Naural Gas Overestimates

Here is another Sunday link, this time to a New York Times article on the natural gas industry.  The article details how industry projections for shale drilling in three separate formations are not matching expectations, and that shall drilling may end up being more expensive than forecast.  Here is a passage summarizing the article:

Company data for more than 10,000 wells in three major shale gas formations raise further questions about the industry’s prospects. There is undoubtedly a vast amount of gas in the formations. The question remains how affordably it can be extracted.

The data show that while there are some very active wells, they are often surrounded by vast zones of less-productive wells that in some cases cost more to drill and operate than the gas they produce is worth. Also, the amount of gas produced by many of the successful wells is falling much faster than initially predicted by energy companies, making it more difficult for them to turn a profit over the long run.

Here is a longer, second passage buried deep in the article:

Production data, provided by companies to state regulators and reviewed by The Times, show that many wells are not performing as the industry expected. In three major shale formations — the Barnett in Texas, the Haynesville in East Texas and Louisiana and the Fayetteville, across Arkansas — less than 20 percent of the area heralded by companies as productive is emerging as likely to be profitable under current market conditions, according to the data and industry analysts. 

Richard K. Stoneburner, president and chief operating officer of Petrohawk Energy, said that looking at entire shale formations was misleading because some companies drilled only in the best areas or had lower costs. “Outside those areas, you can drill a lot of wells that will never live up to expectations,” he added.


Although energy companies routinely project that shale gas wells will produce gas at a reasonable rate for anywhere from 20 to 65 years, these companies have been making such predictions based on limited data and a certain amount of guesswork, since shale drilling is a relatively new practice.
Most gas companies claim that production will drop sharply after the first few years but then level off, allowing most wells to produce gas for decades. 

Gas production data reviewed by The Times suggest that many wells in shale gas fields do not level off the way many companies predict but instead decline steadily. 

“This kind of data is making it harder and harder to deny that the shale gas revolution is being oversold,” said Art Berman, a Houston-based geologist who worked for two decades at Amoco and has been one of the most vocal skeptics of shale gas economics. 

The Barnett shale, which has the longest production history, provides the most reliable case study for predicting future shale gas potential. The data suggest that if the wells’ production continues to decline in the current manner, many will become financially unviable within 10 to 15 years. 

A review of more than 9,000 wells, using data from 2003 to 2009, shows that — based on widely used industry assumptions about the market price of gas and the cost of drilling and operating a well — less than 10 percent of the wells had recouped their estimated costs by the time they were seven years old.

Terry Engelder, a professor of geosciences at Pennsylvania State University, said the debate over long-term well performance was far from resolved. The Haynesville shale has not lived up to early expectations, he said, but industry projections have become more accurate and some wells in the Marcellus shale, which stretches from Virginia to New York, are outperforming expectations.

This article presents nothing new for people that follow the oil and gas industry.  Rosy forecasts that fall short, and costs that exceed expectations have been a hallmark of the oil and gas industry for as long as I have been looking at it, so it makes sense that newly drilled shale formations would cost more and produce less than anticipated.

Sunday Morning Links

I've had two tabs open in my browser for several days in anticipation of writing a longer post on the housing market, jobs and the economy.  I am not going to get to that post anytime soon, but wanted to link the tabs anyway.  The first is from The Economist's Free Exchange blog and is about housing leading the way to a sustained economic recovery.   The second link is to a Wall Street Journal article, (via Yahoo Finance), also discussing housing but from the finance angle.  Is describes mortgage bond security guru Lewis Ranieri's latest venture, which is starting a private, non-traditional lender to step into the mortgage market because banks' credit standards are too restrictive.  Yes, the "subprime" word is mentioned, but I'm convinced Ranieri's and others' ideas on the mortgage market make sense.  I have come to the conclusion that housing is the key to jobs and economic growth, and until housing improves the economy will struggle. 

Rip Van Veres

I saw this Bob Veres' Financial Planning article yesterday morning.  I've read it a couple of times and wonder where Mr. Veres has been the past ten years.  (I will state upfront that this post is not a bash on Bob Veres just this one article, as I have read his material for nearly twenty years, and he has forgotten more about the financial planning industry than I'll ever know.)  Sorry to break this to you Bob, but non-traded REITs are not a "new category of investments."  The non-traded REIT business is now nearly a $100 billion industry, based on data I have seen recently published, and grew through steady equity raise of $5 billion to $10 per year over the past decade.  The comparison of the current non-traded REIT business to the limited partnership boom of the 1980s is weak. 

I broke into the broker / dealer industry in the late 1980s as a junior analyst assigned to the "continuing" due diligence department at a mid-sized independent firm.  Continuing due diligence was a fancy term for the saps assigned to field angry calls from brokers, and sometimes their clients, to tell them that their limited partnership investments were worthless.  A trial by fire.  Coming out of college, I had no clue what a partnership was, and in a short period my bosses that knew answers to questions were fired, so I had to educate myself.  Big partnership sponsors like August, Balcor, Equitec, VMS, Krupp and a slew of smaller ones all went away.  One of the biggest syndicators was Dallas-based Hall Financial Group, run by Craig Hall, which specialized in apartments.  He too failed.  (His afterlife has not been all bad.  His wife was an ambassador to Austria under President Clinton, Craig Hall's current firm is still doing real estate, and he and his wife run a respected wine business, although I won't buy a bottle.)  

The limited partnership business of the 1980s that Bob Veres is trying to compare to today's non-traded REIT business, was marked by massive failure.  Veres states that these deals collapsed under the weight of their fees, costs, expenses and deal structures.  This is true to a point.  Does anyone remember the infamous land deals that where structured as two offerings, one debt and one equity, where the debt investment was used to buy the raw land and the equtiy was used to pay interest on the debt and carry the land for a supposedly short period?   These deals did not end pretty.  I think a case can be made that a favorable tax code, which lead to the overbuilding of commercial real estate, and also caused the S&L collapse, hurt limited partnerships as much as fees.

Most limited partnerships lost their properties or were consolidated into other entities.   The term "Roll-Up" is still a four-letter word in the independent broker / dealer world because of the disastrous late 1980s and early 1990s roll-ups of Equitec, VMS and Krupp, which became the innocuous named entities Hallwood, Banyan and Berkshire, respectively.  Two roll-ups that kept their names, Realty Income Corp and Public Storage, worked out pretty well for investors that stuck around.

The non-traded REIT business of the late 1990s, lead by Wells and Inland, and since with multiple sponsors, has been marked by the lack of catastrophic failure.  This is amazing considering the 49% drop in commercial real estate prices from their 2007 peak.  Some REITs are struggling, as evidenced by net asset valuations of REITs like KBS REIT I, Inland Western, Dividend Capital's Total Realty Trust, Behringer Harvard's Opportunity I and others, which are all valued much less than the original $10 per share offer price.  But while these REITs have seen their net asset values drop, there is no talk (that I know of) of these REITs ceasing to exist.  As noted above, commercial real estate in the 1980s was driven by a favorable tax code that lead to signfianct over building.  Commercial real estate in the 2000s did not, for the large part, have the overbuilding that marked the 1980s, which has helped the non-traded REITs keep their properties occupied.  The non-traded REITs, in general, do not have the high levels of debt that was common in the 1980s.  These factors, in my opinion, have helped the non-traded REITs avoid the problems that faced limited partnerships in the 1980s.

I think Mr. Veres' article would have been stronger and more relevant, if he'd compared the limited partnership industry of the 1980s to the TIC boom of the 2000s.  This is the better analogy because both were marked by tax driven investors looking to avoid or defer taxes as first consideration, and both had highly leveraged properties.  And like the limited partnerships of two decades ago, it's my opinion that most TIC deals will end up being lost to foreclosure, or more likely consolidated with other TICs.  I don't believe TIC consolidation is a four-letter word, but that's a subject for another post.

