CCPT II - Exit Inches Forward

Cole Credit Property Trust II (CCPT II) just filed a letter it is sending to financial advisors.  The bulk the body of the letter is below:

Last summer, we communicated to you that we believed we may be moving into a healthy market environment for a liquidity event for Cole Credit Property Trust II, Inc. (CCPT II), and would be evaluating options to take this investment program full cycle. We want to provide you with an update on this important initiative.

Maximizing shareholder value is our highest priority, and the timing of any exit strategy is crucial. High-quality, income-oriented real estate portfolios like CCPT II are an attractive asset class in the present market environment. As you can imagine, maximizing value in an exit event is a long and complicated process, and the CCPT II Board of Directors and its advisors have been working hard to select the option that is best calculated to produce optimal results for our shareholders. Premature disclosure about the types of transactions under consideration can be problematic for both legal and business reasons.

While we are limited regarding our discussion of specifics at this time, we can report that the CCPT II Board engaged Morgan Stanley and UBS Investment Bank in March 2012, after an extensive investment banking interview process, to move as expeditiously as possible toward a successful exit event for CCPT II. The CCPT II Board is currently working extensively with Morgan Stanley and UBS Investment Bank on a few concrete options to create a successful exit transaction, and we hope to be in a position to share details with you soon.

CCPT II announced in June of 2011 that it would have an exit strategy within the next twelve months. That date passed quietly.  CCPT II, according to the letter, is working on liquidity options, and has engaged two investment banking firms to move the process forward.  It sounds like some form of announcement on exit strategies will be made "soon."  While the letter does not provide any new, concrete exit news, CCPT II working with two investment bankers is a positive step for those wanting a liquidity event. 

Trying To Find The Outrage

I have had several people send me this InvestmentNews article on a Behringer Harvard fund, Strategic Opportunity Fund I, which is to disclose to investors today that it has no remaining equity, as the fund's debt exceeds the value of its properties.   I don't know much about the fund other than what I read in the article.  The situation is unfortunate, but I am not surprised or outraged.  The fund made leverages investments in value opportunity real estate at the top the market.

This paragraph, which is a paraphrased quote from a respected independent analyst, is unclear to me:

First, while many real estate deals known as TICs – or tenant in common exchanges – have gone under since the collapse in real estate, only one commercial property is contained in a TIC offering, he noted. The Behringer Harvard fund had six properties.  

The paragraph reads to me that Strategic Opportunity Fund I invested in properties along side Behringer Harvard's tenant in common investors.   So, the fund partially owns its six properties with various individual investors owning the rest of the properties.  If I am correct, the future looks messy.  Multiple owners through the fund and various TIC offerings complicates matters, as differing personalities and investments objectives are going to clash trying to resolve the issues facing the properties.

Housing Continues to Improve

The housing data I have been reading continues to show an improving housing market.  I have not linked to all the articles I have been reading, but there were a few points this morning worth noting.  First is an article from Calculated Risk on new home sales.  New home sales were at an adjusted annual rate of 372,000, a nearly 25.3% increase from July 2011.   Released with new home sale data was the July monthly supply of new homes, which dropped to 4.6 months, a decrease from June's 4.8 months, and well below the average of 6 months. 

This Bloomberg article reports on a Federal Housing Finance Agency report that states that US housing prices increased 1.8% in the second quarter from the previous quarter, and 3% over the past year.  The second quarter saw the biggest price increase since the fourth quarter of 2005.  The report also noted that the number of homeowners with homes worth less than the value of their mortgages fell by 400,000 over the same second quarter.

Finally, from last weekend, here is an article from the North County Times (via Calculated Risk), which covers northern San Diego County.  The article dissects the myth that a wave of new foreclosures is going to flood the market and drive down home prices.  Fewer new foreclosures, more short sales, declining bank-owned inventory, and rising home prices are preventing widespread distressed sales.  While the article is San Diego County specific, I would imagine the same dynamics are playing out in Phoenix, Las Vegas, California's Inland Empire and other markets hit hard by the housing crisis.

Ping Pong Ball Properties

KBS REIT I sold a portfolio of properties it foreclosed upon back to the company that originally owned the portfolio, according to the linked Bloomberg article.  I have not seen a filing from KBS REIT I on the transaction.  The 115-property transaction is for $470 million in cash: 

Gramercy, in a joint venture with Garrison Investment Group, will acquire the properties for $470 million in cash and 6 million of its shares, valued at $15 million, the New York- based REIT said today in a statement. Gramercy and Garrison each hold a 50 percent interest in the venture.

