BB Gets AA'd

Here is a BusinessWeek article on Best Buy, which is closing 50 stores this year.  The article credits Amazon for impacting BestBuy's sales.  I believe Apple's retail stores are also playing a part in Best Buy's struggles, and this will only get worse when (if?) Apple releases its TV.  The article fails to mention another fact, or at least my strong personal opinion - shopping at BestBuy is an awful retail experience.  The stores are too big, staff is not knowledgeable, inventory is too varied and the checkout is painful.  I am not looking forward to having another retailer leaving empty big box stores.  There are limitations on the number of Halloween stores that can open.

Inland Western, er... Retail Properties of America

The real estate investment trust formerly known as Inland Western REIT,  recently renamed Retail Properties of America (RPA), has filed several recent amendments to its S-11.  The March 23, 2012, amendment had some points worth noting.  RPA's filing listed an expected public offering share price of $10 to $12.  This price is based on RPA's 2.5 to 1 reverse stock split.  To an original investor, the estimated $10 to $12 listing share price is the equivalent of a $4.00 to $4.80 stock price.  Stated another way, the estimated RPA list price is 52% to 60% lower than an investor's original share price.  There is no assurance the estimated listing price will be realized or that the stock, once listed, will stay above the estimated price.

RPA is seeking to raise $320 million in new equity along with the listing, assuming a mid-point listing price of $11 per share.  The underwriters presented on the front page of the S-11 for the listing and stock offering are J.P. Morgan, Citigroup, Deutsche Bank Securities, KeyBanc Capital Markets, Scotiabank, Wells Fargo Securities and PNC Capital Markets.  Page 44 of the S-11, and this is my favorite part of the S-11, states how RPA plans to utilize the offering proceeds:

Affiliates of J.P. Morgan Securities LLC, Citigroup Global Markets Inc., Deutsche Bank Securities Inc., KeyBanc Capital Markets Inc., Wells Fargo Securities, LLC, PNC Capital Markets LLC and Scotia Capital (USA) Inc. are lenders under our senior unsecured revolving line of credit, and will receive their pro rata portion of the $170 million of the net proceeds from this offering used to repay amounts outstanding under our senior unsecured revolving line of credit. Accordingly, more than 5% of the net proceeds of this offering are intended to be used to repay amounts owed to affiliates of these underwriters.

One motivation for the stock offering is clear; over half the offering proceeds ($170 million of $320 million, or 53%) is going to repay the underwriters or their affiliates.  The underwriters are selling RPA equity to get repaid money they've loaned RPA.  The underwriters or their affiliates get repaid immediately, while the original equity investors have an 18-month deferred liquidity period that starts at an estimated 52% to 60% discount to their original investment in RPA.  There is nothing wrong, unethical or untoward with what the underwriters are doing, but it seems like a tough sale to me.

I wrote a post last week sharing my opinion on internalization fees.  RPA is one reason I believe the internalization fee has a limited future.  RPA's S-11, to its credit, neatly lays out many shares RPA received (its internalization fee) for its advisor in 2007:

2007 Internalization

On November 15, 2007, pursuant to an agreement and plan of merger approved by our shareholders on November 13, 2007, we acquired, through a series of mergers, four entities affiliated with our former sponsor, IREIC, which entities provided business management/advisory and property management services to us. Shareholders of the acquired entities received an aggregate of 37,500,000 shares of our common stock valued under the merger agreement at $10.00 per share. In December 2010, certain of the shareholders returned 9,000,000 shares of our common stock to us in connection with our settlement of a lawsuit relating to this

acquisition. As a result of the mergers, we now perform substantially all of our key operational activities internally. In connection with the mergers, we and our former business manager/advisor and our former property managers entered into a number agreements and amendments to agreements with The Inland Group, Inc. and certain of its affiliates. See “Certain Relationships and Related Transactions.”

RPA's former advisor, or its shareholders, owns 28,500,000 shares of RPA stock, not adjusted for the reverse stock split.   Based on the estimated share price of $4.00 to $4.80, this gives the internalization fee a current value of $114,000,000 to $138,800,000.  (Adjusting for the reverse split gives the same result - 28,500,000 shares divided by 2.5 equals 11,400,000 shares, which multiplied by $10.00 is $114,000,000, and multiplied by $12.00 is $136,800,000.)

A four-and-half-year period between internalization and listing is a long time, especially given what has happened to commercial real estate and the capital markets since late 2007.  Internalization fees may not be gone, but I don't think we'll see a situation anytime soon where investors lose over half their investment and management walks away with a $100 million payday.