The end of Veres' article falls further when he discussses non-traded REIT earnings.  He lists some non-traded REIT earnings, all that are bad.  He needs to focus on Funds From Operations (and NOT Modified Funds from Operations).  FFO for REITs, whether listed or non-traded, is the most widely recognized metric for financial health, due to the large amount of non-cash write-offs afforded REITs.

Another area that separates the 1980s' partnership boom and today's non-traded REIT business in the independent broker/dealer business, itself.  I don't have specifics, but I would guess many independent broker / dealers had partnership business that was probably 50% or more of their total revenue and needed partnership sales for their survival.  Today, broker / dealer executives break into a cold sweat if alternative investments (under which non-traded REITs fall) are more than 10% of revenue. 

One area where Mr. Veres focus was correct was raising the specter of Robert Stanger & Co. in the limited partnership boom of the 1980s and today's non-traded REIT industry.   I'd like to know more about this, too.   It is good that Bob Veres has turned his eye to this "new category of investments," and non-traded REIT sponsors better be ready if a bearded man with a ponytail stands up at a conference and starts asking pointed, uncomfortable questions.  He doesn't take BS for an answer.

Inland Western REIT's New Value

Inland Western filed an 8-K yesterday with a new net asset value per share.  Inland Western estimates that its net asset value was $6.95 per share at March 31, 2011.  This is an increase from early 2010's $6.85 per share valuation.  Here is the opaque language, which now is common place with non-traded REIT sponsors, in the 8-K describing how Inland Western determined its valuation:

The estimated value was determined by the use of a combination of different indicators and an internal assessment of value utilizing internal financial information under a common means of valuation under the direct capitalization method.  No independent appraisals were obtained. Specifically, the estimate of the estimated per-share value was made with primary consideration of the valuation of the Company’s real estate assets which was determined by the Company’s management using methodologies consistent with publicly traded real estate investment trusts in establishing net asset values, and the estimated values of other assets and liabilities determined by the Company’s management as of March 31, 2011.

I was pretty outraged in early 2010 when Inland Western presented a value of $6.85, thinking it too high.  I guess I have mellowed over the past year because I read the filing without much of a reaction.  I think this is because Inland Western, if I am not mistaken, is planning on listing its shares in the near future.  A listing will give a true market valuation of Inland Western, and while its net asset valuation may have some merit, the stock price will be the tangible value.

Areas of Interest

I recently signed up for a nifty data collection service that notifies me any time select public companies make an SEC filing.  I set up the system up to receive notification on about a dozen non-traded REITs, and plan to include most all non-traded REITs in the near future.  Yesterday, Monday, I received a huge data dump from about half the non-traded REITs on my watch list.  The filings were all correspondence between the SEC and the non-traded REITs, with the SEC asking questions and wanting clarifications on these non-traded REIT's filings, in particular 10-Ks. 

All notifications included the initial SEC inquiry, the non-traded REITs' follow-up, any future questions and follow-ups, and the final letter from the SEC saying it had no further questions.   There was a general theme and consistency across the SEC's question and answer with the non-traded REITs.  First, the SEC wanted to know how the non-traded REITs determined their average lease rates and if this average included discounts and rent concessions.  The answer across all REITs was "no," the average lease rates excluded concessions.

Second, the SEC wanted to know how the REITs determined cap rates that the REITs included in their  filings.  To me, this seemed more disclosure related than questioning the actual cap rates, as the SEC didn't seem to have an issue with "average" cap rate (which I discussed here), it just seemed to want to know the formula used for calculating the disclosed cap rates.  The cap rates are all pro forma based on the non-traded REIT's estimate for first year net operating income (which is then divided by the purchase price to determine cap rate), or in the case of the averagers, the average pro forma NOI over the anticipated hold period divided by the purchase price. 

Finally, the SEC had questions on Modified Funds from Operations.  I get the sense that the SEC holds MFFO in about as much esteem as I do.  To paraphrase my take on what the SEC was inquiring about regarding MFFO, and again this was a theme across multiple non-traded REITS, was it was trying to determine why the non-traded REITs exclude acquisition costs from MFFO because REITs are in the business of buying and selling real estate, which obviously involves costs.  The response was that non-traded REITs exclude acquisition costs to make prior period comparisons more meaningful.  I am not going to argue this point, but will continue to discount MFFO until a REIT has fully invested its equity and MFFO really only consists of adjustments for straight line leases. 

Fifteen Cents on the Dollar - Vegas Style

Late last month I noted a land sale in Arizona that sold for eight cents on the dollar based on peak mid-2000s pricing.  Here is another example, this time in Las Vegas.  Calculated Risk and the Las Vegas Sun detail a property in Las Vegas (not sixty miles away like the discounted Arizona land sale) that sold for $30.2 million in 2007 and just sold for $4.4 million, an 85% discount.  For some reason, seeing Southwest land sales at discounts of 92% and 85% made me wonder how IMH Mortgage Holdings' portfolio is maintaining its value.

Vintage Years

When I think of vintage years and investing, I think of venture capital or private equity deals.  It is my opinion that the concept of vintage years evolved as a way for managers (and marketers) to explain away poor performance.  They created an excuse to blame bad deals and weak returns on the year in which a fund made its investments, rather than lousy investment decisions.  I have never really heard it widely applied outside the VC world, but its a concept that needs wider application.   Some real estate sponsors can make a strong case to play the vintage blame game. (And can't equipment leasing sponsors blame every year on the vintage?)

I have always been aware of vintage issues related to real estate investments, or, really, any pooled investment that raises and invests money over a particular time period.  This idea solidified when I was recently reviewing the performance of two, large non-traded REITs, both with identical objectives, acquisition philosophies and management, that were issued by the same large real estate sponsor, and that raised about the same amount of investor equity.  The only difference was when the REITs raised and invested capital.  From a performance perspective, the two REITs are Jekyll and Hyde, night and day, black and white.  The REIT that raised and invested money in 2006 to 2008 is having troubles and the REIT that raised and invested money in 2009 to 2010 is looking solid. The first REIT is not alone, as many REITs that were raising money over the same time 2004 to 2008 frame are facing a difficult environment.

I always thought of REITs, even non-traded REITs, as open-ended corporations with infinite lives that had the ability to actively buy and sell property, and that would eventually have a a mix of real estate, bought over different periods.  I did not pay too much attention to the years when the REITs were buying property, as I thought it would all even out over time.  Now I don't believe this.  When a REIT buys its initial portfolio will make a big difference in its long-term performance.  While you can't predict with certainty how current markets will relate to the future or what the future will bring, it is clearly an issue that needs consideration.

What's A Mega-Mansion?

I saw the Orange County Register's real estate blog had a post title referencing a "mega-mansion" and had to click through.  I thought that word "mansion" alone signified a big home, and that "mega" was a redundancy.  I am not so sure after reading about the 12.5-acre estate that has a 17,000 square foot house, private lake, tennis courts, an actual wine cave, vineyard and horse stables.   The estate is near the end of construction but financial problems have resulted in stopped construction and bankruptcy filings.  It was once valued as high as $81 million but now is being shopped at a lowly $37 million.  The home was owned and built by a partnership.  It filed for bankruptcy, following the bankruptcy filing of the mega-mansion's project manager / real estate broker.  There are 299 creditors that filed claims against the partnership.  The slide show of the estate is worth viewing.

Profound Quote
"If you're that upset about how big the bowl for your free cereal is, leave."
Pixar's John Lasseter's response to a new employee who complained in an email about the free cereal bar at Pixar.  The quote is from great article on Pixar in the May 16th issue of The New Yorker.  (The link is only an excerpt from the article.)   The employee did not last at Pixar.