The portfolio comprises 5.6 million square feet (520,000 square meters) of office space, 81 percent of which is leased to to Bank of America Corp. through June 2023. The buildings were previously part of Gramercy’s realty division and were transferred to KBS in September as part of a deal to settle $549.7 million in mortgage debt.

The 115-property portfolio represents only a portion of the properties that were acquired through the settlement of KBS REIT I's mezzanine loan investment.  The following is language from KBS REIT I's 10-Q, which was released last week, describing the entire Gramercy portfolio and settlement:

On September 1, 2011, the Company, through indirect wholly owned subsidiaries (collectively, “KBS”), entered into a Collateral Transfer and Settlement Agreement (the “Settlement Agreement”) with, among other parties, GKK Stars Acquisition LLC (“GKK Stars”), the wholly owned subsidiary of Gramercy Capital Corp. (“Gramercy”) that indirectly owned the Gramercy real estate portfolio, to effect the orderly transfer of certain assets and liabilities of the Gramercy real estate portfolio to KBS in satisfaction of certain debt obligations under a mezzanine loan owed by wholly owned subsidiaries of Gramercy to KBS (the “GKK Mezzanine Loan”) . The Settlement Agreement resulted in the transfer of the equity interests in certain subsidiaries of Gramercy (the “Equity Interests”) that indirectly owned or, with respect to a limited number of properties, held a leasehold interest in, 867 properties (the “GKK Properties”), including 576 bank branch properties and 291 office buildings, operations centers and other properties. As of December 15, 2011, GKK Stars had transferred all of the Equity Interests to the Company, giving the Company title to or, with respect to a limited number of GKK Properties, a leasehold interest in, 867 GKK Properties as of that date.

A Disturbing Situation

Here is a Bloomberg article on banks that are buying Treasuries rather than making loans.  The article's first few paragraphs offer one reason why the economy is growing slowly:

As deposits increased 3.3 percent to $8.88 trillion in the two months ended July 31, business lending rose 0.7 percent to $7.11 trillion, Federal Reserve data show. The record gap of $1.77 trillion has expanded 15 percent since May, the biggest similar-period gain since July, 2010. Banks have already bought $136.4 billion in Treasury and government agency debt this year, more than double the $62.6 billion in all of 2011, pushing their holdings to an all-time high of $1.84 trillion.

Faced with a slowing U.S. economy, unemployment above 8 percent for more than three years and regulations forcing them to hold more and higher-quality assets, banks are lending at below pre-recession levels. The bond purchases help explain why even after rising this month, Treasury 10-year note rates are about half the 3.5 percent median forecast of 43 economists in a Bloomberg survey a year ago. 

The banks should make loans, not invest in Treasuries.  These banks better be good bond traders.  When interest rates move up the crush of banks selling Treasuries is going to make the bankers wish they had made loans.

A Valuation Too, Too Far

I was wrong.  I wrote yesterday that the scant disclosure surrounding CNL Lifestyle's share valuation was too much for me.  Lifestyle has now been surpassed by the valuation released today by TNP Strategic Retail.  Strategic Retail is in the midst of its equity offering period and has determined an net asset value of $10.40 per share.  I'll let you read today's 8-K filing yourself.  The disclosure is better than CNL Lifestyle's, and yesterday's anonymous, Discounted Cash Flow-loving commenter should be ecstatic with the Strategic Retail's valuation methodology.

The REIT was valued by its advisor, but it obtained a Good Housekeeping Seal of Approval by seeking the valuation consulting services of Duff & Phelps.    I don't read that Duff & Phelps valued Strategic Retail's assets, but I'll let you decide:

Our board of directors determined the estimated per share value in its sole discretion and is ultimately and solely responsible for establishing the estimated value of a share of our common stock. Our board of directors did, however, engage the services of Duff & Phelps LLC, or Duff & Phelps, an independent valuation firm, to conduct valuation consulting services regarding all of our real estate assets. We believe there are no material conflicts of interest between Duff & Phelps, on the one hand, and us, our advisor and our directors or officers, on the other hand. 

