Good Commercial Real Estate News
From yesterday's Calculated Risk, here is a post discussing the first drop in office vacancy rates since 2007.  Reis Inc's quarterly survey on office properties shows that the national vacancy rates at the end of the first quarter 2011 stood at 17.5%.  The decrease was only .1% from 2010's fourth quarter, but after the last four years I will take any positive move.   Below is a chart from the post showing quarterly vacancies since 1991:

Today Calculated Risk has a post on Ries' quarterly apartment report, which shows vacancies at a three year low.   The vacancy rate is 6.2%, down from 8% a year ago.  Much of the drop in vacancy has come from the elimination of concessions.  Here is Calculated Risk's analysis on the drop in vacancies:

This is a very large decline from the record vacancy rate set a year ago at 8%. This decline fits with the recent survey from the NMHC that showed lower apartment vacancies. Reis is just for large cities, but this decline in vacancy rates is happening just about everywhere.

A few key points we've been discussing:
• Vacancy rates are falling fast (the excess supply is being absorbed). Note: The excess housing supply includes both apartments and single family homes.

• A record low number of multi-family units will be completed this year (2011). Only 6,000 apartments came on the market in Q1 (in the Reis survey area).

• This will push up effective rents. Via Bloomberg:

Effective rents, or what tenants actually pay, increased in 75 of the 82 markets Reis tracks, to an average $991 a month from $967 a year earlier and $986 in the fourth quarter.

However, when I was at the NMHC conference earlier this year, it sounded like rent growth is mostly coming from reductions in concessions and not from the top line (i.e. not from rent increases). (my short notes from conference here and here). Still, any increase in effective rents will push down the price-to-rent ratio for homes.

• Multi-family starts are increasing, and that will help both GDP and employment growth this year. These new starts will not be completed until 2012 at the earliest, so vacancy rates will probably decline all year.

If You Can't Beat Them, Join Them - Part II
I received the following comment on my previous post:

I read the filing differently. First, looking closely at ARCT’s 10K, the entire award to management is 1.5 million shares ($15 million). Not sure how you are arriving at $75 million. Second, only half the award is time vested. The other half is purely performance based and is paid only after the investor receives 100% of his/her capital back plus a non-compounded annual 6% return on capital. Finally, no vesting occurs at all for two years, and the award vests over a five year period. My take is that the independent board made the stock award based on management’s exemplary performance to date. Seems to me there is a big difference between this type of award and an internalization fee which seeks to retain management, irrespective of performance. At the end of the day, ARCT’s restricted stock plan is pay for performance. It merely recognizes the results achieved.

American Realty Capital Trust (ARCT) initiated the restricted stock awards program in January 2010.  The initial amount available for restricted stock awards was 1% of the amount of shares being offered or 1,500,000 shares, which totaled $15,000,000.  In the post effective amendment filed on March 11, 2011, the amount appears to have been changed to reflect no more than 5% of the shares outstanding, up to a maximum of 7,500,000 shares or $75,00,000 if all ARCT shares in the offering are sold.  At February 28, 2011, the amount of shares outstanding was 74,854,000.  So, 5% of 74,854,000 is 3,742,700 shares available under the incentive restricted share plan, which at $10 per share is $37,437,000.  Obviously, the amount of shares outstanding, and therefore amount available under the incentive restricted share plan, will increase as more shares are sold and ARCT moves towards the close of its offering period.

It is hard for me not to correlate the dropping of internalization fees in June 2010 and the recent, potential five times increase in shares available under the incentive restricted share plan.

The incentive restricted shares are not immediately vested.  Half the shares are paid over a four year period.  Half the shares have a subordination feature.  The subordination feature is not like the one described in the comment above, although that would be excellent if it was.  The incentive (subordination) feature is follows:

50% vest only to the extent our net asset value plus the distributions paid to stockholders equals 106% of the original selling price of our common stock.

I think it is best to use an example to how these shares may vest.  The 106% of the original offering price is $10.60 per share, which is the amount by which the combined net asset value and cumulative distributions must exceed before ARCTs' incentive restricted shares are allowed to vest.

ARCT is required to make a net asset value calculation eighteen months after it closes its offering.  Assuming ARCT closes its offering on June 30, 2011, it would have to provide a net asset valuation by December 31, 2012.  For illustration purposes, I'll use a net asset value of $8.85 per share, which is just the offering price of $10.00 per share less ARCT's offering costs, which are competitive with other non-traded REITs.   It is probable that the net asset value will differ from this amount.   Next you need to add ARCT's cumulative distributions to the net asset value.  (I don't read anything in the description above that reflects the timing of distributions.)  ARCT paid a 6.7% distribution in 2009.  In 2010 it paid 6.7% for three months and 7.0% for nine months.  If it continues to pay a 7% distribution in 2011 and 2012, it will have paid cumulative distributions of $2.74 per share by the end of 2012.   If the cumulative distributions of $2.74 are added to the $8.85 net asset value, and this totals $11.59, which is greater than the $10.60 share price that triggers the vesting.  The following table uses the paid distributions and the $8.85 per share net asset value price estimation:

2009	$0.65
2010	$0.69
2011	$0.70
2012	$0.70
Cumulative Distribuiton	$2.74
NAV at 12/31/2012	$8.85
NAV + Distributions	$11.59

Finally, I'd want to address the exemplary management comment.  I want ARCT's management to be exemplary, and this post or the previous post are not disparaging ARCT.  The non-traded REIT industry needs ARCT's management to be exemplary.  But to me, I think it is too early to bestow awards for excellent management, whether for ARCT or any REIT still in its offering phase.  Olympic gold medals in the 100-meter dash are not awarded after twenty yards, the Lombardi Trophy is not awarded at the end of the first quarter, and I have never heard of a baseball owner giving a manager a performance bonus in the middle of May.  A non-traded REIT (or any investment product) should not award multi-million dollar, dilutive, stock grants, whether restricted or not, to management while the REIT is still in its offering phase and while it is still investing investor capital.

If You Can't Beat Them, Join Them
I was alerted in a comment to this blog that American Realty Capital Trust has awarded its executives shares of restricted stock.  Here is the wording from the post-effective amendment that American Realty Capital Trust filed on March 11, 2011:

On September 13, 2010, our advisor granted 934,159 restricted shares of common stock to Nicholas S. Schorsch, chief executive officer of our advisor, 212,370 restricted shares of common stock to William M. Kahane, president and chief operations officer of our advisor, 160,604 restricted shares of common stock to Peter M. Budko, executive vice president chief investment officer of our advisor, 55,270 restricted shares of common stock to Edward M. Weil, Jr., executive vice president and secretary of our advisor and 37,597 restricted shares of common stock to Brian S. Block, executive vice president and chief financial officer of our advisor. Fifty percent of the restricted shares vest over a four year period commencing with the one year anniversary of the September 13, 2010 grant date and 50% vest only to the extent our net asset value plus the distributions paid to stockholders equals 106% of the original selling price of our common stock.

On June 2, 2010, American Realty Capital Trust announced that it was waiving any internalization fees in the event that it internalizes its external advisor as part of of a sale or listing American Realty Capital Trust's shares on an exchange.  The awards above came about three months after the announced waiver of any internalization fees.   The pool of stock available to award is up to 7.5 million shares, which at $10 per share is $75 million.   In the quote above, at $10 per share, the awards last September are worth nearly $10 million to Nicholas Schorsch and over $2 million to William Kahane. The bulk of the shares that American Realty Capital Trust can allocate to its executives is still available for allocation.


Internalization fees can be lucrative to the external advisor, and some non-traded REITs have paid more than $100 million for their advisors.   American Realty Capital Trust's decision to waive internalization fees was positive for investors.

