, and that "mega" was a redundancy.  I am not so sure after reading about the 12.5-acre estate that has a 17,000 square foot house, private lake, tennis courts, an actual wine cave, vineyard and horse stables.   The estate is near the end of construction but financial problems have resulted in stopped construction and bankruptcy filings.  It was once valued as high as $81 million but now is being shopped at a lowly $37 million.  The home was owned and built by a partnership.  It filed for bankruptcy, following the bankruptcy filing of the mega-mansion's project manager / real estate broker.  There are 299 creditors that filed claims against the partnership.  The slide show of the estate is worth viewing.

Thursday, June 02, 2011

Profound Quote
"If you're that upset about how big the bowl for your free cereal is, leave."
Pixar's John Lasseter's response to a new employee who complained in an email about the free cereal bar at Pixar.  The quote is from great article on Pixar in the May 16th issue of The New Yorker.  (The link is only an excerpt from the article.)   The employee did not last at Pixar.

Wednesday, June 01, 2011

End of an Era
Independent broker / dealer Omni Brokerage has closed its doors.  Omni was a leading proponent and seller of syndicated real estate investments, in particular tenant in common programs.  I suspect that Omni's lack of product diversification was crippling during the real estate downturn.   The Investment News article (linked above) tries to correlate Omni's closure to failed TIC deals by DBSI, but I am not sure I believe this argument.  Omni was the first and loudest champion of strict due diligence and disclosure for TIC products.  It tried to tame the frenzy that was the TIC market place in the early 2000s as much as it tried to capitalize on it.  While Omni's legacy will be inextricably tied to the rise and demise of TIC syndications, investors and broker / dealers benefited, and will continue to benefit, from its efforts to improve deals, emphasize due diligence, and its push for more transparency and disclosure.
David Lerner and Apple REIT
The news that FINRA filed a complaint against David Lerner Associates (DLA) hit yesterday.  Here is a Bloomberg article.  According to the article DLA is accused of "of targeting unsophisticated and elderly customers while selling real estate investment trust shares without considering whether the illiquid security was suitable for its clients."  Here is another quote:
In soliciting customers for Apple REIT Ten, DLA provided misleading information about distribution rates for a series of predecessor securities that are now closed to investors, Finra said. The figures failed to show that distributions far exceeded income and were funded by debt that increased leverage in the REITs, which invest in extended-stay hotels, the regulator said. 
DLA denies the allegations.   I find it shocking that at a non-traded REIT would not only use leverage, but also pay distributions that exceed income.

I don't know anything about the Apple REITs other than what I have read the past day.  The Snyder Kearney blog has a more serious post on this matter and link to the FINRA news release.

Update:  Here is a good Wall Street Journal article on DLA and Apple REITs.  Here is a key section:

At the root of Finra's action against the Lerner firm is the way that four Apple REITs have generated returns in the past and maintained their shares at a constant price of $11. All of the REITs, which were launched from 2004 to 2008 and primarily purchased extended stay hotels, have been paying returns of 7% to 8%, according to the complaint.
But the Lerner firm has failed to disclose, in describing the products on its website, that the income from real estate was insufficient to support these, Finra said. Rather, the distributions were partially funded by "leveraging the REITs through borrowings and returning capital to investors," the complaint states.
Finra also said the constant $11-a-share valuations for the four REITs are inaccurate, given they didn't reprice during the financial crisis when the extended stay hotel market "suffered a significant, material downturn." The valuations, Finra said, should have been a red flag for the Lerner firm, spurring it to conduct further due diligence before selling its latest product, Apple REIT 10.