NorthStar Interview

I hope you were not drinking coffee while reading the DIWire's interview with NorthStar Securities' Tim Toole this morning.  You would have laughed it all over your computer or electronic device.  Gosh, what drivel.  Given that NorthStar Securities had only raised about $30 million over the first eleven months of 2017, or that NorthStar's first two REITs are combining with certain assets from Colony NorthStar to form a new REIT, or that yesterday NorthStar Healthcare Income REIT announced its cutting its 6.75% annualized distribution in half to 3.375%, or that NorthStar executives David Hamamoto, Daniel Gilbert, and Brett Klein have all announced they are leaving Colony NorthStar early in 2018, and finally that Colony NorthStar announced earlier in December that it is combining NorthStar Securities with S2K Financial Holdings, one of the few firms that managed to raise less money in 2017 than NorthStar Securities, the Q&A had plenty of important topics for discussion and explanation.

Nope.  None of these major events were addressed in the Q&A.  Instead we learned Tim's work history, his favorite book, his fear of Trump tweets, and that he is an adventurous vacationer.  Let's call this puff piece what it is:  Tim Toole marketing himself to other sponsors now that he has been made redundant with the S2K transaction. 

Rotten Wood

I just read this InvestmentNews article on the mess that is Woodbridge Group.  Information on one of this outfit's note programs crossed my desk a year or two ago and was summarily dumped in the trash.  According to the InvesmentNews article, Woodbridge raised more than $1 billion, some of which was in its note programs.  In reading Woodbridge's website it states it has "completed over $1 billion in financial transactions," which could mean anything on a real estate promoter's website, but also means it did not raise $1 billion from investors.  Woodbridge has defaulted on its one-year note so investors are no longer getting interest on their notes and their principal is probably in trouble, too, as it now a general unsecured claim. 

For an added outrage and the real reason I am writing this post, Woodbridge's CEO, Robert Shapiro, resigned last Friday but signed a consulting contract that pays him $175,000 a month.  That is stunning.  I am not sure how a bankruptcy judge can let this stand.  This guy needs his previous salary clawed back.

Memo to all:  I don't know if the Woodbridge programs matched any of following points, but as a rule avoid (where avoid means never, never, never consider) note programs where your proceeds are acting, in effect, as development equity for a sponsor.  Here are just some of the issues you face:

• Development real estate does not generate cash flow to pay your interest, which is important if you are a note holder dependent upon interest payments; 
• Your notes are subordinated to all other debt including construction and bridge loans, so if something goes wrong, your notes are likely worthless; 
• The full value of the property, which is essential to repay your note principal and that may or may not secure your notes, is not realized until the development is complete;
• You are the last debt to get repaid; and, 
• You share in none of the economic upside, outside of receiving interest and a return of your principal, if the development is successful.  The sponsor keeps this gain and has used your cheap financing to earn its profit.  You took equity-type risk for debt-like returns.

Second memo to all:  Avoid (see above for definition of avoid) note programs that are unsecured, and really, really avoid unsecured notes that are corporate financing for sponsors.  It is a red flag if an investment fund sponsor also offers investments in itself.  Again, you take all the risk, like Woodbridge note investors, and the sponsor gets all the benefits, and when the sponsor loses your money, its former CEO still gets to make $175,000 per month while you get nothing. 

Third memo to all:  Avoid (see above for definition of avoid) sponsors that claim to offer "next generation financial products." They don't exist. The only next generation that should concern you is is your grandchildren and not losing their inheritance.

UDF's Taint

I heard the rumor a few weeks ago that Houston-based independent broker dealer IMS Securities could close down due to an arbitration claim related to the sale of UDF IV, among other investments.  Today, InvestmentNews is confirming the rumor.  That's too bad.  Whether or not UDF is ever proved to have run ponzi scheme, as alleged, its other major flaws - affiliated dealings, high fees, high distributions supported by loans that generated no current interest, many of which were routinely extended, to name a few  - were clearly visible in filings. 

The Interval Fund Folly

I was at an industry conference last month and was told that there is a double digit number of interval funds in registration. I don't know if this is true, but I have seen plenty of new closed-end funds recently.  I do not understand the enthusiasm sponsors seem to have for these products.  They have better liquidity than non-traded real estate investment trusts and business development companies, which is good.  And the purchase process is easier and the suitability standards are lower than the non-traded products, too, but many broker dealers have implemented suitability standards for interval funds that are similar to those for non-traded products. 

Interval funds offer no deals in terms of fees.  Management fees are based on net asset value and are generally between 1.50% and 2.00% per year, which do not include other fund expenses.  Some interval funds invest in other funds and non-traded products, which have management fees, and potentially carried interest, all of which are in addition to the fees and expenses that the interval funds charge.  This makes a high annual fee hurdle rate that interval funds need to overcome, like 3.00% to 5.00% or more.  Combine these fees with the reality that most interval funds' underlying investments are not high flying investments, but modest return real estate investments, high yield debt investments, and fund investments, and you do not have an outlook for a high returns before any fees. 

Sponsors should check sales figures before entering into the costly interval fund registration process.  Through September, interval funds had raised a net $975 million in 2017, putting them on pace to raise $1.3 billion for all of 2017.  Just two interval funds have accounted for 70% of all sales in 2017.  Yesterday, the DI Wire published an article that says securitized 1031 exchange programs are on pace to raise $1.8 billion in 2017, which is half a billion more than interval funds.  Even the beleaguered non-traded REIT sector, and I exclude the sales of the Blackstone REIT, is on pace to raise $2.6 billion in 2017, or double the money flowing into interval funds. 

Money is leaving interval funds.  Some funds are seeing redemption rates of more than 20% of new sales.  This poses cash management constraints that could further weigh on performance.  Interval funds, in their current form, are not the savior of alternative investments, but an expensive niche investment for clients unsuitable for more sophisticated products.  Sponsors are spending millions to learn this lesson.

Four, Twenty, and Two Hundred Forty-One

Griffin Capital Essential Asset REIT announced a new NAV on Friday, October 27, 2017, of $10.04 per share, which was down from $10.44 per share as of October 27, 2016.  The drop in NAV is just under 4% at 3.8%.  This drop in NAV did not come as a shock.   It is only an estimate since the REIT is not traded on an exchange.  The following bullet point from the investor letter accompanying the valuation notice did surprise me:

The decline in NAV from last year stems, in part, from our close working relationship with our tenants as 17 of them (out of 84 properties) provided us with long-term notice related to space use expectations, influenced mostly by corporate mergers and restructurings. These advanced notices will potentially allow us to capture early termination fees which will offset the costs to re-lease the spaces to new tenants under long-term leases while taking advantage of favorable market fundamentals. While we did not include these potential benefits in this current estimate of NAV, we are optimistic that such potential will be achieved and accounted for in future NAV calculations.

The way I read the above passage is that tenants in 17 of the REIT's 84 properties, or 20%, have given notice that they plan to vacate their space.  At least that is how I read the euphemistic statement "provided us with long-term notice related to space use expectations."  Since nearly all of Griffin Essential Asset REIT's properties are single-tenant net leased properties, the REIT is looking at 20% of its properties being vacant.  A reference to the benefits of capturing lease termination fees confirms my thoughts on tenants vacating the properties.  So much for the concept of Essential Assets.

The REIT must spend the lease termination fees to obtain new tenants through lease incentives and improvements.  Since the majority of the REIT's properties are single-tenant, getting new tenants to take an entire building is going to cost the REIT money. 

Griffin Capital Essential Asset REIT had $3.36 billion in total assets as of June 30, 2017.  Its valuation had a estimated advisor promote of a whopping $241,000.  This meager incentive compensation estimate and a big leasing challenge signal to me that this REIT is not going to be seeking liquidity any time soon.

InHospitable

Hospitality Investors Trust, with the always apt acronym HIT, continues to punch investors.  In response to a tender offer from MacKenzie Realty Capital of $5.33 per share, HIT responded with its own tender offer of $6.50 per share.  What a deal!