End of an Era
Independent broker / dealer Omni Brokerage has closed its doors.  Omni was a leading proponent and seller of syndicated real estate investments, in particular tenant in common programs.  I suspect that Omni's lack of product diversification was crippling during the real estate downturn.   The Investment News article (linked above) tries to correlate Omni's closure to failed TIC deals by DBSI, but I am not sure I believe this argument.  Omni was the first and loudest champion of strict due diligence and disclosure for TIC products.  It tried to tame the frenzy that was the TIC market place in the early 2000s as much as it tried to capitalize on it.  While Omni's legacy will be inextricably tied to the rise and demise of TIC syndications, investors and broker / dealers benefited, and will continue to benefit, from its efforts to improve deals, emphasize due diligence, and its push for more transparency and disclosure.

David Lerner and Apple REIT
The news that FINRA filed a complaint against David Lerner Associates (DLA) hit yesterday.  Here is a Bloomberg article.  According to the article DLA is accused of "of targeting unsophisticated and elderly customers while selling real estate investment trust shares without considering whether the illiquid security was suitable for its clients."  Here is another quote:

In soliciting customers for Apple REIT Ten, DLA provided misleading information about distribution rates for a series of predecessor securities that are now closed to investors, Finra said. The figures failed to show that distributions far exceeded income and were funded by debt that increased leverage in the REITs, which invest in extended-stay hotels, the regulator said. 

DLA denies the allegations.   I find it shocking that at a non-traded REIT would not only use leverage, but also pay distributions that exceed income.

I don't know anything about the Apple REITs other than what I have read the past day.  The Snyder Kearney blog has a more serious post on this matter and link to the FINRA news release.

Update:  Here is a good Wall Street Journal article on DLA and Apple REITs.  Here is a key section:

At the root of Finra's action against the Lerner firm is the way that four Apple REITs have generated returns in the past and maintained their shares at a constant price of $11. All of the REITs, which were launched from 2004 to 2008 and primarily purchased extended stay hotels, have been paying returns of 7% to 8%, according to the complaint.

But the Lerner firm has failed to disclose, in describing the products on its website, that the income from real estate was insufficient to support these, Finra said. Rather, the distributions were partially funded by "leveraging the REITs through borrowings and returning capital to investors," the complaint states.

Finra also said the constant $11-a-share valuations for the four REITs are inaccurate, given they didn't reprice during the financial crisis when the extended stay hotel market "suffered a significant, material downturn." The valuations, Finra said, should have been a red flag for the Lerner firm, spurring it to conduct further due diligence before selling its latest product, Apple REIT 10.

Eight Cents On The Dollar
I have been in the basement over the long weekend.  This Bloomberg article (and related Calculated Risk post) from over the weekend caught my eye.   I'm no Arizona geography expert, but sixty miles southwest of Phoenix sounds like the middle of scorching Nowhere:

A 10,200-acre (4,100-hectare) desert site in Arizona sold for $32.5 million this week, five years after a group with investors including the California Public Employees’ Retirement System paid $400 million for the land.

Arcus Property Solutions LLC, a private-equity fund with about $100 million under management, paid cash for the property in Goodyear, about 60 miles (97 kilometers) southwest of Phoenix, said Kent Kleinman, a spokesman for the Gilbert, Arizona-based company. The site, now called Amaranth Land LLC, had been planned for a 42,000-home community by the Calpers- financed group when it was purchased in 2006.

The plan for the 42,000 homes is on indefinite hold, with cattle grazing the current use and potential future revenue sources that include selling water rights or allowing Goodyear to expand its landfill.  I like this part of the article:

The 2006 buyers were a joint venture of MW Housing Partners III LP, a real estate fund with money from Calpers and Weyerhaeuser Co. (WY); and Scottsdale, Arizona-based Montage Land LLC, according to Arizona Corporation Commission records. The deal was funded by a $250.1 million loan and $150 million in cash, according to Terry McDonnell, publisher of Business Real Estate Weekly of Arizona in Scottsdale. 


“Of all the speculative deals I’ve seen here, this was right at the top,” McDonnell said in a telephone interview. “It’s hard for me to think of a more speculative deal of this magnitude in Maricopa County.”

Hines REIT Reprices
Hines Real Estate Investment Trust, Inc. filed an 8-K yesterday announcing that it has valued its shares, as of March 31, 2011, at a price of $7.78 per share.   The valuations were determined using the following:

The estimate of the per-share value was made with consideration primarily of (1) valuations of the Company’s  real estate investments, including estimates of value which were determined by the Company’s management and independent third parties using methodologies that are commonly used in the commercial real estate industry (including discounted cash flow analyses and reviews of current, historical and projected capitalization rates for properties comparable to those owned by the Company); (2) valuations of notes payable, which were determined by an independent third party; and (3) the estimated values of other assets and liabilities which were determined by management, as of March 31, 2011.  In addition, the Company engaged an independent third party to review management’s market value estimates as of March 31, 2011 for selected assets that represented a substantial portion of the Company's property portfolio, and such third party has opined that management’s market value estimates are fair and reasonable.  Finally, the Board also considered the historical and anticipated results of operations of the Company, liquidity requirements and overall financial condition, the current and anticipated distribution payments, the current and anticipated capital and debt structure, and management’s and the Advisor’s recommendations and assessment of the Company’s prospects and expected execution of the Company’s operating strategies.

In other words, they wrote some potential values on Post-Its, stuck them to a wall and threw a dart.  Joking aside, you should read this post from the Snyder Kearney blog on non-traded REIT valuations. 

Hines Advisors, LP, Hines REIT's external advisor, agreed to reduce its annual asset management fee from .75% to .50%, for the six-month period July 1, 2011 to December 31, 2011.  In other words, investors get a permenant impairment to value while management gets a temporary financial rebuke.

Real Estate Stories
Real estate fascinates me, especially a building with a history.   The story of how a property evolves over time to either become part of a city, town or neighborhood, or slowly erode is one that interests me.  When I was young, I would spend hours looking through my dad's book, Lost New York, which detailed architecturally beautiful or significant buildings that were torn down in New York City to make way for new buildings.  It is hard to imagine all the mansions that used to line Fifth Avenue that were replaced by today's buildings.

I recently came across two articles on two pieces of real estate with history.  The first is on Atlanta's Equitable Building, one of the city's first office towers.  I have seen this building on numerous trips to Atlanta.  The article does not go much into the building itself, except for its recent financial problems, but it was built in the 1960s and has become a landmark.

The second property is a hotel/motel in Orange County and its demise is detailed in three articles from the Orange County Register.  The articles are here, here and here.  (The slideshows in the first two links are worth viewing.)  In the 1960s and 1970s, the Saddleback Inn was the place to stay in Orange County.  It hosted Ronald Reagan and John Wayne, and the Washington Redskins stayed there before a Super Bowl.  In the 1980s a wave of new hotels across Orange County cut into the Saddleback Inn's business and it slowly began to deteriorate.    It is now closed and is associated with vagrancy, drug abuse and prostitution.  A fire in January gutted a portion of the old hotel and demolition is likely.

You can't compare a kitschy Orange County hotel with the Old Penn Station in New York City, but both properites have a story.  It is sad that the Saddleback Inn is going to get razed, especially now that some retro hotels and motels are getting renovated.  Atlanta's Equitable has the advantage of being a high-rise, and looks to have passed a point where it changed from being an office building to a city icon.

Triple Vision
I am trying to make sense of this Bloomberg article.  It's about as clear as an average cap rate.  The article summarizes commercial real estate price valuations from Moody's, CoStar Group and Green Street Advisors, Inc.  All agree that prices have dropped from their 2007 peak, but there is some big discrepencies in their data:

The Moody’s/REAL Commercial Property Price Index dropped 4.2 percent from February and is now 47 percent below the peak of October 2007, Moody’s said in a statement today.


