Bailout Worked
Here is a summary of a new study by economists Alan Blinder and Mark Zandi that gives evidence that the Troubled Asset Relief Program (TARP), and to a lesser extent the stimulus package, worked in keeping the economy out of a depression.  I thought TARP made sense at the time and felt if prevented a complete financial meltdown: 

In a new paper, the economists argue that without the Wall Street bailout, the bank stress tests, the emergency lending and asset purchases by the Federal Reserve, and the Obama administration’s fiscal stimulus program, the nation’s gross domestic product would be about 6.5 percent lower this year.

In addition, there would be about 8.5 million fewer jobs, on top of the more than 8 million already lost; and the economy would be experiencing deflation, instead of low inflation.

Even with the "bailout" the depth of the financial crisis is shocking:

Mr. Blinder and Mr. Zandi emphasize the sheer size of the fallout from the financial crisis. They estimate the total direct cost of the recession at $1.6 trillion, and the total budgetary cost, after adding in nearly $750 billion in lost revenue from the weaker economy, at $2.35 trillion, or about 16 percent of G.D.P.

By comparison, the savings and loan crisis cost about $350 billion in today’s dollars: $275 billion in direct cost and an additional $75 billion from the recession of 1990-91 — or about 6 percent of G.D.P. at the time.

Politicians from both parties need to push back against those that say TARP was a disaster, and those that voted for TARP should be proud.   This article from the New York Times details the backlash against politicians who voted for TARP, including Utah's conservative Bob Bennett who has already been voted out by members of his own party.

Taxes, Deficit Hawks and What's Wrong With The Media
Here are is an interesting blog post from the Financial Times' Martin Wolf that debunks supply side economics.  It is worth reading, especially in light of the pending expiration of the Bush tax cuts.  Here is an excerpt:

True, the theory that cuts would pay for themselves has proved altogether wrong. That this might well be the case was evident: cutting tax rates from, say, 30 per cent to zero would unambiguously reduce revenue to zero. This is not to argue there were no incentive effects. But they were not large enough to offset the fiscal impact of the cuts (see, on this, Wikipedia and a nice chart from Paul Krugman).

Indeed, Greg Mankiw, no less, chairman of the Council of Economic Advisers under George W. Bush, has responded to the view that broad-based tax cuts would pay for themselves, as follows: “I did not find such a claim credible, based on the available evidence. I never have, and I still don’t.” Indeed, he has referred to those who believe this as “charlatans and cranks”. Those are his words, not mine, though I agree. They apply, in force, to contemporary Republicans, alas,

Since the fiscal theory of supply-side economics did not work, the tax-cutting eras of Ronald Reagan and George H. Bush and again of George W. Bush saw very substantial rises in ratios of federal debt to gross domestic product. Under Reagan and the first Bush, the ratio of public debt to GDP went from 33 per cent to 64 per cent. It fell to 57 per cent under Bill Clinton. It then rose to 69 per cent under the second George Bush. Equally, tax cuts in the era of George W. Bush, wars and the economic crisis account for almost all the dire fiscal outlook for the next ten years (see the Center on Budget and Policy Priorities).

No one likes paying taxes and I want the tax cuts that are set to expire to be extended.  Politicians need to get serious about spending cuts, but this is an issue neither side of the aisle wants to deal with.  The areas that need cutting are too popular with voters.   Wolf argues that this is what's so seductive about supply side economics, "Supply-side economics said that one could cut taxes and balance budgets, because incentive effects would generate new activity and so higher revenue."   It's too bad the theory has not worked.  It is my opinion that the economy is too weak to absorb any tax increases, so I'd be surprised if the Bush tax cuts are not extended. 

Rick Santelli, a CNBC on-air editor, was on NBC's Meet the Press yesterday.  He is a huge deficit hawk and stated that he was still against TARP and the stimulus package, and pretty much any government economic assistance that adds to the deficit.  Rick has valid point and his opinions are well known to anyone who watches CNBC.  (I feel that TARP was hugely beneficial in preventing a larger financial meltdown, and that the ultimate cost will be small as most TARP recipients have repaid their loan.)  I like Santelli, he is smart and has excellent analysis, especially on credit markets and interest rates.  I wanted to know his opinion on the expiring tax credits, but Meet the Press host David Gregory chose not to ask Santalli the question, opting instead to ask it to some former Obama administration communication person.  Gregory was obviously turning an economic discussion in a potential political gotcha moment.  The former Obama official gave some convoluted, non-response response, about what you'd expect. 

Gregory failed in not questioning Santelli on the tax cut extensions, especially after asking Santelli his opinion on government spending.  Gregory was practicing political theater, not journalism.  Santelli's opinion on extending the Bush tax cuts is important.  If he is as serious a deficit hawk as he comes across, his answer should be clear - let the tax cuts expire to allow for deficit reduction.  I would have been shocked if Santelli had not given a supply-side answer about the need to extend the tax cuts to allow more money into the economy, and therefore more tax revenue. 

CMBS Returns
Here is an article on the CMBS market from today's Wall Street Journal (not sure where it's behind a paywall).  JP Morgan is leading a $650 million CMBS backed by Vornado Realty Trust, and Goldman and Citigroup are sponsoring a $750 million CMBS backed by Flagship Partners.  The proceeds of both deals will mostly be used to refinance existing debt.

The return of CMBS is encouraging for commercial real estate, but not all are able to get access to CMBS debt.  The market is bifurcated, and I have heard this from several sources, where property owners in major markets with equity and resources have access to capital, including CMBS, while others are not so fortunate.  Here is a quote from the article:

Few expect a rush of new CMBS deals in the near term as the real-estate industry braces for more than $1 trillion of maturing debt over the next five years. While the handful of fresh issues have begun to revive one of the most important funding sources for commercial real estate in the past decade, it will likely provide little solace to owners of hundreds of billions of dollars of office buildings, strip malls and other commercial property now worth less than their mortgages.

This also plays into stabilizing valuations for quality properties, in major markets.  I'll have more on this in a later post, but drop in value for quality properties has been less than the overall market.  So far in 2010, as the article notes, there has been $2.1 billion of CMBS issuance, which is a small amount compared to the more than $200 billion issued in each of 2006 and 2007.

Housing Numbers
The housing numbers released this morning had some conflicting information.  The big news is that housing starts in June fell to their lowest level since October 2009.  A large portion of the drop was attributed to the 22% decline in multifamily building.  Conversely, building permits for multifamily apartments and condos increased 20%.  Interesting.

Miami Condos
Here is an encouraging read from Bloomberg.  The article discusses how Miami's failed condos are having a revival as rentals.  Here are a few informative quotes:

The 7,000 unsold condos in Miami’s core -- a symbol of a building boom that collapsed and dragged the city into recession -- are filling up and giving life to neighborhoods that previously closed after dark. New, year-round residents are cramming into restaurants, nightclubs and bars that didn’t exist a few years ago, and enjoying a lifestyle made possible in part by developers and banks seeking to recoup losses by renting luxury dwellings until the market recovers.

The unsold condos represent almost a third of the 22,079 units in 75 buildings, mostly opened after 2004, tracked in a study released in March by the Miami Downtown Development Authority. The report focused on central neighborhoods including Downtown, Brickell and Wynnwood/Edgewater.  Occupancy rates in the new buildings, including owner- occupants and tenants, increased to 74 percent in February from 62 percent in May 2009, the study shows. 

Effective rents, the amounts actually received by landlords, rose 4 percent in the first five months of the year after falling 2.9 percent during the same period in 2009, according to Axiometrics, whose data tracks professionally managed rental building. Nationally, rents increased 2.75 percent from January to May.  The occupancy rate for Miami climbed to 95.1 percent in May from 93.8 percent a year earlier, Johnsey said.

