A Banal BDC Bash

Here is an article on non-traded business development companies (BDCs) from WealthManagement.com.  It presents some good information but it's mixed with bad information, so read the article carefully.  If you're going to slam a product type, you need to get your facts correct.  

Several times the article refers to non-traded BDCs as private investments. Here is a big quote, the second paragraph of the article:

“In my opinion, brokers should not be selling private anything—private placement, private REIT, private business development corporation—because it limits the flexibility, it limits liquidity, it limits transparency, and it almost always means higher fees internal,” said Joshua Brown, vice president of Investments at Fusion Analytics Investment Partners. “The only reason [non-traded BDCs] get sold is because it’s product and it’s sexy and it’s a way for a broker to get a higher fee for the same dollars that they would put into a public version.”

All the BDCs being offered today, and the ones discussed in the article, are public entities, not private placements.  The disclosure for these public non-traded BDCs is excellent, and should be the same as for traded BDCs.  If you read the SEC filings of non-traded BDCs you get a good sense of how the BDCs are performing.

Financial journalists need to understand the important distinction between non-traded entities and private placements.  Just because an entity is not traded doesn't mean it's a private placement. 

The article points out that many sponsors of non-traded REITs have jumped into the BDC sponsorship business.   This is certainly true, and unfortunately, it's one reason why BDCs and non-traded REITs are lumped together.  Only one sponsor, AR Capital, is managing its BDC portfolio, and it hired an experienced BDC team to build and manage the portfolio, so the real estate guys are not doing double duty learning the leveraged, middle market loan business on the fly.  The typical approach, is for a non-traded REIT sponsor to contract with an experienced sub-advisor to manage the BDC assets, so again, the non-traded REIT sponsors are not managing BDC assets.  The use of sub-advisors has its own issues, but to imply that non-traded REIT sponsors are all of a sudden credit and debt managers is incorrect.

The initial load for all the non-traded BDCs I've seen is 11.50%.  After this, and it's obviously a big this, the on-going fee structures between traded and non-traded BDCs are nearly identical, as the both traded and non-traded BDCs pay asset management fees and incentive compensation to their sponsors.   BDCs can be very lucrative to BDC sponsors and advisors, whether the BDC is traded or non-traded. 

BDCs are not new, but have seen a resurgence due to the credit crisis and the capital raising success of Franklin Square's BDCs.  Advisors and broker / dealers need to understand that BDCs are high yield, leveraged loan funds that make loans to private middle market companies (typically companies with revenue of less than $1 billion).  BDCs are not a panacea, not for every client, and are not some risk-free way to generate high commissions and high yields.  Advisors and broker / dealers need delve into and understand not only BDCs' fee structures but their whole business models.  The wealthmanagement.com article, while providing some good information, does not give broker / dealers and advisors a complete picture of BDCs.

Why I Abandoned CNBC

At the height of the financial crisis in late 2008 I started watching Bloomberg TV, in large part due to its 24-hour coverage and the ability for me to monitor Asian and European markets.  I liked Bloomberg's hard news attitude, delivered in a calm, unbiased manner.  It made me realize how shrill and hyperbolic CNBC had become, and I've rarely switched back.  Erin Burnett's departure to CNN and Mark Haynes' passing cemented my decision.

YahooFinance recently started a partnership with CNBC, where CNBC is now YahooFinance's main news provider, so I now get a steady stream of CNBC headlines.  Here is a news article from yesterday that confirms to me that CNBC is more concerned with headlines than news.  The title of the article is "Home Prices:  Bottom or Bubble?"  Bubble?  Really?  Home prices have stopped their five- or six-year decline for a couple of months and CNBC is already calling it a bubble.  Give me a break. 

The article presents this data:

Nearly one third of the 167 markets Zillow tracks in this survey saw annual price gains from a year ago.

"After four months with rising home values and increasingly positive forecast data, it seems clear that the country has hit a bottom in home values," said Zillow Chief Economist Dr. Stan Humphries. "The housing recovery is holding together despite lower-than-expected job growth, indicating that it has some organic strength of its own."