Prices for investment-grade properties in the U.S. fell 4.9 percent in March from the previous month, CoStar Group Inc. (CSGP), a real estate data service based in Washington, said May 11. Values were up 2.2 percent from March 2010 and down 38 percent from the peak in June 2007, according to the company.


Green Street Advisors Inc., a real estate research company in Newport Beach, California, reported rising prices in April. Commercial property values increased 2 percent from the previous month and 18 percent from a year earlier, the company said May 5. Prices are down 13 percent from the August 2007 peak.

The dates differ and types of properties in the indexes differ.  For example, Green Street includes pending sales, and CoStar excludes properties below a certain size.  The quote below from an economist at a large commercial real estate brokerage made the most sense:

“We have reached the point in the cycle where there is a clear trend in improving demand, falling vacancy and stabilizing rents,” Kevin Thorpe, chief economist at brokerage Cassidy Turley in Washington, said in a telephone interview before the report. “Investors are buying well before commercial real estate has reached a full recovery.”

With data this varied, I have to keep repeating the old axiom that all real estate is local.

"Average" Cap Rates 
Late last year I noted the term "average cap rate" in relation to a Cole REIT's acquisition.  Cole took an average NOI over the anticipated hold period, rather the capitalizing the first year NOI.  Using an average cap rate implies an acquisition at better terms than in actuality.  For example, if you have a 100% triple net leased building that was purchased for $1 million and the first year lease payment is $60,000, the cap rate is 6%.  If the lease rate has 2% annual increases and a ten-year term, the average lease rate over the term of the lease is $65,698.  If the average lease rate is used to calculate the cap rate, the cap rate jumps to 6.57%.  This makes it seem like the buyer did not pay as much for the property.   This is wrong, because cap rates are based only on the first year's NOI.

Now I see another REIT using the bogus average cap rates.  American Realty Healthcare Trust made a filing on Thursday listing three potential acquisitions.  Each of the cap rates disclosed in the filing was based on the average lease rate over the lease term, not the first year NOI. The wordsmithing is:

"calculated by dividing annualized rental income on a straight-line basis less estimated property operating costs by the purchase price"

The phrase "annualized rental income on a straight-line basis" is the slight of pen.  

This cap rate discussion may be a mute point for American Realty Healthcare Trust, as it just broke escrow at $2 million, but will need cash of $28.5 million to close the three targeted acquisitions.  The REIT has to pay offering costs on its equity raise, and it just declared a 6.6% distribution.  It will have to have raise an additional $30 million or more to acquire the three properites, pay its load and distribution.  If the REIT has to use acquisition financing, then the disclosed cap rate figures will be evenless reliable.

Manhattan Development
Here is a Bloomberg article on developments in Manhattan.  The article goes through multiple development projects.  One statistic that jumped out at me was that 64% of Manhattan's office buildings are more than fifty years old.

Real Estate Update
The Blogger blogging software has been having problems since yesterday, which are impacting bloggers everywhere.  My post from yesterday has been temporarily removed, hopefully it will be restored soon.

In the meantime, here is a Calculated Risk post on a Reis report that covers some commercial real estate asset classes.  (Calculated Risk runs on Blogger, too, so it also has not been updating.)  The underlying performance in apartments and office space continues to improve, while malls are experiencing falling rents and increasing vacancies.

Few Degrees of Separation
Here is an interesting article from Bloomberg on Gramercy Capital's failure to repay $790 million of loans secured by approximately 900 properties.  On the surface this looks like another example of the unwinding of the credit boom of the mid-2000s.  To get to the interesting part you have to dig deeper and you'll find that two non-traded REITs are directly and indirectly involved.  In April 2008, Gramercy Capital acquired American Financial Realty, which was a publicly traded REIT.  If that sounds familiar, it should because several of the former principals of American Financial Realty are now running the non-traded REIT, American Realty Capital Trust (ARCT).  The principals had left several years before Gramercy acquired American Financial Realty and were therefore not involved in the acquisition or Gramercy's current financial problems.  The 900 properites that secure the loans in default are the assets from American Financial Realty, and are similar to the properties in the ARCT, stand-along properities subject to long-term leases.

KBS REIT I (through a subsidiary), along with Goldman Sachs, Citigroup and SL Green are the lenders involved. Here is an explanation from another article:

Gramercy Capital Corp. (NYSE: GKK) today announced that the scheduled maturity of its (i) $240.5 million mortgage loan (the "Goldman Mortgage Loan"), with Goldman Sachs Mortgage Company ("GSMC"), Citicorp North America, Inc. ("Citicorp") and SL Green Realty Corp. ("SL Green," and, collectively with GSMC and Citicorp, the "Mortgage Lenders"), and (ii) $549.7 million senior and junior mezzanine loans (the "Gramercy Realty Mezzanine Loans"), with KBS Debt Holdings, LLC ("KBS"), GSMC, Citicorp and SL Green (collectively, the "Mezzanine Lenders") has occurred without repayment by the borrowers thereunder and without an extension or restructuring of the loans by the lenders.

KBS REIT I is in a mezzanine position.  KBS REIT I made a filing last week on this debt that I am trying to understand, and it may be a subject of a future post.

I just found it interesting that the commercial real estate world can sometimes be a small place.

Lame Critique of Non-Traded REITS
Here is an article from Morningstar.com, written by columnist John Wasik on why an investment in non-traded REITs is a bad idea  Its a hack piece of opinion.  The author writes in generalities and innuendo.  Here is an example:

Yet one version of REITs--those that are unlisted--have been attracting unfavorable attention of late. Because they are ripe with problems and there are plenty of alternatives available, they are best avoided.

Regulators have been probing unlisted REITs, which have raised almost $60 billion from investors over the past decade. Watchdogs are concerned that retirees are being sold these investments with the pitch that they are low-cost and low-risk. They are neither.

The article states that non-traded REITs are ripe with problems.  Wasik fails to name the problems and gives no examples of specific malfeasance.  And regulators are probing unlisted REITs?  I have heard that regulators, mainly FINRA, are investigating non-traded REIT marketing and sales practices not the actual non-traded REITs and their operations.

In the nonsensical sentence below, Wasik confuses mutual funds with REITs:

Unlike REIT mutual funds that own stakes in a number of publicly traded companies that own properties, non-listed REITs sell shares directly through brokers.

What???  If you check almost any brokerage firm, mutual fund sales will far exceed the sale of non-traded REITs.  This may be the dumbest point in a stupid article. 

Here is more inanity when the author talks about alternatives to non-traded REITs:

Though you can invest in individual names, for most people, diversification makes even more sense when investing in REITs. You don't want to be too exposed to one sector such as malls, residential, or self-storage, or specific geographic regions. For example, you don't want to be stuck in a REIT that's heavily concentrated in South Florida, where the real estate market is hurting.

Yes, diversification makes sense.  I am not aware, however, of any non-traded REIT exposed to South Florida, or any other single geographic market.   Yes, even noxious non-traded REITs diversify across regions.  Wasik's one alternative to non-traded REITs is a Vanguard index mutual fund.  Its yield is less than 3%, so is it really a competitor?  I am all for indexing, diversification, alternatives and liquidity, but if you are doing a REIT index fund, it's not a stand-alone an income play.  You are going to have to research individual listed REITs that pay strong, consistent dividends to find a true alternative to non-traded REITS.

I know the flaws of non-traded REITs, unfortunately this article added nothing to the conversation.  Quotes from attorneys discussing non-traded REITs adds no credibility.  These attorneys are looking to sue brokerage firms on investor suitability grounds, not because the investment was a REIT.  If you are going to slam non-traded REITs, you have to name names and provide specific examples of why the non-traded REITs are so bad.

