Friday Reading - Glitz and Grit

Here are two interesting articles.  The first is a Wall Street Journal story on MGM's huge City Center development along the Las Vegas Strip.  This project was started six years ago, so it couldn't have had worse timing.  The article provides insight into the Las Vegas housing market:

Las Vegas has experienced some of the worst of the housing bust, exacerbated by overbuilding. Home prices in January in the Las Vegas area were down more than 60% since spring 2006, according to the S&P/Case-Shiller Home Price Index, including a 9% drop during 2011. Luxury high-rise condo towers that were constructed on or around the Las Vegas Strip at the height of the development frenzy were particularly affected.

But some hard-hit markets in the U.S. have begun to show signs of recovery. The high-rise condo market in Miami, for instance, has been buoyed by surprisingly strong demand from foreign buyers, and the Phoenix housing market has recently seen a large jump in demand from investors.

While the Las Vegas economy isn't as diverse as better-performing cities, there are some glimmers of improvement. Housing inventory levels are less than half a year ago, according to Applied Analysis, an economic consulting firm in Las Vegas. And gambling revenue on the Las Vegas Strip is up for the past six months through February, while visitation and room rates also have continued to edge up, according to the Las Vegas Visitors and Convention Authority.

The second article switches from the glitz of Las Vegas to the grit of oil and gas drilling in shale rock formations.  Bloomberg reports on earth quakes caused by fracking the shale for natural gas, in particular the impact of disposal wells used for fracking waste.   This is quite a statistic:

U.S. Geological Survey researchers found that, for three decades prior to 2000, seismic events in the nation’s midsection averaged 21 a year. They jumped to 50 in 2009, 87 in 2010 and 134 in 2011, according to the study, which was presented April 18 at the annual meeting of the Seismological Society of America. 

According to the article, "researchers think an increase in wastewater injected into the ground by drilling operators may be the cause of a sixfold increase in the number of earthquakes that have shaken the central part of the U.S. from 2000 to 2011, according to a U.S. Geological Survey study."

Paging the Editor

Try and decipher this Bloomberg article.  The article's title says that the Fairmont hotel, located on Nob Hill in San Francisco, is being sold for $200 million, but the sale is not mentioned in the article.  The article instead discusses a complex financing plan for the company that owns the Fairmont hotel, Fairmont Hotels & Resorts, Inc.  This sentence made me smile:

The resort chain, used as settings for Alfred Hitchcock films including North by Northwest and Vertigo, has included a so-called ratings grid that would be used to price the $500 million loan when it obtains ratings, said the person, who didn’t want to be identified because the plans aren’t public.

How can a corporation be used used as a movie set?  For someone who agonizes over my own small writing mistakes, the article made me realize I'm not the only one who occasionally makes an error.

The Valuation's Too Damn High - Part I

I have been shaking my head at recent valuation figures for non-traded real estate investment trusts (REITs).   Whether it's last month's release of KBS REIT I's predictable per share value of $5.16, or Strategic Storage's recent, near jaw-dropping valuation of $10.79 per share, the non-traded REIT valuation process is inconsistent and disparate.  I am going to give my opinions and ideas on valuations over four posts.  In this first post I will focus on the difference between a non-traded REIT's net asset value and its market value, with an emphasis on Retail Properties of America (RPAI).  In the second post I will discuss various valuation methods used by non-traded REITs, the conflicts associated them, and what I feel are the responsibilities of the non-traded REITs' independent board members.    I will give my opinion on the recent trend of REITs, in the midst of long offering periods, revaluing their share prices upward, and the marketing frenzy behind this repricing.  Finally, I will give my thoughts on what should be done with non-traded REIT valuations.

RPAI's recent initial public offering and listing brought into harsh relief one problem with non-traded REITs estimating per share valuations - these valuation approximations may vary significantly from the REITs' stock market values.  In June 2011, RPAI (then known as Inland Western REIT) presented shareholders with an estimated per share value of $6.95.  Investors were rightly shocked when in early April 2012, a short eight months later, RPAI had its IPO and listing at a price equivalent of $3.20 per share.  RPAI has settled in around a split-adjusted equivalent price of $3.60 per share (which is $9.00 per share on NASDAQ due to RPAI's reverse stock split), and while better than its IPO price, the current price is no salve to investors.  The stock market is valuing RPAI around half of what RPAI management estimated its share value less than one year ago, and this with the backdrop of a retail real estate market that is gaining strength.

It's important to understand the distinction between what REIT management estimates a REIT's shares are worth and the price at which the public markets value a REIT's shares.  Obviously, in the case of RPAI there was a big difference.  Listed stocks, whether REITs or high flying tech companies, rarely trade at prices that equal to their net asset value.  Stocks trade above or below their estimated net worth all the time.  The whole Benjamin Graham school of value investing is based on the notion of investing in stocks that can be purchased for less than companies' intrinsic values.   Generally, stocks, REITs included, trade based on the outlook for expected future earnings, not necessarily the value of the underlying assets. 