Fees matter.  Strategic Retail offers its shares at $10.00 per share.  From this is deducted 10% in commissions and selling costs, and up to another 3% in organization fees, which the REIT estimates will be 1.75%.  This amount of front-end costs is typical for non-traded REITs.   The $10.00 per share purchase price becomes a net $8.83 (using 1.75% in organization fees) that is being invested in properties.  I did not include the 2.50% acquisition fee paid on the price of each acquisition, which includes debt, and the 1.0% finance fee on the amount of any outstanding debt, which the REIT instituted earlier this year.  So, by reading today's valuation we're to believe that a net investment of $8.83 today is worth $10.40.  Fees matter.

Spanish and Italian Freeze

Here is another article from last weekend, this one from the Financial Times. The article details how Spanish and Italian commercial real estate transactions nearly stopped in the second quarter:

Only three property transactions were registered in Spain during the second quarter, down from 58 deals in the previous quarter. In Italy the slide was even more pronounced, with just two buildings being traded during the period, down from 56, according to data from Real Capital Analytics.

The article is a short, sobering read. 

The Economic Impact of Energy

Here is an article from Bloomberg on the economic impact of oil and gas development.  The article was published last weekend.  This paragraph below presents some encouraging stats and projections:

U.S. energy supplies have been transformed in less than a decade, driven by advances in technology, and the economic implications are only beginning to be understood. U.S. natural gas production will expand to a record this year and oil output swelled in July to its highest point since 1999. Citigroup Inc. (C) estimated in a March report that a “reindustrialization” of America could add as many as 3.6 million jobs by 2020 and increase the gross domestic product by as much as 3 percent.

The article states that US oil imports have dropped 17% sine 2005.  That is good news. The entire article is worth reading.

A Valuation Too Far

CNL Lifestyle Properties released its second quarter 10-Q yesterday.  Lifestyle disclosed deep in the 10-Q a new share valuation of $7.31 per share and a distribution reduction.  A drop in the distribution (from 6.25% to 4.25%) was not unexpected based on previous disclosures from Lifestyle.  The 27% drop in value was not unexpected either, despite the proclamation in June by the REIT's CEO that Lifestyle would steer clear of a sharp drop in valuation (I'll let you decide whether 27% is "sharp").   More disturbing than the distribution cut or value loss was Lifestyle's weak valuation methodology.  It mocks investors and broker / dealers*.

Lifestyle describes its methodology below:

In determining an estimated fair value of the Company’s shares, the Board of Directors considered various analyses and information, a portion of which was provided by the Company’s advisor. In preparing its value estimate, the Company also consulted an independent valuation advisor.

The independent valuation advisor was not disclosed, nor was the scope of its work.  "Consult" can mean many things, but it doesn't mean that the third party firm valued the REIT's assets.  The value was determined by REIT's advisor, and it used a 10-year discounted cash flow analysis.  This a discounted cash flow methodology that involves significant assumptions about future revenues and expenses.  The REIT gives its weighted average growth rate but no information on its expense growth.   A large portion of Lifestyle's debt matures over the next five years, and the assumptions  made for repaying or refinancing this debt would play into the valuation  Lifestyle has had issues with a number of its properites since its inception, so I'd question whether a linear, assumption-based cash flow analysis is the most appropriate methodology.  (Lifestyle did not assign a premium for enterprise value or portfolio aggregation.) 

The valuations for non-traded REITs are getting more and more unbelievable, and Lifestyle's internal valuation, to me, is one valuation too far.  Broker / dealers need to call foul and demand independent valuations**.  Non-traded REIT sponsors are not going to stop these self-serving internal valuations until forced.  The non-traded REIT's use of an independent consultant or advisor is not good enough.  Dropping the name of a third party firm when the actual valuation is done by the REIT's advisor is a joke.   As I have noted before, there are only a few valuation methodologies, so having a third party valuation firm affirm a methodology is not the same as having a third party firm calculate the valuation.  Investors and broker / dealers are the ones harmed by nonsense valuations.  Non-traded REIT sponsors, whether too desperate or thick to realize it, will ultimately be hurt, too.

*  Lifestyle is externally advised by an affiliate.  It does not appear that the advisor will be impacted by the new, lower valuation.  The advisor receives an asset management fee of 1% of the purchase price of the REIT's real estate and principal amount of any mortgage assets.  This fee is not impacted by the new valuation because its based on the purchase price of the assets not Lifestyle's new asset value.  Investors just received a 27% reduction in their investment value, and had 32% chopped from their distribution, but Lifestyle's advisor's income stays steady.   

** For an independent valuation done right, look at last fall's valuation by Wells REIT II, which was completely done by a third party valuation firm.