The company that distributes American Realty Capital Trust is Realty Capital, which also distributed Healthcare Trust of America (HTA).  HTA waived its internalization fees in 2009, but recently expanded its pool for executive and board member stock awards by $80 million.  It looks like American Realty Capital is following HTA's path.

Half of the American Realty Capital executive stock awards are deferred over four years and half vest only "to the extent our (American Realty Capital Trust) net asset value plus distributions paid to stockholders equals 106% of the original selling price of our common stock." 

To me, American Realty Capital's granting of large amounts of stock to its executives is another form of an internalization fee.  The large amount of stock was issued by American Realty Capital Trust after the announcement that there would be no big pay day when it purchased (internalized) its advisor, plus American Realty Capital has plenty more stock it can grant its executives.  Like HTA, American Realty Trust appears to have figured a way around its waived internalization payday.

The Return of Subprime Bonds
Here is a Wall Street Journal article on how pricing on subprime bonds has rebounded and how subprime bonds are attracting investors, including conservative insurance companies.  The focus of the article is on existing subprime bonds, which as an investment class, saw prices drop to near $.30 on the dollar at the worst of the credit crisis.  Subprime bonds are now trading near $.60 on the dollar.  The article's point is that subprime bonds' recent strength signifies a healing of the credit markets, as investors are willing to take on more risk.

The return of subprime bonds, according to the article, is also signaling that the housing market has bottomed and has more upside than downside.  The article focused on subprime bonds issued before the credit crisis.  It did not mention any new issues.  I'd be curious to know if there is any demand for new issue subprime bonds, or if there are even any new subprime mortgages that could be included in a new subprime bond issue.

One encouraging sign is the govenment's refusal to take the short end of an offer by bailed-out insurer AIG:

The market burst into the spotlight in March when an unlikely buyer stepped in: AIG, the giant insurer that had to be bailed out by the government because of its own bad bets on subprime mortgage bonds.

AIG offered to buy back a pool of bonds that the Federal Reserve had taken off its hands during the crisis. AIG's $15.7 billion offer for the bonds, which have a face value of $30 billion, spurred other investors to consider making offers.

Citing "improved conditions" in the market and "a high level of interest by investors," the Fed on Wednesday rejected AIG's offer and said it would begin selling off these mortgage holdings, letting investors bid for pools of bonds and individual securities so the central bank can maximize its profits.

At least four large life insurers, among the most conservative of all investors, are eyeing the subprime bonds the Fed plans to sell, according to people familiar with the matter.

Colony Capital Is Kicking Grubb & Ellis' Tires
Santa Monica-based private equity firm Colony Capital provided Grubb & Ellis an $18 million bridge loan, and received an exclusive sixty-day negotiating and evaluation period to determine whether it will make a larger "strategic investment" in Grubb.  If Colony makes a larger investment, Grubb then has twenty-five days to shop the deal around to try and get a better deal.

Here are two articles regarding the Colony loan, one from GlobeSt and the second from the Orange County Register's real estate blog.  Colony has been involved in multiple transactions over the past several years.  From the GlobeSt article:

The financing deal with Grubb & Ellis is the latest in a series of investments for Colony Capital, which has been involved in some of the largest FDIC deals to date and has been active on a number of other fronts. In 2009, for example, Colony launched a publicly traded REIT, Colony Financial, that focuses primarily on acquiring, originating and managing performing, sub-performing and non-performing commercial mortgage loans.

More recently, Colony led a consortium of investors in acquiring two FDIC loan portfolios with an unpaid balance of $817 million that include 1,505 residential and commercial acquisition, development and construction loans. In Los Angeles recently, funds managed by Colony Capital and R.W. Selby & Co. acquired a portfolio of seven student housing properties adjacent to the University of Southern California comprising 223 units and 836 beds from Westar Associates for $98 million.

In early 2010, investment vehicles managed by Colony paid $90.5 million for a 40% interest in an LLC created by the FDIC to hold assets of 22 failed-bank receiverships and became the managing equity owner of the LLC. Colony was one of 21 bidders who vied for the 40% ownership interest in the LLC, which owned a portfolio of approximately 1,200 distressed commercial real estate loans with an unpaid principal balance of $1.02 billion, of which 70% were delinquent.

Grubb did not waste much time finding a potential suitor, announcing only last week that it had hired an advisor.

Worth Reading... Closely
Healthcare Trust of America filed an 8-K today.  Here is the text of the entire filing:

On March 24, 2011, the board of directors of Healthcare Trust of America, Inc. ("HTA") authorized distributions for the month of April 2011. These distributions will be calculated based on stockholders of record each day during such month at a rate of $0.00198630 per share per day and will equal a daily amount that, if paid each day for a 365-day period, would equal a 7.25% annualized rate based on a share price of $10.00. These distributions will be paid in May 2011 in cash or reinvested in stock for those participating in HTA’s distribution reinvestment plan.

The amount of distributions HTA pays to its stockholders is determined by HTA’s board of directors, at its discretion, and is dependent on a number of factors, including funds available for the payment of distributions, HTA’s financial condition, capital expenditure requirements and annual distribution requirements needed to maintain HTA’s status as a REIT under the Internal Revenue Code, as well as any liquidity alternative HTA may pursue in the future. HTA’s board of directors may reduce its distribution rate and HTA cannot guarantee the amount of distributions paid in the future, if any.

Is it me, or is that second paragraph telling us something?

Disclosure v. Non-Disclosure
In my last post I discussed Healthcare Trust of America's failure to disclose restrictive covenants in an 8-K filing announcing a new line of credit.   As a comparison, I direct you to Wells Real Estate Investment Trust II, which recently announced a short-term bridge credit facility in an 8-K filing.  Like the HTA line of credit, the Wells REIT II credit facility has restrictive covenants regarding paying more in distributions than generated in Funds from Operations (FFO).  The restrictions are clearly disclosed in Wells REIT II's 8-K, and here is the language:

The JPMorgan Chase Bridge Facility agreement also stipulates that the Registrant's net distributions, which equal total dividends and other distributions less the amount reinvested through the Registrant's dividend reinvestment plan, may not exceed the greater of (i) 90% of the Registrant's Funds from Operations through the date of payment or 100% of the Registrant's Funds from Operations for the two most recently completed fiscal quarters; or (ii) the minimum amount required in order for the Registrant to maintain its status as a REIT. Funds from Operations, as defined by the agreement, means net income (loss), minus (or plus) gains (or losses) from debt restructuring, mark-to-market adjustments on interest rate swaps, and sales of property during such period, plus depreciation on real estate assets and amortization (other than amortization of deferred financing costs) for such period, all after adjustments for unconsolidated partnerships and joint ventures. With limited exceptions, the Registrant may not make net distributions if a default or an event of default has occurred and is continuing or would result from the payment of net distributions.

The covenants like those in the Wells REIT II and HTA credit agreements are not uncommon.  My point is not the restrictions, it is that HTA should have disclosed the restrictions in its 8-K.

HTA's 10-K
Healthcare Trust of America filed its 10-K annual report sometime on Friday.  It is nearly 200 pages long, and there is a substantial amount of data to read and analyze.  I recommend reading it carefully if you have an interest in the REIT.  It is going to take me several days to get through it and write coherent posts on the items I feel are important.   I could not get past the section in the 10-K that discussed the credit agreement (Note 9 of the 10-K, starting on page 138) HTA entered into in November 2010 with JP Morgan and other banks.  This section appears very important to me, especially as it pertains to HTA's ability to maintain its current distribution rate.

