Fracking Commentary From The New Yorker

Here is a commentary from Elizabeth Kolbert in the latest issue of The New Yorker.  Here is a stat to think about:

In the past ten months alone, some sixteen hundred new wells have been drilled in Pennsylvania; it is projected that the total number in the state could eventually grow to more than a hundred thousand. Nationally, shale-gas production has increased by a factor of twelve in the past ten years.

This production boom may have something to do with low current gas prices.  It is also worth remembering these statistics when analyzing projections from sponsors offering gas programs.

Oil In Canada

Here is a good article on Canada's oil sands from Bloomberg.  Due to the oil sands, Canada has the world's third most proved oil reserves behind Saudi Arabia and Venezuela.  The problem with this oil is that it's not easy to extract and is environmentally messy.   The extraction cost is in the mid-$60 per barrel range, so current prices make oil sand development viable.  I didn't know all the geopolitical issues surrounding this huge oil reserve.  The interest of the Chinese and its capital are a development to watch. 

Good Euro Article

Here is good, but depressing, article from Bloomberg's BusinessWeek on the euro.  These three paragraphs sum up the euro situation:

The most unfortunate difference between then and now is that the euro, unlike the gold standard, is a raccoon trap: Its designers deliberately left out an exit procedure. That means you can get in, but you can’t get out without leaving a part of yourself behind. Eichengreen points out that Britain was growing again by the end of 1932, just over a year after abandoning gold under duress. Today a country—say, Greece—that quit the euro would take far longer to right itself. That’s because unlike Britain, to get relief Greece would have to default on its euro-denominated debts and damage its credit rating. “The Greek government,” Eichengreen says, “will be hard-pressed to find funds to recapitalize the banking system. Greek companies won’t be able to get credit lines. The new Greek government is going to have to print money hand over fist. At some point they would be able to push down the drachma and become more competitive. But the balance is different now.”

That’s why Eichengreen thinks leaving the euro zone should be a last resort. The better option, he says, is to make the euro work the way the gold standard worked in its best years. Surplus countries should equally share the cost of adjustment with deficit countries. He favors transforming the underfunded European Financial Stability Facility from an emergency fund into a bank. He would have the facility borrow from the European Central Bank so it can make unlimited loans to countries such as Greece and Italy—on the condition, of course, that the countries demonstrate they’re on a path to fixing their competitiveness problems. Those countries don’t have a chance to fix things without the breathing room afforded by official lending, Eichengreen says.

Europe’s fatal mistake was to push ahead with monetary union without having achieved fiscal union. Limits on national budget deficits were flouted with impunity. Now creditor nations are dragging their heels on aid and stimulus because they don’t want profligate debtors to play them for fools. In an echo of the gold-hoarding mentality of the Depression, Germans have reacted angrily to the suggestion that the International Monetary Fund might tap Germany’s gold reserves to bolster the EFSF. The mood is angry and confused. German Chancellor Angela Merkel was correct on Nov. 14 in Leipzig when she described the debt crisis as “maybe Europe’s most difficult hours since World War II.”

Valuation Methodology Differences

Wells REIT II announced its share valuation last week at $7.47 per share.  In May, Hines REIT announced a $7.78 share valuation.  The two REITs bought similar type properties - major market, Class A office buildings -  over the same approximate time period during the mid-2000s.   It makes sense that the two values are close.  It is important to note the distinctions in the valuation methodology used by the two REITs. 

Wells REIT II was clear in its 10-Q that it valued only its real estate, and did not include a value for the REIT as a business, or its enterprise value.  Here is the wording from Wells REIT II:

Our estimated per-share value was calculated by aggregating the value of our real estate and other assets, subtracting the fair value of our liabilities, and dividing the total by the number of our common shares outstanding, all as of September 30, 2011. The potential dilutive effect of our common stock equivalents does not impact our estimated per-share value. Our estimated share value is the same as our net asset value. It does not reflect "enterprise value," which includes a premium for:

 

•	the large size of our portfolio, although it may be true that some buyers are willing to pay more for a large portfolio than they are willing to pay for each property in the portfolio separately;

•	our rights under our advisory agreement and our potential ability to secure the services of a management team on a long-term basis; or

•	the potential increase in our share value if we were to list our shares on a national securities exchange.