HIT throws around a number of percentages in its tender offer announcement.  MacKenzie's tender offer is 58.1% below HIT's most recent NAV of $13.20 per share.  HIT's counter tender offer is only 50.8% below NAV, and it is a 17.5% premium to MacKenzie's offer.  Premium, seriously?  Do not be fooled.  MacKenzie's offer for HIT shares, like all its tender offers, is bottom fishing.  HIT's tender offer seems more like a chance to purchase shares cheap from its own shareholders rather than protect these investors from opportunistic buyers.

There is another percentage HIT does not want you to see.  HIT's tender offer of $6.50 per share is a 74% discount to the $25.00 per share paid by investors.

First Capital Invesment Corporation

From today's DI Wire.

If You're Explaining...

Ronald Reagan said, "If you're explaining, you're losing."  It is a simple statement that has some real truth to it, and it directly applies to all these multiple shares class investments that I have ranted about.  There is an example this morning in a DI Wire article on FS Investment's new non-traded mortgage REIT.  The story devoted two sentences in one paragraph to the REIT's investment thesis, but needed seven paragraphs and about three quarters of the article to detail all the share class options.  I don't think FS is losing yet, but it is sure doing a lot of explaining, which is not good.

Really

Last week I noted First Capital Investment Corporation's (FCIC) dismissal of its auditor and highlighted a passage from the filing disclosing the change.  It looks like the section I noted was on to something, as today the DI Wire is reporting that FCIC's former auditor is disputing FCIC's claim that there was no disagreement on accounting principals and disclosure.  The auditor did take issue with FCIC's affiliated transactions.  Really.  I never would have guessed it.

Ugly, Ugly, Ugly

I was out late last week and am catching up with some news.  This DI Wire story on the legal fight between Vereit and the AR Global executives is ugly, and it looks like it's going to get uglier.  The indemnification clauses that all investments have and that you skim over are now prominently in the open.  Who ever wins in court, it looks like investors are going to get stuck paying a whole lot of legal fees.

Own Worst Enemies

I ranted here about non-traded REITs having too many share classes.  This DI Wire article about Black Creek (formerly Dividend Capital) Diversified Property Fund reads like a parody.  The REIT now has seven share classes: A, D, E, I, T, S, and W.  Seriously, it is freaking ridiculous.   Black Creek / Div Cap, it's time to get real:  This REIT can add twenty-six share classes, but the only time it raises money is when it periodically offers shares bribes broker dealers with a big upfront commission.  Instead of wasting investors' time trying to bring in more money, why not just convert everyone to a single liquidating share class (call it Class L, of course!) and get investors the heck out of this dog.

Black Creek Diversified Property Fund is not the only public non-traded REIT I have seen recently offering a nonsensical number of shares classes.  I have even seen one that is adding numbers after letters, like Class A-1.  Hey sponsors, I am not sure who is advising you to offer so many share classes, but the advice is bad.  Yes, Blackstone's REIT has multiple share classes and is raising hundreds of millions, but it is the exception not the rule.  Do not mimic Blackstone until you get wire house selling agreements.  Until then, you are only confusing your product and getting no sales.

Run Away.... NOW!

The DIWire had an article yesterday about First Capital Investment Corporation's (FCIC) replacement of its auditor and its appointment of a new auditor, chief financial officer, and compliance officer.  The following passage from FCIC's 8-K disclosing the accounting change had this passage, with my emphasis added:

During the fiscal years ended December 31, 2015 and 2016 and the subsequent interim period through August 24, 2017, there were no disagreements between the Company and RSM on any matters of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreements, if not resolved to the satisfaction of RSM, would have caused RSM to make reference to the subject matter of the disagreement in its report on the Company’s financial statements and there were no “reportable events” as that term is defined in Item 304(a)(1)(v) of Regulation S-K, except there existed a difference of opinion between the Company and RSM that had not been resolved to the satisfaction of RSM relating to the Company’s investments in First Capital Retail, LLC (“ FCR ”), as further discussed in Item 8.01 of this Form 8-K. Specifically, the Company’s investments in FCR may be deemed to have been transactions with an affiliate under Section 57 of the Investment Company Act of 1940 and/or a transaction with a related party as defined under U.S. generally accepted accounting principles. If either determination were made, further investigation may conclude that such determination, if not reflected in the Company’s financial statements to be filed for the quarters ended March 31, 2017 and June 30, 2017, could materially impact the reliability of the Company’s financial statements for such periods.

The disclosure reads as though the auditor fired FCIC, as it had an issue with FCIC's two loans to affiliates, which are FSIC's only investments.  It is now August and FCIC has not filed a financial report for 2017.  This is a pattern of First Captial.  When it acquired United Realty Trust in September 2015 and renamed it First Capital Real Estate Trust it shortly thereafter fired the REIT's auditor and has not filed a financial statement since.  The lack of financial filings and disclosure is repeating at FCIC.

I am not going to waste anymore time discussing First Capital and its investments other than to state that firing auditors and not filing financial statements are not positive developments.  FCIC, as far as I am aware, is still trying to raise capital from retail investors, and I have heard that one reputation oblivious third party due diligence firm is still writing reports on First Capital's investments.  Do your homework.

Hines Global II Goes NAV

Hines Global REIT II, which had raised $368,000,000 through July over its almost three-year offer period, is converting to a NAV REIT.   In filings last month, the REIT announced that it will commence a $2,000,000,000 secondary offering, publish a net asset value monthly, and have a perpetual life.  The REIT declared an NAV of $9.65 per share in February 2017.  Hines Global REIT II is eliminating acquisition and disposition fees, which is postive.  "Perpetual life" means that the REIT no longer has an expected term or a plan to provide liquidity through a listing, merger, or asset sale.  Investors that want to liquidate their shares must submit their request through the REIT's share redemption program (SRP).   The REIT's SRP has been expanded to allow for monthly redemptions of 2% of NAV, subject to a redemption cap of 5% of NAV per quarter.  The REIT can suspend, modify, or terminate its SRP at anytime.

NAV REITs are not a bad idea.  They allow their managers to take a long investment view instead of buying investments that fit into a targeted exit period, and a perpetual offering provides for capital inflows and investments over various investment cycles, lessening the seasonality of investing in a particular market, which occurs when money is raised and invested within a specific market cycle. There is no preclusion from Hines Global II having a future liquidity event, but it is no longer management's primary exit strategy.  In steady markets, redemption requests should be processed without an issue.  But NAV REITs will face a test when markets are unsettled, or even if there are specific REIT-level events and redemption requests exceed the monthly limits.  Based on the 2% monthly and 5% quarterly caps, significant requests for liquidity could hinder a REIT for years.

My complaint with Hines Global II's decision is not that it is restructuring as a NAV REIT, but that when investors purchased their shares in the REIT they were not expecting a perpetual life REIT, but an investment that would provide some form of liquidity in eight to ten years from when the REIT's offering started in 2014.  The REIT's investment objective and business plan are being changed because of Hines's failure to raise capital.  If the REIT had raised $1,368,000,000 instead of $368,000,000, there is no way it would be converting to a NAV REIT.

I understand market conditions change, but real estate markets have not changed that much since Hines Global II began raising capital in August 2014.  Interest rates and cap rates are still low, the U.S. economy is still growing, and Europe's economy has improved.  Outside of older, Class B or lower regional malls, most real estate assets classes are as strong as they were in 2014.   What has changed is non-traded REITs' ability to raise capital.  Until that is figured out, every REIT needs to add disclosure about the possibility of becoming a NAV REIT.

Distribution Cuts and Verbal Sparing

It is time to take a trip deep into the woods.  I recommend reading the transcript of yesterday's FSIC earnings call.  FSIC announced a distribution cut of about 14%, dropping the quarterly distribution from $.22 per share to $.19.  FSIC is waiving .25% of its asset management fee for a year as a partial offset, which is about the same percentage reduction as the distribution.  FSIC blamed the distribution drop on a borrowers' market and "non income-producing equity" investments from restructurings.  Non income-producing investments from restructurings are former income producing debt investments that are now equity investments.  There was no discussion as to how the value of the new equity positions compares to the FSIC's original debt investments.

I am seeing across various income oriented BDCs and mortgage REITs that spreads are tightening, which means that the returns on the riskier assets these funds specialize in are dropping.  The situation is not unique to FSIC.

In an almost casual comment at the and of his prepared statements, FSIC CEO and Chairman Michael Forman stated that FSIC's "board is evaluating the timing and benefits of a merger with FSIC II, which remains a key focal point and could be a 2018 event."  This is news.  There is no date or definitive announcement, but a merger that remains liquid is positive news. 

