Thursday, March 14, 2013

The Double-Dip Express

Cole Credit Property Trust III's (CCPT III) letter to investors last Wednesday, and this Seeking Alpha article call CCPT III's acquisition of its sponsor "transformational."   A better word is "retro." The merger is resurrecting a dead fee.  CCPT III is reversing full speed to the early 2000s when non-traded REITs routinely paid big internalization fees to acquire their external advisors.  I thought those days were gone, and even proclaimed the final passing of internalization fees last summer when Wells REIT II announced it would not buy its external advisor.  Sponsor's don't forget big paydays, however, especially when they don't require shareholder vote as in the case of CCPT III buying its sponsor, Cole Holdings.   Cole's move shows the internalization fee is alive and flourishing; a Phoenix that just won't stay dead.

Buried deep in a filing CCPT III made last Friday, is the share price over which Cole starts to earn its subordinated incentive listing fee.   This share price is $10.45.   After 180 days, if the newly listed stock's average price for the subsequent thirty days exceeds $10.45 per share, Cole receives 15% of this profit in stock.  (Cole has agreed to reduce its subordinated incentive listing fee by 25% due to the internalization fee.)  Cole only receives this fee after investors have received a full return of their capital plus an 8% annual return.

I am not going to try and predict the future price of the CCPT III/Cole Holding stock when listed, but is $10.45 that far out of reach?  The market's reaction to the two recent American Realty Capital Trust transactions (three if you include Realty Income Corporation's purchase of ARC Trust), the WP Carey and CPA 15 transaction, and even the Cole Credit Property Trust II / Spirit Realty transaction, makes it apparent that the market likes the steady income of long-term net leased real estate.  If you include CCPT III's dividend increase and the expected accretive benefit of the transaction, $10.45 seems closer than ever.

Subordinated incentive listing fees - not internalization fees - were designed as a sponsor's big payday.  After a non-traded REIT returned investor capital plus a preferred return, a sponsor shared in profits.  Subordinated incentive listing fees are not assured, which, I am guessing, is why Cole is leaving nothing to chance and is taking a large internalization fee, which is nearly $150 million at a $10 per share stock price, and obviously more if the stock price exceeds $10.00 per share.

Based on in formation in last Friday's filing, I have created the following table showing the internalization fee, including the fee at a 25% discount, at various stock prices for the new Cole Real Estate Investment:

Cole Credit Property Trust III Potential Subordinated Incentive Listing Fee*

Shares Outstanding 481,367,453

Share Price  $10.00  $10.45  $10.75  $11.00  $11.50

Value  $4,813,674,530  $5,030,289,884  $5,174,700,120  $5,295,041,983  $5,535,725,710

Profit  $(216,615,354)  $-  $144,410,236  $264,752,099  $505,435,826

15%Profit Sharing  $-  $-  $21,661,535  $39,712,815  $75,815,374

25% Discount

 $16,246,152  $29,784,611  $56,861,530

I determined Cole's potential Profit at several share price levels.  I first determined several possible market capitalizations by multiplying the number of Shares Outstanding by potential stock prices.  To determine Profit, I then took the difference between the various market capitalizations and the market capitalization at $10.45 per share.   No Profit is earned until the share price exceeds $10.45 per share.  Above $10.45, Cole's subordinated incentive fee is 15% any Profit.  Before Cole receives this fee, investors will have received a full return of their original investment, plus an 8% annual return. 

The table also shows Profit Sharing less 25%, which is the amount that Cole is reducing any subordinated incentive listing fee due to it taking an internalization fee.  This is the amount added to Cole's internalization fee.

I am not aware of another instance where a sponsor received both an internalization fee and a subordinated incentive listing fee.  I am sure that it's partly the case that prior non-traded REIT listings or liquidity events where the sponsor received an internalization fee never had subsequent share prices high enough to pay the subordinated listing fee.  The inability to earn a subordinated listing fee is one, if not the main reason why non-traded REIT sponsors began taking the internalization fee in the first place.

If the CCPT III's purchase of Cole Holdings is accretive - and I am all for accretive deals that add full liquidity - why doesn't Cole just take its compensation in the form of the full 15% subordinated incentive listing fee.  The more money investors make, the more money Cole makes.  If investors receive a big payday, no one would care, and no one would complain if Cole takes home $75 million ($11.49 per share), or $150 million ($12.53 per share), or $300 million ($14.60), or more.  It's the dang internalization fee that is so troubling. 