Thoughts on WP Carey CPA 14's Merger into CPA 16 Global
I went through the CPA 14 proxy / merger document in my spare time this week.   The entire transaction is affiliated and the values were determined by the WP Carey not the market.   WP Carey obtained a "fairness opinion" on the transaction, but the firm that issued the fairness opinion, based on my understanding after reading the opinion, did not opine on the values involved in the merger, but on the valuation methodologies used by WP Carey.  (How do I get that gig, getting paid big bucks to write a no-opinion opinion?)

As I noted in my previous email, the entire merger went under my radar.   The initial proxy statement went out in December and the transaction closed last week.  I don't have exact figures on the merger other than was what in the press release, and will have to wait until the second quarter financial results are posted in mid-August to get the final data.  Investors could either choose to take cash of $11.50 per share or merge into CPA 16, and see an increase in yield, from about 8.4% to 9.2%.  Up to 50% of the investors could choose the cash option.  The cash that would be available for choosing the cash out option would come from the following sources:

• CPA 14 was to sell properties to CPA 17 and to WP Carey that would net $89 million
• CPA 16 was to obtain a $300 million line of credit
• CPA 16 was to utilize a portion of its cash (which approximated $59 million at 12/31/2010)
• Finally, WP Carey was to purchase shares of CPA 16, if necessary

I estimate that CPA 14 had approximately $950 million of investor equity at year-end, and half that would be about $475 million.   WP Carey had to purchase $121 million of CPA 16 shares to complete the merger and meet the cash out requests.  I have never heard of a sponsor investing this much money in one of its own funds.  I find this figure staggering.  Non-traded REIT sponsors are notorious for not investing in their own deals, the ultimate chefs who refuse to eat their own cooking.  WP Carey not only had to cook, but also got stuck with the bill for a three-star, five-course meal, served with a couple of bottles of First Growth Bordeaux.

CPA 14 had approximately $1.5 billion in total assets at year end.  If WP Carey gets a 1% annual asset management fee, this is $15 million a year on the CPA 14 assets.  It will take over eight years for WP Carey to recoup its $121 million through the asset management fee.  CPA 16 is a long-term investment and should have at least several more years before a liquidity event.  WP Carey has just tied up $121 million for an indefinite period.

WP Carey will probably try to spin its purchase of $121 million of CPA 16 shares in a positive manner.  I don't believe for a second that WP Carey had any expectation it would have to invest so much money in CPA 16.  WP Carey has a reputation as being one of the smartest operators in the non-traded REIT business.  It looks to me like it was too smart by half in this transaction.  I am guessing that the maximum number of investors chose the cash-out options, despite the premium exchange price offered CPA 14 investors and a nearly .80% increase in distribution.   I know I write this too much, but this transaction and how WP Carey gets its $121 million out bears watching.

WP Carey Flies Under the Radar
I did not know about the WP Carey CPA 14 merger into CPA 16 Global until I saw the press release on my Google News screen.  The complexity of the transaction tells me I need to dig deeper into the filings.  I will have more on this in the next few days, but on first blush, this is one huge affiliated transaction. 

Cornerstone Healthcare Plus REIT Pulls Offering, Hires Stanger
I love Friday afternoons.  I just saw this filing from Cornerstone Healthcare Plus REIT.  It has terminated its offering, and has hired Robert Stanger to assist it with its strategic alternatives.  One of the alternatives could include hiring a new managing broker / dealer, which would mean the REIT would reopen its offering at some future point.  Cornerstone Healthcare Plus began raising capital in August 2007 and has raised an anemic $130 million (approximately) in investor equity.   Here is the entire correspondence:

April 29, 2011

Dear Investor,

We are writing to inform you of a recent decision made by the Independent Directors Committee of the Board of Directors of Cornerstone Healthcare Plus REIT, Inc. (“CHP”). 

At the recommendation of our advisor, the Independent Directors Committee is considering various strategic alternatives for CHP to enhance stockholder value. One of the alternatives under consideration is the hiring of a new dealer manager for the company’s public offering of common stock.  The Independent Directors Committee has engaged Robert A. Stanger & Co. as its independent financial adviser to assist in the consideration of strategic alternatives.

In consideration of the uncertainty associated with these developments, our Independent Directors Committee has directed us to take the following steps with respect to our public offering.

The Public Offering.  Effective immediately, we are suspending our public offering.  Accordingly, we are not making or accepting offers to purchase shares of stock in CHP until further notice.

Suspension of the Distribution Reinvestment Plan.  Our offering included a distribution reinvestment plan under which our stockholders could elect to have all or a portion of their distributions reinvested in additional shares of our common stock.  Consistent with the above decision with respect to the offering, we are suspending our distribution reinvestment plan effective on May 10, 2011.  Therefore all distributions paid after that date will be in cash until further notice.

Suspension of the Stock Repurchase Program.  Our stock repurchase program provides stockholders with a limited ability to sell shares to us for cash until a secondary market develops for our shares.  Consistent with the decisions to suspend our public offering and distribution reinvestment plan, we are suspending repurchases under the program for reasons other than death effective May 29, 2011. We can make no assurances as to when or if repurchases will resume.  The share repurchase program may be amended, resumed, suspended again, or terminated at any time.

We believe that these steps will better position us to maximize stockholder returns over the long term.  We take your investment with us very seriously, and we look forward to continuing to serve you.

Sincerely,

Terry Roussel

President and CEO

The share repurchase programs are always the first casualties when REITs start exploring their "strategic alternatives."  Investors' limited liquidity options are now zero, except for trying to brave the secondary market.   Cornerstone Healtcare Plus has overpaid its distribution since inception, so now that the equity raise is over, I'll watch to see whether the current distribution level is maintained.

Thoughts On Behringer Harvard Multifamily's Recent Acquisitions
Over the past week Behringer Harvard Multifamily REIT I announced two investments.  The first is a 320-unit to-be-built apartment complex in Houston, TX.  The REIT will make a mezzanine loan investment in the development.   I am guessing the loan will accrue interest, which along with the principal, will convert to equity when the property's construction is complete and a permanent mortgage is obtained.

The second property is a 179-unit apartment complex, originally built in 2007 as condos, in downtown San Francisco.  The purchase price was $94 million, or $525,000 per unit.  Here is the 8-K filing.  Here is an article from a San Francisco real estate blog, Socketsite.   The comments are interesting, especially the one that says the cap rate was less than 4%, which is amazing if true. 

There was little financial detail provided in the two filings.  On the surface it appears the Houston investment will not generate meaningful cash flow in the immediate future, unless the mezzanine investment pays current interest rather than accrued interest.  The property's construction is slated for an early 2012 completion, and then it'll have a lease-up period that could take another twelve to eighteen months, so you looking at approximately two years before it is fully operational.  Absent financial data, the return on the San Francisco property is open for speculation. 

What is known is that at year-end 2010, Behringer Harvard Multifamily I's cash from operations and Funds From Operations (FFO) only comprised 5.5% and 15.9%, respectively, of its distributions, with the shortfall paid from offering proceeds.  The REIT closes its offering period at the end of July, meaning its largest source of distribution financing is ending.  While these two properites are only part of a now thirty-five property portfolio, I would have thought the REIT would show more urgency in its efforts to cover its distribution from property cash flow.

T Boone Pickens On Natural Gas Fracking
I heard most of this National Press Club panel interview with T Boone Pickens and Ted Turner while driving on Easter.   Pickens discusses the environmental issue surrounding natural gas fracking at around the 37:00 mark.

American Realty Capital Trust Modifies Its Share Grants
I just saw this press release announcing that American Realty Capital Trust has modified the compensation to its advisor by limiting the amount of shares it can grant to the advisor.  I will look at this in more detail, but on the surface this appears positive for investors.