The sparing is between FSIC management and Wells Fargo analyst Johnathan Bock and came during the question and answer session.  Bock questions the value of Franklin Square in the relationship with GSO as sub-advisor, wondering, "Of the deals that GSO submits to you, how many deals either early or late in the process do you at FS reject, given you are the final investment authority?"  Basically, he is wondering what Franklin Square does to earn a portion of the management fee because, according to Bock's implication, GSO does all the work.  FSIC does not directly answer his question in several answers from its executives, choosing to instead focus on the collaboration between FS and GSO.  Bock gets the final word by questioning FSIC's commitment to transparency as stated on its website. 

Do not think it random that Corporate Capital Trust abandoned its advisor / sub-advisor relationship before its planned listing. 

Money Where Your Mouth Is

W.P. Carey closed its syndication business at the end of June, citing high prices for net lease real estate as a reason.  According to Carey, offering its real estate investment trusts no longer made sense due to low cap rates, which means that net lease real estate is too expensive to buy and the yields too low.  I am going to call baloney on this excuse.   If Carey believed its rhetoric it would be either selling the entire company to maximize shareholder value to take advantage of the high net lease values, or it would be selling individual properties or portfolios in particular low cap rate sectors.  I have not read an announcement that Carey is looking for strategic buyers, and its property sales listed in its most recent 10-Q appear incidental.  Two the four listed dispositions in the first quarter involved giving properties back to the lender, not a real estate company's favorite type of disposition, and not the moves of a company capitalizing on a strong market.  Carey did not buy any meaningful real estate, either.

Carey had a unique syndication business.  It was conservative in its approach to managing its real estate funds - favoring long-term mortgages and not the tempting, low interest, variable rate lines of credit adopted by so many sponsors to increase near term cash flow - and its sales team was always professional.  Carey's core REIT product had some of the highest up-front fees in the industry along with some of the lowest ongoing fees.  This runs against today's market, which wants lower up-front fees so that investor's initial statement values do not differ too much from the share price investors paid for their shares*. 

It is my opinion that Carey, as a listed company, expected to make a certain amount of revenue and profit on the high initial fees of its syndication business, and likely built this revenue into its earnings estimates.  I suspect that Carey was unwilling to adapt to products that provided it less up-front revenue and short-term profit, even if it meant foregoing greater profit potential over time.  If it lowered its initial fee income Carey would have to lower earnings estimates, a task loath to any company.  I have been hearing that net lease real estate is too expensive for years, since at least late 2013 or 2014.  Maybe it is, heck, it probably is, no one knows for sure.  Until Carey puts itself up for sale, or sells large portions of its portfolio, I will stick with my opinion that Carey was unwilling to lower up-front fees and that is why it exited the syndication business.

*For example, an investor buys shares listed at $10.00 per share.  With a traditional front end cost of, let's say, 11%, an investor that bought shares at $10.00 would get an first statement showing a real value of $8.90.  Sponsors have been lowering, paying, deferring, and reclassifying costs to bring the statement value up to a more investor palatable price, which are discounted 4% to 6% ($9.60 to $9.40 per share) rather than the 11%.   

Alphabet Asphyxiation

Alternative investment sponsors are hurting themselves with all their multiple share classes.  There are Class A and Class K, Class C and Class T, Class D and Class P, and Classes S, W, and I.  Oh my!  I am sure there are more share classes, but these are the ones that come to mind.  Sponsors are confusing investors and advisors in an attempt to blur the difference between the price investors pay for their shares and the price that shows up investors' initial statement.  Sponsors have spent millions of dollars creating multiple share classes that try to solve the riddle of what discounted share price is investor-acceptable enough to the initial purchase share price.   

It is time for sponsors to simplify.  I would like to see two share classes:  Class A shares with a 5% commission and a no-load Class I shares.  Sponsors should ditch all other share classes, starting with the malignant Class T shares.  Class T shares penalize investors, advisors, and broker dealers, but allow sponsors to maintain, if not increase their fees.  Class T share investors get a lower distribution because the ongoing "distribution fees" payable to advisors are credited against investor distributions for three or four years, advisors get lower commissions than in an upfront loaded share class, and broker dealers have seen their fees reduced for selling alternatives.  But sponsors get more money because their acquisition fees are based on net investable assets, and because the Class T shares provide more net investable assets, the Sponsors' fees are higher. 

Despite this dichotomy, Class T shares are bringing in the most non-traded REIT capital at funds that are raising any meaningful money.  But there is a glaring consequence to the push for Class T shares - low level equity inflows.  Excluding the Blackstone non-traded REIT, only four non-traded REIT sponsors raised more than $20 million in equity in June, and one of these firms was in a close-out that skewed sales upward.  Only three non-traded REITs raised more than $20 million, and again, one was in a close-out.  Twenty non-traded REITs failed to break the $20 million level, and eighteen of these did not even raise $10 million.  This is bad.  Failure to launch or death by neglect are cliches that have become real points of analysis. 

Advisors, as a group, have never avoided high fee products as long as their compensation was not impacted.  Advisors know their fees have been lowered while sponsors make the same or more, and are looking for other investment options, and twenty-six share classes, or one for every letter in the alphabet will not solve this issue.

Getting Serious

CNL / KKR's Corporate Capital Trust (CCT), a business development company (BDC), filed an 8-K on Monday, July 10, 2017, announcing that it plans to list its shares on the NYSE shortly after its August 3, 2017, shareholder meeting.  It plans to trade under the stock symbol CCT.  The planned liquidity event was initially announced on April 3, 2017, and a fourth-month time from announcement to listing is fast.  As part of its listing, Corporate Capital Trust is lowering its annualized distribution to $.715 per share from $.805 per share.  It will make two special distributions over the next year of $.045 per share each to make up for the $.09 per share by which it is dropping the distribution. 

The distribution adjustment puts it in line with what Corporate Capital Trust is earning in its Net Investment Income, while the bonus distribution is coming from cash reserves.  Realistically, the market's reception to a BDC paying a distribution more than its net investment income would not have been kind, so the cut makes sense for shareholders.  Corporate Capital Trust's Net Asset Value per share is currently $9.00 and has ranged from a high of $10.15 per share in June 2014, to a low of $8.62 per share in March of 2016.  The price investors paid for their shares is NAV plus offering costs.  Investors should use the price they paid for their shares to determine their yield, not the current NAV.  For example, if an investor paid $10.00 per share their yield is 7.15%, and if an investor paid $11.00 per share their yield is 6.5%

A nearly $3 billion liquidity event is good news for a market place that has not seen any liquidity in a long time.

Shroud of Fireworks

FS Energy & Power filed an 8-K late on July 3, 2017, announcing that it had decreased the price at which it would issue shares under its distribution reinvestment plan.  The day before a major holiday is a good time to release some bad news.  The decrease was from $7.65 per share to $7.20 per share, or a 5.9% drop.  This is a big decline in what is essentially the BDC's net asset value.  There is optimism in the energy sector, but like with all other assets, energy is subject to the supply and demand.  Oil closed today at $44.33 a barrel, near its low for the year. 

Just End It Already

According to this Reuters article, Sears is closing another forty-three stores - eight Sears and thirty-five Kmarts - in addition to the 150 stores it had already said it was closing in 2017.  Just shut them all and be done.  Sears is even closing its store in San Diego's UTC mall, a regional mall undergoing a huge expansion and that shows no signs of experiencing the downturn afflicting other regional malls.  If Sears cannot make that location work, it has no business staying in business.

KBS Ditches BDs

The DI Wire reports that KBS is closing its flatlined non-traded REIT, KBS Growth & Income REIT, Inc., effective June 30, 2017.  This REIT raised $5.4 million since its inception in April 2016.  This is a horrible capital raise effort even in a tough DOL dominated market.  I am not optimistic about the REIT's plan to continue to raise capital through an on-line private offering.  KBS Growth & Income is returning to investors the difference between the price investors paid for their shares and the pending NAV price per share, which is the offering load, unless there is some aggressive valuation math.  This is a positive move by the REIT, but at $5.4 million of total capital, KBS should just return all investor money and start fresh.

