No Shock

The Wall Street Journal reported last week that opportunity zone funds are falling short of capital raise expectations.  The article notes that opportunity zone funds, on average, have raised less than 15% of their goals, which I am taking to mean their offering size.  This shortfall comes as no shock, and it's not because of the neighborhoods where properties are located.

An investment in opportunity zone separates when capital gains taxes are due from from when capital can be removed from the opportunity zone to maximize the benefit.  Capital gains taxes must be paid in 2027, and this is a hard date no matter when the opportunity zone investment is made, but an investor must hold the investment for ten years to have all profits from the opportunity zone exempt from taxes.  Investors, therefore, must have other means to pay their capital gains taxes in 2027 than from funds they invested in the opportunity zone.

An opportunity zone fund investment triggers the capital gains tax event, where other investments can continue the capital gains deferral.  An investor in an opportunity zone fund must pay capital gains taxes in 2027, but an real estate investment in a 1031 exchange, for example, can continue to defer taxes.

As time goes by, I don't expect opportunity zone fund sales to increase because the time value of the deferral continues to decline.  By the end of 2020, all step-ups (added incentives) for investing in opportunity zones end, which reduces the incentive to invest in opportunity zone funds, but capital gains taxes are still due in 2027.

It seems to me that the opportunity zone provision was structured to benefit specific properties or one-time events, not as a sustained program to provide long-term benefits through continued opportunity zone investments.  Since I began to write and edit this post last week, I have read two news articles that confirm my opinion that opportunity zones were designed for specific, already in progress projects.   This story from ProPublica talks about Dan Gilbert in Cleveland, and the New York Times details Michael Milken's influence to qualify for tax breaks for his properties, including this passage:

The former “junk bond king” has investments in at least two major real estate projects inside federally designated opportunity zones in Nevada, near Mr. Milken’s Lake Tahoe vacation home, according to public records reviewed by The New York Times.

One of those developments, inside an industrial park, is a nearly 700-acre site in which Mr. Milken is a major investor. Last year, after pressure from Mr. Milken’s business partner and other landowners, the Treasury Department ignored its own guidelines on how to select opportunity zones and made the area eligible for the tax break, according to people involved in the discussions and records reviewed by The Times.

The unusual decision was made at the personal instruction of Mr. Mnuchin, according to internal Treasury Department emails. It came shortly after he had spent time with Mr. Milken at an event his institute hosted.

To make opportunity zone properties sustainable, the timing of capital gains payments needs to be adjusted to match the timing of investment.  The period when capital gains are due needs to be tied to when the investment is made, such as a fixed seven-year time frame, not just a random hard date (2027), which erodes the value of the deferral as the date approaches.  A 10% or 15% step-up should be a permanent incentive.  These changes would help encourage ongoing investment in opportunity zones by providing continued investment and incentive.

Even with political influence and map making that would make a partisan gerrymanderer blush, without a change to make opportunity zone investments attractive over time, I suspect higher values of many properties ascribed by the tax law will languish due to lack of long-term demand inside the opportunity zones.  Future opportunity zone articles are going to focus on the people who had projects in the works before the tax law changed, used their influence to get their properties included in an opportunity zone, then sold the projects a profit because of value of the tax benefit, and how future buyers experienced lost value due to lack of development tax incentives for surrounding properties.

Falling Up

The WeWork story opened a new chapter with SoftBank, WeWork's largest investor, agreeing to take it over.  The deal values WeWork at $8 billion, much lower than the $47 billion value SoftBank figured WeWork was worth in January.  WeWork's founder Adam Neumann will come out of this deal in fine fashion.  According to the New York Times' DealBook:

Yet Mr. Neumann will receive roughly $1.7 billion in consideration as part of the SoftBank deal, according to the people with knowledge of the offer. The Tokyo-based technology giant will buy roughly $1 billion worth of WeWork shares from him, and give him about $500 million worth of financing to repay a credit line from JPMorgan. Mr. Neumann also will receive a $185 million consulting fee.

I want to go on record to state that I am open to this type of deal.  I am willing to ruin a company and walk away with $1.7 billion in cash.  Heck, I will settle for the $185 million consulting fee, and I will even promise to do some consulting work.

Justice

Wow!  InvestmentNews (via Bloomberg) reports that Woodbridge Group of Companies' former CEO Robert Shapiro received the maximum sentence of 25 years for "running a $1.3 billion fraud." 