The overall tone of the article was positive, and one of the few uplifting real estate stories I have read in a while, especially one about Florida.  The article does not touch on issues related to condo associations, whether condo owners are making any money on their rentals, or how the market will react when owners try to sell individual units in a building with mostly renters.

Is This News?
I heard this news about WP Carey replacing its CEO last week.  Here is an excerpt from WP Carey's press release discussing the interim replacement:

Investment firm W. P. Carey & Co. LLC (NYSE: WPC) announced today that board member Trevor P. Bond has been appointed interim Chief Executive Officer effective July 6, 2010. He will remain as a board member but will resign as a member of the Compensation and Audit Committees of the Board.

Mr. Bond has served as an independent director of the company since April 2007 and served as director of several of the company's CPA® REIT programs from 2005 to 2007. He has over 25 years of management experience in several sectors, including finance, development, investment and asset management across a range of property types, as well as direct experience in Asia. Mr. Bond has been the managing member of Maidstone Investment Co., LLC since 2002, a private investment vehicle investing in real estate limited partnerships. Previously he served in several management capacities for Credit Suisse First Boston from 1992 to 2002, where he was co-founder of CSFB's Real Estate Equity Group, which managed approximately $3 billion of real estate assets. Prior to CSFB, he served as an associate to the real estate and finance departments of Tishman Realty & Construction Co. and Goldman, Sachs & Co. in New York. Mr. Bond received an M.B.A. from Harvard University.

Mr. Bond will serve as interim CEO until a permanent successor is named. Mr. Bond's appointment follows the resignation of Gordon F. DuGan, also effective July 6, 2010. Mr. DuGan said that his resignation is based on a disagreement with respect to the degree of authority and control of the Chairman and a disagreement with the Chairman on the strategic direction of the company.

Wm. Polk Carey, Chairman of W. P. Carey & Co., said, "Trevor brings to this role extensive management experience and a strong commitment to our investors and tenants. I thank him for stepping into this interim position. I wish all the best to Gordon DuGan, who has served W. P. Carey with skill and intelligence for many years. Though Gordon and I have not been strategically aligned in the recent years, I remain an admirer of his abundant investment management and general business talent."

I am sure there is more to this story, but it appears that if your name is on the company, you get to make the decisions.

WSJ on Dividend Capital's Total Realty TrustLast Wednesday's Wall Street Journal (July 7, 2010) had an article on Dividend Capital's Total Realty Trust's $1.3 million acquisition of thirty-two office and industrial properties from iStar Financial.  The article's headline, "Sign of Recovery? Or Not? Successful Sale Had Help," gave the impression that there was something wrong with the deal.  The author's idea of trouble with the transaction was that it included Class A properties with some lesser industrial properties and required substantial equity.  If you acquire thirty-two properties, not all can be trophy properties.  The lesser properties are industrial properties leased to the likes of Google and Fed Ex.  The leverage was 64%, with the REIT throwing in $443 million (the math does not match perfectly for some reason).  The author says that during the boom this deal would have qualified for 90% financing.  That amount of leverage is unavailable in today's market so the point of reference is a red herring.  The portfolio is 99% occupied, has an average lease term of over seven years and was acquired on an 8.1% cap rate.  These figures appear positive for the REIT.

Here are a couple of points the article did not address that I think are worth mentioning.  Total Realty Trust had $489 million of cash at March 31, 2010.  The $443 million of equity utilized most of this cash.  The acquisition had $105.6 million of mezzanine financing provided by iStar.  How does Total Realty Trust plan to repay this mezzanine debt?  It's not raising any more equity and will need to either refinance assets or sell assets.  I don't see it being able to refinance legacy assets and receive any extra cash to apply to the mezzanine loan. 

In the first quarter Total Realty Trust paid out $27,609,000 in distributions, but it only had $15,552,000 of operating cash flow and $14,293,000 of Funds From Operations as defined by the REIT.  How will this huge transaction make up this distribution shortfall?  There is limited cash remaining to support distribution shortfalls so the new portfolio is going to have to generate significant cash flow.

Coverage Myopia
The broker / dealer community's focus on distribution coverage ratios is myopic.   Coverage ratios are important and a clear sign of a REIT's health, and a harbinger future distributions, but they are only a piece of a larger puzzle.  Most non-traded REITs have ideas to one day list on an exchange (or merge or even sell their portfolios outright).  If a REIT is going to list on an exchange and hold its value, not only does it need adequate distribution coverage, it needs growth in its Funds from Operations (FFO).  Broker / dealers need to expand their analysis and start looking at FFO growth in addition to distribution coverage ratios.  REITs are stocks, and stocks trade on future growth.  It is not enough to cover a distribution from operations, the distribution and underlying FFO needs to grow for a REIT to hold its value.

I know that many non-traded REITs have appalling coverage ratios that require immediate attention, and some coverage ratios are telegraphing unsustainable distributions.   But for REITs that are fully invested and have sufficient coverage ratios, FFO growth needs to be the focus.  A portfolio of properites with flat long-term leases may look appealing from a safety and coverage ratio standpoint, but over time a REIT with this type of portfolio will trade at a lower FFO multiple (and lower valuation) than a similar REIT that has lease rate growth.   

Another way to view FFO growth is to look at in context of a REIT's estimated time horizon.  A REIT that has a five-year window to list or pursue other liquidation options will likely extend the hold period without FFO growth.  This is because the market will discount this non-growth REIT.  Even the most avaricious REIT sponsor will think twice about listing a REIT that will trade at a significant comparative discount to its initial share price due to limited growth potential.

Austerity Gains Traction
Here is another New York Times article on global austerity measures.  I am not convinced this is smart or prudent economic policy at this point of the economic recovery.  I understand the arguments for cutbacks and am all for debt reduction, but don't feel the economy is fully recovered and at a point where it can depend on corporate growth alone.  Politicians will pay for their decisions if unemployment stays high and growth remains sluggish.  Politicians in the U.S. don't have the courage or conviction to make cuts that will really lower the deficit, such as in Social Security, Medicare or defense, there are just too many vocal, voting parties supporting government spending in these areas.   No US politician, not even a lame duck, would dare float the idea of a tax increase to tackle the debt.  I like to look at the stock and bond markets as good barometers of the future.  The yield on the Ten-Year Treasury is under 3%, which indicates the market is not afraid of current debt levels and that inflation is not a concern, and the recent down trend in the stock market is over concern about the slowing economy due to lack of stimulus spending.  Ceding the economic growth mantle to China and India is bad economic policy.

Hines Distribution Cut
The news that Hines REIT is cutting its distribution is rippling through the broker / dealer community this morning.  Hines is dropping the annualized rate to 5% from 6%.  This is not a huge cut in the whole scheme of non-traded REIT distribution cuts.  Here is text from an email sent to broker / dealers today and the 8-K filed that was filed with the SEC:

The Hines REIT Board of Directors and management team has elected to reduce the dividend on the Hines REIT from 6% to 5% beginning July 1st.  Our management and board of directors believe that aligning our distributions with funds generated by our operations, including the results of certain property sales, and not with funds from offering proceeds or borrowings, is an important objective for the Company. We are proud that, other than our initial quarters of operations, we have been able to meet that objective.