KBS REIT's New Valuation

It should have been a clue when KBS REIT did not file its 2011 10-K last week along with KBS REIT II and KBS REIT III.  In the back of my mind I wondered why KBS REIT hadn't filed its 10-K, and I even checked my filing service to make sure I hadn't missed the filing.  Yesterday we found out why KBS REIT didn't file its 10-K last week.  KBS REIT announced a drop in its valuation and suspended its dividend, as it struggles with its financial problems.   The filings' immediate takeaway points are below:

• KBS REIT valued itself at $5.16 per share, as of March 22, 2012, which is down from its December 2010, valuation of $7.32 per share.  
• On March 20, 2012, the REIT's board of directors approved the suspension of the REIT's distribution.
• The REIT amended its share redemption program to allow redemptions only in the event of death or disability.
• The REIT terminated its dividend reinvestment plan, effective April 10, 2012.

If the above is not bad enough, the tone of the report, from what I've read of it, is negative, preparing investors for more bad news.  I'll post more on the filings as I wade through them.

Lack of Disclosure?

If a non-traded REIT buys a portfolio of properties and the portfolio is only 48% physically occupied, should this be disclosed in the filing discussing the acquisition?  I think that is definitely a disclosure item.  A non-traded REIT purchased a portfolio of properties at year-end 2011 at this level of physical occupancy, and did not disclose it until nearly two months after the transaction.   We have to read what's not in a filing.  And remember, when ever you read "physical occupancy," it means that the actual economic occupancy (tenants paying rent) is lower.

Internalization Fee Horizon

To charge an internalization fee or not to charge an internalization fee, that is the question facing non-traded REIT sponsors.  Starting with Cole Credit Properties Trust II (CCPT II), which announced last summer that it was going to seek a liquidity event within twelve months, a number of non-traded REITs are, or should be, exploring a liquidity event for investors over the next several years.  A non-traded REIT’s liquidity event for shareholders can take various forms, including listing shares on a stock exchange, merging with another REIT, selling the REIT outright to another company, or selling properties individually or as portfolios.  Typically, as part of a REIT offering liquidity to its shareholders, the non-traded REIT sponsor will internalize the REIT's advisor, the separate but affiliated company that serves a conduit for a non-traded REIT's sponsor's management services to the REIT.  (There is no law that says a REIT must internalize its advisor).  The amount paid for a REIT to acquire its advisor is called an internalization fee. *

The internalization fee is important because it is, potentially, the largest form of compensation a REIT sponsor will receive.  Asset management fees and property management fees are fine compensation, but internalization fees are the mother lode.  Past internalization fees have ranged from the tens of millions to the hundreds of millions of dollars.   Internalization fees are unique from other forms of compensation because 1) the fee is not directly based on assets or performance, and 2) a REIT’s sponsor typically sets the price at which the non-traded REIT will acquire its management company.  A third party company will then affirm this valuation through a fairness opinion, but the sponsor typically determines who writes this opinion, and then allows the REIT to pay for it.  It’s no surprise that the third party firm magically confirms the sponsor’s value, but this process is a topic for another post.

Cole’s decision on whether or not to charge an internalization fee for CCPT II's advisor will influence other non-traded REITs that will seek liquidity options in the near future.  This is because CCPT II raised and invested its capital before the credit crisis.  CCPT II is a big REIT, having over $3.4 billion in assets at September 30, 2011, and its size will factor into its sponsor's decision-making process on what it does with CCPT II's advisor.  Other large, non-traded REITs that recently closed their equity offering periods, and that raised capital before, during and after the credit crisis, such as the first two KBS REITs, Wells REIT II, Inland American REIT, and CNL Lifestyle REIT will face the same decision as CCPT II.  How CCPT II deals with its external advisor will provide a clue to how the other non-traded REIT sponsors deal with their REITs' advisors.

I have no idea what CCPT II or the other non-traded REITs will do, but I would be surprised if the REITs pay significant internalization fees for their advisor.  Internalization fees, due the past size of the fees, have a stigma, and broker / dealers, analysts, and attorneys will scrutinize any internalization fees.   For sponsors that are raising capital for new REITs, an internalization fee for an old REIT has sales implications for the new REIT.  I suspect some of the non-traded REIT sponsors won’t charge internalization fees, but look to compensate management in other ways, such as stock grants (see my prior posts on Healthcare Trust of America, which internalized its management company without a fee, but has been granting stock to its executives with abandon (and impunity) ever since), or through lucrative, post-liquidity management compensation.  Some non-traded REIT sponsors may just decide to delay a liquidity event and keep earning their asset and property management fees.