After a REIT completes its offering period, its sponsor must provide shareholders periodic estimates of the REIT's value.  I will discuss this in more detail in my next post, but non-traded REIT sponsors use multiple factors to determine a REIT's share price, including net asset value estimates and comparisons to other public REITs.  REIT management compiles the data and presents the estimate to the REIT's board for approval.  In a June 20, 2011, 8-K filing, RPAI's management provided an estimated per share value of RPAI's shares and disclosed in generalities the methods it used in determining the $6.95 per share value:

On June 14, 2011, the board of directors (the “Board”) of Inland Western Retail Real Estate Trust, Inc. (the “Company”) established an estimated per-share value of the Company’s common stock of $6.95.  This estimated per-share value is being provided solely to assist broker dealers in connection with their obligations under applicable Financial Industry Regulatory Authority (“FINRA”) rules with respect to customer account statements and to assist fiduciaries in discharging their obligations under ERISA reporting requirements.  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.

The estimated per-share value is only an estimate and may not reflect the actual value of our shares or the price that a third party may be willing to pay to acquire our shares.  The Board, in part, relied upon third party sources in arriving at this estimated value, which reflects, among other things, the continuing impact of adverse trends in the economy, the real estate industry and the current public equity markets.  Because this is only an estimate, we may subsequently revise any estimated valuation that is provided.  We cannot provide assurance that:

• this estimate of value reflects the price or prices at which our common stock would or could trade if it were listed on a national stock exchange or included for quotation on a national market system; or 

• this estimate of value could actually be realized by us or by our shareholders upon liquidation; or  

• shareholders could realize this estimate of value if they were to attempt to sell their shares of common stock now or in the future; or

• the methodology utilized to estimate the per-share value, would be found by any regulatory authority to comply with requirements of such regulatory authority, including requirements under ERISA, FINRA rules, other regulatory requirements or applicable law.

Further, the estimated per-share value was calculated as of a moment in time, and, although the value of the Company’s shares will fluctuate over time as a result of, among other things, developments related to individual assets and changes in the real estate and capital markets, the Company does not undertake to update the estimated value per share on a regular basis.

The first paragraph is the key to RPAI's valuation.   RPAI was valued by its management without the use of third party appraisers, or even a third party valuation service, to confirm RPAI's management's assumptions and methodologies.  RPAI's management used the direct capitalization method and "methodologies consistent with publicly traded real estate investment trusts."  No detail is provided on what cap rates were used, or what comparable public company valuation metrics were employed - i.e. FFO multiples.  I'd be curious to know what assumptions RPAI's management made regarding all RPAI's debt, especially the debt maturing over the next several years.  The valuation is only as good as the inputs and assumptions, and while the methods may have been sound, the inputs dictate the output.   

RPAI's management may have convinced itself and the board that RPAI's net asset value was $6.95 per share, but RPAI's stock is currently valued around $3.60 per share share.  The $6.95 price per share may be technically correct based on RPAI's valuation assumptions, but the real, tangible value for investors is, unfortunately, $3.60 per share.  Going forward, the net asset value of RPAI, or any listed stock, is irrelevant to the price an investor can buy or sell shares.

Non-traded REIT managers and the boards of directors better be realistic when providing valuation estimates, because investors rely on these for an accurate approximation of the value of their investment.  If a non-traded REIT expects to list the REIT’s shares on a stock exchange as the planned exit strategy, its management better go the extra step to hone its valuation estimate.  I know it's impossible to accurately guess the price at which the market will value a non-traded REIT.  No one is expecting valuation estimates to exactly match listing prices, but it's not hyperbole to say that a 50% disconnect is unacceptable.  As shown by RPAI, it serves no purpose for a REIT to self-value at a price that has no relationship to what a REIT’s stock could trade for when listed.  Non-traded REIT independent directors need to do their job and demand pricing candor, even if it bruises REIT management egos.

You don't think I was going to pass up a chance to include this picture given the title of this post!

No Where To Hide

Here is a post from the Financial Times' Alphaville blog.  It shows the asset class correlations pre- and post-Lehman collapse.  The post attributes increased correlations to "risk on, risk off" trades, but it sounds like fancy justificaton for lemming money managers. 

Story To Watch - Chesapeake CEO

I bet we've not heard the last about this story on Chesapeake's CEO's $1.1 billion of personal loans. 