And then there is this passage on the rebound on some of the markets hardest hit by the housing decline:

That has other analysts claiming that the overall surge in national prices is due to price bubbles in certain markets.

"Strong demand, particularly in areas of California, Arizona and Nevada, are pushing up home prices very quickly in the short-term. And because many of the home purchases in these areas are cash transactions, there appears to be less braking of prices by our current appraisal system than seen in other parts of the country," noted Thomas Popik, research director for Campbell Surveys and chief analyst for HousingPulse. "The trend raises the distinct possibility of housing price bubbles emerging in some of these hot housing markets." 

Las Vegas and Phoenix started their corrections sooner than other parts of the country and each saw more than a 50% peak-to-trough decline in home values.  Now that a good chunk of the distressed inventory in these markets has either burned off or is quickly being bought by institutional investors, a rise in prices is expected.  A rebound from such a steep decline is not a bubble. 

The article does end with some solid reporting on the mixed messages of recent housing price increases.   Read the article for yourself.  For me, I'll stick with Bloomberg TV for market and business news, and read CalcuatedRisk for housing market updates.

Flying Without A Parachute

Healthcare Trust of America's (HTA) tender offer period expired yesterday, ending the stock's price support.  HTA had offered to purchase up to $150 million of shares at a price range of $10.10 to $10.50.  As expected, the tender offer was oversubscribed, and HTA will purchase $150 million of shares at the $10.10 per share.  (It's time to end these silly Dutch Auction tender offers, which offer a price range for buying tendered shares, but then always fulfill the tender offer at the lower price.)

I wasn't shocked that the HTA tender offer was oversubscribed, but was surprised that a greater number of investors didn't seek to tender their shares.  According to HTA's press release filing this morning, 22.86 million shares were tendered and 14.85 million shares were accepted.  Stated another way, 39.9% of HTA's Class A shares were tendered.  The total tender offer was for 25.9% the the outstanding Class A shares.  I thought that with HTA's distribution cut prior to the listing, the number of investors seeking to exit HTA via the tender would have been higher.  HTA's stock price is down, but stable, this morning, and volume is near normal.

Fees Matter

I posted last Friday that Steadfast Income REIT's advisor recently valued the REIT at $10.24 per share, and will begin offering shares at this new price in September.  I've written extensively about the valuation methods non-traded REIT advisors use to derive values, and am not going to re-argue my concerns in this post.  But I can't reconcile one area of these revaluations and share repricing:  why are the REITs' offering costs ignored?

Strategic Storage re-valued its shares earlier this year and has a net asset value of $10.79 per share, which is the same price at which it is offering its shares to investors.  Steadfast Income REIT announced on July 13, that its shares have a net asset value of $10.24 per share, and will offer shares to investors at this price in September.  The price for both these REITs don't reflect the REITs' offering costs.  I figure Strategic Storage has offering costs of 11.75% and Steadfast Income REIT has offering costs of 11.25%.  These are costs that are paid by investors to buy the REITs' shares, and are in additional to the REITs' net asset values.  These are hard costs that are paid regardless of the REITs' net asset value.  I don't understand why they are not worked into the new offer prices for these REITs.  It's as if these fees somehow magically don't matter anymore and have been whisked away with the new re-valuations.  The REITs' offering fees matter and the REITs' offer prices need to reflect these fees. 

To account for these fees, I figure Strategic Storage's share price should be $12.23 per share to reflect the 11.75% in offering costs investors have to pay, and Steadfast Income REIT's price should be $11.54 per share to reflect its 11.25% in offering costs.  Unfortunately, non-traded REIT's can't re-value away their offering costs. 

The Valuation Charade Continues

Steadfast Income REIT just filed an 8-K that states the REIT is raising its share price from $10.00 to $10.24 on September 10, 2012.  The increase is based on the REIT's advisor's valuation of the REIT's assets.  The REIT engaged Duff & Phelps to:

"review the assumptions and methodologies applied by the Advisor in accordance with a set of limited procedures."

I will have more on this after I review the filing. 