Before you read the 10-K, I recommend you read the 8-K HTA filed on November 23, 2010.   This 8-K announced a $275 million line of credit with JP Morgan and others, and talks about basic terms of the line such as term, interest rate calculations and fees. The 8-K did not disclose the credit line's restrictive covenants, which include the language below: 

Pursuant to the credit agreement, beginning with the quarter ending September 30, 2011, our operating partnership may not make distribution payments to us in excess of the greater of: (i) 100% of its normalized adjusted FFO (as defined in the credit agreement) for the period of four quarters ending September 30, 2011 and December 31, 2011, (ii) 95% of normalized adjusted FFO for the period of four quarters ending March 31, 2012 and (iii) 90% of normalized adjusted FFO for the period of four quarters ending June 30, 2012 and thereafter.

This language was in the credit line agreement that was an exhibit to the 8-K, so I guess the restriction was technically disclosed.  The way I read the credit agreement, the restrictive covenants are effective on HTA whether or not the credit line is drawn.  At year-end the credit line had $7 million outstanding and in a subsequent event (after December 31), HTA repaid the $7 million.

As stated in the 10-K, in 2010 HTA generated $69.4 million in FFO and paid out $116.8 in distributions, or stated another way, distributions were 168% of FFO.  This is well above the 100% covenant listed above.  In 2010's fourth quarter, HTA generated $13.5 million of FFO and paid $33.3 million in distributions, or 246% of FFO.  HTA, as disclosed in the 10-K, has maintained its current distribution rate of 7.25% through April.  My understanding of the dividend covenant above, leads me to believe that at some point before the end of September 2011, HTA is going to have to cut its distribution so that for the four quarters ending September 30, 2011, the combined distributions will not have exceed 100% of FFO.  The only way to avoid a distribution cut is for HTA's FFO to substantially to exceed its current distribution rate for the next two quarters, or if the credit line is canceled.

This restriction on distributions should have been disclosed to investors and broker / dealers in the November 23, 2010 8-K, rather than been buried in the actual credit agreement.  HTA's shareholders are mostly small investors looking for income, not institutions with staff and attorneys to review each document. 

There are other issues in the 10-K that I will address, including the possible elimination of the share repurchase plan, which was sharply restricted last fall, compensation to HTA's executives and directors, including discuss of HTA's CEO Scott Peters taking partial stock awards in cash, rather than shares, at $10 per share (while limiting investor share redemptions), along with presenting financial data.  If you see any gems in the document, post them in the comment section.

Washington DC Stays Strong
Tishman Speyer Properties is buying a suburban Washington DC office building for approximately $500 a square foot, one of the highest prices ever paid for a suburban Washington DC property.  The seller was Beacon Properties, which just sold a downtown Washington DC property to Wells Real Estate Investment Trust II.  I could not find any cap rate disclosure on the Tishman Speyer transaction.  The acquisition helps confirm that the Washington DC commercial real estate market is one of the strongest in the country.

Cole Bets On Phoenix
Cole Properties made news last year when it paid $310 million for a Seattle-area property subject to long-term lease to Microsoft.  I was told today to expect another large Cole acquisition that was big enough for inclusion in tomorrow's Wall Street Journal.   I am guessing Cole's $170 million sale-leaseback of for-profit college Apollo Group's headquarters in Phoenix is the news.  Here is an excerpt from a Wall Street Journal / Dow Jones article:

According to a securities filing, Apollo agreed to sell its headquarters to a unit of Cole Real Estate Investments, a non-traded real estate investment trust based in Phoenix. Apollo then will lease the properties back at an annual rental rate of $12 million, with 2% increases each subsequent year. Apollo expects $28 million in gains on the sale, to be realized throughout the life of the lease. The lease, with an initial term of 20 years, has four five-year renewal options. 

The cap rate is 7% based on the $170 million price tag and $12 million of rent, assuming the lease is triple net.  The acquisition of the 600,000 square foot complex is Cole's largest property in Phoenix.

The article states that Cole plans to make $3 billion worth of acquisition in 2011, up $500 from 2010.

More Grubb & Ellis
Here is a more comprehensive CoStar article on Grubb & Ellis and how its decision to "explore strategic alternatives" is part of bigger changes in the commercial brokerage industry.  The article does not present any new information on Grubb & Ellis, restating the story from the articles I linked to yesterday.  It does put Grubb's decision into context:

"The Grubb & Ellis announcement is part of a natural evolution in the industry where firms in the middle market with revenues between $100 million and $1 billion will really have to either get much, much bigger, or much smaller," said Dylan Taylor, chief executive officer in the U.S. for Colliers International. "Mid-market firms are strategically challenged. They may not be big enough to be multi-billion-dollar global players that can afford to invest in recruitment of talent and technology."

The article goes on to discuss recent commercial brokerage transactions.  This statement on the global push of commercial real estate stuck out to me:

Some of the expanding firms may be international firms looking to enter or grow their presence in the U.S. For example, London-based Savills recently announced it was reviving its U.S. expansion, opening two new offices and forming an international investment group. In February, CBRE agreed to acquire ING Real Estate Investment Management, a unit of Holland-based ING Group NV.

Any article on Grubb & Ellis always mentions the portfolio of tenant in common transactions and the CoStar article does not disappoint:

Although the company has a wide U.S. footprint for delivering transaction and management services, one of the challenges facing Grubb & Ellis is that it also has a large portfolio of troubled tenant-in-common (TIC) assets acquired when Grubb joined with NNN Realty Advisors Inc. in 2007 near the peak of the real estate boom. The company has faced complicated integration issues during the downturn, including management of the NNN Realty legacy assets.

In February, Grubb launched Daymark Realty Advisors Inc. as a wholly owned and separately managed company to manage those assets. Daymark becomes the fourth Grubb & Ellis reporting segment in addition to its transaction, management and investment management businesses. It also becomes one of the nation's largest asset management companies, overseeing a nationwide portfolio of about 33 million square feet, including more than 8,700 multifamily units.

The TIC assets, which ironically gave NNN Realty Advisors the scale to acquire Grubb & Ellis, are now viewed as an albatross to Grubb & Ellis, which I think is a short-sighted view.   But my opinion on the old TIC assets is a topic for a future post.

Grubb & Ellis Exploring "Strategic Alternatives"
Here is an article from GlobeSt.com discussing Grubb & Ellis' (GBE) decision to explore strategic alternatives, including a sale or merger.  The article is mostly an excerpt from a Grubb & Ellis press release.  Grubb & Ellis, in addition to its commercial brokerage business, sponsors the Grubb & Ellis Healthcare REIT II, a non-traded REIT.

Update:  Here is a better article on Grubb from The Orange County Register's real estate blog.

Why The Deficit Will Never Go Away
Politics.  Politicians of both parties need to repay the special interests that helped elect them, and the special interests don't like losing their government perks paid for by taxpayers.  Here is an example from Econobrowser on the House's refusal to tackle $15 billion in annual farm subsidies, which sums up the dilemma when deficit cutting rhetoric meets political reality:

But the Agriculture Committee is dominated by members of Congress from farm states; Chairman Frank Lucas, R-Okla., has reported $445,714 in political contributions from the agricultural industry during the course of his career, and ranking Democrat Collin Peterson of Minnesota reports $809,097 in career donations.

MFFO - It's Not You, It's Me
Modified Funds From Operations (MFFO) is a performance metric used to measure a real estate investment trust's financial health.  I do not like the metric and discount it when looking at a REIT's financial performance.  To me, MFFO adds back too many one-time items to make it useful for analyzing the long-term financial status of a REIT.  Non-traded REIT sponsors like to use MFFO when discussing a REIT's ability to cover its distribution because MFFO is going to be a higher number than operating cash flow or Fund From Operations, making the REIT's performance appear better.  When analyzing a REIT's ability to fund its distribution from cash flow I prefer the old fashioned method of comparing actual operating cash flow and Funds From Operations to a REIT's distributions, because I believe MFFO may inflate a REIT's coverage ratio. 