Digging Deeper

Here is short article worth reading from the Wall Street Journal.  The article discusses a $49 million loan that JP Morgan pulled from a $1 billion commercial mortgage backed security (CMBS) it was set to issue.  The loan was a refinance of two shopping centers in Boca Raton, Florida, with a total of 183,000 square feet.  The properties' combined occupancy was 97% and they were appraised at $72 million in January.   The $49 million loan was replacing a $44.2 million loan that was in default.  The following passage is why I think the loan was removed:

Glades Plaza and The Commons at Town Center, actually two properties on different sides of NW 19th Street in Boca Raton, were developed in 1979 and appraised at $72 million in January, according to a description of the property in the initial J.P. Morgan loan documents. Its occupancy has increased to 97% from 54% in 2009 and its tenants include Hooters, a Brewzzi microbrewery and Barbara Katz Sportswear, the description states.

The complex's largest tenant, with about 11,400 square is its landlord, Woolbright, according to the company's website and loan documents.

The properties are over thirty years old, and despite the combined 183,000 square feet, it does not look like there was a major anchor tenant.  The properties' owner, which is a developer not a retailer, leasing over 6% of the space and being the largest tenant was probably not viewed as a positive. 

Good Golden State Housing News

Here is an article from Bloomberg on housing price increases in California.  Prices were up 1.6% from a year ago, the first year-over-year increase in sixteen months.  The sales were up 9.2% from the previous month, the largest monthly increase since 2004.  While a 9% month-to-month increase was likely an anomaly, the metrics are positive, with supply down to 4.1 months (7 months is normal) and days-to-sale dropping to 53 days from 57 days.

Best Buy Closure List

Here is the Best Buy closure list via The CRE Review.  I need to cross-reference it against some of the non-traded REITs, in particular the Inland REITs, including Retail Properties of America, and Cole REITs, which own retail real estate.  It's important to remember that closing a store doesn't mean that Best Buy is going to stop paying rent.  It's still obligated by its leases to keep making lease payments.

Update:  On a quick overview I didn't see any of Retail Properties of America's Best Buys on the closure list.

Update Update:  Did not see any Best Buy closures in Inland American's portfolio, but its website is clunky (have to search by property for each state), so I didn't check all states.   I only saw one closure in the Cole portfolios, a Best Buy in Fort Meyers, FL, which is owned by Cole Credit Property Trust III. 

(On a separate matter, I don't think I want to know about the 191 Church's Chicken, 42 Applebee's and 26 On The Border restaurants spread across multiple Cole REITs.)

Vornado's Outlook

From Bloomberg, here is a commercial real estate outlook from Vornado Realty Trust's Steven Roth.  He has an optimistic tone here:

“We are in a recovery (but by no means recovered),” he wrote in the letter. “Consensus is that the recovery will be shallow and as such, I believe it will be much longer in duration than the three to five to seven year economic cycles that we are used to. All this will prove to be a very good environment for our business.”

He goes on to say:

“I must say, I find investing in this market difficult,” he wrote. “Nobody expected building prices to bounce back as strongly or as quickly as they did -- but they did. Assets are not cheap, either historically or in relation to current rents.”

The article is short and worth reading.

Price-To-Rent

Below is a great graph from Calculated Risk, which provides visual evidence that the housing market is going to rebound.  The graph shows the price-to-rent ratio between the cost to own a home versus renting.  The higher the higher the ratio, the more expensive it is to own a home.  Looking at this graph, the housing bubble is easy to see.  The ratio is approaching levels last seen in the late 1990s, indicating that home ownership is nearly as cheap as renting.

The graph also ties in with my previous post on AIG.  If AIG is looking for large multifamily development investments, it's probably a sign that large multifamily projects are near a top.

Back In The Game

Here is a Wall Street Journal article by way of Yahoo Finance on AIG's reentry into the commercial real estate market.  AIG, according to the article, is going to focus on apartment developments in major metropolitan markets. 

Your Mother Was A Hamster and Your Father Smelled Of Elderberries

The following is a letter sent yesterday (and filed in an 8-K) by American Realty Capital Healthcare Trust to the board of directors of Griffin-American Healthcare REIT II:

American Realty Capital Healthcare Trust, Inc. (“ARC Healthcare”) no longer sees the acquisition of the former Grubb & Ellis Healthcare REIT II, Inc. (“GEHRII”), now Griffin-American Healthcare REIT II, Inc. (“GAHRII”), to be viable due to the substantial risk of litigation between GAHRII and Grubb & Ellis, and the potential sizeable liability and cost to defend such action. Therefore, effective immediately, we are withdrawing our offer to acquire GAHRII.

There exists an allegation in a pending bankruptcy petition¹ that GAHRII has failed to pay millions of dollars currently due and owing to Grubb & Ellis. Furthermore, Grubb & Ellis maintains that they have material and substantial claims against GAHRII. Moreover, some of these monies, Grubb & Ellis alleges, are owed to Grubb & Ellis and have been paid instead to American Healthcare Investors, an entity owned and operated by Mr. Hanson and other former executive officers of Grubb & Ellis.

Because, in our view, there is risk of potential litigation between GAHRII and Grubb & Ellis which could result in an unquantifiable liability to ARC Healthcare’s stockholders, we believe it would be imprudent for our board of directors to expose ARC Healthcare to a risk that cannot be insured against or limited in amount.