 

Our key objectives are to arrive at an estimated per-share value that is supported by methodologies and assumptions that are appropriate based on our current circumstances and calculated using processes and procedures that may be repeated in future periods. Wells REIT II believes that this approach reflects the conservative investment principles that guided the assembly of our portfolio over the past eight years, and comports with industry-standard valuation methodologies used for nontraded real estate companies.

Details:

 

As of September 30, 2011, our estimated per-share value was calculated as follows:

Real estate assets	$	10.13		(1)
Debt	(2.65)			(2)
Other	(0.01)			(3)
Estimated net asset value per-share value	$	7.47
Estimated enterprise value premium	None assumed
Total estimated per-share value	$	7.47

(1)

Our real estate assets were appraised using valuation methods that we believe are typically used by investors for properties that are similar to ours, including capitalization of the net property operating income, 10-year discounted cash flow models, and comparison with sales of similar properties.  Primary emphasis was placed on the discounted cash flow analysis, with the other approaches used to confirm the reasonableness of the value conclusion. Using this methodology, the appraised value of our real estate assets reflects an overall decline from original purchase price, exclusive of acquisition costs, plus post-acquisition capital investments, of 8.1%.  We believe that the assumptions employed in the valuation are within the ranges used for properties that are similar to ours and held by investors with similar expectations to our investors.

 

The following are the key assumptions (shown on a weighted-average basis) that are used in the discounted cash flow models to estimate the value of our real estate assets:

Exit capitalization rate	7.19	%
Discount rate/internal rate of return ("IRR")	8.19	%
Annual market rent growth rate	3.31	%
Annual holding period	10.3 years

While we believe our assumptions are reasonable, a change in these assumptions would impact the calculation of the value of our real estate assets.  For example, assuming all other factors remain unchanged, a change in the weighted-average annual discount rate/IRR of 0.25% would yield a change in our total real estate asset value of 1.83%.

 

(2)	The fair value of our debt instruments was estimated using discounted cash flow models, which incorporate assumptions that we believe reflect the terms currently available on similar borrowing arrangements to borrowers with credit profiles similar to ours.

(3)	The fair value of our non-real estate assets and liabilities is estimated to materially reflect book value given their typically short-term (less than 1 year) settlement periods.

Hines REIT, which I discussed earlier this year here, uses the following language, and it does have an enterprise component:

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.

Hines REIT's first three valuation points look like Wells REIT II's, but unlike Wells, none of the Hines' assumptions are disclosed.  The last sentence in the Hines REIT disclosure is where the analysis slips into the qualitative.  The board considered additional items like anticipated results of operations, anticipated capital structure, and the "Advisor's recommendations and assessment of the Company's prospects and expected execution of the Company's operating strategies."  It's naive to think the board would factor in negative projections.  It's not disclosed what percentage of Hines REIT's $7.78 per share valuation is represented by these intangible assumptions. 

I chose Hines in my comparison because I had its filing language readily available, and it's similar to Wells REIT II.  Hines REIT is not the only non-traded REIT that adds in an enterprise component when valuing its shares.  I am not against non-traded REITs having an enterprise valuation component, because non-traded REITs are companies and there is a value to that.  I just need to see how the REITs value their ongoing business, because in my opinion, it's an easy way for non-traded REITs to report a higher share value. 

I appreciate Wells REIT II's board's decision to disclose the assumptions used in determining a per share valuation.  The board should get some credit for excluding the enterprise component, which had it been included, would have resulted in a higher net asset value.

I am skeptical of any valuation for a non-traded REIT until it lists on an exchange.  That's the only valuation that's going to matter to most investors.

Is This TIC Article For Real?