Our portfolio continues to be well leased overall at 90%; however, given the economic environment, we have experienced a decline in occupancy and rental rates over the last few quarters, which have reduced our net operating income as we re-lease expiring space to new or existing tenants. Unfortunately, the downward trends in real estate fundamentals may continue for several more quarters before they begin improving, and the rebound may be slow. As a result of these market conditions, our board of directors has decided to reduce our current annual distribution rate from 6% to 5% (based on our last share price of $10.08 per share)* effective for the quarter beginning July 1, 2010, in order to maintain our practice of aligning distributions with our operating performance as described above. The reduction is not the result of liquidity needs such as debt maturities or pay downs or capital expenditure requirements of our properties. In fact, our liquidity position is quite solid and we have relatively low levels of debt maturities in the next 24 months. The reduction simply better aligns our distributions with our forecasted operating performance over the near term.

The language above sounds prudent, but the Hines REIT's second quarter 10-Q is now a must-read (the excitement is palpable) to look behind the spin.  Bear in mind that Hines REIT stopped its share repurchase plan late last year, albeit the REIT's liquidity was the typical non-traded REIT limited liquidity.  Hines REIT also has the distinguishing feature of not having a set liquidity plan, such as a time frame to sell assets or list shares on an exchange.  Investors are going to have to learn to live with the REIT's 5% yield, or whatever yield they can get.  I guess my bigger question is given the declining distribution rate and Hines' statement on declining occupancy and lease rates, how valid is Hines REIT's Net Asset Valuation of $10.08 per share? 

Irish Austerity
Here is an article from the New York Times that I found depressing but informative.  Ireland's economy in the mid-2000s, despite its embrace of technology firms and their skilled, high paying jobs in the 90s, became driven by real estate development and a housing bubble.  When the housing market collapsed and the credit crisis started, Ireland was rocked by recession.  In response Ireland instituted wage cuts and tax increases without any stimulus spending.   Its economy is still in the tank nearly three years on, with unemployment at 13% and growth not expected to return until 2012.  Here is a passage from the article:

Rather than being rewarded for its actions (spending cuts and tax increases), though, Ireland is being penalized. Its downturn has certainly been sharper than if the government had spent more to keep people working. Lacking stimulus money, the Irish economy shrank 7.1 percent last year and remains in recession.

Joblessness in this country of 4.5 million is above 13 percent, and the ranks of the long-term unemployed — those out of work for a year or more — have more than doubled, to 5.3 percent.

Now, the Irish are being warned of more pain to come.

Policy makers around the globe should view the Irish experience as a warning.  National debts are not good, but sometimes the alternatives are worse.  The article ends predicting that Ireland's government will likely get voted out of office in 2012.

Sea Change?
The public, non-traded REIT business is competitive.  I am not sure how many sponsors are fighting for broker /  dealer shelf space and investor dollars, but it must be several dozen, with, I am sure, more programs in registration.  Competition is generally good for consumers, but this has not always been the case in the non-traded REIT business when it comes to fees.  The fees across the various REITs are remarkably similar.  This may be starting to change.

Grubb & Ellis has eliminated internalization fees on its two public, non-traded REITs.  Another REIT sponsor quickly followed suit.  In conversations with more REIT sponsors, the elimination of the fee is being watched.  If Grubb & Ellis can grab market share, you can bet most non-traded REIT sponsors will ditch this fee.

This is a fee that is hard to quantify when a REIT is raising capital, because in all likelihood it won't be paid for years and the amount of the fee cannot be determined until the REIT decides to prepare for listing or liquidation.   These fees are huge, despite the inability to calculate them during the early stages of a REIT.  Some REITs don't even disclose potential internalization costs in their prospectus' fee section, instead disclosing it with amorphous language in the business plan or risk sections. 

Most REITs are advised by an affiliated company.  When a REIT's board of directors decides to list the REIT on an exchange it must acquire its advisor, a process known as internalization.  Therefore, a value must be placed on this advisor, and then the REIT, typically using its shares, acquires this advisor.  The valuations are determined by the advisor, and many REITs will get a rubber-stamp third party confirmation of the valuation.  On large REITs, the advisor can get a windfall of hundreds of millions of dollars while investors get their equity diluted.  Some past internalizations have paid REIT advisors up to $300 million.  It's not hard to see who's the beneficiary in an internalization transaction.

If Grubb & Ellis' move starts a fee war, this is good for investors.  Hopefully other sponsors will follow suit and start lowering or eliminating more immediately tangible fees and expenses, like offering costs, acquisition fees, property management and asset management fees and compensation to brokers selling the REITs.  Lower fees put less pressure on the portfolio to meet dividend coverage ratios and should allow the REITs to acquire better properties.

Bloomberg on Non-Traded REITs
Here is a Bloomberg article on non-traded REITs.  It's a harsh, but fair article, and it gets its facts right. It is well worth the read.

Extended Stay
Here is an article from the Financial Times.  It summarizes Centerbridge's and John Paulson's $4 billion acquisition of the bankrupt hotelier.  Lightstone Group bought Extended Stay in April 2007 for $8 billion, using mostly CMBS debt.  The debt was $4.1 billion of senior debt and $3.3 billion of mezzanine debt.  The Centerbridge deal will repay the senior debt, but wipe out the mezzanine debt, of which taxpayers owned $750 million.  Here is how the CMBS structure complicates deals that go bad:

The Extended Stay bankruptcy offers a rare insight into how securitisation complicates the Chapter 11 process. There were 18 separate classes of commercial mortgage-backed securities worth $4.1bn.  According to documents, 90 per cent of each class would have to approve any agreement - an arrangement that could have delayed a settlement indefinitely.  But the servicer in charge of the trust agreed to an arrangement that allowed pivotal classes of debtholders to control the outcome.

The article does not mention this, but I think these bankruptcy and purchase hinged, in part, on Lightstone's founder, David Lichtenstein, being relieved of approximately $100 million of personal liability in the event of default. 

Confusing Non-Traded REITs with Private Placements
Here is a link to an Investment News article on FINRA examinations. The article's author mistakenly calls non-traded REITs private placements.

Mr. Ketchum, chairman and CEO, also said that exams of broker-dealers at the Financial Industry Regulatory Authority Inc. are paying close attention to sales of non-traded real estate investment trusts, or private REITs.

The non-traded REITs being discussed in this article are public programs, not private placements.  These REITs are required to register with the SEC and are subject to filing requirements.  Investors in these REITs are also subject to suitability requirements.  Just because a REIT is not traded on an exchange does not mean it's a private placement.    This is sloppy, misleading reporting. 

W-T-F
Healthcare Trust of America (HTA) filed an 8-K this afternoon. It's a doozy.  HTA's President and Chief Executive Officer, Scott Peters, has received a 50% jump in his base salary.  His salary went to $750,000 a year from $500,000.  If you remember, last year his base salary was increased to $500,000 from around $160,000.  The reason for the raise listed in the 8-K is here:

• the successful completion of the Company’s transition to self-management;
• the recent commencement of the Company’s follow-on offering;
• the substantial level and quality of new acquisitions completed by the Company over the past nine months;
• the Company’s increasing distribution coverage;
• the gross cost savings of $10.8 million in 2009 and $5.5 million in the first quarter of 2010 resulting from the Company’s self-management program; and
• the overall financial strength and growth of the Company

If you review HTA's 10-K, you will find many of the the same reasons above as justification for giving Mr. Peters his massive bonus that brought his 2009 total pay to $2.8 million.  I am no compensation expert but this looks like double-dipping to me.

In addition to the increase in base pay, Mr. Peters and other executives were awarded equity grants.  Mr. Peters' equity grant is 100,000 shares per year for the next three years (which at $10 per share is valued at $1,000,000 per year), and he gets interest on those shares at HTA's 7.25% distribution rate, or $72,500 per year the first year, $145,000 the second year, and $217,500 thereafter.  WTF!