Funds from Operations (FFO) takes a REIT's net operating income and adds back non-cash accounting entries like depreciation.  It also includes an adjustment for property sales.  This leaves you with a pretty good estimation of a REIT's cash available for distribution.  Modified Funds From Operations takes FFO and then adds or subtracts other one time items, in particular acquisition expenses.  A REIT in its capital raising stage will have significant acquisition expense additions, skewing MFFO upward.  Neither FFO or MFFO are GAAP (Generally Accepted Accounting Principals) figures, only operating cash flow is a GAAP figure.  Because MFFO is a non-GAAP calculation, I always check the footnotes to see what items were added back to MFFO.

If a REIT purchases a significant number of properites late in the year the MFFO to actual cash will be even greater, as all acquisition expenses are added to MFFO while actual cash received is small.  Here is a simple example of a property acquired for $50 million.  I assumed the acquisition expenses are 3.50%, and a cap rate of 7%, which all goes to cash flow.  If the purchase closed on December 1, here is what the flow of funds would be:

Purchase Price	$50,000,000
Acq Cost %	3.50%
Acq Cost	$1,750,000
Addition to MFFO	$1,750,000
Cap Rate	7%
Annualized NOI	$3,500,000
One Month NOI	$291,667
Actual Cash	$291,667

The REIT would receive $291,667 in cash from the property, but would be able to add an additional $1,750,000 to its MFFO.  Even though the MFFO looks great, only the $291,667 is available for distribution.  Bear this in mind as non-traded REITs release their 2010 results in the coming weeks and tout their levels of MFFO. 

If you must look at MFFO, beware of the above and look for an improving trend, i.e. more MFFO covered by actual cash over multiple periods.  The disparity between operating cash flow, FFO and MFFO should narrow over time.  Wide differences in an established REITs operating cash flow, FFO and MFFO, when compared to the REIT's distribution, may signify that the current distribution is not sustainable.  For REITs early in their life cycle the divergence is going to be large but watching the trend is vital.  Chronic overpayment of distributions, while good for marketing, is bad and untenable long-term.  A trend where FFO and operating cash are getting closer to MFFO is positive. 

I have looked at enough financial statements over the years to know that it is not a good sign when distributions exceed operating cash flow for extended periods.  Many people in the broker / dealer and real estate industries have worked hard to make MFFO a more consistent and relevant figure, and I applaud them.  But for me, I will stick to my old fashioned method of comparing operating cash flow and FFO to distributions, it has rarely steered me wrong.

Healthcare Trust of America's $80 Million Non-Internalization Fee
Healthcare Trust of America (HTA) closed its offering period on February 28, 2011.  A mere two days after the offering period closed, on March 2, 2011, HTA filed an 8-K that announced major changes to its original 2006 Incentive Plan for executives and directors.  HTA's board increased by five times the number of shares that can be granted to executives and board members from 2,000,000 shares to 10,000,000 shares.  At $10 per share the increase is worth $80,000,000.  The 8-K states:

The plan is designed to provide maximum flexibility to our Board and Compensation Committee in designing individual awards. 

Cha-Ching!  I take this as HTA's board's intention to pay themselves and HTA's executives as much as possible.  It looks to me like any stock awards under the plan have favorable vesting for HTA's board members and executives, as detailed in the 8-K filing:

Unless otherwise provided in an award certificate or any special plan document governing an award, upon the occurrence of a change in control of the company (as defined in the Amended and Restated 2006 Plan) in which awards are not assumed by the surviving entity or otherwise equitably converted or substituted in connection with the change in control in a manner approved by the Compensation Committee or our Board: (i) all outstanding options and stock appreciation rights will become fully vested and exercisable; (ii) all time-based vesting restrictions on outstanding awards will lapse as of the date of termination; and (iii) the payout level under outstanding performance-based awards will be determined and deemed to have been earned as of the effective date of the change in control based upon an assumed achievement of all relevant performance goals at the "target" level, and the awards will payout on a pro rata basis, based on the time within the performance period that has elapsed prior to the change in control. With respect to awards assumed by the surviving entity or otherwise equitably converted or substituted in connection with a change in control, if within one year after the effective date of the change in control, a participant’s employment is terminated without cause or the participant resigns for good reason (as such terms are defined in the Amended and Restated 2006 Plan), then: (i) all of that participant’s outstanding options and stock appreciation rights will become fully vested and exercisable; (ii) all time-based vesting restrictions on that participant’s outstanding awards will lapse as of the date of termination; and (iii) the payout level under all of that participant’s performance-based awards that were outstanding immediately prior to effective time of the change in control will be determined and deemed to have been earned as of the date of termination based upon an assumed achievement of all relevant performance goals at the "target" level, and the awards will payout on a pro rata basis, based on the time within the performance period that has elapsed prior to the date of termination.

HTA's board has not yet awarded the $80 million in new stock, it has just increased the amount of stock it can award.  In reading the above legalese, HTA's board has seen all the recent health care mergers and has positioned the board and executives for a big payday in the event of an HTA merger or acquisition.

The HTA message board at ReitWrecks has a serious take-down of the increase in shares available under the Incentive Plan.  I agree with ReitWrecks that the large increase of stock in the Incentive Plan is HTA's attempt to pay itself the internalization fee it waived in 2009 when it became self managed.  Here is what HTA said one year ago in its 2009 annual report stressing the benefits to investors of its plan to become self-managed:

No Internalization Fees.  Unlike many other non-listed REITs that internalize or pay to acquire various management functions and personnel, such as advisory and asset management functions, from their sponsor or advisor prior to listing on a national securities exchange for substantial fees, we will not be required to pay such fees under self-management.  We believe that by not paying such fees, as well as by operating more cost-effectively under self-management, we will save a substantial amount of money for the benefit of our stockholders.  To the extent that our management and board of directors determine that utilizing third party service providers for certain services is more cost effective that performing such services internally, we will pay for these services based on negotiated terms and conditions consistent with the current marketplace for such services on an as-needed basis.

I guess it seemed like a good (marketing) idea at the time to forego the internalization fees.  HTA's executives seem to have figured a way to recoup the big internalization payday that was waived less than two years ago.  HTA's board conveniently waited until after it finished its capital raising period to disclose the changed Incentive Plan.  An internalization would have required a shareholder approval, and however distasteful the internalization price tag, at least it would have been put to a shareholder vote.  This new, potential $80 million change to the Incentive Plan was not put to an investor vote.  HTA's board unilaterally made the decision to boost the Incentive Plan.  Investors had no say in this enormous potential payday to management.  HTA's ploy is a sucker punch to investors and the broker / dealers that sold HTA.

The 8-K ends ominously for investors:

Based on their ongoing review of our current compensation structure, our Compensation Committee and Board of Directors are actively involved in the process of assessing various changes to our compensation programs, which include without limitation, the review of key employment agreements and the discussion and negotiation of changes to such agreements. It is anticipated that changes to our compensation programs will be implemented in the future, consistent with, among other things (1) our current strategic initiatives and achievements and (2) the actual level of employee performance successfully undertaken to date and the expected level of performance in the future in order to achieve these initiatives.

HTA's board is giving notice that it's set to bestow on HTA's management another big payday - including salary boosts, bonuses and stock awards under the Incentive Plan - just like it did last year.  I noted the egregious increase in HTA management pay here.  Sucker punch number two should be announced in HTA's 10-K, which should be released within the next two weeks.