For these reasons, we no longer see the acquisition of GAHRII to be viable from a financial or portfolio standpoint, and therefore effective immediately we are withdrawing our offer to acquire GAHRII.

This letter is an instant classic, a candidate for the "Wow" Hall of Fame. 

The letter can be read another way.   American Realty Capital Healthcare Trust, on the heels of American Realty Capital Trust's successful NASDAQ listing, is raising substantial amounts of equity every month and gaining scale fast.  It doesn't need the headache and potentially Pyrrhic outcome that a stockholder fight to gain control of Griffin-American Healthcare REIT II would entail.  

American Realty Capital Healthcare Trust couldn't resist a competitive taunt on withdrawing its offer for Griffin-American Healthcare REIT II.  It reminded me of this classic scene from Monty Python and the Holy Grail:

Natural Gas Approaches Mendoza Line

The price of natural gas is approaching the $2.00 per MMBtu Mendoza Line.  The price for the Nymex Henry Hub Future is $2.07 MMBtu. 

Real Estate Round Up

I saw the three articles linked to below earlier in the week on Calculated Risk.  The posts discuss Reis' quarterly updates on the commercial real estate segments of apartments, office buildings and strip malls.

Apartments

Office

Strip Malls

Apartments continue to improve, with vacancy rates falling to 4.9% and rents up nearly 1% in the first quarter.  The national office market saw a fractional drop in vacancy and a .5% increase in asking rents.  Strip malls saw vacancies drop for the first time in seven years.

Retail Properties - Use of Proceeds

Retail Properties of America just filed its final prospectus related to its IPO and listing. It raised $254.4 million, and expects to net $231 million after underwriting discounts and expenses.  From the net proceeds, $82 million will pay down RPAI's senior unsecured line of credit, which will be paid to affiliates of the underwriters.  RPAI will use $95 million to repay a cross-collateralized pool of mortgages.  The final $55 million will go to repurchase an affiliate's interest in a joint venture between RPAI and the affiliate. 

Retail Properities of America Prices

Retail Properties of America's (RPAI) IPO was priced last night at $8.00 per share.  This was below the anticipated price range of $10 per share to $12 per share.  The $8.00 price is equivalent to $3.20 per share for original investors due to the 2.5 to 1 reverse stock split RPAI recently executed.  Based on the $8 share price, RPAI raised $254.4 million in the IPO, which was below the estimated $350 million specified in RPAI's S-11 filing last week.   I am not sure if the use of proceeds changed based on this lower equity raise, but originally, lending affiliates of the underwriters were scheduled to receive $170 million from IPO proceeds to repay RPAI debt.

The $8.00 IPO price does not mean the stock will trade at this price.  It looks like early trades are about 9% to 10% above the IPO price, which is positive.

Retail Property of America's Listing Set

I saw this on Seeking Alpha.  Retail Properties of America (RPA) is set to be priced tomorrow night, Wednesday, April 4, 2012, and to begin trading on Thursday, April 5th.  Based on last week's S-11, the target price is $10 - $12 (remember the 2.5:1 reverse stock split).

Inland is distancing itself further from RPA by changing its stock symbol.   RPA will trade under the symbol RPAI.

More Foreclosure to Rental

Here is another article on large scale foreclosure purchases with the intent to rent, this time from the New York Times.  Waypoint Real Estate Group, which I wrote about last month, was profiled again, and the article says much of the same.  I still think the exit strategy will frustrate the private equity / hedge fund investors.  One point not discussed in the article is home affordability.  Several years ago, even after home prices started collapsing, you couldn't buy homes in Southern California as competitive rental properties.  The yield was too low, I'd guess in the 2% to 4% range.  Waypoint is earning 8%, after improvements on its acquisitions:

An algorithm calculates a maximum bid for each home, taking into account the cost of renovations, the potential rent and target investment returns — right now the company averages about 8 percent per property on rental income alone.

While this is good for Waypoint investors, it's better news for other potential home buyers and current home owners, because it addresses home affordability.  Yields this high on home rentals indicate that home prices are more affordable, because price and yield are inversely related - low yield equals high prices and high yield equals low prices.  

Waypoint's growth projections are amazing.  It started buying homes in 2008 and now owns 1,200 homes, but it expects to have 10,000 to 15,000 homes by the end of next year.  An important part of these rental transactions is the "turn" - making the improvements and getting the property rented after acquisition.   Time and low costs are crucial, as cost overruns and delayed rentals at the outset impact the long-term total return of a property.  Good property management is vital, and Waypoint is going to have up to 15,0000 different locations that need overseeing.  The properties need to stay leased and maintained over the hold period so that the properites can benefit from rising real estate prices.  It's easy to spot the opportunity with foreclosed homes, but the profit potential is not so great that sloppy upfront execution and bad property management won't spoil the investment.