Commenting in hindsight is easy, but looking back, KBS really should have listed or sold the $1.8 billion in equity KBS REIT II outright in 2014 rather than liquidating the portfolio asset by asset.  KBS REIT still owns eleven properties four years after it began to sell its portfolio.  It had an estimated NAV of $5.49 per share as of December 31, 2016, so the REIT still has a long way to full liquidation.  An outright sale would have allowed for a potential large capital reinvestment.  Periodic distributions, even if they eventually total more than the initial $10.00 per share, are harder to reinvest, especially when spread out over more than four years.

Testimony Confirmation

Here is a Wall Street Journal article from yesterday.  The article discusses the securities fraud trial against former American Realty Capital Partner CFO Brian Block.  I had always assumed Block and former ARCP chief accounting officer Lisa McAlister were acting either direct or implied orders.  McAlister's testimony at the trial has confirmed this, but her acknowledgement of past lies does not help her credibility.  This is an ugly mess.

Sounds Legit

First Capital Investment Corporation's (FCIC) board of directors has named its chairman as interim chief financial officer, treasurer, and secretary, as filed in an 8-K on June 23, 2017.  His interim term ends when the business development company files its March 31, 2017, financial statement.  The interim tile may be permanent, given that FCIC's real estate investment trust sibling, First Capital Real Estate Trust (FCRET), has not filed a financial statement since said chairman it took over nearly two years ago.  What could go wrong given that FCIC's first investment was to an affiliate and that multiple FCRET subsidiaries are filing bankruptcy?

Griffin Pounces

That did not take long.  Late Thursday W. P. Carey announced it was exiting the distribution of non-traded investments, and today Griffin Capital announced that it has hired former W. P. Carey executive Mark Goldberg, who among other duties at W. P. Carey served as Chairman of Carey Financial and President of W. P. Carey Investment Management.  I guess Griffin Capital is not the "other" non-traded alternative investment sponsor rumored to follow W. P. Carey's example and quit the industry.

Separately, I always laugh at the sycophantic claptrap quotes in press releases.  Just once I would like to read: "We hired Mr. So-and-so because he is a ruthless SOB who will not only help us gain market share and crush our competitors, but he also will fire the slacking employees we did not have the courage to terminate."

W.P. Carey Quits Selling Non-Traded Products

W. P. Carey filed an 8-K and press release late yesterday afternoon announcing that it will no longer sell non-traded products.  The 8-K was short and to the point:

On June 15, 2017, the Board of Directors of W. P. Carey Inc. (the “Company”) approved a plan to exit all non-traded retail fundraising activities carried out by its wholly-owned broker-dealer subsidiary, Carey Financial LLC, effective June 30, 2017, in  keeping with the Company’s long-term strategy of focusing exclusively on net lease investing for its balance sheet. The Company anticipates that it will incur non-recurring charges to exit its fundraising activities of approximately $10.0 million, in aggregate, during the second and third quarters of 2017, consisting primarily of severance costs.

The news was unexpected, but when you think about the management turnover at W. P. Carey over the past year, culminating in the departure of Carey Financial's President Mark Goldberg earlier this month, the decision should have surprised no one.  W. P. Carey is a large listed REIT and carrying a syndication division that is raising limited capital puts pressure on earnings. 

W. P. Carey provides sponsors that remain in the non-traded space some clear lessons for moving forward:

1  Know your skill set.  W. P. Carey was known for its CPA net leased real estate investment trusts (REITs), not business development companies (BDCs) or hotel REITs.  Carey tried to move away from something it knew, believing its sales organization and substitute products were interchangeable, and that broker dealers would adapt to products based on Carey’s earned reputation with its CPA product.  W. P. Carey's net lease knowledge did not transfer to new product acceptance.

2.  Products matter.  W. P. Carey was late to offer a BDC and then came in with a lackluster sub-advisor and a structure that left W. P. Carey open to broker dealer objections.  (I liked the master / feeder structure.)   Its sub-advised hotel REIT was fine, but as a sector investment it was no replacement product for the core CPA product.   Sponsors need to stick with their knowledge and competency, not chase sectors or product fads. 

3.  Fees matter.  W. P. Carey products were always expensive, especially on the front end, which is a difficult position to maintain in market now focused and concerned with DOL and its low fee requirements.    Yesterday's decision tells me that W. P. Carey was unwilling to adjust its fee structures in a manner to compete with broker dealer requirements in a DOL dominated environment.

The most attractive new products have low upfront costs, and align and subordinate sponsor compensation with investor returns.  Investors need profitable sponsors, and meaningful and attainable incentives for sponsors are required as the industry moves forward.

One final note on W. P. Carey.  Exiting the new product distribution removes a big incentive for W. P. Carey to provide liquidity to its existing investments.  These investments are externally advised, which means they pay asset management fees to W. P Carey.  A liquidity event means those fees go away.  An earnings focused public company will want to extend the fee inflow.

Juggling Chainsaws

Sometimes I get opaque on this blog, and this is one of those times.  I have been reading through several health care REITs' 10-Qs and 10-Ks, and while I am not ready to sound an alarm, I do see an area of concern.  In particular, REITs holding skilled nursing facilities worry me.  Skilled nursing investments are the medical sector that can juice up a healthcare portfolio.  Like student housing is to a multifamily portfolio or mezzanine loans are to a mortgage portfolio, skilled nursing has the potential to add return to a healthcare portfolio.  Skilled nursing properites typically trade at cap rate of 10% or more, which is 200 to 400 basis points or more than other healthcare properties, so when I see REITs buying these properties I take notice.

Skilled nursing is heavily dependent on medicaid reimbursements, which is the lowest level of reimbursement and can represent 80% or more of patients in a skilled nursing facility.  The balance is from much higher paying medicare and private pay patients.  A well run skilled nursing facility needs administrators that can work with hospitals and families to keep the "quality ratio" of medicare and private pay patients high compared to medicaid patients.  Skilled nursing properties that are subject to net leases with operators offer a REIT some protection, putting the patient risk on the operator, not the REIT.  I am seeing skilled nursing facilities in healthcare REITs where the REIT or a subsidiary is the operator, which means the REIT is taking on the operating risk of the facility.  
Skilled nursing facilities trade at cap rates higher than other healthcare properties for a reason - and that reason is risk.  If things go well the extra 200 to 400 basis points is great, but a slip in the quality ratio and that return goes away.  Investing in skilled nursing is a tantalizing opportunity for REIT managers to overcome loads, support distributions, and generate total return.  I am watching to see whether some managers went too far into skilled nursing and bought assets they did not fully understand.

The Unraveling

First Capital keeps falling apart.   Here is an InvestmentNews article on the most recent round of layoffs at the wannbe product sponsor.  The employees no longer on the First Capital "journey" should be grateful.  I bet the First Capital journey won't appear on resumes.  Neither of First Capital's two public programs have filed financial statements, although the InvestmentNews article quotes First Capital's CEO Suneet Singal saying "We plan to have all filings current in short order."  Right.  The DI Wire reported a week ago that the third party firm that provided First Capital's BDC with a chief financial officer and chief compliance officer has terminated its contract with First Capital, leaving the BDC without a CFO or a COO.   This is quite the horror show, but I can't look away.

Palace Intrigue

W.P. Carey's Carey Credit Income Fund 2016 T and Carey Credit Income Fund 2018 T filed 8-Ks late on Friday with the following news:

On May 30, 2017, Mr. Mark M. Goldberg informed W. P. Carey Inc. (“W. P. Carey”) of his intended resignation, effective as of July 10, 2017, from his positions with W. P. Carey, the ultimate parent of the investment adviser to Carey Credit Income Fund (the “Master Fund”) and his positions as President of the Master Fund, Carey Credit Income Fund 2016 T (the “Company”) and each of the other feeder funds, to pursue other interests.

Additionally, Mr. Goldberg has resigned as the Chief Executive Officer and President of the Master Fund's investment adviser Carey Credit Advisors, LLC (“CCA”). Mr. Jason E. Fox, President of W. P. Carey, has been named Chief Executive Officer and President of CCA.