HTA is owned by the shareholders, not HTA executives or the board.  If HTA has any independent board members they need to earn their outsized pay and look after investors' interests.  Broker / dealers, HTA is mocking you, and you should not stand for it.

Allaying Municipal Bond Fears
Here is an informative post on a Roubini bond research report.  It's a good read and discusses the historical perspective of muni bond defaults and presents the legalities that states face if they try to re-work bonds.

Update:  Roger Lowenstein has an article on municipal problems.  I don't feel as good now.  But this point early in the article makes Meridith Whitney's dire default scenairo seem overstated:

These and other struggling locales do not begin to approach Whitney’s forecast of hundreds of billions in municipal defaults this year. (It would take defaults by 40 cities with as much debt as Detroit to reach even $100 billion.) Some industry experts accuse Whitney of exaggerating the crisis and of worsening the cities’ problems by frightening away investors. Whitney’s theory is that states, whose finances are also in desperate shape, will cut off local aid to preserve their own budgets; cities that have been subsisting on government transfers would become fiscal orphans and, in a financial sense, unworkable. She has not elaborated on her thesis beyond a few well-chosen television appearances. (She declined to talk to me.) But in the two months following Whitney’s warning, investors unloaded about $25 billion in shares of mutual funds that invest in municipal bonds. The selling spree sent the prices of these munis, typically among the most reliable investments, into a free fall.

A Whole Fracking Series
I referenced a New York Times article earlier in the week on natural gas drilling and the process of hydrofracking and its environmental impact.  The article is one in a series of three on the issue.  Here is a link to the entire series.

What?
This Bloomberg headline is as strange as it is incomprehensible:

Marijuana-Like High Helps Ex-Trashman's Syn Battle Solid Sex

Why Senior Housing
Wednesday's Wall Street Journal article on senior housing was complex.  It was one of those articles that you read quickly, realizing that a second or third more comprehensive reading is required, and one that I usually don't go back to re-read despite my best intentions.  Here is a CoStar article that says many of the same points, but is easier to understand.  The key driver is a 2008 REIT tax law change that allows health care REITs to by senior housing operating companies and not lose their REIT tax status.  Senior housing is as much a business as it is real estate so REITs' ability to buy operating entities is a significant change.  Here are two key paragraphs that summarize my thoughts from earlier in the week and the tax changes:

Senior care facilities suffered more pain than other health-care properties during the recession as older Americans postponed decisions to move into retirement housing. The sector also endured uncertainty in 2008 and 2009 over the future of government health care legislation and reduced Medicare and Medicaid reimbursements. As baby boomers begin to enter retirement and the population of 85+ -year-old Americans grows, cash-flush real estate investment trusts have scrambled to acquire a diminishing supply of available seniors housing, assisted-living and post-acute facilities.

These factors, combined with a change in REIT tax law that allows health care REITs to own third-party operators to manage and collect income from their facilities similar to hotels, have helped fuel a number of large transactions in recent months, including the two huge deals announced on Monday. As CoStar Group reported last week, . industry executives predict more mergers and acquisitions between both public and private companies.

The senior housing decision is an economic decision.  Growth in senior housing demand is a positive sign for the economy, and it will have more impact than the repositioning due to tax law changes.

The Apartment Disconnect
The Wall Street Journal's Development's blog notes the same problem with apartments that I've noticed.  Defaults keep rising on apartment CMBS debt, but apartments still command price premiums due to their perceived safety.  Apartments have the highest CMBS default, at 16.6%, topping even lodging's 14.6%, and the apartment default rate is much higher than the CMBS default rate of 9.4%.  I have seen plenty of large apartment investment funds over the past several years that have ranged from bad to scary.  I have seen two interesting private placement deals that are buying below the radar (i.e. small) multifamily deals.

Wells REIT II - Channeling Joe Biden
To paraphrase the vice president, it's a big freaking deal. Wells REIT II made two filings today, one not unexpected and another that just jumped off the page.  Wells REIT II announced that it was cutting its dividend from 6% to 5%.  The REIT had been telegraphing this for sometime, disclosing in at least its last two 10-Qs that its distribution was not fully covered by operational cash flow and the board was monitoring whether the REIT could maintain the dividend.  Wells REIT II follows the trend of non-traded REITs - Hines REIT, Inland American to name two - that dropped distributions after closing their offering period.  While the drop in distribution is unfortunate, it was not unexpected, and appears prudent. 

Wells REIT II also announced a huge acquisition.  The REIT is paying $615 million for Market Square, a 679,710 square foot, Class A office complex in Washington DC.  This equates to $905 per square foot.  This monster transaction should represent at least 10% of Wells REIT II's portfolio.  I am not sure whether it's comparable, but another downtown DC office property recently sold for $596 per square foot.  If the sale is comparable, REIT II did not get the property on the cheap.  Wells REIT II's purchase of Market Square is not going to tamper the opinion that Washington DC is the hottest commercial real estate market in the country.  It was a big freaking deal.

My Two Cents on Two Health Care Mergers
I noted two health care mergers yesterday.  It appears that both deals were driven by senior housing, which includes skilled nursing facilities.  There are a couple of forces behind the focus on these types of health care properites.  Many senior housing and skilled nursing facilities qualify for government agency debt, which means the leverage can be higher (70% to 80% debt) and the interest rate lower than traditional financing.  Medical office buildings do not qualify for the agency debt and have debt options that require more equity, leaving leverage ratios typically between 45% to 55%.  It appears that health care companies are giving premiums to property types that can utilize attractive financing.

The focus on senior housing is also a bullish sign for the economy.  Much of senior housing is elective.   When seniors and families decide it's better for an elder person to live in an assisted living facility, compared to moving in with families or staying alone, it's an expensive decision and long-term financial commitment.  (Obviously, skilled nursing and memory care facilities are less optional.) Financing aside, the demand by buyers of senior housing tells me these buyers believe that demand for senior housing will increase.

Yet Another Health Care Merger
The third largest health care REIT, Health Care REIT, Inc, agreed to acquire privately owned Genesis HeatlhCare, a leading provider of senior care and senior rehabilitative centers for $2.4 billion.  Because Genesis is private, no FFO multiple data was provided.  Health Care REIT states that the transaction will accretive to its earnings.

Big Health Care Merger
I just saw on Bloomberg.com that senior care and medical property owner Ventas, Inc. is purchasing Nationwide Health Properties, Inc. for $5.4 billion.   The combined company will, apparently, be the largest health care REIT in the United States.  I am trying to get more information on the valuation.   Both companies have medical office properties and hospitals, but it appears that the biggest component is senior housing and skilled nursing.

Update:  I was told by an industry insider that he was hearing that the deal was priced at 17 to 18 times NHP's FFO, which must be this year's anticipated FFO.  NHP had FFO of $2.14 per share in in 2010, based on its results released yesterday.  The trailing multiple was 21 times 2010's FFO, which dropped to 19.5 times using NHP's $2.30 of AFFO.

More Environmental News
Here is an article from yesterday's New York Times to cheer you up on a Monday.  The article goes in depth on waste water generated in natural gas drilling. 

Sure it’s got to go up. But how much?
Here is an interesting item on health care costs from a website called The Incidental Economist.  Below is a graph from the post above:

The disconnect on health care spending in the US is startling.

Please Explain This To Me
The hotel market is confusing.  In San Diego, the 670-room Hotel Del Coronado just sold for $880,000 per room.  Across the San Diego Bay, another luxury hotel, the 1,625-room Manchester Hyatt, just announced that it is under contract for $351,000 per room.  I understand that more rooms may result in a lower price per room, but for two luxury hotels in the same town, the price dichotomy seems large.  I don't know for sure, but I doubt a night's stay at the Hotel Del costs more than twice much as a night at the Manchester Hyatt.