Don't Trust The Titles

Via Calculated Risk, a smart smack down of a CNBC article titled "When Foreclosure Supplies Fall, The Bottom Falls Out Of Housing."  It's just the opposite, as Calculated Risk points out.  Read the CNBC article first, it makes no sense.

Interest Suspension Sparks Speculation

InvestmentNews published an article on Monday about Thompson National Properties' TNP 12 Percent Notes Program, LLC's decision to suspend interest payments for the remainder of 2012.  The article is full of important information, including a quote stating that the notes, which were issued in 2008, have returned 35% of investor capital.  I suspect this is the notes' interest payments, not a return of capital, so investors are still entitled to 100% face value of the notes, as well as any accrued interest, until the notes are repaid.

The name of the company that issued the notes, TNP 12 Percent Notes Program, LLC, signifies to me that it was a special purpose entity formed for the sole purpose of issuing the notes for its capital, and then used the proceeds from the notes as equity to purchase real estate or for other investment purposes.  There is nothing wrong with this structure, as long as there are safeguards for investors / note holders and its complexity is understood.  Because of the structure, any collateral supporting the notes is likely at the issuing company level, not directly at the property or asset level.

Towards the end of the article, the author, Bruce Kelly, writes:

It's important for broker-dealers to understand the structure of such note programs. Pivotal information includes the value on the assets, whether such deals contain an “equity cushion” — meaning the property values is greater than the amount of money raised — and if the debt service on the note is manageable. 

I would add a few other points:

• Does the "suspension" of interest payments constitute an event of default, and what is the default rate of interest?  (I have seen note programs where deferred, skipped or suspended interest payments don't trigger a default for six months, so it's possible that the suspension doesn't immediately put the notes into default.) 
• If the suspension of interest payments didn't trigger a default, what does constitute a default?
• Do the notes have an agent to represent note holders, or are note holders on their own to seek remedy?
• Is there any debt that is senior to the notes?  (This goes to the equity cushion comment above.)
• Are there any affiliated investments and what are these worth? 
• Does the interest payment suspension impact any other TNP entity debt (i.e. negative covenants), including debt in TNP's public non-traded REIT?
• Is the suspension an isolated event or are other TNP entities facing debt problems?

The article has the following paragraphs:

A spokeswoman for Thompson National Properties, Jill Swartz, said Mr. Thompson was traveling Tuesday morning and was not available for an interview. But in an e-mail to InvestmentNews, she wrote that TNP had taken steps to reduce overhead costs and increase revenues. These steps will strengthen the company's finances and benefit thousands of investors, she wrote.

“One of these steps was to defer payments related to the TNP 12% Notes program through the end of 2012,” Ms. Swartz wrote. “We fully intend to pay investors in this program all remaining interest and principal on or prior to the maturity date of June 10, 2013.”

 Let's hope Ms. Swartz is correct.

Unlinked, Overstated And Leaving The Nest

I received an unlinked acknowledgement yesterday in an InvestmentNews article (yes, I thought about being snarky and not including a link back) on Wells REIT II's wise decision to waive its internalization fee.  The article mentioned that Wells manages $11 billion of real estate assets.  My guess it that the real estate assets of Piedmont Office Realty Trust were incorrectly included in this calculation.  Piedmont was the original Wells REIT, but it is now a separate company, with separate management and a separate location, so its assets need to be excluded from Wells' asset under management.  When Wells REIT II internalizes its management, it too will separate from Wells and take its $6.2 billion of assets with it.  

Losing significant assets is a major consideration for sponsors exploring liquidity options for their REITs.  I hypothesized last week that Cole doesn't want to see the $3.5 billion in Cole Credit Property Trust II assets leave the fold.  The master of keeping assets is WP Carey, which through multiple internal mergers still manages the assets raised through its investment funds.  Inland Real Estate Group has had three of its non-traded REITs go full cycle, two that are still operating (the third was an outright sale of the REIT).  The two still in existence, Inland Real Estate Corporation (IRC) and Retail Properties of America (RPAI), have separate management from Inland Real Estate Group, but operate out of the same office building.  I am not sure why Piedmont physically left Wells, or why Inland stayed.  Maybe it's like children becoming adults and deciding whether to move out or stay at home living with their parents. 