I believe sponsors need to think long and hard before taking an internalization fee.  The financial temptation to take an internalization fee in some form or another will be great.  The REITs' boards of directors need to weigh the pros and cons of taking an internalization fee, including the negative connotation surrounding this fee that could impact the sponsors' current offerings and the cost of potential legal action by unhappy investors and aggressive attorneys.   I don’t want sponsors working for free, they do deserve fair compensation, but the compensation needs to be aligned with investors' financial interests, not at the expense of investors.  The decision to take an internalization fee doesn’t need to become a Shakespearean Tragedy. 

  *Internalization fee is the cost a non-traded REIT pays to acquire its management company from its sponsor.  Most non-traded REITs are structured as externally advised entities, where the REIT pays for management services from its sponsor.  Typically, a REIT “internalizes” its management as a process to separate itself from its sponsor.  The REIT typically pays the internalization fee to its sponsor in the form of REIT stock.  After an internalization fee the REIT will no longer pay asset management fees or property management fees, but pay directly for the management services. 

Trustee Authority

I read this long New Yorker article when it came out last year.  It's about the New York Mets' owners' involvement with Bernie Madoff.  I remember being struck by the absolute authority of the bankruptcy trustee overseeing the remaining assets of the Madoff ponzi scheme.  I thought about it again with today's $162 million settlement by the owners of the Mets.

Vegas Housing

Here's a post from Calculated Risk on the Las Vegas housing market.  Las Vegas has seen the largest drop in home prices of any of the Case-Shiller composite 20 cities, according to the post.  Through December 2011, Las Vegas home prices were off 61.8% from the peak, and were down 9% in 2011.  There is good news:

Sales in 2011 were at record levels, more than during the bubble, and it looks like 2012 will be an even stronger year - even with some new rules that slow the foreclosure process.

And this:

From the LVGAR: GLVAR reports increasing home sales, prices, decreasing inventory. First on a record sales pace:

According to GLVAR, the total number of local homes, condominiums and townhomes sold in February was 3,794. That’s up from 3,591 in January, and up from 3,371 total sales in February 2011.

Compared to one year ago, single-family home sales during February increased by 17.8 percent, while sales of condos and townhomes decreased by 5.0 percent.

The Calcualted Risk post ends with this:

So 71.3% of the sales were distressed, and over half were purchased with cash.

One of the keys is the decline in inventory. Note that the GLVAR reports both total inventory, and inventory excluding "contingent" listings (usually short sales). Total single family inventory was down 15.4% from a year ago, and excluding contingent listings, inventory was down 45.6%!

This is good news and one of the reasons why I am a housing bull.  I have read other articles supporting my belief, and will try and link to them.

Home Investing

Here is a good article from Bloomberg on private equity investors buying foreclosed homes as rental properties.  The properties should generate good cash flow to sustain investors until the properties are sold.  I'm not sure I buy this thesis:

In starting Waypoint, Wiel and Brien set out to show institutional investors that by using technology they could amass single-family homes the same way Sam Zell’s Equity Group Investments Inc. (EQR) and other real-estate giants gather apartment units in cities from New York to San Francisco.

The home rental market boasts a total property value of $3 trillion, according to Morgan Stanley (MS) housing analyst Oliver Chang. Yet institutions have long shunned it as too scattered and impractical to be profitable.

Wiel and Brien are using cloud computing, proprietary algorithms and iPads to create a virtual assembly line for buying, renovating and renting houses on a large scale. They’re also betting that many former homeowners who have jobs but couldn’t afford their mortgages will still want to live in the same communities as renters.

“The economics never made sense for a big investor to come into the market, and the technology for managing all that complexity didn’t previously exist,” says Brien, who still possesses the steely stare of a field goal kicker. “The confluence of those two events has provided a window of opportunity for large investors to enter this space.”

The article mentions that Waypoint has over 1,100 homes.  The exit strategy is still selling the homes individually, which will take months, and likely years.  This will test the institutions' patience.  Institutional money is great, but local knowledge is critical.

Shifting Sands' Job Gains

Here is a good Bloomberg BusinessWeek article on job growth in sand states (Florida, Arizona, Nevada and California).  These states had the most job declines during the recession, but are now leading the nation in job growth.  The BusinessWeek article seemed surprised at this trend.  What I'd like to know, and what's not addressed in the article, is what impact the collapsing housing market had on the job losses and what impact a rebounding housing market is having and will have on job recovery.

Creativity Fail

Inland Western REIT has changed its name to Retail Properties of America, Inc.   American Realty Capital is already offering a similar product, Retail Centers of America, Inc.  Why would Inland Western change its name to almost match a competitor's exisitng product?  Maybe imitation is the best form of compliment, or maybe it's a case of dialing it in.  It's creativity failure either way.  To me, it's more likely that Inland is distancing itself from a product that has struggled so that Inland can protect its brand for its current and future offerings.  