Inland Western and Borders
I did a quick cross reference between the Borders stores in the Inland Western portfolio and the list of planned Borders closures.  I count only five of the eleven Borders in the Inland Western portfolio that are closing.  Stores closing stinks, but with the size of the Inland Western portfolio - 312 properties and nearly $6 billion of investment in properties - the closure of five stores seems small.  The Inland Western website is excellent for searching out properties and tenants.

I will post on Inland Western's planned stock listing in the next few days.

Strong Correlation
I am not an economist, but I read plenty of economic articles.  It doesn't take an economist to connect the strong relationship between housing and the unemployment rate. When the housing market was booming unemployment dipped below 5%.  When the housing market tanked unemployment rose.  Now the housing market and the employment market are both stagnant.  I believe that unemployment will stay high until the housing market rebounds, which means a significant increase in new home sales and housing starts.  (Note that the housing figures released yesterday showed a 14% increase in housing starts in January over December, but all the growth was in multifamily units, and single family starts actually declined 1%, and are at their lowest level in two years.)  I recently read two articles that tie my theory together.

Here is an article on the "new normal" unemployment rate, which one economist estimates is 6.7%.  I don't doubt this number, as all the jobs related to housing bubble, such as in construction, real estate sales, design, and finance (how many people do you know who are former mortgage brokers or real estate agents?) will not rebound to the levels seen during the boom.  I think that the housing boom was responsible for dropping the unemployment rates down from 6% to under 5%. 

Here is a second article from yesterday's Wall Street Journal (no subscription required) on how banks now require more equity for homeowners.  Here are a few paragraphs and a graph from the article:

The median down payment in nine major U.S. cities rose to 22% last year on properties purchased through conventional mortgages, according to an analysis for The Wall Street Journal by real-estate portal Zillow.com. That percentage doubled in three years and represents the highest median down payment since the data were first tracked in 1997.

 

The move to force home buyers to lay out more cash is driven mostly by banks, who have found that larger down payments discourage delinquencies by increasing the buyers' exposure to loss and reducing the impact of declining prices. Many home buyers placed little, if anything, down during the boom.

Keeping otherwise qualified and willing borrowers on the sidelines makes no sense to me.  I am not advocating going back to the crazy mortgages of the mid-2000s, but the swing of the pendulum, 22% down payment and strict credit guidelines, has gone too far.  Easing credit in a sensible manner will help the housing market.  It will help eliminate excess supply, and hopefully start a sustained increase in home values.  Existing homeowners (and banks!) will benefit from increased values.

Real estate has always been finance driven, the more money available, the more people will buy homes.  The demand for homes is there, banks just have to meet it.  Homeowners need equity in a home, or they will treat the home like a rental, which is what happened during the housing bubble. Having a financial stake in home is vital, but current draconian terms are going to prolong the housing mess.  Lending policies that make home ownership easier should drop unemployment.  Without a prudent easing of home lending credit terms the housing market will stay in its current bog and unemployment won't drop to its "new natural" level.

More Bluerock
I have a few comments on my previous post on Bluerock Multifamily Trust.   I noted that it was uncommon for a REITs single purpose entity to enter into its own working capital line of credit.  But the more I thought about it, I can see the logic of having the single purpose entity's line of credit.  The property has four owners, and it was probably unlikely that one of the four owners was going to commit financially without committing the other three, unless it received additional ownership or protections, which probably would not have been forthcoming.  In this scenario,  the line of credit at the special purpose entity level makes sense.

It is important to note that the working capital loan, because it is at the property ownership entity level and not at the REIT level, is an off-balance sheet transaction for the REIT, and the REIT's share of the obligation needs to be added when determining the REIT's debt level.

Bluerock Multifamily's restated September 30, 2010 10-Q lists all four of its property investments as investments in unconsolidated entities, which is how you should account for joint venture investments.   Unconsolidated investments are shown on the REIT's balance sheet as a net figure, and don't reflect any debt of the joint venture.  Again, this is the proper method to account for joint ventures, which is how the REIT invested in all four of its properties.  Investors now need to dig through the financial statements' notes to find property-level data.  The four Bluerock Multifamily  investments have an aggregate leverage of 78%, and none of that debt is on the REIT's balance sheet.  The debt on Bluerock Multifamily's balance sheet, which is 74% of its unconsolidated investments, is its borrowings from affiliates that the REIT used to make its equity investments.  This debt is separate from the REIT's property specific debt.  I getting light headed with debt this high.

Bluerock Multifamily Reopens and Raises Another Eyebrow
I wrote late last year about Bluerock Multifamily Trust.   It had to suspend the sale of its shares in November until it restated its past financial statements and filed them in a post-effective amendment with the SEC.  In mid-January, the REIT re-filed is past financial statements and the SEC declared the REIT effective again on January 31, 2011.

On January 26th, Bluerock Multifamily filed an 8-K, which is a filing that a public entity has to make when it has a material event, which disclosed that one of the entities through which it owns its properites had entered into a $500,000 line of credit agreement with an affiliate of Bluerock Multifamily.  Text from the 8-K is below:

On January 20, 2011, BEMT Meadowmont, LLC, a wholly owned subsidiary of our operating partnership (“BEMT Meadowmont”) entered into an agreement with Bluerock Special Opportunity + Income Fund II, an affiliate of our sponsor (“SOIF II”) for a line of credit represented by a promissory note (the "Note").  Under the terms of the Note, BEMT Meadowmont may borrow, from time to time, up to $500,000, for general working capital.  The Note has a six-month term from the date of the first advance and matures on July 20, 2011.  It bears interest compounding monthly at a rate of 30-day LIBOR + 5.00%, subject to a minimum rate of 7.00%, annualized.  Interest on the loan will be paid on a current basis from cash flow distributed to us from BR Meadowmont JV Member, LLC (the “Meadowmont JV Member"). The Note may be prepaid in whole or in part at any time or from time to time without penalty. The Note is secured by a pledge of our indirect membership interest in the Meadowmont Property and a pledge of our direct membership interest in the Meadowmont JV Member.

I can't think of another instance where a separate single-purpose entity obtained its own working capital line of credit away from the parent entity.  Not that it's wrong, it is just not that common.  Working capital needs of single purpose entities are typically paid from property revenue.  Is the property not generating sufficient revenue to sustain itself?  You can't tell from the filing.   It is common for real estate funds to own their investments indirectly through separate entities. These are typically single-purpose entities that own nothing but the underlying property.

The line of credit poses several issues that bear watching.  The affiliated entity that made the loan to the property is a private fund that is paying an 8% distribution.  (It also has an equity investment in the property.)   The same entity made a loan to Bluerock Multifamily at a 7% interest rate so the REIT could acquire the property, and now it made a working capital loan at a 7% interest rate.  If the entity keeps making loans at 7%, and has offering and operating fees to overcome, how can it pay 8% to its investors over the long term?  Bluerock Multifamily is paying a 7% distribution.  It has borrowed money to fund its equity investments in its properties, and now a property in which it invested is borrowing money for working capital, both of which would take away money from distributions.   I will be looking at this REIT's ability to pay its distribution when it releases its 10-K in a month or so.