The View Through A Distorted Prism

Here is a must-read InvestmentNews article from last Friday, where Inland Group of Companies CEO Daniel Goodwin discussed Retail Properties of America's (RPAI) investor lawsuit, and its $254.4 million stock offering and listing from earlier this year.  Goodwin's audacity is hard to believe.  I've had to read this article several times, even cross-referencing it to RPAI's filings, to confirm just how obtuse he is.  The point I took from the article is that Inland is upset with RPAI for its low stock price and has not ruled out joining an investor lawsuit against RPAI. Here are a few paragraphs from the article, which I will address below:

In an interview Thursday, Mr. Goodwin was quick to note that Inland has no control over Retail Properties of America.

“Although we are shareholders, we have not managed the REIT for the past four-and-a-half years,” he said.

Inland owns about 2 million shares of the REIT through various businesses, Mr. Goodwin said.

Some members of Inland's board “disagreed with the timing and execution” of the initial public offering, he said.

“Those opinions were largely ignored,” Mr. Goodwin said.

When asked whether Inland would join the class action against Retail Properties of America, Mr. Goodwin said: “We have discussed various potential actions but haven't reached a conclusion. Our interests are clearly aligned with the shareholders.”

RPAI and Inland do have separate management.  In terms of control, Inland had a representative, Brenda G. Gujral, on RPAI's board until mid-May, so Goodwin's control comment only spans a couple of months.  Ms. Gujral is an executive officer of various Inland entities, and I have listed  below an excerpt from RPAI's 8-K disclosing Ms. Gujral's resignation from RPAI, which was after RPAI's listing (my emphasis added):

On May 14, 2012, Brenda G. Gujral resigned as a Director of Retail Properties of America, Inc. (the “Company”) effective on May 31, 2012. Ms. Gujral has confirmed to the Company’s Board of Directors that her resignation was not due to a disagreement with the Company on any matter relating to the Company’s operations, policies or practices. 

If you can believe the filing, it doesn't sound as though Ms. Gujral, and presumably Inland, had any issues with RPAI's listing back in May.   RPAI and Inland operate out of the same building.  It reminds me of a situation where an adult still lives at home with his or her parents.  (Inland Realty Corp (IRC), another Inland REIT that is listed on the NYSE, still offices at Inland's headquarter building, too.)  With RPAI's focus on retail properties and Inland's focus on retail properties, among other property types, it's disingenuous to think that in four years, two teams of executives acquiring, managing, leasing and financing similar properties and working in the same building operated in isolation, especially when one of the teams is due a big payday based on the other's performance.  If Inland joins the investor lawsuit, it should make for some tense trips in the elevator or maybe some road rage in the parking lot.

RPAI used $55 million of its $237 million net IPO proceeds to repay an affiliate of Inland Group.  In 2009 the affiliate made a $50 million investment into a joint venture between it and RPAI.  It's hard to imagine Inland whining about a receiving $55 million for its $50 million investment.  RPAI's IPO proceeds were smaller than anticipated ($254 million compared to an estimated of $350 million), and the amount of IPO proceeds that went to pay down its underwriters' affiliates' debt was less than originally anticipated.  Inland didn't take a discount and received a repayment of its 2009 joint venture investment in full, plus an extra $5 million.

Inland's $50 million joint venture investment in 2009 probably allowed RPAI to refinance $625 million of debt.*  You can't be revisionist in 2012 and question this deal because the credit markets were non-existent in 2009, and it's to Inland's and RPAI's credit that they were able to complete the refinance in the middle of the credit crisis.  I find it incredulous that Goodwin is complaining about an IPO after proceeds from it repaid Inland its joint venture investment plus 10%.  I'm sure RPAI shareholders would jump at the chance for the same return on investment.

In the article Goodwin states that Inland only owns 2 million shares of RPAI stock.  In a blog post earlier this year, I noted that as part of its 2007 internalization, RPAI acquired its former advisor, an affiliate of Inland.  RPAI paid for its advisor with 11.4 million in split-adjusted shares.  I'm not sure what to make of Goodwin's comment that Inland only owns 2 million shares.  If Inland really only owns 2 million shares, I'd like to know what happened to the other 9.4 million shares.