A link to this article on Tenant In Common investments just showed up on my Yahoo! Finance front page.  It was written by a securities attorney who is listed as a contributor to Forbes.  What a sloppy, credibility-destroying article.   I'd expect an attorney to at least get basic facts right.  He starts by saying that Tenant In Common (TIC) investments offered safe, guaranteed returns.  I am not aware of any TIC deal offered guaranteed returns.  Certain TIC deals were structured with contractual lease payments to pay income (Master Leases), but this is not a guarantee. 

The attorney calls TIC deals "strange partnerships."  Wrong.  As the name states, a TIC deal is direct, tenant in common ownership of a piece of real estate, not a partnership.  Investors own a specific percentage of a property, not an interest in a partnership, which in turns owns the property.   Direct property ownership is why investors were able to defer taxes. 

I love the contradictory use of the negative buzz words - private, illiquid and volatile - in this sentence:

Problem is, the value on the partnership, which is privately held and completely illiquid, can be extremely volatile and not nearly as safe as promised.

Yes, TIC deals were private and illiquid, all of which was fully disclosed.  Private, illiquid investments cannot be volatile.  Volatility implies a market that frequently sets prices - up and down - which an illiquid investment does not have.  Any investor buying a TIC deal had just sold an illiquid property that had been held privately.   There are many faults with TIC deals, but the private and illiquid argument fails, and the use of the term "volatile" is the author trolling for clients. 

The other negative buzzword the author uses is "stock broker."  TICs were not sold by stock brokers, but by financial planners and advisors that focused on real estate.  Transaction oriented stock brokers avoid illiquid deals that are going to tie up investor capital for five to ten years or more. 

There are more problems with the article, but I've wasted enough time with it.  If I was an unhappy TIC investor this author would be the last attorney I'd call.

Wells REIT II $7.47 NAV

It's been a long day.  I'd been trying to finish a project that's taken much longer than I expected, and then I get hit with two bombshells.  The first was the news on Grubb & Ellis Healthcare REIT II, which I noted in the previous post.  The second was the $7.47 per share price of Wells REIT II.  Maybe I shouldn't have been surprised at the low valuation, but I was.  I was expecting a Net Asset Value per share closer to $8.50 or $9.00, not below $7.50.  Here is an Investment News article on the filing.  (The article implies a front end load of 20.3% - $5.9 million raised an $4.7 million in the ground - which seems high too me.)   The REIT's dividend is not being adjusted, so the 5% yield on the original $10 per share investment is now a 6.67% yield on the new valuation.  (Oh boy, a yield increase!)  A third party, Altus Group, Inc., provided the valuation.

After a few hours digesting the new valuation, maybe it makes sense.  Office property prices are down more than 40% from their 2007 peak.  Wells REIT II acquired its properties from 2004 to 2011, with the majority acquired in the 2004 to 2007 time range, which was before the credit crisis and during a period of lower cap rates than in today's market.  (Remember, real estate prices and cap rates move inversely, with low cap rates meaning high prices, and high cap rates signifying low prices.)  Many of Wells REIT II's properties are suburban office properties, and suburban properties are just beginning to attract investors and see a rebound in pricing.  For many investors in Wells REIT II the $7.47 share price, while unsettling, is not directly relevant because the REIT is non-traded.  Investors who are reinvesting dividends will do so at the new lower price, which is a benefit as the current distribution will now buy more shares.  Shareholders' real value will be realized when the REIT is listed on an exchange, is merged or sold, or sells its assets directly.

Update:  The Snyder Kearny Blog likes Wells REIT II's disclosure related to the valuation.  Maybe the added disclosure will start a trend.

Griffin-American Healthcare Trust, Inc.