Too Good To Be True?
I get plenty of junk emails, and I usually just delete them.  One caught my eye this morning.  Here is a partial reprint of the email, touting the product's highlights:

Product Features & Highlights:

 - Senior Secured Bonds for safety-
    these are NOT promissory notes !!

 - Interest rates:   6% for 1 year
                             7% for 2 years
                             9% for 3 years
                             12% for 5 years

 - Interest paid quarterly

 - BD Commission:  4.5% on 1 year bonds
                                       5.0% on 2 year bonds
                                       5.5% on 3 year bonds
                                       6.5% on 5 year bonds

Look, a CD equivalent!  6% for one year, and it pays a 4.5% commission that can probably be renewed every year.  Everybody's a winner!

Another Record
Last month this blog noted that Wells REIT II paid a near record price for a downtown Washington DC office property.  The Wall Street Journal reports that CB Richard Ellis REIT has paid a record price for a Jersey City property.  The REIT is paying $350 per square foot, and the return expectations are in the high 7% range, which, according to the Wall Street Journal article is a bargin compared to Manhattan real estate just across the Hudson River.  Here are some specifics from the article:

Hartz Mountain Industries Inc. this week sold twin 12-story office buildings in Jersey City’s Colgate Center in a deal that values them at about $310 million. That translates into a record $375 a square foot, according to Real Capital Analytics, a real-estate research firm.

The buyer, CB Richard Ellis Realty Trust, a nontraded REIT, is paying about $70 million and assuming $240 million in debt for the buildings at 70 and 90 Hudson St., which offer unobstructed views of Manhattan and are 100% leased.

Private Equity Real Estate
Bloomberg has a long, informative article on private equity real estate investment.  The article states that 439 private equity funds are looking for $160 billion in commitments.  That is a significant sum of capital.  The capital behind some of these private equity firms is staggering.  Firms like Blackstone have to make huge investments, like the $9.4 billion it paid to acquire Australia's Centro Properties' US mall portfolio earlier this year, and can't spend the time on individual properties.  The $9.4 billion in one transaction is more then four to six times what the typical non-traded REIT will raise in equity over two years.  (The article did not give specifics on the equity Blackstone used to acquire the Centro portfolio (I doubt it was $9.4 billion), but still, the comparative scale to non-traded REITs is impressive.)

New Tenant In Common Consolidation Venture
A new company, Ascent Realty Advisors, has been formed to help tenant in common investors and sponsors.  Here is an article from GlobeSt.com discussing the new venture.  The principals behind the new entity are from TIC Properties, a sponsor of tenant in common programs, and CapHarbor.  Ascent has formed a limited partnership, Ascent Commercial Property Limited Partnership, which will allow tenant in common investors (and presumably Delaware Statutory Trust (DST) investors as well) to exchange their interests for limited partnership units.  The exchange is called a 721 exchange and would allow TIC or DST investors to maintain their tax deferral while becoming part of a diversified portfolio.  The partnership will focus on office and industrial TIC and DST properties.  Ascent will likely form a public non-traded that will be affiliated with the partnership. 

Here is a quote from the GlobeSt article:

Ascent intends to allow for the roll-up of properties on a tax-deferred basis through section 721 of the IRS code. The company is also considering the formation of a publicly registered, non-traded REIT. The Ascent Fund, which will focus on office and industrial properties, will be managed by Ascent Commercial Property Management LLC, led by president Barry Gruebbel.

It is this blog's opinion that modifying the TIC or DST structure is going to be the only way many TIC or DST deals are going to be able to modify debt, short of selling the properites, and to get access to capital.   The above deal is the third that I have seen or heard about so far this year.   There are going to be more programs like this over the coming months.

More Fracking News
Here is an article from yesterday's New York Times.  It summarizes the finding of a Congressional investigation that was initiated last year when Democrats controlled the House.

Big Boy Pants
I have noticed over the past year or more that non-traded REITs are getting sophisticated in their financing, credit crisis notwithstanding.  Just last week it was announced that Wells REIT II raised $250 million in a bond offering (5.875% interest for seven years) and CNL Lifestyle REIT raised $400 million in a bond offering (7.25% interest for eight years).  The Wells REIT II bond offering is a rated bond, which is why its interest is lower than the rate on the CNL Lifestyle bond.  I am not aware of any non-traded REIT that had issued bonds before last week.

Last month this blog noted Health Care Trust of America's line of credit and its strict controls on distributions.  Other non-traded REITs are also obtaining lines of credits to facilitate acquiring properites and in some cases to help pay distributions.  (For without distributions, the REITs don't get equity flows, which means they won't be able to repay their lines of credit.  "We must borrow money to pay distributions, so we can raise money to repay the debt."  A classic Catch-22 if there ever was one!)

I understand that the lines of credit are being used to smooth cash flows and to facilitate acquisitions in advance of equity.  The Wells and CNL bond issues are a sign of maturity and may benefit these REITs in the long run by exposing them to the capital markets before their listings (although I am still trying to figure out how CNL Lifestyle benefits from a 7.25% interest rate).  The non-traded REITS are entering into sophisticated transactions that contain strict financial restrictions and require the REITs to operate within the debt covenants.  As an example of the level of complexity, the following passage is from CNL Lifestyle's indenture for its recent bond offering and details the restrictions, in mind-numbing legalese, on Lifestyle's distributions:

Section 4.07 Restricted Payments.

(a) The Company will not, and will not permit any of its Restricted Subsidiaries to, directly or indirectly:

(1) declare or pay any dividend or make any other payment or distribution on account of the Company’s or any of its Restricted Subsidiaries’ Equity Interests (including, without limitation, any payment in connection with any merger or consolidation involving the Company or any of its Restricted Subsidiaries) or to the direct or indirect holders of the Company’s or any of its Restricted Subsidiaries’ Equity Interests in their capacity as such (other than dividends or distributions payable in Equity Interests (other than Disqualified Stock) of the Company and other than dividends or distributions payable to the Company or a Restricted Subsidiary of the Company);

(2) purchase, redeem or otherwise acquire or retire for value (including, without limitation, in connection with any merger or consolidation involving the Company) any Equity Interests of the Company or any direct or indirect parent of the Company;

(3) make any payment on or with respect to, or purchase, redeem, defease or otherwise acquire or retire for value any Indebtedness of the Company or any Guarantor that is contractually subordinated to the Notes or to any Note Guarantee (excluding any intercompany Indebtedness between or among the Company and any of its Restricted Subsidiaries), except a payment of interest or principal at the Stated Maturity thereof; or

(4) make any Restricted Investment (all such payments and other actions set forth in these clauses (1) through (4) above being collectively referred to as “Restricted Payments”),

unless, at the time of and after giving effect to such Restricted Payment:

(1) no Default or Event of Default has occurred and is continuing or would occur as a consequence of such Restricted Payment;

(2) the Company would, at the time of such Restricted Payment and after giving pro forma effect thereto as if such Restricted Payment had been made at the beginning of the applicable four-quarter period, have been permitted to incur at least $1.00 of additional Indebtedness pursuant to the tests set forth in Section 4.09(a), 4.09(b) and 4.09(c) hereof; and

(3) such Restricted Payment, together with the aggregate amount of all other Restricted Payments made by the Company and its Restricted Subsidiaries since the date of this Indenture (excluding Restricted Payments permitted by clauses (2), (3), (4), (5), (6), (7), (8) and (9) of paragraph (b) of this Section 4.07), is less than the sum, without duplication, of:

(A) 95% of Funds From Operations of the Company for the period (taken as one accounting period) from January 1, 2011 to the end of the Company’s most recently ended fiscal quarter for which internal financial statements are available at the time of such Restricted Payment (or, if such Funds From Operations for such period is a deficit, less 100% of such deficit); plus