HTA also instituted an Employee Retention Plan  - you knew it was going to get better - that granted Mr. Peters an additional 100,000 HTA shares.  Mr. Peters elected to take 50,000 shares in cash, which is $500,000.  This will be paid in thirds on the anniversary of the grant date.  Come on, is an Employee Retention Plan necessary for a guy getting this much compensation?  Where the heck is he going to go? 

This compensation increase is outrageous.  This REIT increased its dividend coverage in the first quarter, but operating cash flow only covered 48% of the dividend without any adjustments.  News flash - this is not stellar performance for a REIT over three years old.   HTA board of directors - DO YOUR JOB!

Read HTA's 10-K and most recent 10-Q.  HTA has $300 million of low interest rate variable debt that matures before end of 2011. Then read the blog post below on refinance scenarios.  It is my opinion that with a current 48% dividend coverage and $300 million of low interest rate debt maturing over the next eighteen months, this REIT has its work cut out to generate sufficient operating cash to cover its distribution.

Elephant in the Room
I've read plenty of 10-Qs over the past few weeks.  I am beginning to think that many broker / dealers' and analysts' obsession with distribution coverage and Funds From Operations is too myopic.  Don't get me wrong, this is an important area, especially for the non-traded REITs raising significant amounts of investor capital based on high dividends.  Coverage ratios are convenient because they give a clear indication of REIT performance.   I feel that broker / dealers need to expand their analysis and start looking at maturing debt and how this could impact future cash flows.

I am concerned with non-traded REITs that have debt maturing over the next several years, and how these maturities will impact the REITs' balance sheets and future distributions.  I am not going to call out any particular REIT, but have put together the spreadsheet below based on composite data that I feel represents what could happen to a REIT as it goes to refinance its debt:
 

                                                        Original Purchase                   Refinance

Property Leverage		70%		60%
Cap Rate		6.50%		7.50%
Debt Interest Rate		3.50%		6.50%
Annual Debt Svc		$1,225,000		$1,972,052
Purchase Price / Value		$50,000,000		$43,333,333	-13.33%
Leverage		$35,000,000		$26,000,000
Original Equity		$15,000,000		$15,000,000
Required Additional Equity		-		$9,000,000
Total Equity		$15,000,000		$24,000,000
NOI		$3,250,000		$3,250,000
Debt Svc		$1,225,000		$1,972,052	60.98%
Net Cash Flow		$2,025,000		$1,277,948	-36.89%
Cash Return On Equity		13.50%		5.32%		-60.56%

The assumptions are that a property was acquired for $50 million.  I assumed 70% leverage, or $35 million and $15 million of equity.  I assumed the property was acquired at a 6.5% cap rate on net operating income of $3.25 million.  I assumed the original loan was interest-only and had variable rate interest at a rate of 3.5%.  This gave the property a cash return on equity of 13.5%. 

Now this hypothetical property has to refinance this favorable debt.  In my refinance assumption I kept the NOI the same.   Cap rates have increased and leverage ratios have dropped over the past two years.  I used a new valuation cap rate of 7.5% and a 60% leverage ratio.  The property is now valued at $43.3 million (using a 7.5% cap rate on the unchanged NOI), and the amount of a new loan is only $26 million (60% leverage on the new $43.3 million value).  This leaves a $9 million shortfall that the REIT needs to retire the original loan.  So, the original $15 million of equity needs to be increased to $24 million.  Looked at another way, the REIT needs to add an additional $9 million to a property that has lost $6.7 million of value.  I assumed the new loan has a rate of 6.5% and amortizes on a thirty-year schedule.

The end result is that the debt service increases, despite the lower leverage, and the cash flow decreases.  In the example above, the return on equity drops to 5.3%.  The other option is to walk away from the property, but this has its downside, too.  How can a sponsor justify walking away from property with positive operations?

Non-traded REITs that are raising capital may be able to pay down original debt.  REITs that are not raising capital may have to cut distributions to preserve cash to repay debt.  The end result may be long-term lower cash flow, as shown above.

This scenario can get worse if it is expanded to lease renewals.  Lower lease rates would lead to a lower NOI, which leads to a lower valuation, which leads to lower refinance debt amounts, which leads to more REIT cash to repay the exisitng loan, which leads to lower returns on equity.  You get the picture. 

It is not a bold statement to say that REITs struggling to cover their current distributions, and that have significant debt maturing over the next few years, will be hard pressed to maintain their current dividends.  Analysts and broker / dealers need to turn their attention to non-traded REITs maturing debt and be aware of the potential impact on cash levels and distributions.

How Much Does $500,000 Really Cost?
Bloomberg TV just had a segment stating that since the start of the oil spill in the Gulf, British Petroleum has lost $57 billion in market capitalizaton.  Bloomberg estimates that clean-up will cost BP $24 billion.  And who can estimate far ranging legal and settlement costs, which will extend for years.  The oil and gas industry successfully fought regulation that would require the installation of a remote acoustic trigger to shut off oil wells in the event of a blow out.   Acoustic triggers cost $500,000.  There is no guarantee that the trigger would have worked to stop the flow of oil at BP's well, but countries with extensive off shore drilling, like Norway and Brazil, require these devices.  At a price of $70 per barrel of oil, the trigger is the equivalent of 7,150 barrels of oil.  It is estimated that the BP well is leaking 75,000 barrels a day.   The switch would have been two hours and twenty minutes of production.  At this point, I don't think BP will survive this disaster.  I hope other oil companies are looking at this example, and are realizing that $500,000 is cheap.  Here is a link to a Wall Street Journal article discussing the acoustic valves.

Appears Important
This article from Bloomberg about Well Fargo and LNR selling distress loans and real estate strikes me as important.  LNR is the largest special servicer of CMBS loans, which means it is tasked to deal with loans in CMBS that have gone bad.  Hear is what they are looking to sell:

Wells Fargo of San Francisco, the biggest U.S. commercial real estate lender, is taking bids on $500 million to $1 billion of office and hotel mortgages and properties, said four people, who asked not to be identified because the sale is private. LNR, the largest special servicer of commercial mortgage-backed securities, is trying to sell about $1 billion of defaulted loans, two people said. 

And here is what they hold in non-performing assets:

Wells Fargo had $12.9 billion in nonperforming commercial property loans in the first quarter, the firm said, while LNR is the special servicer on $24 billion of delinquent assets, according to data compiled by Bloomberg.

Most of the Wells loans relate to its takeover of Wachoiva.  I would guess that the LNR loans need to be bought and then foreclosed upon, with the proceeds LNR receiving going to CMBS holders.  Not sure but I think this is encouraging news.

Four Dollars and Twenty-Five Freaking Cents
$4.25.  That is the price per share that the Behringer Harvard REIT is now values itself.  The original share price was $10.  I heard rumblings a few weeks ago that a large devaluation was pending.  I have never analyzed this REIT, so I am not sure the valuation is that shocking, but on its face, a 57.5% loss of value is troubling.  Here is a link to the SEC's website where BH posted its document that puts forth the valuation - buried at the bottom of page 26 of a 32 page document. The REIT also cut its distribution to 1%.  The Moody / REAL All Type Property Aggregate Index for commercial real estate shows a 41.8% drop in commercial real estate prices from their peak in August 2007 through February 2010.