Mark Goldberg has been around non-traded alternative investments since the 1980s on both the broker dealer and product sides.  I view his departure as big news, and it's probably not random.  Carey is coming up on two months with no commission-based non-traded products available to sell, and had to send money back to investors in its Carey Credit Income Fund 2016 T when the offering closed on April 28, 2017, a move anathema to a product sponsor.  Carey Credit Income Fund 2018 T, which was declared effective by the SEC in October 2018, had to refile its prospectus and is pending SEC re-approval before it can offer shares.  The refiling clarifies Carey Credit Income Funds' accounting method for the ongoing trail commission it must pay broker dealers on T shares.  (The ongoing trail commissions are future obligations and a liability that lowers net asset value, and one more reason T shares stink.)  I can't help but wonder whether Goldberg is the fall guy for Carey's product missteps.

Tough To Read

Here is a Bloomberg article on the decline of Sears.  It is a sad story for a company that was America's top retailer for nearly 100 years.  The article states that Sears' decline in the 1980s when it "made a real estate play instead of focusing on selling stuff."  I am not a fan of financiers owning retailers, but Sears' issues pre-date Eddie Lambert's acquisition of it in 2004, although he has played his part in Sears' downfall:

Since then, Sears and Kmart have been slowly dismantled by Lampert. Implementing a culture of warring tribes, one in which divisions would battle it out for resources, little cash was funneled back into reviving physical stores. Chunks of the business were sold to keep the lights on. In January, the company sold the famous tool brand Craftsman to Stanley Black & Decker Inc. for about $900 million. “He did nothing to maintain the stores—nothing to spiff them up and make them a nice place to go shopping,” said Robin Lewis, a longtime industry analyst and chief executive of the Robin Report.

Is A Financial Flu Contagious?

I received a long email from Walton International, the large land syndicator, describing its Canadian parent's restructuring.  I don't know Canadian bankruptcy terms, but it sounds like a Chapter 11 restructuring.  Walton offered many land deals in the United States, but its Canadian housing operations were always touted as the backbone of the organization.  Here is part of the email:

On April 28th, 2017 Walton International Group Inc. (“Walton Canada”), an entity organized in the province of Alberta Canada, and several other Canadian affiliates and Canadian development entities (collectively, the “Canadian Filing Entities”), announced that they have obtained an Initial Order from the Court of Queen’s Bench of Alberta (the “Canadian Court”) for creditor protection under the Companies’ Creditors Arrangement Act (“CCAA”). This filing in Canada (the “CCAA Proceeding”), allows Walton Canada to stabilize its affairs, with a goal of restructuring certain obligations and other attributes of the Canadian Filing Entities and Walton Canada emerging as quickly as possible as a more profitable operating company. The Canadian Filing Entities are wholly owned direct and indirect subsidiaries of Walton Global Investments, Ltd. (“Walton Global”), a parent company also organized in Alberta Canada, which is not a Canadian Filing Entity.

The relief requested by the Canadian Filing Entities was precipitated by the downturn in the Alberta economy. The primary driver of the poor economic situation in Alberta is the severe and sustained drop in energy prices that began in 2014. The resulting decrease in demand for Walton’s products in Canada and resulting liquidity and financial difficulties of certain development projects in Alberta has created this situation.

I have been trying to think of a situation where the financial problems of a sponsor have not impacted its funds, even though the funds are separate entities from the sponsor.  No example jumps to mind.  Walton goes to great lengths in its email to distinguish between its Canadian operations and entities and its American land funds, and this is correct.  One thing about Walton though, there was always lack of transparency on the other entities involved, besides the U.S. funds, on its U.S. land deals, so I would not be surprised to learn that U.S. investors own land near or adjacent to land owned by a Walton Canadian entity.

Walton has been sloooooow to sell its land deals, in large part, in my opinion, because the longer Walton owns the land the more of the up front reserved management fees it gets to keep (and believe me, Walton reserved years of fees).  With its Canadian financial problems, and a stack of prepaid, reserved fees in its U.S. land funds, do not look for Walton to start selling properties until its gets all those reserved fees.

Towards the end of the email Walton says, "While we know this information may cause concern, we ask for your patience in contacting Walton with further inquiries on the situation while we work through this restructuring."  Don't call us, we'll call you.  Comforting.

Yanking The Deal

I read in this morning's DI Wire that Resource Real Estate is suspending its Resource Innovation Office REIT, and will restructure it as a Net Asset Value REIT.  The REIT had raised less than $5 million in the nearly two years since it was declared effective, so I am guessing that tweaking the fee structure is not going to suddenly make this REIT attractive to broker dealers and investors.  Resource America, the parent of Resource Realty, was purchased by C-III Capital Partners, a large real estate investment firm, in deal that closed in early September of last year.  

I don't know C-III's plan for the Resource non-traded REITs, but I think broker dealers and investors would like to see an investment offering C-III's real estate expertise.  Trying to push legacy Resource deals in a tough environment is not working.  C-III has controlled Resource for eight months and its time put its institutional real estate expertise and its balance sheet to work attracting retail investors. 

Quicksand

Yesterday's DI Wire was full of press release reprints.  I noted one in my previous post, and here is another on First Capital Realty Trust hiring a new CFO.  I have lost track of how many CFOs this firm has had since new management took over in September 2015, but I am running out fingers to count them.  First Capital still has not filed any financial statements since the second quarter of 2015.  I don't see working with outside auditors as a job description when I read the duties of the new CFO: "overseeing all aspects of the finance function, including capital market activities, financial reporting, accounting, tax and internal audit." This new guy will last until he realizes he is getting paid in Operating Partnership units.

The DI Wire story also noted First Capital's big transaction in Sacramento, California, called Township Nine, and how it is working on a strategic transaction with Presidential Realty Corporation.  The story omitted that the mortgage securing Township Nine is in default and how resolving this debt supersedes any activity on the property.  Oops.  I wrote about the Township Nine mess here. 

The good news is that there are still third party "due diligence" firms writing reports on this outfit.  I bet they are not getting paid in OP Units.

Mystery Solved

Strategic Storage Growth Trust Inc. raised over $93.5 million in equity in the last month of its offering.  The March equity inflow represented nearly 41% of all the equity the REIT received in its entire offering period, which was over two years, and the REIT's last three months of equity inflows totaled a staggering 57% of its equity.  A non-traded REIT, long into a previously weak offering, does not experience big inflows without a reason.  

Yesterday, I believe I learned the reason.  The DI Wire reported (OK, mostly reprinted Strategic Storage's press release) that Strategic Storage Growth Trust had announced a Net Asset Value per share of $11.56 per share.  All the new money - $131.5 million in the first three months of 2017 -  that went into the REIT at $10.05 per share, now have a new value of $11.56 per share.  Nice!  

I suspect Strategic Storage was whispering about the higher pending valuation and that resulted in the huge money inflow.  This strategy has been used before by Strategic Storage and other sponsors to raise big money over the short period between when they receive the new valuation and when they announce the new revaluation.  It is a good story: market a non-traded REIT at price per share that the sponsor knows for sure is going to show a much higher value in a matter of weeks, and then sponsor and financial advisor look like geniuses and new investors are happy.    If something works, stick with it.  But remember, you can't spend a valuation increase in a non-traded security.

Retail Tipping Point and Wider Impact

Here is a New York Times article from over the weekend on the impact of store closings.  The article is broad in its scope.  There are so many factors impacting retail that it is hard to point to one dominant cause for retail's problems.  E-commerce is surely a factor and the improvements to delivery will drive its growth.  Still, trying clothes on before purchase is not going to go away.  Buying online on spec and hoping clothes fit gets old fast with the hassle of returns. But something big is happening, especially since the overall economy is still growing.

Store closures, meanwhile, are on pace this year to eclipse the number of stores that closed in the depths of the Great Recession of 2008. Back then Americans, mired in foreclosures and investment losses, retrenched away from buying stuff.

The current torrent of closures comes as consumer confidence is strong and unemployment is low, suggesting that a permanent restructuring is underway, rather than a dip in the normal business cycle. In short, traditional retail may never recover.

A strong real estate market is not helping retailers.  As landlords push rents they are forcing retailers to close, and apparently, it is not just the small, local retailers, as evidenced by empty stores on 5th Avenue, Beverly Hills, and SoHo.  I noted this urban high rent blight here. 