(B) 100% of the aggregate net cash proceeds received by the Company since the date of this Indenture as a contribution to its common equity capital or from the issue or sale of Qualifying Equity Interests of the Company or from an issuance of Qualifying Equity Interests of the Company pursuant to the DRP (it being understood that for the purposes of this clause (3)(B), with respect to any issuance pursuant to the DRP, the Company will be deemed to receive net cash proceeds equal to the amount of the cash dividend they otherwise would have paid in respect of such Equity Interests) or from the issue or sale of convertible or exchangeable Disqualified Stock of the Company or convertible or exchangeable debt securities of the Company, in each case that have been converted into or exchanged for Qualifying Equity Interests of the Company (other than Qualifying Equity Interests and convertible or exchangeable Disqualified Stock or debt securities sold to a Subsidiary of the Company); plus

(C) to the extent that any Restricted Investment that was made after the date of this Indenture is (a) sold for cash or otherwise cancelled, liquidated or repaid for cash, or (b) made in an entity that subsequently becomes a Restricted Subsidiary of the Company, the initial amount of such Restricted Investment (or, if less, the amount of cash received upon repayment or sale); plus

(D) to the extent that any Unrestricted Subsidiary of the Company designated as such after the date of this Indenture is redesignated as a Restricted Subsidiary after the date of this Indenture, the lesser of (i) the Fair Market Value of the Company’s Restricted Investment in such Subsidiary as of the date of such redesignation or (ii) such Fair Market Value as of the date on which such Subsidiary was originally designated as an Unrestricted Subsidiary after the date of this Indenture.

Notwithstanding the foregoing, the Company and any of its Restricted Subsidiaries may declare or pay any dividend or make any distribution or take other action (that would have otherwise been a Restricted Payment) that is necessary to maintain the Company’s status as a real estate investment trust under the Internal Revenue Code if (i) the aggregate principal amount of all outstanding Indebtedness of the Company and its Restricted Subsidiaries on a consolidated basis at such time is less than 60% of Adjusted Total Assets and (ii) no Default or Event of Default shall have occurred and be continuing.

This is a very complex agreement, with repeated references to defined terms located elsewhere in the indenture.  It's a document written by lawyers for lawyers.  The way my non-lawyer eyes read the above clause is that Lifestyle can continue paying its current distribution rate to investors, but if Lifestyle's leverage exceeds 60% of assets, than the restrictions kick-in.  The REIT's leverage was at 55% of assets at year-end 2010.

The point is not the above legal jungle, but that this jungle is complex and the once financially staid world of non-traded REITs has embraced a treacherous path.  I don't believe that REITs accessing sophisticated financing is bad, actually I think it's good.  Interest rates are still near historic lows and it makes sense to take advantage of the low rates, if done in a prudent manner.  But the REITs need to understand that the banks are not their friends.  These lines of credits and bonds have restrictive covenants that REIT managers (as well as the broker / dealers that sell these non-traded REITs) need to read and understand.  Investors, too, need easy-to-understand disclosure - i.e. "if our leverage ratio (amount of debt divided by total assets) exceeds 60%, we will have to cut the distribution we pay you."  Banks will pounce if the covenants are not obeyed and ignorance is not a defense.   Banks do not come out on the short end of too many deals.

The low interest rates on the lines of credit are enticing, and make acquisitions more attractive.  But buying a long-term asset with short-term debt that provides accentuated returns is seductive, but unsustainable.  I am seeing lines of credit being used to repay maturing debt.  Retiring debt with a line of credit without a plan to replace the line of credit with either equity of permanent mortgage debt is reckless.  If REIT advisors don't act to quickly match property debt with the property's expected hold period, the REITs could be caught in a squeeze if interest rates rise, or if equity raises fail to match short-term debt maturities.  I suspect I'll be writing multiple posts about debt covenants in the future.

ARC Snark
This press release from American Realty Capital Trust (ARCT) popped up on my Google News feed over the weekend.  Here is the important part of the press release:

With the pending July 25, 2011, close of ARCT’s initial public offering, the Company’s advisor, American Realty Capital Advisors, LLC, intends to initiate the process of interviewing investment banking firms and other advisory firms to provide its board of directors with recommendations in exploring various strategic actions to maximize shareholder value, including the assessment of various liquidity alternatives.

ARCT commenced its initial public offering on January 25, 2008, and as of the date of this press release has raised total gross proceeds of $885.2 million. As of the date of this press release, the Company has acquired 320 properties for a total purchase price of $1.27 billion, consistent with the Company’s investment strategy, i.e., acquiring free standing, single tenant properties net leased long-term to investment grade and credit worthy tenants.”

Let me guess what's going to happen.  ARCT will hire JP Morgan as its advisor, ARCT will announce a plan to list its shares sometime before the middle of 2014, once ARCT's a listed company, investor shares will convert to liquid shares on a deferred basis, probably over eighteen months, and for the next three months wild rumors about near-term liquidity and high per share valuations will spread.   This is the playbook from Healthcare Trust of America.   Like Healthcare Trust of America, it is important to watch the liquidity and vesting of the shares paid to management, to make sure management is not cashing out first.   Buying a non-traded REIT is a long-term investment, never an arbitrage play.

Retail Fails to Follow Office and Apartments
The commercial retail real estate vacancy rate increased to 9.1% in 2010's first quarter, highest level in ten years.  Here is info from Calculated Risk and a detailed Bloomberg article. 

Good Commercial Real Estate News
From yesterday's Calculated Risk, here is a post discussing the first drop in office vacancy rates since 2007.  Reis Inc's quarterly survey on office properties shows that the national vacancy rates at the end of the first quarter 2011 stood at 17.5%.  The decrease was only .1% from 2010's fourth quarter, but after the last four years I will take any positive move.   Below is a chart from the post showing quarterly vacancies since 1991:

Today Calculated Risk has a post on Ries' quarterly apartment report, which shows vacancies at a three year low.   The vacancy rate is 6.2%, down from 8% a year ago.  Much of the drop in vacancy has come from the elimination of concessions.  Here is Calculated Risk's analysis on the drop in vacancies:

This is a very large decline from the record vacancy rate set a year ago at 8%. This decline fits with the recent survey from the NMHC that showed lower apartment vacancies. Reis is just for large cities, but this decline in vacancy rates is happening just about everywhere.

A few key points we've been discussing:
• Vacancy rates are falling fast (the excess supply is being absorbed). Note: The excess housing supply includes both apartments and single family homes.

• A record low number of multi-family units will be completed this year (2011). Only 6,000 apartments came on the market in Q1 (in the Reis survey area).

• This will push up effective rents. Via Bloomberg:

Effective rents, or what tenants actually pay, increased in 75 of the 82 markets Reis tracks, to an average $991 a month from $967 a year earlier and $986 in the fourth quarter.

However, when I was at the NMHC conference earlier this year, it sounded like rent growth is mostly coming from reductions in concessions and not from the top line (i.e. not from rent increases). (my short notes from conference here and here). Still, any increase in effective rents will push down the price-to-rent ratio for homes.

• Multi-family starts are increasing, and that will help both GDP and employment growth this year. These new starts will not be completed until 2012 at the earliest, so vacancy rates will probably decline all year.

If You Can't Beat Them, Join Them - Part II
I received the following comment on my previous post:

I read the filing differently. First, looking closely at ARCT’s 10K, the entire award to management is 1.5 million shares ($15 million). Not sure how you are arriving at $75 million. Second, only half the award is time vested. The other half is purely performance based and is paid only after the investor receives 100% of his/her capital back plus a non-compounded annual 6% return on capital. Finally, no vesting occurs at all for two years, and the award vests over a five year period. My take is that the independent board made the stock award based on management’s exemplary performance to date. Seems to me there is a big difference between this type of award and an internalization fee which seeks to retain management, irrespective of performance. At the end of the day, ARCT’s restricted stock plan is pay for performance. It merely recognizes the results achieved.