Can't Look Away

I am reading in the Financial Times this morning that WeWork is working on a $5 billion finance package that includes $2 billion of payment-in-kind debt.  The PIK portion is expected to have a yield of 15%.  (The PIK feature means that interest is paid in more bonds, not cash.)  The FT further reports that WeWork's bonds that mature in 2025 are trading at $.79 on the dollar, down from over $.90 on the dollar late last week.  Yikes. 

via GIPHY

Scary

The Financial Times keeps good tabs on the leveraged loan market.  Last summer the FT had an article (the article was published July 4) that stated that 80% of US loans are structured as "covenant-lite," compared to 20% in 2008 and 2009, which was during the Credit Crisis.  Covenant-lite means loans have been stripped of features to protect lenders, like coverage requirements, reporting requirements, and restricted payment clauses.  Restricted payment clauses prevent firms from borrowing money and then taking the money out of the business to pay big dividends.   Private equity firms, which are big leveraged loan borrowers, have been behind the push for weaker covenants. 

The Washington Post had an article last week about Fannie Mae, Freddie Mac, and FHA's exposure to risky loans.  The three government firms now guarantee $7 trillion of mortgages, 33% more than before the Credit Crisis.  Many of these mortgages are to borrowers that have high income to mortgage payment ratios, which are deemed risky as a large portion of borrowers' income is going to mortgage payments. 

The stock markets always get the headlines but I am watching the loan market, and some of the articles I am reading scare me.

WeWorked Over

I am late to the WeWork story, but in my speed education I find it fascinating.  The non-traded alt space is not the only place were reality can get suspended.  In August, WeWork was looking to go public at a $47 billion valuation, and some investment banks had its valuation close to $100 billion, and today, IPO shelved, WeWork is laying off employees and may have to face bankruptcy.  WeWork will inspire a book similiar to Bad Blood's telling of Theranos' rise and fall. 

WeWork's tale to me is simple, and does not involve Theranos' scientific shroud.  WeWork took venture money along with heavy debt and entered into long-term leases with expensive improvements, then leased the office space on a short-term basis.  The timing mismatch between WeWork's lease obligations and its revenue from short-term releases is enough to make me question the viability and sustainability of its business model.  Like Theranos, WeWork had a charismatic founder/CEO who was as able to get continued financing and continued increased valuations for up-round financing. 

The real-world reality of the WeWork story is that it is the largest tenant in New York City and one of the largest in London.  I bet there are some nervous major market landlords.

NorthStar Healthcare (No)Income

NorthStar Healthcare Income needs to remove Income from its name.  The REIT filed an 8-K late on Thursday (February 7th) announcing that it is suspending its distribution effective immediately.  It's a move that can't be a shock to anyone who has looked at the REIT's financial statements.  Here is the entirety of the statement:

On February 1, 2019, the board of directors (the “Board”) of NorthStar Healthcare Income, Inc. (“NorthStar Healthcare”) determined to suspend the monthly distribution payments to stockholders, effective immediately.

 

In determining to suspend monthly distribution payments to stockholders, the Board performed a thorough analysis of NorthStar Healthcare’s business, financial condition, liquidity sources and capital needs. The Board believes it is prudent to preserve capital and protect NorthStar Healthcare’s financial position by suspending distributions at this time. NorthStar Healthcare expects that cash retained by the suspension of cash distributions will allow NorthStar Healthcare to reinvest in its assets through maintenance and strategic capital expenditures and reduce leverage in order to drive long-term value for stockholders.

The Board will continue to assess NorthStar Healthcare’s distribution policy in light of its operating performance and capital needs. However, there can be no assurance that distributions will be declared again in any future periods or at any particular rate.

When the post-Crash history of non-traded alternative investments is written, NorthStar Healthcare Income's saga will span chapters and include the arrival of deal-happy James Flaherty, the subsequent participation (helping to finance) in joint ventures with parent NorthStar Realty Finance, including NorthStar's highly leveraged acquisition Griffin American Healthcare REIT II, and the irresistible lure of operating skilled nursing facilities.  The original NorthStar executives and Flaherty are long gone but investors in NorthStar Healthcare are stuck with the detritus of their investment hubris.

Need A Google Finance Translator

I think I am pretty good at reading and understanding financial filings, it's what I do.  N-1 Liquidating Trust, the entity that holds the assets of the former NorthStar Real Estate Income Trust that were not part of the Colony Credit Real Estate merger and listing, made a filing today that shouts, "Ha! You want complicated, hold my beer!"  Bifurcation, junior participation, modification, multi-year extension... I read it all as obfuscation to cover capital elimination. 

Eyebrows Raised

I wrote about the merger of three Medley/Sierra entities last summer, but it was one of several posts Blogger pulled citing a complaint.  A sponsor (I suspect) complained about certain posts and included posts involving several sponsors in its complaint, and Blogger, per its policy, removed all the mentioned posts.  Anyway, that was then and this is now.  I read on the DI Wire this morning that NextPoint has submitted an alternative proposal to the Medley/Sierra proposal.  I have not read the proposal in full, but NextPoint's plan to scrap a $125 million internalization fee to Medley caught my attention.  I am curious as to how this drama plays out.  I do encourage you to take a look at Medley Capital Corp's (MCC) five-year stock chart.

