Monday, July 02, 2012

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.


Anonymous said...

You may find this interesting...I was told a couple of weeks ago that Cole is now looking at the 3rd or 4th quarter of this year to implement the exit strategy. I was also told that it is more than likely going to be a private sale (whatever that means) because of the size of the portfolio. There isn't much information being release by Cole, but this is what I was told a couple of weeks ago by my advisor who called Cole to find out.

Also, it is interesting to note that he said Christopher Cole was personally calling select advisors (those who have placed the most business with Cole) to give them an update. I would love to know what he is saying!

Rational Realist said...

Thanks, and hey, we are in the third quarter! To me, private sale means that the REIT will be sold. This usually means investors will receive cash. If this is the case, I suspect Cole will try and direct as much money as it can back into Cole's three current offerings.

As a public company, CCPT II can't selectively release material information.