I try to stay away from politics on this blog, but one thing I noticed after Tuesday's election was how wrong some of the professional pundits were in their pre-election predictions. If so many pundits can make shot-in-the-dark guesses why can't I? I can't help but wonder whether Cole Credit Property Trust III's successful sale of the Microsoft Property is good news before some unpleasant news on Cole Credit Property Trust II's (CCPT II) pending liquidation. CCPT II announced in the summer of 2011 that it would seek a liquidity event within twelve months. This date came and went with no announcement.
In late August 2012, CCPT II filed an 8-K announcing that it had hired two investment bankers. This was good news, and a step forward towards liquidation, but there is still no news on an exit strategy nearly three months later. I won't believe Cole is serious about liquidity until it waives any internalization fees. Wells REIT II waived internalization fees earlier this year, and KBS REIT II waived internalization fees this fall. These were significant developments for the non-traded REIT industry, and a continued referendum on the stigma of internalization fees. The longer Cole is quiet on this huge potential payday, the less convinced I am that Cole is serious about CCPT II liquidity or foregoing an egregious internalization fee.
There is another factor that I'm sure plays against the liquidity and internalization fee waiver: the increasing deficit between CCPT II's 8.0% preferred return and its 6.25% current distribution. This figure grows daily, diminishing Cole's chances of sharing in liquidation profits. I am going to get wonky, but follow the premise. CCPT II is paying a 6.25% distribution, and its annual preferred return, or hurdle rate, is 8.0% per year. When the REIT provides investors a return of capital and an 8.0% per year return, its advisor shares in 10% of all additional proceeds. (The 10.0% incentive amount is less than many other non-traded REITs.) Any annual shortfall essentially gets added to the initial share price, increasing the price needed before Cole is paid its incentive fee. The current annual difference for CCPT II is $.175 per share per year ($.80 perferred return, less $.625 current distribution). CCPT II has never paid a distribution equal to its preferred return, so the annual deficit has been added to the initial share price since the initial distribution in late 2005.
The longer Cole waits the bigger the hurdle becomes. I figure the approximate accumulated difference at $1.0625 per share, through September 2012. This requires any liquidation event price to exceed $11.0625 before Cole begins to share in its 10% incentive fee. (I'm sure CCPT II's investment bankers have spent considerable time figuring the exact share price where CCPT II's advisor starts to receive its incentive.) I am not going to predict a liquidation value for CCPT II, I'll let the market determine that, but I will state that the longer CCPT II waits to liquidate the more the deficit grows. Time is not Cole's friend.
(CCPT II pays its advisor an asset management fee of .25% of its aggregate asset value, which is low compared to many other REITs, and not in my opinion, a strong financial incentive to delay a liquidation.)
This brings us back to the internalization fee. This is a big potential payday, which can run into the tens to hundreds of millions of dollars, especially for a REIT the size of CCPT II. If Cole thinks an incentive fee is out of reach, an internalization fee looks all the more enticing. Wells REIT II has a similar dynamic, maybe more so than CCPT II - a long-term deficit between its distribution and its preferred return - and it waived its internalization fee. It was the right decision, and it met industry expectations.
Political pundits are in a safe bubble and none have any repercussions - the networks will keep calling no matter how wrong their predictions. I hope Cole isn't in a delusional bubble where it believes it can slip a large internalization fee past investors. That would be bad for Cole and bad for the industry. Cole needs to build on the success of its Microsoft Property transaction, not ruin it with bad news on CCPT II's liquidation. Unlike the political pundits, I hope I'm wrong.