Here is some additional information on Bluerock Multifamily's ownership in the property that obtained the working capital loan:

Bluerock Multifamily owns the apartment complex with two affiliates and a third party and one of the affiliates loaned money to the REIT to allow the REIT to make its equity investment in the property.  If it sounds complicated, it is.  Here is the ownership description from the REIT's re-stated 10-Q:

We invested $1.52 million to acquire a 32.5% equity interest in BR Meadowmont Managing Member, LLC (the “Meadowmont Managing Member JV Entity”) through a wholly owned subsidiary of our operating partnership, BEMT Meadowmont, LLC (“BEMT Meadowmont”).  BEMT Co-Investor invested $1.17 million to acquire a 25% interest and BEMT Co-Investor II invested $1.98 million to acquire the remaining 42.5% interest in the Meadowmont Managing Member JV Entity.  BEMT Meadowmont, BEMT Co-Investor and BEMT Co-Investor II are co-managers of the Meadowmont Managing Member JV Entity.  Under the terms of the operating agreement for the Meadowmont Managing Member JV Entity, certain major decisions regarding the investments of the Meadowmont Managing Member JV Entity require the unanimous approval of the Company (through BEMT Meadowmont), BEMT Co-Investor and BEMT Co-Investor II.  If the Company, BEMT Co-Investor and BEMT Co-Investor II are not able to agree on a major decision or at any time after April 9, 2013, any party may initiate a buy-sell proceeding.  Additionally, any time after April 9, 2013, any party may initiate a proceeding to force the sale of the Meadowmont Managing Member JV Entity’s interest in the Meadowmont JV Entity (defined below) to a third party, or, in the instance of the non-initiating parties’ rejection of a sale, cause the non-initiating parties to purchase the initiating party’s interest in the Meadowmont Managing Member JV Entity.

The Meadowmont Managing Member JV Entity contributed $4.65 million of equity capital to acquire a 50% equity interest in Bell BR Meadowmont JV, LLC (the “Meadowmont JV Entity”).  A Bell Partners Inc. affiliate that is unaffiliated with the Company, Fund III Meadowmont Apartments, LLC (“Bell”), invested $4.65 to acquire the remaining 50% interest in the Meadowmont JV Entity.  The Meadowmont Managing Member JV Entity and Bell are co-managers of the Meadowmont JV Entity. The Meadowmont JV Entity is the sole owner of Bell BR Meadowmont, LLC, a special-purpose entity that holds title to the Meadowmont Property (“BR Meadowmont”).  Under the terms of the operating agreement of the Meadowmont JV Entity, decisions with respect to the joint venture or the Meadowmont Property are made by unanimous approval of the managers.  Further, to the extent that the Meadowmont Managing Member JV Entity and Bell are not able to agree on certain major decisions, either party may initiate a buy-sell proceeding.  Additionally, any time after April 9, 2013, either party may initiate a proceeding to force the sale of the Meadowmont Property to a third party, or, in the instance of the non-initiating party’s rejection of a sale, cause the non-initiating party to purchase the initiating party’s interest in the Meadowmont JV Entity.

As a result of the structure described above, the Company holds a 16.25% indirect equity interest, BEMT Co-Investor holds a 12.5% indirect equity interest and BEMT Co-Investor II holds a 21.25% indirect equity interest in the Meadowmont Property (50% in the aggregate), and Bell holds the remaining 50% indirect equity interest.  The Company, BEMT Co-Investor, BEMT Co-Investor II and Bell will each receive current distributions from the operating cash flow generated by the Meadowmont Property in proportion to these respective percentage equity interests.

If you find this Byzantine ownership structure confusing, so do I.  The addition of a working capital loan just added to Bluerock Multifamily's complexity.

Texas v. California
As a Californian, I found this opinion piece by Michael Hiltzik in the Los Angeles Times interesting.  Texas has similar debt problems to those in California.  Here are a few quotes, but the entire article is worth reading:

The budget crises afflicting states coast to coast arise from a combination of the nationwide recession and obsolete or wrongheaded state taxing schemes. The National Council of State Legislatures says that at least 15 states face large deficits this year and 35 in fiscal 2012. 

As things stand now, the council's figures place California's projected 2012 deficit at $19.2 billion, or 18.7% of its general fund, and the Texas deficit at $7.4 billion, or 17% of its budget. States with broad-based tax policies that balance property, income and sales taxes are best equipped to ride out economic cycles, because those levies don't all move in lockstep with the economy. Neither California, with its over-reliance on income and sales taxes, nor Texas, which has no income tax, qualifies.

Here is another quote from the article:

The supposed superiority of Texas over California in fiscal policy long has been a conservative article of faith. In 2009 the libertarian American Legislative Exchange Council published a report co-authored by the conservative economist Arthur Laffer underscoring the contrast. The report posited that "Texas' superior policies over the past several years are making the Lone Star State more resilient to the current economic downturn."

But Texas was hardly immune to the recession. From 2006 through 2010, the unemployment rate in Texas soared from 4.4% to 8.3%. Yes, that's a better showing than California, which went from 4.9% to 12.5%, but the difference may reflect the huge effect on California's economy of the popping of the housing bubble, which jumped our unemployment rate to a new magnitude and is likely to keep it there for a while.

And finally this:

Curiously, Texas' reputation as a low-tax, business-friendly state survives although its state and local business levies exceed California's as a percentage of each state's business activity (4.9% versus 4.7% in 2009, according to a report by the accounting firm Ernst & Young). What's different is that Texas business taxation relies more on property, sales and excise taxes and government fees than California, which relies on taxing corporate income.

I got a kick out of talk of Texas secession.   With this kind of deficit and such limited government, good luck with forming a new country.

Really?  
Google News is my new toy (yes, I know I am late to the party, and the party has probably moved to Twitter).  I just saw this Reuters' article summarizing an interview with Vornado CEO Michael Fascitelli.  This line in the article jumped out to me:

Since hitting lows in mid-2009, U.S. commercial property prices are up 33 percent but still off 18 percent from their peak in 2007, according to the Green Street Advisors Commercial Property Price Index.

That is quite a recovery, and if it's correct should take the sting off those nagging legacy property concerns.  I don't, unfortunately, believe the claim, although I'd like too.  It may be true for certain top-end properties in specific major markets, but I would bet that aggregate commercial real estate have not recovered 33% from their 2009 low.

Update:  The above information runs counter to Moody's data that shows property values still 42% below the 2007 peak.  Obviously, someone's numbers are wrong.

Non-Traded REIT Article
I am not sure what to make of this article in Registered Rep magazine.  It is worth a read, at a minimum to see perspective from a financial advisor's point of view.  I found some of the comparisons between non-traded REITs and traded REITs weak.  One proponent of non-traded REITs says that non-traded REITs buying properties now don't have the legacy property issues that plague some traded REITs.  True on the surface, but the counter point is that traded REITs, since they're continually priced, have already been discounted by the market for their legacy assets.  Another weak point is this:

The illiquidity of public non-listed REITs actually drives what makes them popular with many investors — that they are valued based on appraisals of their underlying properties, and can't be sold on an exchange for instant liquidity, Goldberg says. Because their returns are not correlated to publicly traded securities, they can be attractive for diversifying an investor's portfolio.

“I think in large part that's what's fueled the interest,” Goldberg says.  (Mark Goldberg is managing director at WP Carey & Co.,  a sponsor of non-traded REITs.)

I didn't know illiquidity was so popular.  I guess this popularity was why so many non-traded REITs stopped or restricted redemption requests during the credit crisis.  The only reason there is no correlation between non-traded REITs and traded REITs is because non-traded REITs are priced at their offer price, which does not change until eighteen months after non-traded REITs end their capital raising.  Over time, the underlying assets of traded REITs and non-traded REITs should correlate.