I repeat this passage in the middle of the New York Times article without much comment because of its severity:

Between 2010 and 2014, e-commerce grew by an average of $30 billion annually. Over the past three years, average annual growth has increased to $40 billion.

“That is the tipping point, right there,” said Barbara Denham, a senior economist at Reis, a real estate data and analytics firm. “It’s like the Doppler effect. The change is coming at you so fast, it feels like it is accelerating.”

This transformation is hollowing out suburban shopping malls, bankrupting longtime brands and leading to staggering job losses.

More workers in general merchandise stores have been laid off since October, about 89,000 Americans. That is more than all of the people employed in the United States coal industry, which President Trump championed during the campaign as a prime example of the workers who have been left behind in the economic recovery.

The job losses in retail could have unexpected social and political consequences, as huge numbers of low-wage retail employees become economically unhinged, just as manufacturing workers did in recent decades. About one out of every 10 Americans works in retail.

I think it's time to start start re-purposing or razing real estate.

Another Reason Altnertative Sales Are Down?

Last weekend, I read this article on the Above The Market blog describing various financial advisor personality types.  In short, these personality types base their investment recommendations on alternatives to evidence-based investing.   The article's examples include fear-based advisors, intuitive-based advisors, and self-righteous-based advisors.  The advisor type that is hurting alternative sales is the ideology-based advisor.  These advisors believe that when an opposing political party is in office the stock market is bad and hard assets are where to invest, and when their political party is in power the stock market is where to invest.  The investment recommendations are based on political beliefs, not solid investment research. 

The New York Times had an article on how even economic data is now partisan.  It appears that the partisan divide is getting worse.  The following is from the article:

Since Donald J. Trump’s victory in November, consumer sentiment has diverged in an unprecedented way, with Republicans convinced that a boom is at hand, and Democrats foreseeing an imminent recession.

“We’ve never recorded this before,” said Richard Curtin, who directs the University of Michigan’s monthly survey of consumer sentiment. Although the outlook has occasionally varied by political party since the survey began in 1946, “the partisan divide has never had as large an impact on consumers’ economic expectations,” he said.

This is scary from an investor standpoint, as even hard data is being skewed or interpreted through a partisan filter.  Anecdotally, based on my interaction with financial advisors that favor alternative investments, many fall on the right side of the political spectrum, some to the right of right.  This political outlook, coming after the credit crisis and recession of 2008 and 2009 and the election of a Democratic president, I believe, led many advisors to recommend the perceived safety of hard assets and helped the sale of non-traded securities.  This world view is now bringing money back to the stock market.  (Poorly designed T Shares are hurting sales, too.)

Advisors and investors need to start looking at evidence and make decisions based on sound, unbiased data, not a gut feel, or a pundit's opinion on Fox News, or MSNBC.   I'll be the first to admit that the political channels and websites are entertaining these days, but take your investment advice from the business pages, not the editorial pages.  Markets and investments are politically unbiased, and they perform independent of what ever party is charge.  Policies may help specific investments, like how easy lending standards boosted home prices in the 2000s, but over the long term, markets react to underlying economic principals, not politics.

Corporate Captial Trust Explores Liquidity

Corporate Capital Trust, the $2.8 billion CNL/KKR business development corporation, released a filing on Wednesday stating that its board has approved a plan for the BDC to seek liquidity within the year through a listing on an exchange.   As part of the liquidity, KKR will move from a sub-advisor role to advisor, replacing CNL in this capacity.  CNL will have representation on a special advisory committee that will be formed upon liquidity. 

Of course, seeking liquidity is not assured liquidity.  This seems like positive news for the non-traded alternative industry.

More Malls

Here is a Washington Post article on the troubles facing malls and retailers.  This passage is a great summary of the current retail environment:

The retrenchment comes as shoppers move online and begin to embrace smaller, niche merchants. As a result, many major chains now find themselves victims of a problem of their own making, having elbowed their way into so many locations that the nation now has more retail square footage per capita than any other. To use the industry vernacular, they are simply “overstored.”

You can add "overleveraged' to overstored to describe the trouble facing many retailers.  I think I am part or the problem because I seek out and shop at "smaller, niche merchants."  It is time to start razing malls and building housing.

Zero + Zero = Zero (And a Loss of Dignity)

The I received an email yesterday announcing the acquisition of Freedom Capital Investment Management by First Capital Real Estate Investments.  The merger to end all mergers - a fringe non-traded REIT sponsor buys an aborted business development company.  First Capital, whose flagship public REIT has not filed a financial statement since the second quarter of 2015, is apparently taking over a BDC that never raised any money.  What can go wrong?

Freedom Capital was formed in June 2014 and its escrow agent finally terminated the escrow agreement at the end of 2016 because the BDC could not raise any money.   In typical First Capital fashion, its acquisition of Freedom Capital involves no cash, but a secured promissory note payable over time.   Hey, Freedom Capital guys, good luck getting any money.  But really, is a BDC that never raised any money worth more than a "payable over time promissory note?"

What broker dealers are lining up to offer shares in this can't miss cesspool?  Somehow - and the most shocking revelation in the March 30, 2017, supplement that announced the Freedom Capital acquisition - the new First Capital Investment Corporation has $6,130,000 in investor capital.  I wonder where this money came from?

And Dr. Robert Froehlich, you earned some fame last year when you resigned as an independent director from two AR Global REITs and publicly blasted AR Global's conflicts of interest, but what the heck are you doing entangling yourself with these numbskulls?  I get it that you miss the independent director compensation, but this outfit is a dignity black hole.  You can't get it back.  Did you bother to look at the BDC's portfolio?  Its only investment is a loan to an affiliated company, First Capital Retail, LLC.  I'll spell it out and underline it for you in case you forgot: C-O-N-F-L-I-C-T O-F I-N-T-E-R-E-S-T!!   The affiliated loan is $1,500,000 at LIBOR plus 9%, and is due March 31, 2018.  I would not be surprised if this affiliated loan pays no current interest but has all interest due at maturity.  BDCs are regulated companies and have strict prohibitions about investing in affiliated transactions.  Dr Bob, you are a conflicts of interest magnet.

Garbage like this is why I get up in the morning. 

Retail's Preppy PE Blues

Here is a Bloomberg article that was sent to me on the departure of J. Crew's long-time creative director.  I don't care too much about the fashion loss, but these two paragraphs jumped out at me:

The change brings fresh upheaval to a chain suffering from sputtering sales, heavy debt and a broader shift away from mall-based retail. Same-store sales -- a key measure -- fell 7 percent last year and 8 percent in 2015. The company also has been hobbled by borrowing tied to its 2011 purchase by TPG Capital and Leonard Green & Partners LP.

J. Crew, led by Chief Executive Officer Mickey Drexler, has been trying to turn around its operations by closing stores, cutting costs and streamlining its inventory. The efforts have helped reduce red ink: The company posted net income of $1.1 million in its most recently reported quarter, compared with a loss of $7 million a year earlier.

I italicized the sentence above.  Add J. Crew to the list of retailers potentially ruined by private equity firms.  Mickey Drexler is a retail veteran, which is positive for J. Crew, but the private equity debt expense makes his job tougher.  The fashion industry is difficult enough with changing consumer trends and tastes, without adding the noose of private equity instituted debt.  Of course, the private equity principals paid themselves from the borrowings that now threaten J. Crew, so they don't care. 

Turn Out The Lights

Lightstone Capital Markets announced today, March 31, 2017, that it is terminating the offering of its hotel equity Lightstone Value Plus III and its affiliated mezzanine lending Lightstone Real Estate Income Trust.  Lightstone's letter explaining the offering terminations stated that a combination of (unspecified) factors lead to the decision to stop raising capital in its two public non-traded REITs.  It assured investors that concerns for the capital already invested was not a reason.

Lightstone has never been a capital raising powerhouse.  It was bringing in $10 million to $15 million per month combined in the two REITs on a consistent basis.  By current standards this is a respectable capital inflow, but it is by no means great.  I suspect this slow, expensive raise, was the leading factor in Lightstone's decision to close the two REITs' capital offerings.  Through February 2017, Lightstone Value Plus III had raised $124 million in equity and Lightstone Real Estate Income Trust had raised $73 million.   Let's be clear, real estate companies never stop steady capital inflows regardless of the market outlooks - unless cheaper money is available.  Any notion that Lightstone is halting capital because it cannot find attractive deals is nonsense.  