I am sure other non-traded REIT sponsors are watching this transaction closely.  If Cole can pull off the duel fees - internalization and subordinated incentive listing fee - and not damage its brand (ability to raise equity through broker / dealers) going forward, I suspect other sponsors will leap back on the internalization train.  Investors better put on a seat belt and grip their wallet tight because its "All Aboard the Double-Dip Express!"

* I determined the figures in the table above based solely on my reading of CCPT III's filed documents, without any verification of any share adjustments or valuation formulas and are for illustrative purposes only.


Anonymous said...

Nice post, bro. Unfortunately, nobody cares. Advisors still get paid. BD's still get paid (a TON). Clients still make out pretty well.

Rational Realist said...

Thanks. I am getting the sense you may be right. But this is true only if the stock trades high enough for investors to sell at a price high enough to get their principal back. If the listed stock trades below $10, everyone will care.

Anonymous said...

BD's get paid? The 1% doesn't quite cut it when you think about the risk involved allowing alternative investments on their platform.

Anonymous said...

1% to BD's is just the taste they get from the sponsor. Think of all the REIT dollars invested (approx $10 billion annually). The advisor makes 7% on those dollars ($700 million). The BD typically takes 10%-15% of those commissions. Don't kid yourself, BD's love 'em some REITs.

Anonymous said...

Of course BDs get paid. They make a ton more than MF and ETF providers pay out. All BDs take an override on the advisor's business as well as the haircut they take from the rep payout. Thats why reps and BDs love, love, love American Realty going to liquidation so quickly with their own funds. Everyone makes a ton of money upfront except the shareholder who shoulders the load each time the money goes into the REIT.

With Cole, I'm actually not too upset about the payout to Chris Cole and management. Its not a true internalization like the NT REIT space has seen in the past (i.e. Wells REIT 1 and Inland) where these sponsors paid themselves to separate the sponsor from the actual listed REIT. Cole Holdings will be wrapped up into their Trust 3 (think Franklin Templeton and BlackRock as examples in the MF and ETF space) and have to report their financials going forward, including fees made from the distribution of future REITs. That adds a degree of transparency the NT REIT space has rarely seen.

Anonymous said...

So if a firm raises $10M for a REIT, the BD keeps $100k and then another 70-100k of the rep's commission. They have to have a dept to oversee alternatives if they are doing it right. There are expenses associated with that. If any product blows up they are on the hook in settlements for way more than they made on the commissions.

Anonymous said...

You do understand that this is the internalization of the entire business? I'm not necessarily defending the dollar amounts, but it's definitely not apples-to-apples, when other REITs have internalized 'some' staff and $7mm worth of furniture, while the sponsor still existed in it's full form to continue operations. In any case, what's the profit on selling $7mm worth of furniture and buying it back for $1.00? Not a bad deal for not having to lift your cheeks off the chair...

Anonymous said...

If this was such a good deal, why doesn't Cole go out and get shareholder approval?

It was the shareholders who raised the money for Chris Cole - not the board of directors.

Anytime the investor opinion are left out, something is wrong with the transaction!

I'm an advisor who sold CCPT3 and will NEVER sell this firms products again and I will voice this to my BDs. Cole has put me in a bad position with my client.

Anonymous said...

My advisor colleague above seems woefully misinformed and must not have read the initial offering prospectus. Board of directors are voted on each year and their purpose is to be make decisions on behalf of the shareholders. Based upon the information available, they feel that this merger/listing is in the best interest of the shareholders of the fund. My clients are very pleased with the news considering the distribution will be going up, Cole will still manage the fund with more transparency, and they will soon have liquidity with an expected gain on the share price. If clients are upset, there will be a proxy in which shareholders can elect to allow the company to list or not.

The author of this blog is normally a very well informed poster when it comes to these types of investments. He misses the mark here when he calls this an internalization of the past. Previous internalizations in the industry didnt include the sponsoring company being listed in those deals as well. From what I can gather, the revenue the Cole brings in will help to enhance the cashflow of Trust 3 and make the deal very accretive. I will continue to work with Cole considering the way they've handled themselves in Trust 2 and Trust 3. I've had plenty of bad experiences with other REITs, but Cole (along with very few others) seem to do things the right way.