The former Inland Western's Net Asset Value per share is 30% below its original offer price, and while it has worked hard for investors to keep paying a distribution, and has increased it nine quarters in a row, the current distribution (2.6% annualized) is well below the REIT's original distribution.  In the REIT's defense it raised and deployed capital in the mid-2000s in retail real estate, one of the real estate asset classes most impacted by the recession and housing slump.  The former Inland Western also fought to refinance debt that matured near the worst of the credit crisis.  Inland should have put more thought and originality into the name change.

Calling BS At Forbes

This Forbes article popped up on my Google News feed.  It reads like PR for TNP Strategic Retail Trust, a non-traded REIT that has raised about $65 million in over 2.5 years.  I don't put much credence in Forbes' articles like this after I read an error-filled one from an attorney last fall (my comments are linked here).  The article on TNP Strategic Retail is worth reading for the comments alone, as readers quickly saw through the author's propaganda and called him out.

Inland Western's (Archaic) Listing?

On February 28, Inland Western REIT filed a letter it sent to investors.  The letter is optimistic, and I could write a snarky post poking each sanguine point.   But the key paragraph that caught my eye was at the end of the letter where Inland Western stated:

As previously communicated, we continue to pursue the initial listing of our existing common stock on a national securities exchange. We currently intend to complete the listing in 2012, and we are in the process of finalizing the terms of the phased-in liquidity program that we intend to implement in connection with the listing. As was described in our proxy statement for our special meeting in February 2011, we currently anticipate that we will implement a phased-in liquidity program that will provide for the listing of 25% of your existing shares of common stock concurrent with the initial listing and the listing of an additional 25% of your existing shares of common stock on each of the six-month, 12-month and 18-month anniversaries of our initial listing. We will provide you with further information regarding the expected timing of the listing and impact of the listing of our common stock on your existing holdings as the process progresses. Although we do currently intend to pursue an initial listing within the foregoing timeframe, we cannot guarantee that such a listing will occur and timing could be impacted by overall economic and other conditions and factors.

Inland Western told investors that it plans to list its shares sometime in 2012, but it will only make shares available in 25% increments, with each share release spaced out over six months.  Under this structure, investors will not receive full liquidity for eighteen months after the date Inland Western initially lists its shares.

Inland Western internalized (bought with its stock) its advisor in 2007, at a value of $375 million.  (This fee was approximately 8% of Inland Western's equity, which, based on this metric, was not the cheapest nor the most expensive internalization.)  The internalization generated lawsuits and in July 2010, Inland Western agreed to return 9,000,000 shares, which lowered the internalization to $285 million (assuming the initial valuations were done on the REIT's $10 per share offer price).  Based on Inland Western's current $6.95 net asset value share price, I figure the internalization fee is now 30.5% less than $285 million, or $198 million.  If anyone has more accurate figures, I will post them.  Obviously, at minimum, Inland Western's sponsor is likely subject to the same delayed listing schedule as investors, and the $198 million will fluctuate with the market price for Inland Western's shares. 

(Here is a June 2010 article from CRENews.com that discusses non-traded REIT internalization fees and from which I obtained the $375 million value listed above.  The article has this whopper quote from Stanger's Kevin Gannon:

"There is nothing wrong with non-traded REITs paying to internalize management because they bring in-house good people, who know the REITs and their assets. But sometimes the dollar amounts have been large and there's been some criticism for that," said Kevin Gannon, a managing director with Stanger.

 There's no wonder why non-traded REIT sponsors love this guy.)

There are plenty of other non-traded REITs that raised money in the mid-2000s that have yet to internalize their external advisor.  Unless a REIT sponsor has specifically amended its REIT's documents, most REITs offered in the mid-2000s have the ability to internalize their advisors.   In today's environment, it'd be hard for a sponsor to justify, rationalize or explain a huge internalization fee.  A situation where a REIT's NAV per share is less than the original offer share price per share would make an internalization decision even more difficult.  If a sponsor is raising capital in another REIT, all the fees associated with that offering or offerings would be in jeopardy if broker / dealers cancel selling agreements due to the internalization fees.  Termination agreements may not be wide spread, but what REIT sponsor is going to take the chance.  Let's hope Inland Western is the last non-traded REIT that hits investors with a large internalization fee.

More ARCT Listing

Here is a partial screen shot from yahoo.finance of the closing of ARCT's opening day of trading:

I circled the day's trading range.  I wonder who was part of the trade at $5.54, especially the sell side.  Someone took a nearly 50% loss when ARCT has a tender offer to purchase shares at $10.50 per share.  You can't fix stupid.

ARCT Listing

American Realty Capital Trust is now listed on NASDAQ and and began trading this morning under the symbol ARCT.