Circumstance

The audio clip below was secretly recorded at the board meetings of KBS REIT I, Inland Western and the Behringer Harvard REITs, and passed on to me under strict conditions of anonymity:



It's amazing that the comment was identical at all the REITs.

Inland American's Hotel Expansion

Here is a free Wall Street Journal article on Inland American REIT's recent acquisition of five upscale hotels in three transactions.  Inland American is expanding out of limited service hotels into higher-end hotels.  Before the three acquisitions, Inland American owned 98 limited service and extended stay hotels.  It will pay $393.1 million for the five hotels. 

Here is chart from Calculated Risk showing a steady improvement in hotel occupancy:

The Calculated Risk article linked to above also detail steady improvement in hotel RevPAR, or revenue per available room.

BB Gets AA'd

Here is a BusinessWeek article on Best Buy, which is closing 50 stores this year.  The article credits Amazon for impacting BestBuy's sales.  I believe Apple's retail stores are also playing a part in Best Buy's struggles, and this will only get worse when (if?) Apple releases its TV.  The article fails to mention another fact, or at least my strong personal opinion - shopping at BestBuy is an awful retail experience.  The stores are too big, staff is not knowledgeable, inventory is too varied and the checkout is painful.  I am not looking forward to having another retailer leaving empty big box stores.  There are limitations on the number of Halloween stores that can open.

Inland Western, er... Retail Properties of America

The real estate investment trust formerly known as Inland Western REIT,  recently renamed Retail Properties of America (RPA), has filed several recent amendments to its S-11.  The March 23, 2012, amendment had some points worth noting.  RPA's filing listed an expected public offering share price of $10 to $12.  This price is based on RPA's 2.5 to 1 reverse stock split.  To an original investor, the estimated $10 to $12 listing share price is the equivalent of a $4.00 to $4.80 stock price.  Stated another way, the estimated RPA list price is 52% to 60% lower than an investor's original share price.  There is no assurance the estimated listing price will be realized or that the stock, once listed, will stay above the estimated price.

RPA is seeking to raise $320 million in new equity along with the listing, assuming a mid-point listing price of $11 per share.  The underwriters presented on the front page of the S-11 for the listing and stock offering are J.P. Morgan, Citigroup, Deutsche Bank Securities, KeyBanc Capital Markets, Scotiabank, Wells Fargo Securities and PNC Capital Markets.  Page 44 of the S-11, and this is my favorite part of the S-11, states how RPA plans to utilize the offering proceeds:

Affiliates of J.P. Morgan Securities LLC, Citigroup Global Markets Inc., Deutsche Bank Securities Inc., KeyBanc Capital Markets Inc., Wells Fargo Securities, LLC, PNC Capital Markets LLC and Scotia Capital (USA) Inc. are lenders under our senior unsecured revolving line of credit, and will receive their pro rata portion of the $170 million of the net proceeds from this offering used to repay amounts outstanding under our senior unsecured revolving line of credit. Accordingly, more than 5% of the net proceeds of this offering are intended to be used to repay amounts owed to affiliates of these underwriters.

One motivation for the stock offering is clear; over half the offering proceeds ($170 million of $320 million, or 53%) is going to repay the underwriters or their affiliates.  The underwriters are selling RPA equity to get repaid money they've loaned RPA.  The underwriters or their affiliates get repaid immediately, while the original equity investors have an 18-month deferred liquidity period that starts at an estimated 52% to 60% discount to their original investment in RPA.  There is nothing wrong, unethical or untoward with what the underwriters are doing, but it seems like a tough sale to me.

I wrote a post last week sharing my opinion on internalization fees.  RPA is one reason I believe the internalization fee has a limited future.  RPA's S-11, to its credit, neatly lays out many shares RPA received (its internalization fee) for its advisor in 2007:

2007 Internalization

On November 15, 2007, pursuant to an agreement and plan of merger approved by our shareholders on November 13, 2007, we acquired, through a series of mergers, four entities affiliated with our former sponsor, IREIC, which entities provided business management/advisory and property management services to us. Shareholders of the acquired entities received an aggregate of 37,500,000 shares of our common stock valued under the merger agreement at $10.00 per share. In December 2010, certain of the shareholders returned 9,000,000 shares of our common stock to us in connection with our settlement of a lawsuit relating to this

acquisition. As a result of the mergers, we now perform substantially all of our key operational activities internally. In connection with the mergers, we and our former business manager/advisor and our former property managers entered into a number agreements and amendments to agreements with The Inland Group, Inc. and certain of its affiliates. See “Certain Relationships and Related Transactions.”

RPA's former advisor, or its shareholders, owns 28,500,000 shares of RPA stock, not adjusted for the reverse stock split.   Based on the estimated share price of $4.00 to $4.80, this gives the internalization fee a current value of $114,000,000 to $138,800,000.  (Adjusting for the reverse split gives the same result - 28,500,000 shares divided by 2.5 equals 11,400,000 shares, which multiplied by $10.00 is $114,000,000, and multiplied by $12.00 is $136,800,000.)

