Canary In The Coal Mine

Early yesterday, TNP Strategic Retail Trust Inc. filed a short update with the SEC, and it's a must-read for anyone following the non-traded REIT industry.  In the filing, among other big issues, the REIT disclosed that it may not be in compliance with provisions in two of its secured loans, one a revolving line of credit with KeyBank secured by five properties, and the second a loan on a single property.  In addition, the REIT disclosed that its November 9, 2012 value of $10.60 per share may not be an accurate measure of the REIT's current value.  TNP Strategic Retail's problems, in this blog's opinion, show huge cracks in the operations of non-traded REITs and will have broader implications for the entire industry, particularly in financing and REIT-created valuations.

Lines of credit have become vital to non-traded REITs, and KeyBank provides many non-traded REIT financing facilities.  Bankers may design creative financing options, buy they're ultimately lemmings, and conservative in making broader decisions.  I'd suspect KeyBank is frantically reviewing all its loans to non-traded REITs, because with banker mentality one sour episode means all non-traded REITs are now suspect.  The easy money provided non-traded REITs by banks - which come with a long list of negative covenants - gives non-traded REITs plenty of opportunity to over borrow and get into financial trouble. 

The typical non-traded REIT credit arrangements have conditions that must be maintained, or negative covenants are triggered.  The conditions vary per financing transaction, and so do the negative covenants.  For example, a non-traded REIT may have low cost financing as long as it raises a certain amount of equity per month or keeps total leverage below certain levels, and if the REIT fails to meet these requirements then the interest rate may increase, a large principal payment could be due, or the loan could be considered in default.  This is common sense, but non-traded REITs need to borrow within their means, not based on future fund raising or financing events.

TNP Strategic Retail's disclosure that its November 2012 value of $10.60 per share may not be accurate is an understatement.  (This blog questioned this REIT's valuation methods in August 2012 when the value was a mere $10.40 per share).  Non-traded REITs have upfront costs that typically range from 10% to 12%, excluding acquisition and financing fee and expenses.  If a REIT's offer share price is $10 and its offering costs are $1.10 (11%), it's left with $8.90 (89%) to invest in real estate.  This $8.90 of real estate then becomes the REIT's net assets.  No real estate investor can consistently buy assets at an across the board 13% discount, which is the amount of appreciation needed for a non-traded REIT to recover an 11% load.  There is no acquisition arbitrage, and if there was one, every finance company and investment bank on Wall Street and beyond would inundate non-traded REITs with capital until the arbitrage disappeared. 

Recent mid-offering revaluations, across multiple REITs, have magically resulted in net asset values greater than the initial share offer prices.  This is not shocking because if a non-traded generated a value less than its offer price - even though the offering costs are fully disclosed - the fear is new equity sales would plummet (and remember those negative covenants!).  The whole revaluation process has become nothing more than a mid-offering marketing boost.  The thin credibility behind advisor generated valuations, whether the advisor gets a rubber stamp from a third party firm or not, has been shattered by TNP Strategic Retail.  (I'd be nervous if I was a Strategic Retail independent board member that approved the $10.60 per share value just two months ago when the impending financial problems were looming.) 

After non-traded REIT sponsors get over their Tony Thompson schadenfreude, they better look closely at their own shops and realize TNP Strategic Retail's situation is an industry harbinger.  Bankers are not your friends or partners - they're sheep with self-interest.  Today's easy, short-term money could become difficult money quickly, and non-traded REIT advisors better understand this.  The charade of internal, advisor generated valuations must stop.  Offering costs are real - which is OK - and can't be revalued away.  Unfortunately, the industry can't or won't fix this problem as long as the revaluation marketing efforts are successful, which means responsibility will fall to regulators.