New Non-Traded REIT Performance Indexes

Robert A Stanger and the Institute for Portfolio Alternatives (IPA) just released a comprehensive report tracking the performance of many non-traded REITs.  The two indexes are a Life Style REIT index that includes all the multi-share class non-traded REITs, and a NAV Index for REITs that publish NAVs on a daily or frequent basis.  The returns for both indexes were determined without sales loads and with distributions reinvested, with a start date of January 1, 2015.

Shock upon astonished shock, the two firms - one that consults (Stanger) to the non-traded REIT industry and one that is the trade and lobbying group (IPA) for the non-traded REIT industry - have developed two indexes that show non-traded REITs outperforming the big four publicly traded REIT indexes.  Ten percent offering costs be damned!

Snark aside, Stanger's methodology appears sound, but the data should be used as a guide not as gospel.  Stanger uses the REITs' published NAVs when available, or Net Investment per share, as described by NASD Rule 2340.  I am wary of sponsor approved NAVs, not that they are inherently inflated, but due to the gap between stated REIT NAVs and real market values when REITs list (which seems to show inherent inflated valuations).  For example, American Finance Trust (AFIN) and Colony Credit Real Estate ((CLNC) which along with certain Colony Capital assets is the two NorthStar Real Estate Income REITs) trade well far their last stated NAVs.  Guide not gospel.

The new indexes' total return figures also include REIT distributions.  I won't go into the impact of paying more in distributions than is generated from Funds from Operations, other than to say that REITs that over pay their distributions better have a corresponding offset that lowers NAV.   At some point, systemic distribution over payment will be corrected and reflected in a REIT's valuation.  Gospel not a guide.

This is good time to release an index of non-traded securities.  Public REITs had a bad year in 2018 due to a poor performing overall stock market and the impact of rising interest rates on REIT stock prices.  Non-traded REITs, while affected by rising rates, do not see an added market discount in their NAV calculations.  Markets are cyclical, so a rise in REIT stock prices can erase index under performance in a short period of time.  Guide not gospel. 

In the mean time, with the release of these new indexes, look out for the marketing blasts from Hartman, the sponsor of Hartman Short Term Properties XX, Inc., the top performing Lifestyle REIT over a three-year period.

That's A Lot Of X-Boxes

The Toys-R-Us bankruptcy cost $200 million in adviser fees, presumably paid to bankers and attorneys, according to the Financial Times.  The Financial Times does not like links to its articles, but you can and should Google-search for the FT's excellent series The Debt Machine. 

2019's First Turd

That did not take long.  After their big announcement in late 2018, EJF Capital and Skybridge Capital have parted ways on the private $3 billion Skybridge-EJF Opportunity Zone REIT.  EJF was to act as the sub-advisor to the REIT.  Skybridge gave distribution firms' concerns about EJF's lack of experience managing real estate funds as the excuse to dump EJF.  The DI Wire article does not mention a sub-advisor replacement.

Opportunity zone investing is going to attract capital, possibly big capital, and just because a firm is first to market is no reason to throw it money.  Private equity firms, or hedge fund investors like Skybridge Capital, are transactional investors.  They look for opportunities, invest, recapitalize (take out profits), stabilize (take management fees), and exit (take more profits and return investor capital).  Opportunity zone investing is a long-term process.  It will ten years to realize the full tax benefits of opportunity zone investing. 

It makes sense to look at multiple opportunity zone sponsors and managers before investing.  A long-term track record of successful development is crucial.  A sponsor's ability to commit to the investment is crucial, too.  The big real estate sponsors are bashed on a regular basis, but with opportunity zone investing, I am waiting to see deals, if any, from sponsors like Inland, Hines, Griffin, CNL, or Black Creek.  I know that not all their deals have worked out, but they know the space, have the investor relations infrastructure, and have been around for more than ten years.

Ripped Toughskins

Sears Holdings, which owns Sears and Kmart, announced today that it is closing all its stores.  After 126 years Sears is done.  This CNBC article has a good summary of Sears' decline.  I don't believe Sears' death was inevitable.  It did face tough competition from Walmart and Target and then Amazon, but Target and Walmart have not gone out of business due to Amazon.  Sears did not have the retail management expertise to face its rivals and shifting consumer tastes and buying patterns.  This passage from the CNBC article gets to the heart of what happened to Sears:

(Eddie) Lampert saw opportunity in both (Sears and Kmart). The former Goldman Sachs intern had wowed investors with his ability to turn around the auto parts store . Armed with his hedge fund ESL Investments and the confidence of a man nicknamed “the next Warren Buffet,” Lampert believed he could concoct a similar turnaround in Kmart and Sears. He believed he saw value where others didn’t.