Inland's internalization fee is now worth $114 million, based on the 11.4 million shares and yesterday's closing price of $10.00 per share.  Is Goodwin's complaint about the listing really a complaint about the low list price, which resulted in Inland's internalization fee not being large enough?  (Originally, the internalization fee, based on RPAI's $10.00 offer price, was $375 million.  This was later reduced to $285 million after a lawsuit.)

I fail to see how Inland's interest is aligned with investors.  RPAI gave paid Inland its internationalization fee in stock at a price determined by Inland.  Investors had to pay cash for their shares.   Inland was well-paid throughout the time it managed RPAI.  The internalization fee was a gift, not a performance fee earned for providing a specified return to investors.   I don't feel any sympathy for a gripe about shares not paid for that have dropped in value from $285 million to $114 million.

RPAI's initial public offering was at $8.00 per share, which was well below estimates of $10 to $12 per share.   It's stock closed yesterday at $10.00, up nearly 20% since its listing (while the IPO was at $8.00, RPAI began trading around $8.50 per share).  As far as I know, Inland's shares are subject to the same multi-staged listing as other RPAI shareholders.  Investors in RPAI's original offering have still lost nearly 60% in share price value, but Inland is still $114 million ahead.

* From RPAI's March 12, 2012's S-11:  "In addition, in 2009, in connection with a $625 million debt refinancing transaction, we raised additional capital of $50 million from an affiliate of the Inland Group in exchange for a 23% noncontrolling interest in a newly formed joint venture to which we contributed 55 of our properties."

A Statistic To Watch

Several non-traded business development corporations (BDCs) have raised and invested enough capital that they are reporting meaningful results, and key performance metrics can be analyzed.  One statistic I find important is the average price, as a percentage of par, at which BDCs are buying their investments.  Par for a loan investment, like a bond, is typically the face value of the loan.  For example, if a bank, or BDC, or other entity makes a loan for $100, par is $100, because that is the price the borrower will repay when the loan matures.

When you have a loaded investment, like a non-traded BDC, the ability to purchase investments below par should help to offset the BDC's initial load.  As a simple example, if a BDC purchases a loan for $95 that has a $100 par value, it's buying the loan at 95% of par and the $5 difference earned when the loan matures could help partially recoup the BDC's initial load.

CNL's KKR-sub-advised BDC, Corporate Capital Trust, disclosed in a recent Form 497 filing that it has acquired its $426 million portfolio of investments at an average price of 100.1% of par.  So, its loan portfolio will mature at the price the BDC paid for the loans, assuming the loans are held to maturity.  There are other factors that could help recover or offset the load in this BDC other than just the average price as a percentage of par - skillful use leverage, a change in interest rates, realization of equity participations, or reserving excess interest, to name just a few - but it's an interesting figure to watch over time. 

Just because Corporate Capital Trust paid 100% of par for its investments doesn't mean it can't sell the loans for a premium, or that there are not other ways for the BDC to recover its load.  I need to find the same price-to-par ratio for other non-traded BDCs to determine whether all the BDCs are buying their investments at 100% of par.  

Internalization Fee Rises Like A Phoenix

No sooner had I declared the internalization fee dead, than it appears that I proclaimed its death too soon.  TNP Strategic Retail Trust filed an 8-K today disclosing that it has amended its advisory agreement between the REIT and its external advisor.  According to the 8-K, the amended advisory agreement will:

Delete in its entirety Section 13 of the Advisory Agreement, which provided, among other things, that before the Company could complete a business combination with the Advisor to become self-administered, certain conditions would have to be satisfied, including (i) the formation of a special committee comprised entirely of the Company’s independent directors, (ii) the receipt of an opinion from a qualified investment banking firm concluding that consideration to be paid to acquire the Advisor was financially fair to the Company’s stockholders and (iii) the approval of the business combination by the Company’s stockholders entitled to vote thereon in accordance with the Company’s charter.

The way I read the above passage is that the REIT's safeguards related to the REIT acquiring its advisor are being removed, which would make charging an internalization fee much easier.  (It would also make the internalization process much faster as a committee, third party report and shareholder vote are being eliminated.)  Remember, an internalization fee is the price that a REIT pays to acquire its external advisor, and this price has historically been paid in REIT stock.  TNP Strategic Retail has not disclosed a management internalization or the cost of an internalization (internalization fee), and the deleted sections from the advisory agreement would not have prevented an internalization fee, but it's apparent to me that some of the REIT's investor protection provisions have been removed.  

The 8-K also disclosed that the REIT's Chief Financial Officer has resigned.  The entire 8-K is worth reading.