Part of the BH document is dedicated to laying out a case that part of its troubles stem from problems in commercial real estate and the greater economy.  There is obviously some truth to this.  But not all real estate firms have lost 57.5% of their value.  Publicly traded Federal Realty Trust (FRT) has gained nearly 19% since the start of 2006.  It pays a quarterly dividend that it has managed to increase from $.56 a share to $.66 a share over the same period.  I know that comparing Behringer Harvard REIT I to FRT is not an apples-to-apples comparison, but I show it to illustrate that while all real estate firms have faced the same economy, using a bad economy and tough real estate market cannot be used to explain away all problems.

Something to Ponder
I can't believe it's been almost a month since my last post.  There are plenty of post coming.  In the meantime, here is a post I saw last week on the blog Marginal Revolution that's worth thinking about:

The challenge

David Leonhardt spells it out clearly:

As a rough estimate, the government will need to find spending cuts and tax increases equal to 7 to 10 percent of G.D.P. The longer we wait, the bigger the cuts will need to be (because of the accumulating interest costs).
Seven percent of G.D.P. is about $1 trillion today. In concrete terms, Medicare’s entire budget is about $450 billion. The combined budgets of the Education, Energy, Homeland Security, Justice, Labor, State, Transportation and Veterans Affairs Departments are less than $600 billion.
This is why fixing the budget through spending cuts alone, as Congressional Republicans say they favor, would be so hard.

Here is related commentary.

The permalink is here, but includes all the comments, many that are inane partisan blather.  Marginal Revolution is a libertarian blog.

CMBS Article
Here is an article (subscription required unless you email it to yourself) from today's Wall Street Journal on the CMBS market.  Commercial mortgage default rates, defined as more than 60 days past due, for mortgages in CMBS are now at 7%, and are expected to reach 11% by year-end.  This article confirms what I have been hearing, in that special servicers, the firms tasked with handling defaulted mortgages, are getting more creative in restructuring mortgages.  Until recently, the special servicers only real options were to extend a mortgage for a short period or give a break on interest rates, as their sole goal was to protect CMBS investors from losses.  This task is getting untenable as the scale of defaults and pending maturities are changing CMBS dynamics.  Here is a long quote from the article:

Servicers have restructured about $13.7 billion of those loans, according to estimates by analysts at Deutsche Bank. Such restructurings, which include extending loan maturities and reducing interest rates, could help bondholders and borrowers avoid bigger losses as the economy recovers. But some borrowers still wind up defaulting.

Such firms—including LNR Property Corp., owned by private-equity firm Cerberus Capital Management LP, and CW Capital, majority-owned by Canadian pension manager Caisse de Dépôt et Placement du Québec—are "going to trot out the entire playbook" used during the real-estate crash of the early 1990s, said Mark Warner, a managing director at BlackRock Inc.

One emerging restructuring strategy involves cutting mortgages into good and bad pieces. For example, Grossman Company Properties was in danger about a year ago of defaulting on the $190 million mortgage for its Arizona Grand Resort in Phoenix, which is suffering from a decline in business and leisure travel.

The loan, originated by Greenwich Capital, was part of the Goldman/Greenwich deal in 2006, which also includes troubled loans on an office complex in downtown Los Angels and six retail stores. Grossman is led by real-estate investor Sam Grossman, who made a name for himself by snapping up distressed assets in the early 1990s. After months of negotiations with CW Capital, Mr. Grossman's company struck a deal allowing it to keep the property in return for a $5.8 million capital infusion.

The original Grossman loan was split into two parts, with the cash flow from the 640-room resort, equipped with two golf courses and a water park, now used only to service the debt on the $100 million part of the loan, Deutsche Bank said. The second slice, totaling $90 million, will get no payments until the loan matures in 2016 and the first part of the loan gets paid off.

The net effect of this restructuring is that it allows the subordinate bondholders to avoid taking a loss before the loan matures while delaying the recoveries for senior bondholders, Deutsche Bank analysts note. Supporters of the restructuring said the move was in the best interest of all bondholders and the borrower because liquidating the property likely would have resulted in large losses.

It is my opinion that this new flexibility will help the real estate market.  I suspect it will also spur more commercial mortgage refinancings, which will also help the real estate market.

More HTA
The table below shows how Healthcare Trust of America funded its distributions in 2009 on a quarter-by-quarter basis.  The table was derived from data in a March 8-K filing by HTA.    The key to me is the second half of the year where operating cash flow is much less than in the first half of the year.

	12/31/09	9/30/09	6/30/09	3/31/09
Total Distributions	$23,900,000	$21,908,000	$18,004,000	$14,247,000
OP Cash Flow	$5,033,000	$1,718,000	$8,355,000	$5,895,000
Offering Proceeds	$18,867,000	$20,190,000	$9,649,000	$8,352,000
Dist as % Op Cash	21.06%	7.84%	46.41%	41.38%
Dist as % of Offering Proceeds	78.94%	92.16%	53.59%	58.62%

Yes, the REIT saw increased equity in the second half of the year, which would contribute to the drop in the operating cash flow-to-distribution coverage ratio discussed in the previous post, but it also saw a drop in operating cash flow over the same period.  The low operating cash flow-to-distribution coverage ratio cannot be fully explained away by problem of raising too much equity.  This ratio bears close attention in the coming quarters, especially since HTA made more than $400 million of acquisitions late in the fourth quarter, which ideally should be accretive to the REIT's current 7.25% distribution.

It'd Be Funny, If it Wasn't Serious
I need to stop reading public non-traded REITs' 10-Ks.  They're not good for my mental health, but reading them is like watching Kate Gosselin on Dancing With The Stars, so bad, yet you can't look away, or stop from snickering.   Healthcare Trust of America's (HTA) 2009 10-K has plenty of gems, and it may take more than this post to point some of them out.  The latest outrageous example of egregiousness is the compensation of HTA's Chief Executive Officer / President / Chairman of the Board.  This executive saw his total compensation jump from $504,753 in 2008 to $2,834,688 in 2009, the same year in which cash distributions as percentage of operating cash flow dropped to 25.5% from 66.3%.   I know HTA carried a large cash balance in 2009 as it dealt with large inflows of investor equity, and I know HTA did not acquire significant properites until late in the fourth quarter, and I have not done an analysis on the extent to which new investors may have increased the distribution pool, but a $2.3 million, or 5.6 times increase in total comp is troubling.

It is important to note that while an increase in investor equity would cause the amount of cash required to pay distributions to increase, it would not have an impact on operating cash flow.  HTA's operating cash flow increased $324,000, or 1.6% in 2009.  The properties bought late in 2009 likely did not show up in cash flow, but the properties acquired in 2008 should have, as they had a full year on the books.  Is that minuscule rise in operating cash flow worth $2.3 million?

I list below a large portion of the compensation discussion that is taken directly from HTA's 10-K:

Base Salary. Base salary provides the fixed portion of compensation for our named executive officers and is intended to reward core competence in their role relative to skill, experience and contributions to us. In connection with entering into the employment agreements, the compensation committee approved the following initial annual base salaries: Mr. Peters, $500,000; Mr. Engstrom, $275,000; and Ms. Pruitt, $180,000.  The compensation committee approved an increase to Mr. Peters’ 2008 base salary in order to more
closely align his base salary with our peers. However, due to the compensation committee’s focus on  performance-based compensation, Mr. Peters’ base salary approximates the lower end of the scale of base salaries provided by our peer companies. To emphasize performance-based compensation, the compensation committee designed Mr. Peters’ compensation package so that the majority of his cash-based compensation may be earned through an annual bonus after the compensation committee’s assessment of his performance during the year.