Separately, Lightstone had told broker dealers for several years that Lightstone Value Plus REIT II, the predecessor REIT to the now-closed Lightstone Value Plus REIT III, was ready for a liquidity event and that it was in advance talks with potential purchasers of the REIT.  It is my opinion that any near-term liquidity event for Lightstone Value Plus REIT II is now unlikely.  Investor capital from a liquidity event no longer has a Lightstone fund in which to reinvest and would leave to other non-Lightstone investments, which is the biggest fear of firms that receive asset management fees, and a disincentive for Lightstone Value Plus II to seek liquidity.   

My Retail Obsession

Here is another post on failing retailers.  I can't help it, I find it fascinating.  Last weekend the Financial Times published a long article on the decline of Sears and the shopping mall.  Sears' failures are the result of losing the competitive battle with WalMart and an owner who may have been a hot shot Goldman Sachs financial wunderkid but knew nothing about retail when he bought Sears and has not seemed to learn on the job. 

I find this graphic from the article illustrative of the problems facing retailers:

The retailers having so much trouble - JC Penney, Macy's, and Sears - have wide exposure in Class B and Class C malls, which are older malls in poorer areas and/or more rural locations.  These are the malls in WalMart territory.  Retailers in Class A malls like Nordstrom and Bloomingdale's are not facing the problems of retailers in the lower grade malls, and you can't tell me that Nordstrom's and Bloomingdale's shoppers are not as active online as those shoppers at Sears, Penney's and Macy's.  How the Class B and Class C malls compete with WalMart and other single-stop discounters, or the sociological and demographic shifts impacting retail and shopping malls, are more important stories than Sears' inept operation since Eddie Lampert acquired it in 2004. 

Another PE Retailer Bankruptcy

Bloomberg is reporting that Payless, the discount shoe retailer, is set to file for bankruptcy next week.  Payless was purchased in 2012 by private equity firms Golden Gate Capital and Blum Capital.  I wrote last week about the disaster private equity owners have been to retailers.

The Moody Merger Hot Mess

I thought this blog was the place for sharp analysis in a snark covered wrapper regarding alternative investments.  It seems I have some competition from an old industry player.  Robert Stanger & Co. has published some brutal commentary on the American Financial Trust (AFIN) and Retail Centers of America merger, and Brookfield Strategic Real Estate Partners II's advantageous investment into ARC Hospitality.  Last week Stanger shredded the cockamamie proposed merger of Moody National REIT II's (Moody's II) proposal to merge with Moody National REIT I (Moody I).  Here is the link (via the DI Wire) to read the entire Stanger commentary on the Moody merger.

The merger was originally announced last September.  It makes no sense for me to resummairze the merger because Stanger's report is excellent. The following is Stanger's summary of the merger and the fees involved with it:

So now comes Moody II with an offer to merge with Moody I by issuing shares of Moody II or, subject to an aggregate limit of 50%, cash for each Moody I share. The stated range of nominal consideration to the Moody I shareholders is $10.25 to $11.00 per share, depending upon the level of transaction costs incurred in the deal. While the structure is unusual to say the least, the transaction cannibalizes the inherent value of Moody I investors’ shares by burdening that value with up to $21.8 million of transaction costs. We estimate these transaction costs represent 13.8% of the aggregate Moody I equity value.

To take another bite out of the Moody I investors, Moody II will be denominating the value of the shares of Moody II at $25.00 per share rather than the pro forma Combined Net Investment Amount of approximately $23.00. By our calculation, the aggregate cost and discount related to the fees and possibly overstated stock price ascribed to Moody II in the merger totals about $29.3 million, or about 19% of the pre-transaction equity value of Moody I.

Looked at from a different perspective, the investors in Moody I are incurring up to $21.8 mil- lion of transaction costs to merge with a portfolio comprised of two hotel properties and one note purchased at an aggregate cost of $113 million – a merger which at best will provide liquidity to half of the Moody I investors.

Stanger goes on to detail Moody's II's skirting of the intent of FINRA 15-02, the lack of disclosure to investors regarding financial details of the merger, lack of fee disclosure, and how Moody's is paying financial advisors to recommend clients select the non-cash merger option of taking shares in Moody's II rather than cashing out. 

Moody's II has raised $91.7 million of investor equity through February 2017.   It has been raising equity capital for two years and only owns two hotel properties and a note receivable.  Moody's I closed its offering in early 2015, raised $133 million, and owns twelve hotel properties.  

I will add two points that I did not read in the Stanger report.  First, by merging Moody's I into Moody's II, Moody's I investors now own shares in a non-traded REIT that is still raising money.  Moody's II can extend its offer period another three years.  This is not a liquidity event, but some kind of twisted non-traded REIT hell where investors in a closed REIT get stuck in a capital raising reset.  

Second, if half the Moody's I investors select the cash option, where will Moody's II come up with the cash?  At a $133 million equity raise for Moody's I, that is at least $66 million Moody's II has to find to cash out the 50% limit.  Add this to all the fees Moody's is paying itself, and it is likely Moody's II will have to borrow money to cash out investors and pay fees.  (Moody's II had about $12 million in cash at September 30, 2016, the date of its most recent financial statement.  It is raising about $7 million a month in new equity.)

I urge you to read the Stanger commentary. 

Dark Corners

There are some strange stories on financial websites and message boards.  I found an odd post on a bizarre transaction on the Seeking Alpha website.  It discusses a transaction between Presidential REIT and First Capital Real Estate Trust, Inc., where First Capital entered into an "interest contribution agreement" with Presidential on a 23-acre development site in Sacramento.  First Capital is contributing a 66% interest in its 92% ownership interest in the development project in exchange for 37,281,000 convertible Operating Partnership units.   The author of the Seeking Alpha article somehow thought this transaction added value to Presidential, and allowed investors to buy Presidential's stock at a 39% discount.

A non-cash transaction involving a development property and operating partnership units in a REIT with a market capitalization of $4 million is suspect.  The story then goes from suspect to downright dodgy.  The Seeking Alpha article makes no mention that as part of the "interest contribution agreement" Presidential is assuming 66% of First Capital's liabilities on the project, and that the project with the supposed hidden value is in default on its mortgage.  The Sacramento property is subject to a mortgage with a $20 million principal, but the mortgage is in default due to First Capital's inability make principal and accrued interest payments, and First Capital now owes $42 million on the mortgage.  First Capital has received a "Notice of Default and Election to Sell under Deed of Trust" from its lender.  

(Think about it, the original mortgage value of $20 million requires a $42 million payment, or more than double the principal outstanding.  This is due to accrued interest that gets paid at loan maturity along with principal, and not in regular interest payments.  To accrue this much interest, even at an assumed high interest rate, would require years of accrual.  This loan had to have been extended repeatedly, which shows the poor management at First Capital.  This is staggering.)

If the astute Seeking Alpha analyst/author determined its supposed $23 million net value for the development project with the outstanding $20 million principal, the addition of $22 million eliminates all value.  The analyst should have read First Capital's filings.  This whole transaction is nuts.  It is as if both sides are trying to take advantage of one another - Presidential trying to buy assets with worthless operating partnership units as currency, and First Capital passing off a near underwater property with a defaulted mortgage to a dupe.  And even if the analyst incorporated the $42 million mortgage into his valuation, how is Presidential, with a market cap of less than $5 million, going to repay this mortgage? 

I wrote about First Capital last fall.  It has not filed financial statements since the second quarter of 2015.   It is a public company; it has to file financial statements.  Its reverse merger with Presidential, although announced in July 2016, has not happened, and instead it is entering into non-cash deals with Presidential and others.  This company is toxic.  Oh, and it is still trying to raise money from investors in private placements.

Carter Validus' Whisper Sale

On March 3, 2017, Reuters published an exclusive article stating that public, non-traded REIT Carter Validus was up for sale at a price tag of more than $3.5 billion.  The article cited unnamed people "familiar with the matter."  Carter Validus has not made any public filings to confirm or deny the article.  This would be great news if Carter Validus liquidates.  The Reuters article reads as though Carter Validus is shopping its data center properties and its health care properties to separate buyers.

