The Valuation's Too Damn High - Part III - Fool's Gold

This the third installment in my four-part The Valuation's Too Damn High series.  This post will focus on non-traded REITs that value their shares during their equity offerings.  This is fine on its face as it usually occurs in a REIT's third year of raising capital, but there is a disturbing twist - non-traded REITs that announce a new valuation can wait sixty days to adjust their share price.  For non-traded REITs that are adjusting their share price up, sixty days is a long marketing period to sell their shares at a "discount" to the new "value."  Two non-traded REITs, Dividend Capital Industrial Income Trust and Strategic Storage Trust (SST), have used their share reprice and 60-day marketing period to their benefit this year, substantially increasing their equity inflows.

Recently-moribund SST raised nearly $40 million in equity in May as the REIT prepared to re-price its shares from $10.00 to $10.79 on June 1, 2012.  SST sold its shares for $10.00 per share for the months of April and May, after announcing the pending, higher valuation in early April.  This manufactured share appreciation proved an effective marketing tool.  SST only raised $4.7 million of equity in March.  Sales jumped to $12.5 million in April after the new value was announced, and surged to nearly $40 million in May before the new price went into effect.

SST had its shares valued by an outside firm, Cushman & Wakefield.  Here is part of the valuation disclosure from SST's April 3, 2012, 8-K (my emphasis added):

Cushman & Wakefield has an internal Quality Control Oversight Program. This Program mandates a “second read” of all appraisals. Assignments prepared and signed solely by designated members (MAIs) are read by another MAI who is not participating in the assignment. Assignments prepared, in whole or in part, by non-designated appraisers require MAI participation, Quality Control Oversight, and signature. For this assignment, Quality Control Oversight was provided.

As described above, Cushman & Wakefield utilized the Income Capitalization Approach, which is a method of converting the anticipated economic benefits of owning property into a value through the capitalization process. The two most common methods of converting net income into value are direct capitalization and discounted cash flow. In the direct capitalization method, net operating income is divided by an overall capitalization rate to indicate an opinion of market value. In the discounted cash flow method, anticipated future cash flows and a reversionary value are discounted to an opinion of net present value at a chosen yield rate (internal rate of return). Cushman & Wakefield utilized the discounted cash flow method to determine the “as-is” value.

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Cushman & Wakefield estimated the value of the Registrant’s real estate portfolio by using a 10-year discounted cash flow analysis. Cushman & Wakefield calculated the value of the Registrant’s real estate portfolio using cash flow estimates provided by the Advisor, terminal capitalization rates and discount rates that fall within ranges Cushman & Wakefield believes would be used by similar investors to value the properties the Registrant owns. The capitalization rates and discount rates were calculated utilizing methodologies that adjust for market specific information and national trends in self storage. The resulting capitalization rates were compared to historical average capitalization rate ranges that were obtained from third-party service providers. As a test of reasonableness, Cushman & Wakefield compared the metrics of the valuation of the Registrant’s portfolio to current market activity of self storage portfolios. Finally, due to the impact of financing in the current market, Cushman & Wakefield performed a leveraged analysis that is typical of the viewpoint of a portfolio buyer.

From inception through December 31, 2011, the Registrant had acquired 91 wholly-owned self storage properties for approximately $522 million, exclusive of acquisition fees and expenses. As of December 31, 2011, the estimated “as-is” value of the Registrant’s real estate portfolio using the valuation method described above was approximately $663 million. This represents a 27% increase in the value of the portfolio. The following summarizes the key assumptions that were used by Cushman & Wakefield in the discounted cash flow models to estimate the value of the Registrant’s real estate portfolio:

Terminal capitalization rate		7.0%
Discount rate		10.0%
Annual market rent growth rate		3.25%
Annual expense growth rate		3.0%
Holding Period		10 years

Cushman & Wakefield utilized the above terminal capitalization rate of 7.0% and discount rate of 10.0% in calculating the “as-is” value of the Registrant’s real estate portfolio and did not use a range or weighted average for these rates in the calculation. While the Registrant believes that Cushman & Wakefield’s assumptions and inputs are reasonable, a change in these assumptions and inputs would change the estimated value of its real estate.