As discussed above, the initial base salaries for Ms. Pruitt and Mr. Engstrom were negotiated in connection with their joining our company. Also as discussed above, a key priority for us is to attract, retain and motivate a top quality management team. In order to attract a high caliber management team, the compensation packages offered must be competitive within the market, as well as reflective of the executive’s level of skill and expected contributions. These were the guiding principles followed by Mr. Peters and the compensation committee in negotiating the compensation packages with Ms. Pruitt and Mr. Engstrom.

Annual Bonus. Annual bonuses reward and recognize contributions to our financial goals and achievement of individual objectives. In 2009, we did not have a formal bonus program. Each of the named executive officers is eligible to earn an annual performance bonus in an amount determined at the sole discretion of the compensation committee for each year. Pursuant to the terms of their employment agreements, Mr. Peters’ initial maximum bonus is 200% of base salary. Mr. Engstrom’s and Ms. Pruitt’s initial target bonus is 100% and 60%, respectively, of base salary.

The compensation committee, together with Mr. Peters, developed a broad list of goals and objectives for 2009. The compensation committee awarded Mr. Peters the maximum bonus payable to him under his employment agreement based on its assessment of his performance during fiscal year 2009. In reviewing his performance, the compensation committee concluded that Mr. Peters accomplished, and in many cases, exceeded such goals and objectives, which included:

•  effectively leading the expansion of the company, including growing our portfolio through the acquisition of quality, performing assets;  
• successfully negotiating substantial and creative value-added transaction terms and conditions;    
• coordinating successful and competitive refinancing transactions during a time of significant dislocations in the credit markets;
  leading our successful transition to self-management;
• recruiting and effectively supervising our employees;  
• implementing effective risk management at all key levels of the company;
• maintaining a strong and solid balance sheet; 
• coordinating the engagement of new, competitively-priced and performance-driven property management companies for our portfolio; 
• leading the extension of our initial offering for up to 180 days, successfully transitioning the dealer manager for our initial offering to RCS and spearheading the registration of the follow-on offering; 
• establishing and enhancing our relationships with commercial and investment banks; 
• maintaining and actively enhancing our “stockholder first,” performance- driven philosophy; 
• effectively establishing our independent brand name as an asset to our company; and, 
• facilitating an open and effective dialogue with our board.

In addition to the annual bonus available under his employment agreement, after an extensive review of the peer group information and Mr. Peters’ performance in 2009, the compensation committee also awarded Mr. Peters an extraordinary bonus of $200,000. The extraordinary bonus recognizes and rewards Mr. Peters for (i) his expanded role and extraordinary efforts in providing demonstrated and effective leadership to our company, and (ii) positioning the company for continued success during recent unprecedented, difficult economic times, and in the future.

I like that extraordinary bonus of $200,000.  I wonder whether it was for ""facilitating an open and effective dialogue with the board," or "leading the extension of the Company's initial offering for up to 180 days."  How is the nearly six times jump in CEO pay putting "stockholder first," unless that stockholder is the CEO.  To me, the bonus targets are too subjective and several sound like normal tasks that are part of any CEO/President/Chairman job duties, and not factors that should be included in a bonus determination.   I examined a few other REITs' executive compensation plans, and all were quantitative in the metrics that their executives needed to achieve, not subjective goals like HTA.

As you read further, the data gets more interesting.  The increase in CEO's total compensation is disturbing, but his termination clause is hard to believe.  I list the description of HTA's senior executive termination clauses listed in the 10-K below:

Termination without Cause; Resignation for Good Reason. If we terminate the executive’s employment without Cause, or he or she resigns for Good Reason (as such terms are defined in the employment agreement), the executive will be entitled to the following benefits:

 • in the case of Mr. Peters, a lump sum severance payment equal to (a) the sum of (1) three times his then-current base salary plus (2) an amount equal to the average of the annual bonuses earned prior to the termination date (if termination occurs in the first year, the bonus will be calculated at $1,000,000), multiplied by (b) (1) if the date of termination occurs during the initial term, the greater of one, or the number of full calendar months remaining in the initial term, divided by 12, or (2) if the date of
termination occurs during a renewal term after December 31, 2013, 1; provided that in no event may the severance benefit be less than $3,000,000; 
• in the case of Mr. Engstrom and Ms. Pruitt, a lump sum severance payment equal to two times his or her then-current base salary;
• continued health care coverage under COBRA for 18 months, in the case of Mr. Peters, or six months, in the case of Mr. Engstrom and Ms. Pruitt, with all premiums paid by us; and
• immediate vesting of Mr. Peters’ shares of restricted stock and restricted cash award(s) and Mr. Engstrom’s and Ms. Pruitt’s restricted stock units.

“Cause,” as defined in the employment agreements, generally means: (i) the executive’s conviction of or entering into a plea of guilty or no contest to a felony or a crime involving moral turpitude or the intentional commission of any other act or omission involving dishonesty or fraud that is materially injurious to us; (ii) the executive’s substantial and repeated failure to perform his or her duties; (iii) with respect to Ms. Pruitt and Mr. Engstrom, gross negligence or willful misconduct in the performance of the executive’s duties which materially injures us or our reputation; or (iv) with respect to Ms. Pruitt and Mr. Engstrom, the executive’s willful breach of the material covenants of his or her employment agreement.

“Good Reason,” as defined in Mr. Peters’ employment agreement generally means, in the absence of his written consent: (i) a material diminution in his authority, duties or responsibilities; (ii) a material diminution in the his base salary; (iii) relocation more than 35 miles from Scottsdale, Arizona; or (iv) a material diminution in the authority, duties, or responsibilities of the supervisor to whom he is required to report, including a requirement that he report to a corporate officer or employee instead of reporting directly to the Board. “Good Reason” as defined in Ms. Pruitt’s and Mr. Engstrom’s employment agreements, generally means, in the absence of a written consent of the executive: (i) except for executive nonperformance, a material diminution in the executive’s authority, duties or responsibilities (provided that this provision will not apply if executive’s then-current base salary is kept in place) or (ii) except in connection with a material decrease in our business, a diminution in the executive’s base salary in excess of 30%.

I like the "Good Reason" clause that states that if HTA's offices are moved more than thirty-five miles from Scottsdale it is reason enough to trigger the CEO's termination clause.   HTA's 10-K states that the termination amount at the end of 2009 for the CEO / President/ Chairman of the board would have been $11,037,118.   If moving the office more than thirty-five miles is worth $11million, what's it worth if the printer runs out of toner?  $500,000?  What a crazy clause.  This REIT's board needs to get its act together and straighten out this compensation.  If the CEO saw a nearly six times leap in salary for lackluster financial performance, it's hard to imagine what's he going to want in compensation if performance improves for real.

Can't Fix Stupid
AIG looks to sue Goldman Sachs over losses in mortgage-backed securities that AIG insured, and then on which AIG had to pay claims when the insured securities failed.  (I think the taxpayers, via AIG's bailout, played a large role in paying AIG's claims).  AIG reminds me of a fat guy trying to hustle Michael Jordan in a game of H-O-R-S-E because he has one trick shot, and then claiming Jordan cheated after he gets beat and loses all his money.  Goldman, other Wall Street firms and hedge funds took advantage of AIG's dimwitted, short-term thinking, where AIG collected premiums for insurance it did not reserve against because it was unregulated (and therefore AIG was under no legal obligation to reserve against it), and that it never expected it'd have to honor.   The explosion in credit default swap demand should have alerted AIG to the huge problems in the mortgage market, but AIG thought it had created a new way to mint money.  The guys from State College should not play financial H-O-R-S-E with the guys from Harvard and Stanford.