Sponsor assets under management is a serious issue, and one that will play into all non-traded REIT liquidation decisions.

Housing Price Support

Here is a Bloomberg article on institutional investors buying single family homes.  I believe this is providing support for the housing market and is a mitigating factor to concerns that waves of foreclosures will bring the whole housing market down.   One interesting point is that investors have expanded their geographic net and are now buying homes in cities like Houston, TX, rather than just Phoenix and Las Vegas.

Update:  I just saw this post on Calculated Risk.   This passage is amazing and explains why the institutional investors are moving to Texas:

Tom Lawler sent me an update on Phoenix today:

The Arizona MLS reported that residential home sales by realtors in the Greater Phoenix, Arizona area totaled 9,129 in June, down 17.9% from last June’s pace. Bank-owned properties were 14.1% of last month’s sales, down from 40.8% last June, while last month’s short-sales share was 32.8%, up from 27.0% last June. Active listings in June totaled 19,857, down 1.5% from May and down 32.0% from a year ago. The median sales price last month was $141,000, up 27.6% from last June. Citing data from the Cromford Report, ARMLS said that foreclosures pending in Maricopa County in June totaled 17,910, down 35.1% from a year ago.

Look at the sharp decline in bank owned properties sold - this was down to 14.1% of all sales, down from 40.8% last June.

There are not enough properties in Phoenix to support all the money institutional investors are raising.

Updated Update:  Here is another post from Calculated Risk, this one on declining inventory in Las Vegas, the city hit hardest by the housing crash.   Read the whole, short post, because there is too much information for me to extract a few data points without confusing the context.  The bottom line is that inventory is dropping, distressed sales are dropping and Vegas is on track for a record year.

Apartment Vacancy Update

Here is a Bloomberg article on Reis' second quarter apartment vacancy report.  Rents continue to rise and vacancy is at its lowest level since 2001.  The article is short and worth reading.

Office Vacancy Update

Here is the latest information from Reis, via Calculated Risk, on office vacancy.  The national vacancy rate in the second quarter stayed flat at 17.2%.  This paragraph has good and bad news:

Supply growth in the office sector remains muted. During the second quarter of 2012 only 1.606 million square feet of office space were completed, the equivalent of one large office building. This represents the lowest quarterly level on record since Reis began tracking quarterly market data in 1999. Nonetheless, demand for space during the quarter was so weak that even with such little supply being delivered, the level of absorption that we observed during the quarter was insufficient to generate a vacancy rate decline.

The lack of new office supply will eventually result in lower vacancy rates and higher rents.

Silence In The Desert

A year has come and gone since Cole Credit Property Trust II (CCPT II) announced on June 28, 2011:

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. 

In May, I noted that it appeared Cole was hedging its one-year liquidation time frame, so the casual passage of the specified twelve months was expected.  CCPT II has not provided an update to its planned liquidation date.  My personal opinion is that CCPT II is not going to liquidate any time soon, and that when it does, it won't take an internalize-and-list format.  I think Cole will try and somehow follow the WP Carey model where it will offer investors liquidity, possibly through the merger with another affiliated entity, while keeping control of CCPT II's assets, estimating that most investors will choose to stay invested in the REIT rather than liquidate.  CCPT II is a $3.4 billion REIT, so separating it from Cole and listing it as its own company would leave a big hole in Cole's asset base.

There is another factor to bear in mind, and one that probably has as much to do with Cole's decision as does the potential loss of assets.  CCPT II has an 8% annual preferred return hurdle it needs to achieve before its advisor can receive its 10% liquidation carried interest.  CCPT II has never paid an 8% distribution, so any annual short fall is added to the REIT's stock price.  For a simple example, with CCPT II's $10.00 initial offer price, it needs to generate $.80 per year (8.0%) in preferred return distributions.   If it only generates a $.65 per share (6.5%) in distribution in one year, the difference, of $.15 per share is added to the $10.00 share price (again this is only an example to illustrate the carried interest mechanics and is not based on actual CCPT II results). 