American Realty Capital Trust (ARCT) initiated the restricted stock awards program in January 2010.  The initial amount available for restricted stock awards was 1% of the amount of shares being offered or 1,500,000 shares, which totaled $15,000,000.  In the post effective amendment filed on March 11, 2011, the amount appears to have been changed to reflect no more than 5% of the shares outstanding, up to a maximum of 7,500,000 shares or $75,00,000 if all ARCT shares in the offering are sold.  At February 28, 2011, the amount of shares outstanding was 74,854,000.  So, 5% of 74,854,000 is 3,742,700 shares available under the incentive restricted share plan, which at $10 per share is $37,437,000.  Obviously, the amount of shares outstanding, and therefore amount available under the incentive restricted share plan, will increase as more shares are sold and ARCT moves towards the close of its offering period.

It is hard for me not to correlate the dropping of internalization fees in June 2010 and the recent, potential five times increase in shares available under the incentive restricted share plan.

The incentive restricted shares are not immediately vested.  Half the shares are paid over a four year period.  Half the shares have a subordination feature.  The subordination feature is not like the one described in the comment above, although that would be excellent if it was.  The incentive (subordination) feature is follows:

50% vest only to the extent our net asset value plus the distributions paid to stockholders equals 106% of the original selling price of our common stock.

I think it is best to use an example to how these shares may vest.  The 106% of the original offering price is $10.60 per share, which is the amount by which the combined net asset value and cumulative distributions must exceed before ARCTs' incentive restricted shares are allowed to vest.

ARCT is required to make a net asset value calculation eighteen months after it closes its offering.  Assuming ARCT closes its offering on June 30, 2011, it would have to provide a net asset valuation by December 31, 2012.  For illustration purposes, I'll use a net asset value of $8.85 per share, which is just the offering price of $10.00 per share less ARCT's offering costs, which are competitive with other non-traded REITs.   It is probable that the net asset value will differ from this amount.   Next you need to add ARCT's cumulative distributions to the net asset value.  (I don't read anything in the description above that reflects the timing of distributions.)  ARCT paid a 6.7% distribution in 2009.  In 2010 it paid 6.7% for three months and 7.0% for nine months.  If it continues to pay a 7% distribution in 2011 and 2012, it will have paid cumulative distributions of $2.74 per share by the end of 2012.   If the cumulative distributions of $2.74 are added to the $8.85 net asset value, and this totals $11.59, which is greater than the $10.60 share price that triggers the vesting.  The following table uses the paid distributions and the $8.85 per share net asset value price estimation:

2009	$0.65
2010	$0.69
2011	$0.70
2012	$0.70
Cumulative Distribuiton	$2.74
NAV at 12/31/2012	$8.85
NAV + Distributions	$11.59

Finally, I'd want to address the exemplary management comment.  I want ARCT's management to be exemplary, and this post or the previous post are not disparaging ARCT.  The non-traded REIT industry needs ARCT's management to be exemplary.  But to me, I think it is too early to bestow awards for excellent management, whether for ARCT or any REIT still in its offering phase.  Olympic gold medals in the 100-meter dash are not awarded after twenty yards, the Lombardi Trophy is not awarded at the end of the first quarter, and I have never heard of a baseball owner giving a manager a performance bonus in the middle of May.  A non-traded REIT (or any investment product) should not award multi-million dollar, dilutive, stock grants, whether restricted or not, to management while the REIT is still in its offering phase and while it is still investing investor capital.

If You Can't Beat Them, Join Them
I was alerted in a comment to this blog that American Realty Capital Trust has awarded its executives shares of restricted stock.  Here is the wording from the post-effective amendment that American Realty Capital Trust filed on March 11, 2011:

On September 13, 2010, our advisor granted 934,159 restricted shares of common stock to Nicholas S. Schorsch, chief executive officer of our advisor, 212,370 restricted shares of common stock to William M. Kahane, president and chief operations officer of our advisor, 160,604 restricted shares of common stock to Peter M. Budko, executive vice president chief investment officer of our advisor, 55,270 restricted shares of common stock to Edward M. Weil, Jr., executive vice president and secretary of our advisor and 37,597 restricted shares of common stock to Brian S. Block, executive vice president and chief financial officer of our advisor. Fifty percent of the restricted shares vest over a four year period commencing with the one year anniversary of the September 13, 2010 grant date and 50% vest only to the extent our net asset value plus the distributions paid to stockholders equals 106% of the original selling price of our common stock.

On June 2, 2010, American Realty Capital Trust announced that it was waiving any internalization fees in the event that it internalizes its external advisor as part of of a sale or listing American Realty Capital Trust's shares on an exchange.  The awards above came about three months after the announced waiver of any internalization fees.   The pool of stock available to award is up to 7.5 million shares, which at $10 per share is $75 million.   In the quote above, at $10 per share, the awards last September are worth nearly $10 million to Nicholas Schorsch and over $2 million to William Kahane. The bulk of the shares that American Realty Capital Trust can allocate to its executives is still available for allocation.


Internalization fees can be lucrative to the external advisor, and some non-traded REITs have paid more than $100 million for their advisors.   American Realty Capital Trust's decision to waive internalization fees was positive for investors.

The company that distributes American Realty Capital Trust is Realty Capital, which also distributed Healthcare Trust of America (HTA).  HTA waived its internalization fees in 2009, but recently expanded its pool for executive and board member stock awards by $80 million.  It looks like American Realty Capital is following HTA's path.

Half of the American Realty Capital executive stock awards are deferred over four years and half vest only "to the extent our (American Realty Capital Trust) net asset value plus distributions paid to stockholders equals 106% of the original selling price of our common stock." 

To me, American Realty Capital's granting of large amounts of stock to its executives is another form of an internalization fee.  The large amount of stock was issued by American Realty Capital Trust after the announcement that there would be no big pay day when it purchased (internalized) its advisor, plus American Realty Capital has plenty more stock it can grant its executives.  Like HTA, American Realty Trust appears to have figured a way around its waived internalization payday.

The Return of Subprime Bonds
Here is a Wall Street Journal article on how pricing on subprime bonds has rebounded and how subprime bonds are attracting investors, including conservative insurance companies.  The focus of the article is on existing subprime bonds, which as an investment class, saw prices drop to near $.30 on the dollar at the worst of the credit crisis.  Subprime bonds are now trading near $.60 on the dollar.  The article's point is that subprime bonds' recent strength signifies a healing of the credit markets, as investors are willing to take on more risk.

The return of subprime bonds, according to the article, is also signaling that the housing market has bottomed and has more upside than downside.  The article focused on subprime bonds issued before the credit crisis.  It did not mention any new issues.  I'd be curious to know if there is any demand for new issue subprime bonds, or if there are even any new subprime mortgages that could be included in a new subprime bond issue.

One encouraging sign is the govenment's refusal to take the short end of an offer by bailed-out insurer AIG:

The market burst into the spotlight in March when an unlikely buyer stepped in: AIG, the giant insurer that had to be bailed out by the government because of its own bad bets on subprime mortgage bonds.

AIG offered to buy back a pool of bonds that the Federal Reserve had taken off its hands during the crisis. AIG's $15.7 billion offer for the bonds, which have a face value of $30 billion, spurred other investors to consider making offers.

Citing "improved conditions" in the market and "a high level of interest by investors," the Fed on Wednesday rejected AIG's offer and said it would begin selling off these mortgage holdings, letting investors bid for pools of bonds and individual securities so the central bank can maximize its profits.

At least four large life insurers, among the most conservative of all investors, are eyeing the subprime bonds the Fed plans to sell, according to people familiar with the matter.