Smoking Gun?
Here is an article from yesterday's New York Times about the involvement of Goldman Sach's senior management in decisions relating to the mortgage market.  I don't see a smoking gun here, I read just the opposite, that Goldman's senior management was actively engaged in what the firm's mortgage traders were doing.  This is the type of engagement that shareholders should expect from top management, especially in a line of business that had seen dramatic growth in a relatively short period of time.  It's the type of engagement that taxpayers would have liked to have seen at AIG, as a once small division (Financial Products) became huge in very short time writing un-reserved insurance policies against newly created securities that never been exposed to a full market cycle.

The article details Goldman Sach's internal debate over the housing market and how the bears prevailed in late 2006.  This was before the early-2007 collapse of the two Bear Stearns' funds that started the subprime mortgage implosion.  Goldman made a lot of money when the crap mortgage securities began to decline in value.  Here is a long quote from the article:

Goldman’s top ranks changed its stance on housing in December 2006. In a meeting in a windowless conference room on the executive floor, Mr. Viniar, the chief financial officer, and Mr. Cohn, the president, gathered about 10 executives for a briefing. Mr. Sparks, the head of the mortgage unit, walked them through the numbers. The group was unanimous: Goldman had to reduce its exposure to the increasingly troubled mortgage market

A few months later, in February 2007, senior executives began turning up on the trading floor. The message, one former employee said, was clear: management was watching.

“They basically said, ‘What does this department do? Tell us everything about mortgages,’ ” this person said.
The executives told Mr. Sparks to tell his traders to sell Goldman’s positive bets on housing. The traders’ short positions — that is, negative bets, mostly used to hedge other investments — were placed in a central trading account.

Not everyone was happy about it. One trader leaving the firm wrote the mortgage unit a one-word e-mail message: “goodbye.”

Goldman turned over all these negative positions to Mr. Swenson and Mr. Birnbaum, the traders who had previously been positive on the market. Along with Mr. Sparks, they have been credited for managing the short position that yielded a $4 billion profit for Goldman in 2007. Mr. Sparks retired in 2008. Mr. Birnbaum also left in 2008, to start his own hedge fund.

But former Goldman employees said those traders benefited from the short positions that were given to them. And their trading was tightly overseen by senior executives.

At one point in the summer of 2007, for instance, Mr. Birnbaum made a case to Mr. Cohn that some mortgage assets were cheap and that Goldman should let him add $10 billion in positive bets. Mr. Cohn said no.

Goldman / Paulson's Magnetar Trade

My last post linked to an article that detailed how a hedge fund helped create CDOs and then bet against those CDOs.  Today, the SEC charged Goldman Sachs with doing nearly the same thing.  Goldman, according to the civil suit filed today, allowed hedge fund manager Paulson & Co to select mortgages for inclusion into CDOs.  Paulson selected the mortgages it felt had the most default risk.  Goldman then sold the CDO to institutional investors while Paulson bought a credit default swap (insurance) that paid off when the CDO defaulted.  Here is an explanation from the New York Times:

According to the complaint, Goldman created Abacus 2007-AC1 in February 2007, at the request of John A. Paulson, a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst. 

Goldman let Mr. Paulson select mortgage bonds that he wanted to bet against — the ones he believed were most likely to lose value — and packaged those bonds into Abacus 2007-AC1, according to the S.E.C. complaint. Goldman then sold the Abacus deal to investors like foreign banks, pension funds, insurance companies and other hedge funds. 

But the deck was stacked against the Abacus investors, the complaint contends, because the investment was filled with bonds chosen by Mr. Paulson as likely to default. Goldman told investors in Abacus marketing materials reviewed by The Times that the bonds would be chosen by an independent manager.

I like this paragraph near the end of the article.  Our old friends at AIG, of course, provided the insurance through the credit default swaps that made Paulson so much money:

In seven of Goldman’s Abacus deals, the bank went to the American International Group for insurance on the bonds. Those deals have led to billions of dollars in losses at A.I.G., which was the subject of an $180 billion taxpayer rescue. The Abacus deal in the S.E.C. complaint was not one of them.

Must Read
Here is a link to an incredible article about the financial crisis.  It details how one hedge fund helped prolong the credit boom.  Cracks in the system began to show in 2005 when spreads on securitized loans (CDOs) began to expand, as Wall Street became nervous about the quality of the securitized offerings.  In stepped a new hedge fund, Magnetar, which aggressively sought the riskiest pieces of new CDOs called the "equity" tranche.  Magnetar's willingness to acquire the small portion of equity, in the range of $10 million, and typically the hardest part of a CDO to sell, allowed investment banks to create CDOs in the range of $1.5 billion or more.  Magnetar even had a hand in developing the CDOs, picking actual securities that would comprise a CDO's holdings.  Magnetar wanted the riskiest loans available in the CDOs where it bought the equity.  While Magnetar was buying the equity and loading up the CDOs with as much risk as possible,  it was also buying credit default swaps, betting that its CDOs would default.  Defaults was where it made huge profits, more than offsetting the loss of the equity portion.  At one point, Magnetar was even able to package and sell some of its CDO equity portions.

Magnetar's willingness to buy high risk CDO equity sparked a resurgence in the CDO market, and therefore mortgage lending, leading to record underwriting of CDOs in 2006 and into 2007, until the whole market collapsed in the summer of 2007.  Magnetar posted huge profits in 2007 as its bets against its CDOs paid off.  This article debunks the thought that no one saw the credit crisis coming.  As early as 2005 the warning signs were apparent, but the availability of money, especially equity, caused investment banks to overlook the obvious.

Employment Figures
The economy added 162,000 net new jobs in March.  I think this is good news, even if about a quarter of the jobs are temporary Census hires.  I like the look of the chart below, stolen from FiveThirtyEight.com:

It shows employment trending in the right direction.  The unemployment rate stayed at 9.7%, reflecting in part more people who'd been out of the work force coming back looking for work.  The link above to FiveThirtyEight has more in depth analysis of today's report.

More on Non-Traded REITs 
I mentioned at the end of the last post that I'd have more to write on Behringer Harvard Multifamily REIT I (BHMF).  I think it is important that broker / dealers and investors read its 10-K.  It's complicated, but will give you a good picture of what the REIT owns.  It may surprise some broker / dealers to know that the REIT's strategy has been to acquire apartment complexes via development, and more specifically through mezzanine loans to apartment developers.  The mezzanine loans are junior to construction loans and the mezzanine loans will convert to equity when the developments are complete.  Many of the REIT's recent acquisitions have been newly constructed apartment complexes (or properties originally build as condos that are now being rented as apartment communities) that need to be leased. 

I don't have a problem with BHMF's investment strategy.  It's a perfectly fine, legitimate method of acquiring real estate.  Broker / dealers need to understand that BHMF is not simply buying cash flowing garden style apartment complexes.   BHFM's investment strategy will not allow it to pay distributions from operating cash in the near term because its properties are either under construction or in lease up.  Given the strategy, the negative Funds From Operation is not shocking or even unexpected, but it's eye-opening when you see that the REIT paid a 7% distribution to investors.   I don't have a guess when operations will fully cover the REIT's distribution, but I wouldn't expect it to cover in 2010.  Note that the BHMF had actual rental revenue in the fourth quarter.

Investors need to be compensated for the extra risk of development and acquiring properites in their lease-up phase.  This is simple investment risk/reward, where a risky investment should pay a higher return than a less risky investment.  Obviously, an investment that develops its properties should generate a higher return to its investors than an investment that acquires existing properties with established, stable income.