So, in the above example, $10.15 per share is the new price at which CCPT II would have to achieve upon liquidation before its advisor starts to earn its 10% carried interest.  So, given this example, if CCPT II were to liquidate for $10.25 per share, its advisor is entitled to 10% on the $.10 per share difference between the liquidation price of $10.25 per share and the $10.15 per share hurdle price.  If CCPT II liquidates below its hurdle price, its advisor does not earn its liquidation carried interest.

Each year, any shortfall to the 8% preferred return is added to the initial share price to create a new hurdle share price.   Because CCPT II has not generated the 8% annual preferred return, its hurdle share price now exceeds $10.00 per share.   I don't know the exact share price at which CCPT II would have to list at or sell for before its advisor begins to receive its carried interest, but it would be an important number to know.   I'm sorry to trudge off into the wild explaining the arcane features of liquidation carried interest, but it's important because most sponsors are going to make decisions that will pay them the most money.

While the 8% preferred return is favorable for investors, CCPT II's advisor has no incentive to liquidate unless it believes it has a reasonable chance of earning its 10% carried interest.  It's a Catch-22, the longer CCPT II delays liquidating, the higher its share price becomes before its advisor can earn its carried interest (unless somehow the REIT starts paying an 8% distribution).  If CCPT II were to internalize its advisor, it would lose the property management and asset management fees it now earns.  CCPT II's ever increasing hurdle rate share price, which makes achieving the carried interest more difficult, along with losing the asset management and property management fees, to me, increases the likelihood Cole will attempt to try and maintain CCPT II's assets even as it figures a way to provide liquidity to investors.

I am not against Cole trying to imitate the WP Carey model, in fact I'm all for it if Cole can pull off a positive return to investors while providing real liquidity to investors.  Investors in WP Carey funds have fared well with this model.  I like that investors can either liquidate or choose to stay invested and maintain their distribution and real estate allocation.   There are plenty of conflicts of interest with the WP Carey method- valuation and sponsor compensation, come to mind - but this is a topic for another post.  

I have no knowledge of Cole's plans for CCPT II, and speculate only as an internal parlor game.  I'll be watching its filings looking for direction.  Cole is on record stating that is seeking "options to successfully exit CCPT II's portfolio," so it will have to give an update either way on its liquidity plans in the near future.

Recent Housing Articles

I have been meaning to link to several housing articles for about a week.  The first link is a NPR article (audio, too) that, to me, explained why the huge glut of pending foreclosed homes, which for years has been seen as a threat to derail any housing recovery and suppress prices, could be overblown.  Institutional investors are snapping up foreclose homes as fast as they come on the market:

Paul Herrera, government affairs director for the Inland Valleys Association of Realtors in Riverside, says there are 40 percent fewer homes on the market compared with last year, and sales volume is up.

Herrera says homebuyers like Bryant are often losing to a growing field of investors, often backed by Wall Street, who are willing to pay cash.

"Cash is always king in this sort of situation," he says.

And then there are the ridiculous stories:

No one here is bidding on a home to live in it. They're people like Gabriel Anguiano, who's recast himself from golf course manager to minor real estate tycoon. In the past four years, he's bought and rehabbed 120 houses to rent or flip.

"I would buy a $30,000 condo, put in another $5,000 in remodels and then sell it for 80, 90. So you make $50,000," he says.

I don't believe this story for a second.  If a former golf course starter can routinely earn more than 100% returns flipping homes and condos, there would be a tidal wave of capital flowing to distressed housing.  Institutional investors are buying distressed homes as income plays, with investment income of 7% to 9%, not 100%.

The second article details the rebound in Las Vegas housing prices, which is a positive sign.

The third article is actually commentary from The Economist's Free Exchange blog.  The following paragraph summarizes much of what I've been reading lately:

Price rises have looked imminent for some time. Sales figures have been trending upward and inventory numbers are at remarkably low levels. Rents have also been increasing, making home purchases look ever more attractive. There is still an ample stock of distressed and bank-owned homes to work off, but America seems to have achieved bottoms for both sales and prices. Housing markets have adjusted.