I am skeptical of any transaction until I see a confirmation from Carter Validus.  It hired Goldman Sachs in 2015 to find liquidity but nothing happened.  Carter Validus is an established, fully invested REIT that continues to over pay its distribution.  According to its third quarter 10-Q, the REIT had overpaid its distributions in 2015 and for the first nine months of 2016.  For the first nine months of 2016 distributions were $96 million and modified funds from operation (MFFO) were $85.9 million.  (Carter Validus added a risk disclosure at the end of its third quarter 10-Q regarding the over payment of its distribution.) 

In addition to its distribution over payment, the REIT has about a third of its nearly $1 billion of debt in variable rate borrowings.  Interest rates have increased since November.  The thirty-day LIBOR rates have increased about 50 basis points over this time.  Carter Validus' third quarter 10-Q states that a 50 basis point increase in interest rates would increase the REIT's interest expense rate by $1.5 million per year.  The increased interest expense lowers amounts available for distribution.   The REIT has another $542 million of variable rate debt that is currently fixed using interest rate hedges.  These hedges expire between late-2017 and mid-2020.  If the hedged debt is not retired before the hedges expire, the REIT will have to buy more expense hedges to keep rates fixed or pay higher interest expense.

I state the last two items because under certain liquidation scenarios Carter Validus is going to have to deal with its distribution over payment.  Any buyer of the REIT will lower the current distribution.   As interest rates have increased capitalization rates have increased, too.  Cap rates and valuation are inversely related, so an increase in cap rates means a lower valuation for an underlying property.  (I have not seen an article on cap rates increasing, but have talked to real estate professionals who told me that cap rates have increased, but not at the pace of interest rates.)

I hope Carter Validus has a buyer(s) and executes a transaction soon. If Carter Validus liquidates its portfolio in two more more transactions, capital is going to come back in multiple payments, not one big lump sum payment.  

Retail's Other Problem

On-line shopping has hurt retailers.  In 2016, ecommerce sales were estimated at $1.9 trillion, and are expected to double to over $4 trillion by 2020.  In shopping malls, anchor tenants are closing and the surrounding retailers are impacted by fewer shoppers.  I am reading this morning that Neiman Marcus is looking to sell itself because of a sales slump.  Its same store sales fell 6.8% for the quarter ending January 28.  Neiman Marcus has a bigger problem than declining sales, and this line from the Bloomberg article linked to above tells it all:

The company has about $4.9 billion of debt outstanding, some of it tied to its $6 billion acquisition in 2013 led by Ares Management LLC and the Canada Pension Plan Investment Board. They bought the chain from TPG Capital and Warburg Pincus LLC, which acquired Neiman Marcus for about $5 billion in a 2005 leveraged buyout.

Neiman Marcus is over 80% leveraged, and that is based on its 2013 purchase price.  It has $4.9 billion of debt outstanding and S&P recently said Neiman Marcus' debt is unsustainable.  The private equity firms that acquired trophy retailers with extreme debt levels give firms like Neiman Marcus little room to operate in a slump.  Neiman Marcus' capital issue is now more pressing than its sales decline, and its likely taking more of management time than thinking of creative ways to attract new customers.  The Bloomberg article says that one Neiman Marcus bond issue is trading at $.49 on the dollar, a price that says the market expects default.   Private equity firms have ruined many retailers, restraining management and growth because of demands to service debt.

DI Wire's Click-Bait

Today's headline in the DI Wire's daily news and public relations passing-as-news email is wrong.  The headline states:  "AR Global's BDCA Appoints Two New Board Members."   AR Global is no longer involved with BDCA.  As of November 1, 2016, an affiliate of Benefit Street acquired BDCA's advisor from AR Global.  I guess any mention of AR Global in a headline is good for solid click-bait.  The DI Wire article is correct for those that bothered to read past the email's error.

The T Share Scourge

I hate T Shares.  They were a preemptive answer to a problem that did not exist.  T Shares were forced upon the non-traded alternative investment industry by sponsors scared of a pending statement rule that would require them to show investors the price of their investment net of initial fees.  The thinking was that if investors realized how much the up front costs were for non-traded REITs and business development companies (BDCs) they would never buy a non-traded product.  For example, a $10.00 per share investment with 10% in initial offer costs would show $9.00 on the first client statement, or an implied immediate 10% loss.  The initial costs of these investments is already well disclosed to investors, as well as the net investment amount, regardless whether the statement reads $9.00 or $10.00 per share.

There was a consensus that a statement value showing a decline of 4% to 6% would be acceptable, but much lower than this would raise unwanted questions and concerns.  Therefore a statement value of $9.40 or $9.60 per share was thought OK, but a value of $9.00 per share would invite investor wrath.  I do not think investors were asked their opinion.

Of course, the fees must still be paid.  A financial advisor would never sell a non-traded REIT or BDC without full commissions, right?  A sponsor must make its immediate profit, right?  T Shares led to the financial gymnastics of reclassifying, adjusting, and delaying fees to show a high statement value but maintain fees.  Key jargon terms are "above the line" and  "below the line."  Fees paid directly from offering proceeds are "above the line," and fees not paid from offering proceeds are "below the line."  Fees accounted for as "below the line" do not lower the statement value.

In T Shares, the upfront sales commission to financial advisors is reduced to 3%, with an additional 1% paid per year for up to four years, from the traditional 7% commission paid up front.  Therefore, in a T Share, only 3% of the commission is "above the line" and not deducted from the statement value, a big savings.  The 1% ongoing commission typically has a euphemism like "Distribution Supervision Fee" or some other similar nonsensical term.  How exactly does a financial advisor supervise a distribution?  If financial advisors actually supervised distributions, distributions would increase every year.

I have seen investments that now classify organization fees and expenses, typically .50% to 2.0% or more of the investment price and incurred and paid at the earliest stages of the investment, as "below the line" ongoing expenses that no longer count them against the statement value.  Sponsors, in many cases, have lowered their marketing fees (dealer manager fees) by .25% to 1.00%, which are "above the line" expenses, so the lower fees boost statement values.  Many sponsors have elected to adjust their acquisition and finance fees, which are "below the line" expenses, to offset lower dealer manager fees.  One sponsor, when it introduced its product's T Shares in 2016, lowered dealer manager fees by 1.0%, but raised its acquisition fees by 1.10%.  This adjustment of fees increased the combined above and below line fees by more than 1.50%, after leverage.

Here is where the T Shares go from farcical to putrid.  The 1% Distribution Supervision Fee is paid from a REIT's or BDC's on going cash flow, or monies available for distribution, and lowers a T Share investor's distribution by about 1% per year.  For example, a REIT that pays a 6.5% distribution on its traditional Class A shares pays a 5.5% distribution on its Class T shares.

T Shares are counter-intuitive, they have lower up front costs, therefore a higher statement value, and more money is invested rather than paid in fees, which are positives for investors.  But their distribution is lower than a share class with a higher load due to shifting and reclassification of fees. It is a Stranger Things' Upside Down World.

Financial advisors have never been the largest voice for lower fees.  As long as they got paid and believed the investment solid, they have been willing to overlook high fee investments.  Most financial advisors are not going to stand for having their clients paid less in distributions, having their commissions cut, while sponsors maintain or increase their fees.  There no great shock that sales of non-traded REITs and BDCs were so bad last year.

There have been other challenges that have helped slow the sale of non-traded REITs and BDCs: the looming DOL changes (I am not going to open that discussion here), the lack of liquidity events, the collapse of the Realty Capital sales empire, and the sharp declines in BDC NAVs that started in late 2014 and provided acute proof that high yield BDCs were high yield for a reason.  But to me to me, the largest sales impediment was the rush to T Shares and the tepid response due to their flawed structure.

Financial advisors won't continue to sell a product where their clients get a lower return and get they paid less.   Low commissions are here to stay, so its time to create a better product structure.  If commissions are lowered, distributions to investors must increase.  The sponsors that understand this simple financial physics and design products to address it are going to see inflows of capital.  The industry needs products with tangible and attainable incentive compensation for sponsors, after providing returns to investors, even if it means higher long-term sponsor compensation.  Sponsors that cling to high acquisition fees or high asset management fees that provide no incentive except to overpay for assets will lose.  Until sponsors and broker dealers address their T Share problem, expect sales to stay moribund.