Sponsors of non-traded REITs get pulled by competing forces.  Broker/dealers want high distributions, but they want those distributions to be stable, low-risk and covered from operations immediately.  BHMF raised more than $40 million a month for the first two months of 2010.  I wonder how much this REIT would raise if it told broker/dealers it would only pay distributions generated from operating cash?  I don't think it would be $40 million a month.  You can't single out BHMF for "buying" its equity capital with the 7% distribution, because it is not alone in this practice, far from it.

Broker / dealers should analyze specific acquisitions made by their approved non-traded REITs that are in capital raising mode.  This eliminates the influence of excess cash waiting to be invested, and determines whether acquisitions are accretive to the REITs' expected or current distributions.  (A specific property's cash return to a REIT, based on the  REIT's investment in the property, should generate sufficient cash to support a REIT's distribution.)  If a REIT is acquiring non-accretive properites, broker / dealers better ask why, because REITs that are acquiring properties that are not accretive to their current distributions will eventually have to cut their distributions.  Broker / dealers should not feign surprise when distribution rates get cut.

Never Ceased to be Amazed
I am reading Behringer Harvard Multifamily REIT I's  2009 10-K, which was released today.  In 2009, it had Funds From Operations of -$700K.  That's right, a negative FFO.  Its operating cash flow was a measly $244K, which was at least positive.  These robust cash returns allowed the REIT declare distributions of $22.7 million.   Well, at least this REIT's mortgage debt was only $51 million on $525 million of total assets. Ahh, but not so fast.  You need to read those pesky footnotes.  The actual amount of debt is higher, much higher.  This additional debt, of which $247 million is the REIT's portion, is off-balance sheet financing and attributable to a joint venture and property-level operating entities that the REIT owns or has ownership in.   I will leave my findings at these gems, because I need to eat dinner soon and for some reason have lost my appetite.

In all seriousness, and the above snarky post is serious, I encourage you to download and read this 10-K.  I only read snippets of this massive document to pull out the teasers above, so I am sure a wider, more comprehensive reading will reveal more material passages.

Today's Housing Figures
The reaction to today's release of the monthly S&P / Case-Shiller index of twenty metropolitan markets has been mixed.  I for one think the news is good.  The index, which was up .3%, showed that the housing market was improving without the Government's tax credit for first time homebuyers.  Yes, the credit is still available, but from what I have read, its impact on the most recent numbers is much less than last fall when buyers rushed to take advantage of the tax credit that was initially set to expire at the end of November.  California was a big beneficiary of the increases with some markets up 1% or more.  

Here is a quote from a naysayer in the LA Times:

"If you look at the last two big real estate bubbles in the late 80s and 70s, you didn't see the market rebound for five years," said Christopher Thornberg, principal of Beacon Economics. "It's amazing to me that people can look at a rebounding market after the largest bubble ever and possibly think this could be sustainable."

He is right of course, but the key is when the bubble peaked.  In California, and other areas like Las Vegas and Phoenix, the bubble peaked much earlier than other parts of the country.  The bubble's peak was not marked by by the subprime explosion in mid-2007, but when values stopped increasing, which lead to the prime and subprime borrowers not being able to continue their cycle of endless refinance.  I reckon that California peaked in the summer of 2005, not the summer of 2007, so we are approaching the magical fifth year. 

Don't Look Now...
Piedmont Office Realty Trust (PDM), formerly named Wells Real Estate Investment Trust, crossed $20 per share this morning.  It had its IPO in mid-February, began trading near $15 per share, and has been creeping up ever since.  As part of its listing process, PDM had a three-for-one reverse split, so to figure an investor's breakeven share price, you need to adjust for the split.  The breakeven share price reflecting the split is $25.14 per share.   The current price of $20 is therefore about 20% under its breakeven.  It is worth considering that PDM raised most of its equity capital and acquired the bulk of its portfolio in the late 1990s and early 2000s, and as noted in a post yesterday, Moody's states that commercial real estate prices are now at 2003 levels.

Commercial Real Estate Prices
I have read several articles over the past few weeks stating that Commercial Real Estate (CRE) prices are increasing, so I figure it's now time to start commenting.  Here is a link to a Calculated Risk post (scroll down) about a Moody's report that CRE prices increased 1% in January.  Overall, CRE prices are 40% off their 2007 high, and near 2003 levels.  I have not seen this article yet, but am waiting for the article equating the increase in CRE prices to an increase in available financing.  Commercial Mortgage Backed Securities (CMBS) are staging a slow comeback that will make for more non-distressed transactions.  Real estate always has and always will be a finance game - if affordable debt is available, there will be buyers and sellers.  Low interest rates and an improving economy are also signaling that a bottom has passed in CRE prices. 

In Praise of Cash Flow
Over the past few weeks I have looked through numerous public non-traded REIT 10-Ks and supplemental financial filings.  All present Funds from Operations (FFO) and Modified (or Adjusted) Funds from Operations (MFFO).  FFO used to be a fairly simple calculation:  Net Operating Income plus depreciation and amortization, and less any cash from property sales.  But over the years, this non-GAAP number appears to have become bastardized, and in my opinion, less reliable.  Non-traded REIT sponsors used to shun this number, but with the rise of MFFO, they are embracing the figure as it has the impact of making distribution coverage look better.  MFFO figures now include items from investing - acquisition fees - and from financing - interest hedging gains and losses - which may or may not be actual cash figures, and are not operational figures.

That is why I am spending more time looking at cash flow from operations, which is a GAAP number and that is adjusted for non-cash items like depreciation, and discounting MFFO figures.  I review all three figures to the amount of total distributions (cash and reinvested) the non-traded REITs have paid during the year.  The more the REIT covers from operating cash and FFO the better.  Lack of operational cash flow coverage is a harbinger of potential future distribution cuts.

Condo Link
Here is a link to a Calculated Risk post on vacant condos in South Florida.  One 32-story high rise condo in Fort Meyers has only one owner living in the building.  The lone owner is fighting the condo developer The Related Group to get out of his condo.  Good luck with that.  Condo developments that only sell portion of their units are a mess because the whole complex is then subject to the condo association, which makes conversion to an apartment rental property difficult.

Non-Starter
I did a cursory review of a tenant in common deal yesterday (yes there are still some available).  This deal acquired the property last summer and is still raising equity.  The property's underlying operations have deteriorated over the past year.  The deal's sponsor felt it had a great buy, which may have been true when the property was acquired, but based on current operations I am figuring a cap rate to TIC investors of less than 5%.  Most of the distribution is being paid from reserves.   Why? Why? WHY? 

This deal has legacy economics (low cap rate, negative leverage (cap rate less than mortgage rate) and supplemented distribution) in a non-legacy world.   Paying the taxes makes sense over investing in this deal.

There are other tenant in common deals raising equity that acquired their properties before September 2008.  Talk about legacy deals.

Financial Times Profiles Stuyvesant Town and Peter Cooper Village
Last Saturday the Financial Times profiled the poster child of real estate excess - Blackrock's and Tishman Speyer's 2006 acquisition of Stuyvesant Town and Peter Cooper Village (STPC).  The $5.4 billion transaction was eye-opening even in an era of wild deals.  Earlier this year the 11,200-unit apartment complex, which started construction in 1943, defaulted on its debt and is now with its special servicer.  Prominent real estate investors are looking at the huge property, and the drama is sure to drag on for a long time.  The estimated value for STPC is $1.8 billion.

One party that gets no press in the whole STPC discussion is Met Life Insurance.  Met Life developed and owned STPC since its inception.  Met Life sold it at the top of the market for a huge price.  Met Life sold other real estate in around New York, including its landmark headquarters.  I'm not sure what Met Life did with the proceeds (hopefully it did not load up on subprime mortgage bonds) but its divestiture strategy was prescient.