A four-and-half-year period between internalization and listing is a long time, especially given what has happened to commercial real estate and the capital markets since late 2007.  Internalization fees may not be gone, but I don't think we'll see a situation anytime soon where investors lose over half their investment and management walks away with a $100 million payday.

KBS REIT's New Valuation

It should have been a clue when KBS REIT did not file its 2011 10-K last week along with KBS REIT II and KBS REIT III.  In the back of my mind I wondered why KBS REIT hadn't filed its 10-K, and I even checked my filing service to make sure I hadn't missed the filing.  Yesterday we found out why KBS REIT didn't file its 10-K last week.  KBS REIT announced a drop in its valuation and suspended its dividend, as it struggles with its financial problems.   The filings' immediate takeaway points are below:

• KBS REIT valued itself at $5.16 per share, as of March 22, 2012, which is down from its December 2010, valuation of $7.32 per share.  
• On March 20, 2012, the REIT's board of directors approved the suspension of the REIT's distribution.
• The REIT amended its share redemption program to allow redemptions only in the event of death or disability.
• The REIT terminated its dividend reinvestment plan, effective April 10, 2012.

If the above is not bad enough, the tone of the report, from what I've read of it, is negative, preparing investors for more bad news.  I'll post more on the filings as I wade through them.

Lack of Disclosure?

If a non-traded REIT buys a portfolio of properties and the portfolio is only 48% physically occupied, should this be disclosed in the filing discussing the acquisition?  I think that is definitely a disclosure item.  A non-traded REIT purchased a portfolio of properties at year-end 2011 at this level of physical occupancy, and did not disclose it until nearly two months after the transaction.   We have to read what's not in a filing.  And remember, when ever you read "physical occupancy," it means that the actual economic occupancy (tenants paying rent) is lower.

Internalization Fee Horizon

To charge an internalization fee or not to charge an internalization fee, that is the question facing non-traded REIT sponsors.  Starting with Cole Credit Properties Trust II (CCPT II), which announced last summer that it was going to seek a liquidity event within twelve months, a number of non-traded REITs are, or should be, exploring a liquidity event for investors over the next several years.  A non-traded REIT’s liquidity event for shareholders can take various forms, including listing shares on a stock exchange, merging with another REIT, selling the REIT outright to another company, or selling properties individually or as portfolios.  Typically, as part of a REIT offering liquidity to its shareholders, the non-traded REIT sponsor will internalize the REIT's advisor, the separate but affiliated company that serves a conduit for a non-traded REIT's sponsor's management services to the REIT.  (There is no law that says a REIT must internalize its advisor).  The amount paid for a REIT to acquire its advisor is called an internalization fee. *

The internalization fee is important because it is, potentially, the largest form of compensation a REIT sponsor will receive.  Asset management fees and property management fees are fine compensation, but internalization fees are the mother lode.  Past internalization fees have ranged from the tens of millions to the hundreds of millions of dollars.   Internalization fees are unique from other forms of compensation because 1) the fee is not directly based on assets or performance, and 2) a REIT’s sponsor typically sets the price at which the non-traded REIT will acquire its management company.  A third party company will then affirm this valuation through a fairness opinion, but the sponsor typically determines who writes this opinion, and then allows the REIT to pay for it.  It’s no surprise that the third party firm magically confirms the sponsor’s value, but this process is a topic for another post.

Cole’s decision on whether or not to charge an internalization fee for CCPT II's advisor will influence other non-traded REITs that will seek liquidity options in the near future.  This is because CCPT II raised and invested its capital before the credit crisis.  CCPT II is a big REIT, having over $3.4 billion in assets at September 30, 2011, and its size will factor into its sponsor's decision-making process on what it does with CCPT II's advisor.  Other large, non-traded REITs that recently closed their equity offering periods, and that raised capital before, during and after the credit crisis, such as the first two KBS REITs, Wells REIT II, Inland American REIT, and CNL Lifestyle REIT will face the same decision as CCPT II.  How CCPT II deals with its external advisor will provide a clue to how the other non-traded REIT sponsors deal with their REITs' advisors.

I have no idea what CCPT II or the other non-traded REITs will do, but I would be surprised if the REITs pay significant internalization fees for their advisor.  Internalization fees, due the past size of the fees, have a stigma, and broker / dealers, analysts, and attorneys will scrutinize any internalization fees.   For sponsors that are raising capital for new REITs, an internalization fee for an old REIT has sales implications for the new REIT.  I suspect some of the non-traded REIT sponsors won’t charge internalization fees, but look to compensate management in other ways, such as stock grants (see my prior posts on Healthcare Trust of America, which internalized its management company without a fee, but has been granting stock to its executives with abandon (and impunity) ever since), or through lucrative, post-liquidity management compensation.  Some non-traded REIT sponsors may just decide to delay a liquidity event and keep earning their asset and property management fees.

I believe sponsors need to think long and hard before taking an internalization fee.  The financial temptation to take an internalization fee in some form or another will be great.  The REITs' boards of directors need to weigh the pros and cons of taking an internalization fee, including the negative connotation surrounding this fee that could impact the sponsors' current offerings and the cost of potential legal action by unhappy investors and aggressive attorneys.   I don’t want sponsors working for free, they do deserve fair compensation, but the compensation needs to be aligned with investors' financial interests, not at the expense of investors.  The decision to take an internalization fee doesn’t need to become a Shakespearean Tragedy. 

  *Internalization fee is the cost a non-traded REIT pays to acquire its management company from its sponsor.  Most non-traded REITs are structured as externally advised entities, where the REIT pays for management services from its sponsor.  Typically, a REIT “internalizes” its management as a process to separate itself from its sponsor.  The REIT typically pays the internalization fee to its sponsor in the form of REIT stock.  After an internalization fee the REIT will no longer pay asset management fees or property management fees, but pay directly for the management services. 

Trustee Authority

I read this long New Yorker article when it came out last year.  It's about the New York Mets' owners' involvement with Bernie Madoff.  I remember being struck by the absolute authority of the bankruptcy trustee overseeing the remaining assets of the Madoff ponzi scheme.  I thought about it again with today's $162 million settlement by the owners of the Mets.

Vegas Housing

Here's a post from Calculated Risk on the Las Vegas housing market.  Las Vegas has seen the largest drop in home prices of any of the Case-Shiller composite 20 cities, according to the post.  Through December 2011, Las Vegas home prices were off 61.8% from the peak, and were down 9% in 2011.  There is good news:

Sales in 2011 were at record levels, more than during the bubble, and it looks like 2012 will be an even stronger year - even with some new rules that slow the foreclosure process.

And this:

From the LVGAR: GLVAR reports increasing home sales, prices, decreasing inventory. First on a record sales pace:

According to GLVAR, the total number of local homes, condominiums and townhomes sold in February was 3,794. That’s up from 3,591 in January, and up from 3,371 total sales in February 2011.

Compared to one year ago, single-family home sales during February increased by 17.8 percent, while sales of condos and townhomes decreased by 5.0 percent.

The Calcualted Risk post ends with this:

So 71.3% of the sales were distressed, and over half were purchased with cash.

One of the keys is the decline in inventory. Note that the GLVAR reports both total inventory, and inventory excluding "contingent" listings (usually short sales). Total single family inventory was down 15.4% from a year ago, and excluding contingent listings, inventory was down 45.6%!

This is good news and one of the reasons why I am a housing bull.  I have read other articles supporting my belief, and will try and link to them.

Home Investing

Here is a good article from Bloomberg on private equity investors buying foreclosed homes as rental properties.  The properties should generate good cash flow to sustain investors until the properties are sold.  I'm not sure I buy this thesis:

In starting Waypoint, Wiel and Brien set out to show institutional investors that by using technology they could amass single-family homes the same way Sam Zell’s Equity Group Investments Inc. (EQR) and other real-estate giants gather apartment units in cities from New York to San Francisco.

The home rental market boasts a total property value of $3 trillion, according to Morgan Stanley (MS) housing analyst Oliver Chang. Yet institutions have long shunned it as too scattered and impractical to be profitable.

Wiel and Brien are using cloud computing, proprietary algorithms and iPads to create a virtual assembly line for buying, renovating and renting houses on a large scale. They’re also betting that many former homeowners who have jobs but couldn’t afford their mortgages will still want to live in the same communities as renters.

“The economics never made sense for a big investor to come into the market, and the technology for managing all that complexity didn’t previously exist,” says Brien, who still possesses the steely stare of a field goal kicker. “The confluence of those two events has provided a window of opportunity for large investors to enter this space.”

The article mentions that Waypoint has over 1,100 homes.  The exit strategy is still selling the homes individually, which will take months, and likely years.  This will test the institutions' patience.  Institutional money is great, but local knowledge is critical.

Shifting Sands' Job Gains

Here is a good Bloomberg BusinessWeek article on job growth in sand states (Florida, Arizona, Nevada and California).  These states had the most job declines during the recession, but are now leading the nation in job growth.  The BusinessWeek article seemed surprised at this trend.  What I'd like to know, and what's not addressed in the article, is what impact the collapsing housing market had on the job losses and what impact a rebounding housing market is having and will have on job recovery.

Creativity Fail

Inland Western REIT has changed its name to Retail Properties of America, Inc.   American Realty Capital is already offering a similar product, Retail Centers of America, Inc.  Why would Inland Western change its name to almost match a competitor's exisitng product?  Maybe imitation is the best form of compliment, or maybe it's a case of dialing it in.  It's creativity failure either way.  To me, it's more likely that Inland is distancing itself from a product that has struggled so that Inland can protect its brand for its current and future offerings.  

The former Inland Western's Net Asset Value per share is 30% below its original offer price, and while it has worked hard for investors to keep paying a distribution, and has increased it nine quarters in a row, the current distribution (2.6% annualized) is well below the REIT's original distribution.  In the REIT's defense it raised and deployed capital in the mid-2000s in retail real estate, one of the real estate asset classes most impacted by the recession and housing slump.  The former Inland Western also fought to refinance debt that matured near the worst of the credit crisis.  Inland should have put more thought and originality into the name change.

Calling BS At Forbes

This Forbes article popped up on my Google News feed.  It reads like PR for TNP Strategic Retail Trust, a non-traded REIT that has raised about $65 million in over 2.5 years.  I don't put much credence in Forbes' articles like this after I read an error-filled one from an attorney last fall (my comments are linked here).  The article on TNP Strategic Retail is worth reading for the comments alone, as readers quickly saw through the author's propaganda and called him out.

Inland Western's (Archaic) Listing?

On February 28, Inland Western REIT filed a letter it sent to investors.  The letter is optimistic, and I could write a snarky post poking each sanguine point.   But the key paragraph that caught my eye was at the end of the letter where Inland Western stated:

As previously communicated, we continue to pursue the initial listing of our existing common stock on a national securities exchange. We currently intend to complete the listing in 2012, and we are in the process of finalizing the terms of the phased-in liquidity program that we intend to implement in connection with the listing. As was described in our proxy statement for our special meeting in February 2011, we currently anticipate that we will implement a phased-in liquidity program that will provide for the listing of 25% of your existing shares of common stock concurrent with the initial listing and the listing of an additional 25% of your existing shares of common stock on each of the six-month, 12-month and 18-month anniversaries of our initial listing. We will provide you with further information regarding the expected timing of the listing and impact of the listing of our common stock on your existing holdings as the process progresses. Although we do currently intend to pursue an initial listing within the foregoing timeframe, we cannot guarantee that such a listing will occur and timing could be impacted by overall economic and other conditions and factors.

Inland Western told investors that it plans to list its shares sometime in 2012, but it will only make shares available in 25% increments, with each share release spaced out over six months.  Under this structure, investors will not receive full liquidity for eighteen months after the date Inland Western initially lists its shares.

Inland Western internalized (bought with its stock) its advisor in 2007, at a value of $375 million.  (This fee was approximately 8% of Inland Western's equity, which, based on this metric, was not the cheapest nor the most expensive internalization.)  The internalization generated lawsuits and in July 2010, Inland Western agreed to return 9,000,000 shares, which lowered the internalization to $285 million (assuming the initial valuations were done on the REIT's $10 per share offer price).  Based on Inland Western's current $6.95 net asset value share price, I figure the internalization fee is now 30.5% less than $285 million, or $198 million.  If anyone has more accurate figures, I will post them.  Obviously, at minimum, Inland Western's sponsor is likely subject to the same delayed listing schedule as investors, and the $198 million will fluctuate with the market price for Inland Western's shares. 

(Here is a June 2010 article from CRENews.com that discusses non-traded REIT internalization fees and from which I obtained the $375 million value listed above.  The article has this whopper quote from Stanger's Kevin Gannon:

"There is nothing wrong with non-traded REITs paying to internalize management because they bring in-house good people, who know the REITs and their assets. But sometimes the dollar amounts have been large and there's been some criticism for that," said Kevin Gannon, a managing director with Stanger.

 There's no wonder why non-traded REIT sponsors love this guy.)

There are plenty of other non-traded REITs that raised money in the mid-2000s that have yet to internalize their external advisor.  Unless a REIT sponsor has specifically amended its REIT's documents, most REITs offered in the mid-2000s have the ability to internalize their advisors.   In today's environment, it'd be hard for a sponsor to justify, rationalize or explain a huge internalization fee.  A situation where a REIT's NAV per share is less than the original offer share price per share would make an internalization decision even more difficult.  If a sponsor is raising capital in another REIT, all the fees associated with that offering or offerings would be in jeopardy if broker / dealers cancel selling agreements due to the internalization fees.  Termination agreements may not be wide spread, but what REIT sponsor is going to take the chance.  Let's hope Inland Western is the last non-traded REIT that hits investors with a large internalization fee.

More ARCT Listing

Here is a partial screen shot from yahoo.finance of the closing of ARCT's opening day of trading:

I circled the day's trading range.  I wonder who was part of the trade at $5.54, especially the sell side.  Someone took a nearly 50% loss when ARCT has a tender offer to purchase shares at $10.50 per share.  You can't fix stupid.

ARCT Listing

American Realty Capital Trust is now listed on NASDAQ and and began trading this morning under the symbol ARCT.