The board of directors for Grubb & Ellis Healthcare REIT II, Inc. determined that it was in the best interest of the REIT to transition advisory and dealer manager duties performed by affiliates of Grubb & Ellis Company to American Healthcare Investors, LLC and Griffin Capital Corporation, who will serve as co-sponsors of the REIT.  Grubb & Ellis Healthcare REIT II will change its name to Griffin-American Healthcare Trust, Inc.   The REIT will remain externally advised per this convoluted paragraph:

As a result of the co-sponsorship arrangement, Griffin-American Healthcare REIT Advisor, LLC (“Griffin-American Advisor”), an affiliate of Griffin Capital, will serve as our new advisor, and will delegate advisory duties to Griffin-American Healthcare REIT Sub-Advisor, LLC (“Griffin-American Sub-Advisor”), a sub-advisor jointly owned by Griffin Capital and American Healthcare Investors. Griffin Capital Securities, Inc. (“Griffin Securities”), an affiliate of Griffin Capital, will serve as our new dealer-manager. We are not affiliated with Griffin Capital, Griffin-American Advisor or Griffin Securities; however, we are affiliated with Griffin-American Sub-Advisor and American Healthcare Investors(.)

I recommend reading today's 8-K filing that describes the transaction and rational behind it in more detail. 

Can't sponsors get more creative than automatically resorting to using "American" in their name.  Including "American" somewhere in the name does not give a deal or a sponsor additional credibility.  Credibility is earned over time through performance, not through what a company calls itself or its deals.  Why don't sponsors just come out with the BFDE (Best F*c%&ng Deal Ever) REIT, because that is what I believe is being implied anytime "American" is used in a title.  (And, isn't there already a similar sounding non-traded REIT in the marketplace, American Realty Captial Healthcare Trust?)

The winners in this deal, long-term, are the principals of Griffin Capital and American Healthcare Investors, LLC, but this is always the case.  This transaction is a coup for Griffin Capital and its principal Kevin Shields, as Grubb & Ellis Healthcare REIT II has been raising about ten times more equity per month than Griffin Capital's non-traded REIT.  I can almost hear Griffin's Shields paraphrasing Charlie Sheen, "Winner, winner chicken dinner.  Winner, winner Shields dinner."

Another Sunday Read - Financial Crisis Edition

Here is a good article in today's Washington Post about financial crisis revisionist history.  The article is good because I agree with its premise.  The financial crisis, at its core, was fueled by the quest for yield, caused by artificially low interest rates, combined with an economic environment that masked the real underlying risk of many securities.  This also caused investors to relax their guidelines.  Blaming the government instead of honestly examining the real reasons for the crisis will ensure future crises.

Morningstar, Call Me

Morningstar is getting into writing analysis on non-traded REITs.  Here is a link to an InvestmentNews article on the decision.  On the surface, it's hard to see how this is not good news.  I think Morningstar will have its work cut out for it, especially based on the tone of this quote from Philip J. Martin, the person Morningstar hired to direct its non-traded REIT efforts:

“Presently, Morningstar does not believe a significant investment in nonlisted REITs makes sense for most investors as there are still too many drawbacks and unresolved issues,” he wrote in the note.” “We believe listed REITs to be the most appropriate option, from the standpoint of both the alignment of shareholder interests and long-term risk/return potential.”


But the deficiencies can be remedied, Mr. Martin said. 

Let's not kid ourselves, the above comment is code for saying that non-traded REITs' fees are too high for representatives, broker / dealers and sponsors, and high fees limit non-traded REITs' chances for success.  I'd like to be the fly on the wall when Morningstar tells Nick Schorsch, Jeffery Hines, Leo Wells and all the other non-traded REIT executives that they make too much money, and oh-by-the-way they need to disclose how much they're paid by the REITs' external advisors.  And wait until Morningstar finds out how non-traded REITs spend their O&O money. 

One thing I don't expect from Morningstar research is a Z-Score predicting that the entire non-traded REIT industry is a bankruptcy risk, which was recently produced by one of what InvestmentNews called "hodgepodge" due diligence firms.  With (faulty) red herring analysis like that, Morningstar's presence is needed. 

Morningstar, you need to call me, I'll shorten your learning curve in this industry where each of these REITs are different.  

MF Global Nightmare

Wow.  A huge story out of the MF Global implosion this morning.  Regulators are trying to determine whether MF Global tapped into customer accounts to support its bad trades.  This story keeps getting worse.