Lampert bought Kmart out of bankruptcy through ESL and ultimately combined it with Sears, to create Sears Holdings Corporation.

But Lampert was battling a national decline in the department store industry, as shoppers abandoned the mall and favored casual over formal wear. Department stores accounted for 14.5 percent of all North American retail purchases in 1985 but only 4.3 percent last year, according to Neil Saunders, managing director of GlobalData Retail. Sears’ peers, like Bon-Ton and Mervyn’s, whittled away, while rivals like and poured money into their businesses to be among the ones left standing.

Walmart and Target proved relentless in their competition. The companies scaled quickly and poured money into private label brands, which were better in quality than those sold at Sears and Kmart.

As Sears’ competitors invested in its stores, Sears took a different approach. Lampert believed that a strong loyalty program and data made investing in stores and advertising optional, people familiar with the situation have said. Then, as Sears’ sales fell and its losses piled up, it no longer had a choice — investment fell out of reach.

Sears shrank its store-base, in a desperate attempt of to regain profitability. The stores that remained were in disarray, with outdated fixtures, dark lighting and piles of unwanted clothes. Sears lost relevancy and its customers’ loyalty.

I am not upset about Sears, but it is another example of private equity buying a retailer and then not having the retail skills to operate the business.  Confidence and access to capital are great, but they are not the same as retail expertise.  If you are a landlord and a private equity firm buys one of your retail tenants you better start reserving for the day that tenant stops paying rent.

Separately, and much cooler than Sears' closure, is this episode of the podcast 99% Invisible about Sears Roebuck selling complete home kits through the mail.  The Sears' homes included everything to build a home, all the way down to light and plumbing fixtures, along with complete instructions.  Sears may soon be gone, but some of its mail order homes and other buildings are still in use.

Energy Embargo

FS Energy and Power Fund announced in an 8-K today that it has decreased the price at which it it issues shares under its distribution reinvestment plan from $6.50 per share to $6.10 per share, or a drop of over 6%.  I view the prices at which business development companies (BDCs) issue shares as part of their distribution reinvestment plans as a proxies for their net asset values.  FS Energy and Power is an energy sector BDC, and is, apparently, facing the same industry-wide problems as other leveraged loan lenders, which I mentioned late last week. 

Another PE Example

Here is another example of a private equity firm buying, stripping, ruining, and closing a retail firm.  This Washington Post article describes Sun Capital's acquisition and management of Marsh Supermarkets, with a particular emphasis on how Sun Capital used bankruptcy to get out of meeting employee pension obligations.  These stories seem to write themselves: Wall Street bankers start a private equity firm and raise investment capital, buy a business they now nothing about and have no skills to run or improve, sell valuable assets, leverage remaining assets, declare bankruptcy and close business, all the while taking out big fees and salaries.  This is a lopsided ledger, but Sun Capital's investors got their money out, probably at some positive Internal Rate of Return, so Sun Capital can claim its investment in Marsh Supermarket a success to raise more money and inflict its management on another company.

Financial Times Article

Boy, my last post was in late September and titled Disappearing Sponsors.  I did not also mean disappearing blogger.  Well, I have not gone away yet, although the sales to many alternative investments have gone away.  I will be honest, though, I am thinking of more effective ways to express my thoughts on alternative investments.  This blog will be just one outlet.

The Financial Times does not like links to its website, but it has an article from December 30, 2018, on KKR, Franklin Square, and Blackstone GSO that is worth your time to find and read.  The point of the article is that KKR has initiated big write-downs on some of the loans in the Franklin Square Investment Corp BDC that were originated by Blackstone's GSO.  (This BDC, after its merger with Corporate Capital Trust, re-named itself FS-KKR Capital Corp and trades under the symbol FSK.)  The write-downs is not new news to anyone that watched the falling stock price of FSIC or the lowered NAVs of the FS Investments' non-traded BDCs.  What has caught the attention of analysts is KKR's ballooning of the watch list, which tripled in 2018, and now encompasses 28% of the portfolio.

It looks like the high yield and leveraged loan market is going to be a story in 2019.  The Financial Times has had some good recent articles on the issues facing the high yield market.  In the KKR article noted above, The Financial Times notes that, industry wide, 70% of the leverage loans being issued are "covenant-lite," which means the loans lack the strict controls that would allow creditors to seize assets of under performing loans.  This also means that the underlying business do not have to meet as strict an operating criteria as do loans with stronger covenants.  The saying that "it was all good until it wasn't" could be 2019's leveraged loan market mantra.