Cushman & Wakefield, as part of its estimate, used cash flow estimates provided by SST's advisor.  The second bolded sentence reads to me as though Cushman Wakefield provided as one of its valuations for SST, a figure as if a buyer would acquire the entire company, which is a portfolio valuation, a methodology that would increase SST's final valuation figure, because a number of small properties as a group are worth more than if valued individually.  The table includes other assumptions, including rent growth that exceeds expense growth, which is not uncommon, but over ten years provides a growth in future projected net operating income on which to determine valuations.

I only excerpted part of the 8-K's discussion on how SST derived its valuation,  I'd encourage you to go read the entire April 3, 2012, 8-K.   I said in two previous posts on valuations - here and here - that the methodologies are not the problem, it's the inputs into the methodologies that can inflate values.  While SST was able to derive a $10.79 per share valuation, changing some of the inputs could have come up with values higher or lower than $10.79, and these figures would be just as valid (the 8-K discloses this).  I don't think SST would have raised $40 million in May if it had revalued at $8.50 per share, and if it had revalued at $11.50 per share, who knows how much equity it would have raised.

Earlier this year Dividend Capital's Industrial Income Trust used a similar strategy - revaluing its shares from $10.00 per share to $10.40 per share - and saw sales more than triple before the new higher share price went into effect.  After the new share price went into effect, Industrial Income Trust's sales dropped to $21 million in May, from $150 million in April.  That is a substantial drop.  Next up is SST, and it'll be interesting to see if it maintains its sales momentum in June, or reverts to the $3 million to $5 million per month it was raising before its share reprice. 

If a REIT on life support, like SST, can see sales jump nearly ten-fold, and Dividend Capital and see its Industrial Income Trust's sales jump from less than $50 million a month to more than $150 million a month all based on a new valuation, what's to stop other REITs from trying the same tactic.  REITs are allowed to reprice their shares and wait up to 60 days to implement the new share price.  Other non-traded REIT sponsors likely watched the jump in equity inflows at SST and Industrial Income Trust and must be thinking of following suit, and who could blame them.  When there's a gold rush, you better stake your claim.

Below are some examples of other REITs in their secondary offering period or near the end of their initial two-year offering period that I think would be candidates for a re-pricing:

• Corporate Property Associates 17
• Griffin Capital Net Lease
• Griffin-American Healthcare REIT II
• Inland Diversified REIT
• Hines Global REIT
• Lightstone Value Plus REIT II
• Paladin Realty Income Properties
• Philips Edison - ARC Shopping Center REIT
• United Development Funding IV
• Wells Core Office REIT

All these REITs could use a two-month shot of equity steroids.  It'd be hard to blame them if they chose to take the easy equity.  Even if a REIT experiences a large drop in sales after the new price is effective, like what happened with Industrial Income Trust, it's worth it to have the two month's sales frenzy.   Some broker / dealers don't seem to have any concerns about the strange, 60-day re-price window, as they, too, benefit from the short-term sales boost.  The third party valuation firms need to be careful, because they are being relied upon for the accuracy and credibility of their valuations.  Their valuations are considered sacrosanct in large part because they're third parties, but they need autonomy and should not just run computations based on data provided them by the REITs.  Garbage in, garbage out.  At some point, the REITs, their boards, the valuation firms, and possibly broker / dealers, are going to have to justify their processes, inputs and rationales.

This "value today, re-price in 60 days" strategy is going to attract regulators, which no one wants.  The non-traded REIT industry better police itself - fast.   Independent board members at REITs looking to revalue need to stand up to REIT management and turn the valuation process over completely to a third party valuation firm and accept the independent value without adjustment.    If a non-traded REIT gets a valuation that is higher - or God forbid lower, wait, that won't happen - than the current offer price, the shares should be repriced as soon as possible.  Non-traded REITs should not have a 60-day marketing period (not to mention the "whisper" period before the new valuation is announced) to sell into the new increased valuation that was based on a specific set of criteria that the REIT's management had input.  Better yet, if a REIT receives a share valuation higher than the current offer share price, and really wants to stand by the new valuation, the REIT's board should list the shares on an exchange and access the capital markets for future equity needs.

The whole valuation process reminds me of this Seinfeld clip: