Riddle Me This

I see that Franklin Square Investment Company (FSIC) now has an investment grade rating of BBB- from S&P and Fitch's.  This follows on Corporate Capital Trust's BBB- rating from S&P.  I'm trying to understand how the two business development companies (BDCs) raise equity and borrow money to make loans to non-investment grade companies and come away as investment grade companies.    (And at year-end 2013 CCT had 16% of its investment portfolio in investments with active payment in kind elections, but this is a whole separate topic.)  I guess the sum of the parts is greater - much greater apparently - than the parts by themselves.  It's like a sausage, no one wants to know how it's made or the ingredients used, just that the end result tastes good.  I'm reminded of this scene from the Wizard of Oz whenever I think too hard about BDCs:

About Time

I have been waiting to read about investment funds moving into Spanish real estate.  Here is a Bloomberg article on a new REIT, Merlin Properties SA, being formed to buy commercial real estate in Spain and to a lesser extent Portugal. 

Do You Know What's In Your BDC?

Business development companies (BDCs) publish a list of their investments every quarter.  But do you really know what's in your BDC?  Probably not.  This article from the Financial Times is worth reading (requires free registration if not a FT subscriber).

According to the article, leveraged loans (loans to companies already with substantial debt) classified as single B, which are the main components of BDCs, made up more than a third of new issuance in 2013.  This reversed a recent trend where more higher rated bonds were issued, and this was the first time since 2004 and 2005 where more single B loans were issued than double B loans.  The resurgence of lower rated loans indicate a loosening of credit markets as investors seek higher returns in investments with higher risk.

 

The article also touches on the return of covenant-lite loans (think no-doc mortgages) and payment-in-kind loans (interest payments added to loan principal, not cash, so think negative amortizing mortgages).  I have not seen any payment-in-kind loans in BDCs, but I'm not sure whether a BDC would have to disclose whether its loan portfolio included covenant-lite loans.

 

BDCs own, originate and purchase high yield loans.  That's no secret.   Lending to small, unrated businesses is the primary mandate of the BDC structure.  The article concludes by stating that investors are attracted to B-rated loans by the chance to earn high returns will retaining seniority.  I want to see more information on the borrowers and types of loans in BDCs. 

D'Oh

At a conference earlier this week I over heard a real estate sponsor claim with pride - and a strait face -  that his REIT had no debt.  He then added the caveat that he didn't count the REIT's $40 million line of credit as debt (I'm sure his bankers have the same impression).  The sponsor also didn't include the 60%-plus debt on each of the REIT's properties.  The sponsor can make this specious boast because the REIT owns the properties through what is known as special purpose entities (SPEs), stand-alone companies (usually limited liabilities companies) whose sole purpose is to own one asset.  The catch is that the SPE's sole owner is the REIT.  So the while the sponsor's pronouncement is technically correct, it is also complete BS.

Nothing Story

This InvestmentNews story is a big fat nothing.  When I read the headline I thought ARC and KBS were in a new fight, but it turns out its an old (2009) issue.  I am shocked to learn that wholesalers would take their contact lists with them when changing jobs.  What has this world come to?

The New Bankers

Here is a great New York Times article on Blackstone's GSO debt financing unit (the same GSO that manages the Franklin Square non-traded BDCs) and its investments in Ireland.  The story is a fascinating read.  The recent financial crisis was, in my opinion, the most significant financial event since the Great Depression, and I believe we still haven't seen all its ramifications.  (And, more importantly, we have not learned the hard lessons the crisis was screaming at us.)

The rise of firms like Blackstone, which neatly stepped into the financial crisis' banking void, is real.  The article ends on an ominous note:

And the type of shadow banking that most concerns regulators — short-term borrowing involving broker dealers, hedge funds and money market funds — does not apply to Blackstone.

But, there is no doubt that its fast-growing credit business is breaking new financial ground.

“If the fund in question knows right up front what the risks are and its exposure is quasi-equity in nature that can be beneficial,” said Adair Turner, formerly Britain’s top financial regulator and co-chairman of a comprehensive study of the shadow banking industry.

“But we also know that the financial industry is forever innovating and when it does it tends to put more leverage in the system so we have to watch this very carefully.”

With firms like Blackstone, which has $265 billion to invest, the new bankers are a major force in business.

Go Global

My Bloomberg app on my iPhone does not update its industry articles as fast as Bloomberg's website.  I read this article on Blackstone's view on real estate opportunities on my iPhone last night.  The article originally appeared last Thursday.  Anyway, I guess I'm glad the app is slow because I missed the story when it was first published.

Blackstone is looking at the dislocation in emerging markets as an opportunity.  Of more interest to me is Blackstone's opinion on Europe:

While Europe’s economic crisis has eased, the shrinkage of loans and other assets that regulators are pressing banks to undertake will “be taking some oxygen” out of the region’s economies. Blackstone is forecasting “very slow growth,” (Jonathan) Gray said. (Mr. Gray is Blackstone's global head of real estate.)

For real estate investors, Gray expects forced sales by European banks to continue for several more years, fostering opportunity. Blackstone is seeking distressed warehouses, hotels and office buildings throughout the region, he said.

“When people are forced to sell, the pricing tends to be better,” he said. “In Europe, it’s not a growth story. It’s a distress story.”

Blackstone also sees "great strength" in the US housing market as construction still trails pre-recession levels.  Finally, Blackstone sees "good signs" in the US lodging market.  The "good signs" is somewhat substantiated by this Calculated Risk blog post that Las Vegas Convention traffic is 18% below pre-recession levels, telling me that one important demand component is still recovering.

Of course the global head of real estate, responsible for an $80 billion portfolio, is going to be optimistic, but it's still interesting to read where one of the largest real estate investors in the world sees opportunities.

Update

Work has intercepted blogging, but I expect more regular posts soon.   In the mean time, I've been at a loss for a pithy analysis of Kite Realty's $1.2 billion acquisition of the non-traded REIT Inland Diversified, other than it's hard to believe this deal would not have happened without American Realty Capital's and Cole's successful liquidity in several of their REITs.  Combine this with the sour aftertaste from Inland's last listing, Retail Properties of America, and any price above the $10.00 per share offer price paid by investors is a win for Inland, and for Inland Diversified shareholders who'll get fully liquidity when the merger closes.

Healthcare REITs

Here is a Bloomberg article on healthcare REITs.  The positive, but awkward article highlights two non-traded REITs, Griffin-American Healthcare REIT II and ARC Healthcare Trust.  The reporter credits, in part, Obamacare for spurring demand for medical office space as more people gain health insurance - 975,000 people signed up for insurance in December, according to the article -  and presumably are visiting doctors.  The report's main focus is medical office buildings, and excludes hospitals and senior housing, which are generally included in healthcare REITs' portfolios.

Here is a passage:

Investor interest in medical-office buildings is driving up values. Capitalization rates, a measure of returns that declines as purchase prices rise, reached a six-year low of 7.3 percent nationally in 2013, Real Capital data show. That’s still higher than the 6.4 percent average cap rate for general offices and 5.7 percent for apartments, according to the firm.

I don't understand the first sentence of the next passage, but the subsequent information on the lack of new supply makes sense:

The large pool of properties to buy gives medical office investors ample opportunities to generate more income, according to Hanson of Griffin-American. A limited amount of construction should help landlords retain tenants and keep building occupancies high, he said.

Almost 15 million square feet (1.4 million square meters) of medical offices were completed in the past two years, compared with 41 million square feet in 2008 and 2009, according to Marcus & Millichap Real Estate Investment Services. (emphasis added)

Despite the positive trends the article reports that "Bloomberg's index of 11 health-care trusts fell 11 percent, making them the worst-performing industry group in 2013. The broader REIT index slipped 1.4 percent."  I hope the reporter means that health-care was the worst REIT sector and not the worst industry in the entire market. 

Bloomberg TV

I watch and like Bloomberg TV.  I switched to Bloomberg during the financial crisis for sound, hyperbole-free news and never went back to CNBC.  I read here in this Business Insider article that Bloomberg is in the "midst of some kind of reassessment of its TV business."  I hope that doesn't mean Bloomberg plans to kill its business news channel.  It's level-headed and informative, and if you watch it on a regular basis you won't find it boring.  You also won't switch back to CNBC.  (Fox Business News is horrible and in its own strange orbit.)

Think For Yourself

Back in my corporate days - many years ago - a series of corporate sales left the company I worked for as a twice-acquired company.  The second and final acquirer, then part of one of the largest financial companies in the world, instituted predictive indicator personality tests for all employees.  My test showed that I was too rational, an independent thinker, a "threat" to teamwork, and was an employee who could "potentially" question authority.  (Really?  Mild-mannered me, a corporate subversive?  Awesome.)  This flimsy test was all a group of new, inexperienced managers needed to make life unpleasant for a double-sold employee.  I left the then-behemoth conglomerate not long after the test and in wonderful example of schadenfreude the managers were fired within a year.  Sometimes it's better to read tea leaves than test results.

The test was right:  I am "rational" and do question conventional thinking, which are important qualities for an analyst.  Here is a must-read article from Research Magazine on the perils of following conventional thinking, and the difficulty in challenging it.  The author, Rob Seawright, details historical examples of detrimental collective thought that is eventually proved wrong. 

Questioning conventional wisdom is important, especially as the stock market hits new high and alternative investments - specifically non-traded REITs and business development companies -  are about to see their greatest annual inflow of investor equity.  Sales are more concentrated than ever in just a handful of firms, a clear, cliched case of the rich getting richer.  As the rich get richer, questions and dissent are going to get narrower, which is the opposite of what should be happening.  Not only do the big sponsors need tough scrutiny, but smaller competitors need closer review, too, as they may make risky moves to try and stay competitive.

(As an aside, Seawright mentions the "self-serving bias (where the good stuff is my doing and the bad stuff is always someone else’s fault)."  The owners of the twice-sold company where I originally worked could have their picture in the dictionary next to the definition for this bias.  I still crack a wry smile at some of the admonishments delivered to employees, the self-created, self-congratulatory awards they earnestly gave themselves, and the unabashed usurpment of employee initiative, hard work and success.)

Check Under The Hood

Here is a gem of a Wall Street Journal article (WSJ subscription required) that I hope was not lost in last week's Thanksgiving feasting and traveling.  Collateralized loan obligations (CLOs) are showing up in retail investments, including business development companies (BDCs).  CLOs have multiple tranches that offer varying levels of risk.  In general, I question the transparency of BDC portfolios, and with CLOs appearing in multiple BDC portfolios my suspicions are not allayed. 

Random Articles

I saved two articles from last week.  The first is about Devon Energy's $6 billion purchase of "producing oil properties and other property" in Texas' Eagle Ford shale formation.  The size of the transaction caught my eye along with the seller, GeoSouthern.  Apparently, Blackstone owns a portion of GeoSouthern and will exit its investment in GeoSouthern with the Devon transaction. 

The second article is from Bloomberg and reports that rising home prices are allowing US home owners to re-build equity.  The number of homes with negative equity - home value less than current mortgage balance - in the third quarter dropped to 21%, down from 23.8% in the second quarter.  This is a big drop in under water homes and the picture should improve if home prices continue to rise.  There is a ripple effect across the entire economy when people have home equity.  They can now sell their homes or refinance their mortgages.  Buried deep in the article was this passage:

The shortage of homes for sale has been worsened by investors buying properties to rent, said Lawler, the real estate consultant. Institutional investors including Blackstone Group LP have depleted inventory as they built portfolios of single-family houses to turn into rentals, he said. Blackstone has spent about $7.5 billion acquiring 40,000 homes in the U.S.

While that added to the record pace of price growth, the lower inventory has limited options for private buyers, he said.

This inventory situation is more acute in areas like Las Vegas, Phoenix, and in much of Florida, which were hardest hit by the housing crisis. 

CMBS Article

Real estate goes as the financing goes.  Here is a Bloomberg article on commercial mortgage backed securities (CMBS).  CMBS originations are expected to reach $80 billion in 2013 and over $100 billion in 2014.  This is below the amount of CMBS issued between 2005 and 2007 levels, but well above the amount issued for each of the past five years.  When there is money available real estate deals get done.   Here is an idea on lenders' market sentiment:

Investor demand for commercial real estate should grow along with a steadily improving economy, even if interest rates climb, according to the report. The reason, in part, is a rising level of comfort among lenders, including commercial banks, insurers and private investment firms, said Mitchell Roschelle, PwC’s national real estate practice leader and co-chairman of the study, based on responses from more than 1,000 property investors and lenders.

“Some of the credit-quality concerns that people had with real estate have evaporated with time,” he said in a telephone interview from New York, where the professional-services firm is based. “We’ve worked through those problems, and the other thing is what used to be headwinds have changed to tailwinds, in many cases, in the eyes of real estate market participants.”

The horses are at the starting gate.  And away they go....

Columbia Untethered

Columbia Property Trust's (CXP) $300 million modified Dutch Auction tender offer ended last Friday.  Columbia's stock, which ended the week around the auction's $22.50 floor price, has jumped early this week, and as I write this post is trading over $24.00 per share.  Who again supposedly benefits from these tender offers?

Barbarians At The Gate

You didn't think the more than $16 billion raised in non-traded REITs so far in 2013 was going to go unnoticed did you?  For several years big money Wall Street firms have been playing on the periphery of independent broker / dealer capital through their third party management of business development companies.  Now we have the first (at least first that I can think of) large scale investment by a Wall Street investment firm into a non-traded REIT.  According to a filing yesterday, Starwood Property Trust has made a $250 million preferred equity investment into Griffin Capital Essential Asset REIT to help the REIT close on an 18-property acquisition from Columbia Property Trust.  Yesterday's filing was a press release and states that as part of the acquisition financing, "the balance of the (over $500 million) acquisition was funded with $250 million of preferred equity provided by an affiliate of Starwood Property Trust, Inc."  The terms of the financing were disclosed today in Griffin Capital Essential Asset REIT's 10-Q.

I don't see deals like the Griffin Capital Essential Asset REIT / Starwood preferred equity tranaction as a one time occurrences.   The money flowing to non-traded REITs is too great to ignore.  Total equity in 2013 will likely exceed $20 billion.  This is expensive, small ticket, retail money that hedge funds and private equity have previously ignored.  Combine the large capital inflows to a concentration of sales - American Realty Capital Properties and Cole Real Estate Investments, which are merging, represent a 2013 market share of more than 58% - and it's market ready for new, well capitalized entrants.   While the big Wall Street private equity shops and hedge funds want a piece of a $20 billion passive money pie, the pitfalls are not so obvious.

Independent broker / dealers are a fickle bunch operating on razor thin profits.  They extract a price for doing business because non-traded REITs offer one of the few remaining sources of revenue.  Once a non-traded REIT figures out the broker / dealer override (based on sales) then it's time to get solicited for a conference fee (just because), without which the non-traded REIT gets no tacit or explicit endorsement or exposure.    Each broker / dealer is a little kingdom and the marketing and due diligence areas act as fiefdoms within the realm.  Independent broker /dealers make the idea of herding cats seem like a military parade.  Throw in that independent broker /dealers have an innate distrust of Wall Street because many independent brokers started with big Wall Street brokerages and are now independent for a reason, and you have an immediate barrier.   Hedge funds and private equity firms are going to realize, many for the first time, the true meaning of a "best efforts" selling agreement. 

A Real Life Hermione

In the third Harry Potter book, Prisoner of Azkaban, Hermione Granger uses a magical time device that allows her to take a double class load.  I think I found a real life Hermione Granger working at the Carter Validus Mission Critical REIT.  I generally read prospectus biographies with a grain of salt but this one jumped out at me (it was filed last week): 

Name		Age				Position(s)
Luke Lee			33			Vice President of Acquisitions and Due Diligence —Healthcare Division

Luke Lee is the Vice President—Healthcare Division of Carter/Validus Advisors, LLC. Mr. Lee brings 15 years of experience in the West/Southwest United States as a finance and real estate professional with a focus in acquisition, valuation, modeling and analysis of real estate assets. Most recently Mr. Lee was an acquisitions manager at Healthcare Trust of America, Inc. (HTA), a leading publicly traded REIT. In that role Mr. Lee sourced and closed over $500 million in acquisitions and analyzed over $6 billion in healthcare acquisition opportunities. Mr. Lee was also responsible for building argus models, underwriting acquisition opportunities and due diligence. Prior to HTA, Mr. Lee earned his appraisal license in 2010 as a valuation manager at CB Richard Ellis. Additionally, Mr. Lee achieved his CPA designation in 2005 during his tenure at Ernst & Young, LLP, where he was promoted to a manager within the Real Estate Advisory Services Group. Mr. Lee began his career at Raymond James as a financial analyst where he attained his Series 7 and Series 63 licenses in 1999. Mr. Lee’s educational degrees include a Bachelor of Science in Finance from Arizona State University in 2001 and a Master of Science in Accountancy from the University of Notre Dame in 2002.

Mr. Lee has fifteen years of real estate finance experience, which is good.  But he is only thirty-three, which means he started is professional work at eighteen.  He must have used a time machine to work as a real estate professional (at least enough to put on a biography) while earning degrees at Arizona State University and Notre Dame, unless he had the dullest college experience ever and never slept.

Pile of Dog Schiff

I found this Bloomberg article on Peter Schiff's dystopian outlook pathetic.  Here's some optimistic thinking:

Schiff, 50, isn’t fazed that gold is heading for its first annual price drop in 13 years, or that Goldman Sachs Group Inc. has called it a “slam-dunk sell.” He predicts bullion will reverse its 21 percent year-to-date decline and probably surge 52 percent to reach a record $2,000 an ounce within a year. That’s just the beginning: Before President Barack Obama leaves office in 2017 the U.S. will default, the dollar will collapse, hyperinflation will strike and gold will skyrocket, he says.

“I’m waiting for the dollar crash, I’m waiting for the real crisis to hit that I know will benefit gold,” Schiff said Oct. 18 over lunch of spinach-and-beet salad and stewed rabbit in the sun room after the radio show. “The longer it takes, the longer I have to wait for that payday. But the longer it takes, the bigger that payday is going to be.”

Goldman Sachs predicts gold near $1,000 an ounce, half of Schiff's prediction. This passage is encouraging:

The unabashed gold bug’s Euro Pacific Capital Inc. manages a $20 million mutual fund that invests in stocks related to the metal and lost 4.5 percent since it began in July. The Philadelphia Stock Exchange Gold and Silver Index slid 2.9 percent in the same period.

A $20 million mutual fund is nothing, so people aren't flocking to his theories.  The fund has under performed its index by a wide margin, which is probably to due in part to high fees.  Not only has he been wrong in his outlook, he has been worse than the index, and is getting paid for this poor performing, bunker-mentality advice.

Another Blackstone Listing

I noted earlier this week that Blackstone plans four REIT IPOs in the near future.  Not included in the four was Extended Stay, the mid-priced lodging chain that Blackstone owns with investment firms Centerbridge Partners and Paulson & Co.   According to Bloomberg, Extended Stay seeks to raise up to $593 million in an IPO.  Extended Stay's ownership trail is amazing:

Extended Stay was founded 18 years ago by billionaire H. Wayne Huizenga and his longtime business associate George Johnson. The two formed the company in January 1995 and took it public that December with two properties, raising about $60 million. Johnson was chief executive officer of Extended Stay and Huizenga was chairman.

The company had expanded to 472 hotels by the time Blackstone bought it in May 2004 for $3.1 billion, after the 2001 terrorist attacks and recession had depressed travel and hotel-property values.

When the commercial property market peaked in 2007, Blackstone sold Extended Stay to Lightstone Group LLC for $8 billion. After the credit crisis hit, Lightstone couldn’t refinance Extended Stay’s debt and the company filed for bankruptcy protection in 2009.

The following year, Blackstone joined New York-based Centerbridge, a lender who had worked to restructure Extended Stay debt, and Paulson, the hedge fund firm led by billionaire John Paulson, to buy back the hotel chain at a bankruptcy auction for about $3.9 billion.

 Blackstone is expected to have an IPO for its Hilton Worldwide Holdings as early as December.

The One Houisng Chart You Need

The Price-to-Rent ratio is the one housing statistic that tells you when home prices are getting out of line.  Below, borrowed from Calculated Risk, is a chart on historic Price-to-Rent ratio:

Price-to-Rent is the ratio of a home's cost to its rent equivalent, similar to a stock's price-to-dividend ratio.  For much of the '80s and '90s the ratio ranged from 1.0 to 1.2.  It started to rise in the early 2000s, and exceeded 1.8 at the housing peak.  The ratio dropped to under 1.2 with the housing collapse.  Price-to-Rent is increasing again as home prices rise, but is only at levels of the early 2000s.  Housing prices have been increasing for over a year, but it doesn't appear that the price rise is out of line.