Another point is non-traded REITs' yields.  Advisors and investors like the high yields offered by non-traded REITs.  I would caution that not all yields are not equal.  Many non-traded REITs have higher initial yields than the non-traded REIT can generate or support over time.  These high initial yields are to attract capital, and are hopefully based on realistic assumptions for returns the REITs can generate.   Non-traded REIT sponsors have to acquire assets that can support the non-traded REIT's yield.  A non-traded REIT (or any REIT) that continually overpays its distribution will eventually have to drop its distribution.  It's uncanny how the drop in yield seems to correspond with the end of a non-traded REIT's capital raising period.

One huge point not addressed in the article is compensation to financial advisors, which can be a gross commission of up to 7%.  I wonder whether financial advisors would still be enamored with non-traded REITs if their commissions were a half or third of the current rate?  I don't expect a rush sponsors trying to find out.

Channeling Peter Gabriel
As events unfold in Egypt and turn bloody, I am reminded of the lyrics in Peter Gabriel's song Biko:

You can blow out a candle
But you can't blow out a fire
Once the flames begin to catch
The wind will only blow it higher

And the eyes of the world are 
Watching now
Watching now

CMBS Delinquencies Hit Record High
CMBS have hit a record delinquency rate of 9.1%, as defined by sixty or more days late with payments.  The apartment sector was the hardest hit, with a delinquency rate of 15.8%.  Here is an article with all the depressing news.  I did not read much positive news in the article, except that it restated that CMBS issuance is supposed to increase to nearly $40 million in 2011, which we noted last week.

Fracking-A Bubba
Here is a New York Times article on the fracking process for natural gas extraction.  This article details how some drillers used diesel fuel as part of the "cocktail" that is shot into wells to loosen natural gas:

The diesel fuel was used by drillers as part of a contentious process known as hydraulic fracturing, or fracking, which involves the high-pressure injection of a mixture of water, sand and chemical additives — including diesel fuel — into rock formations deep underground. The process, which has opened up vast new deposits of natural gas to drilling, creates and props open fissures in the rock to ease the release of oil and gas.

But concerns have been growing over the potential for fracking chemicals — particularly those found in diesel fuel — to contaminate underground sources of drinking water.

Here is more information:

Two years later, when Congress amended the Safe Water Drinking Act to exclude regulation of hydraulic fracturing, it made an express exception that allowed regulation of diesel fuel used in fracking.

The Congressional investigators sent letters to 14 companies requesting details on the type and volume of fracking chemicals they used. Although many companies said they had eliminated or were cutting back on use of diesel, 12 companies reported having used 32.2 million gallons of diesel fuel, or fluids containing diesel fuel, in their fracking processes from 2005 to 2009.

The diesel-laced fluids were used in a total of 19 states. Approximately half the total volume was deployed in Texas, but at least a million gallons of diesel-containing fluids were also used in Oklahoma (3.3 million gallons); North Dakota (3.1 million); Louisiana (2.9 million); Wyoming (2.9 million); and Colorado (1.3 million).

Where this leaves the companies in relation to federal law is unclear. 

This "fracking" issue is going to be big as allegations of contaminated groundwater grow.

Seizure and Bankruptcy
Here is the latest on the former CNL hotels.  The Bloomberg article is hard to follow, but it looks like junior lenders, led by hedge fund Paulson & Co., completed the foreclosure on the hotels, which Morgan Stanley had acquired in early 2007, and once getting control promptly put five of the the resort properites into bankruptcy.   This is the junior lender's (now owners) strategy to renegotiate and change the terms on the senior underlying debt.  The bankrupt properties included Hawaii's Grand Wailea and PGA West in La Quinta, California.  Paulson & Co., and the other lenders/owners will continue to manage the hotels through the bankruptcy process.

AMB Property Corp Acquires Prologis
AMB Property Corp acquired agreed to acquire ProLogis yesterday.  The deal valued ProLogis near its Friday close of approximately $15.00 per share price.  Based on one estimate of ProLogis' 2011 Fund From Operations, it appears the sales price is at 23 times Prologis' expected 2011 FFO.  This seems like a high multiple given ProLogis debt, but is lower than AMB's 33 AFFO (trailing) multiple.  Some of the executives that formed Dividend Capital, a sponsor of non-traded REITs, have backgrounds at ProLogis.  AMB and ProLogis are the two largest industrial REITs, and combined would be a $14 billion company.  The new company will keep the ProLogis name and symbol (PLD). 

The non-traded REIT sponsors are going to love FFO multiples over twenty and be delirious with a an FFO multiple above thirty.   The impact of the front end costs will be a wiped away with FFO multiples this high.  Better yet, non-traded REITs are now an arbitrage play!  Seriously, the valuations should be kept in the nine to twelve range for Adjusted Fund from Operations for back of the envelope valuation estimates. 

Ex-CNL Hotel Portfolio Update
Here is a good article from Bloomberg on attempts to restructure $1.5 billion of debt on the old CNL Hotel REIT portfolio, which was bought by Morgan Stanley in early 2007, and which CNL has no current association.  The $1.5 billion of debt is due on February 1 (Tuesday).  One billion dollars of the debt is associated with just five trophy properties, and some of the trophy properties in the portfolio include:

The properties are the Grand Wailea Resort Hotel and Spa in Hawaii; the La Quinta Resort and Club and adjacent PGA West golf course in La Quinta, California; the JW Marriott Desert Ridge Resort and Arizona Biltmore Resort and Spa, both in Phoenix; the Doral Golf Resort and Spa in Miami; the JW Marriott Grande Lakes and Ritz-Carlton Grande Lakes, both in Orlando, Florida; and the Claremont Resort & Spa in Berkeley, California.

At one point, the original CNL REIT owned the famous Hotel Del Coronado, located near downtown San Diego. 

This quote could have been said about any property in any property class that was underwritten in 2005 to 2007:

The Doral, Claremont, Grand Wailea, Arizona Biltmore and La Quinta resorts have all suffered from a decline in revenue per available room and low debt service coverage ratio, according to Bloomberg data from last month. 

“Based on operating figures for the first six months of 2010, none of the properties is performing above original underwriting,” Realpoint LLC, a Horsham, Pennsylvania-based credit-rating company, said in a January report about the five properties. 

I'll try to follow what happens to the debt negotiations later this week.

Total Realty Trust - A Rush to the Exits?
I just saw this 8-K, which was filed late last month.  In the fourth quarter, Dividend Capital's Total Realty Trust only met 7% of redemption requests.  The non-traded REIT filled the requests on a pro rata basis.  Another way to look at this is that 93% of redemption requests were not met.  I wonder if part of the redemption requests was due to Total Realty Trust having to disclose a net asset value (NAV) in early 2011.  Investors are probably suspecting that the NAV will be less than the redemption price, and are trying to get out before the redemption price is reset to the new NAV.

Houston Apartments
Back during the tenant in common boom of 2005 to 2007, it seemed like every other TIC deal was a Houston apartment complex.   I'm sure that most of the debt on these TIC transactions ended up in CMBS.  TIC sponsors, apparently, weren't the only people who thought Houston apartments were strong investments, as there is $777 million of seriously impaired loans (see article below) in Houston.  Here is a National Real Estate Investor article on the "sky-high" delinquency rate of loans tied to Houston apartments.   Houston's apartment loan delinquency rate is 21.5%,  higher than the national average of 16.5%.  Here is a strong takeaway from the article:

Of the $777 million in seriously impaired loans in the Houston apartment market today, lenders originated 71% of that volume during the notoriously lax underwriting period of 2005 through 2007, reports Trepp. That’s when the economy was booming and commercial real estate was riding high.


Local broker Jeffrey Fript, a senior associate in the National Multi Housing Group of Marcus & Millichap, says Houston’s high CMBS apartment loan delinquency rate doesn’t surprise him. After all, Houston is the fourth largest city in America based on population. 

Houston also was one of the most active markets for CMBS loan originations from 2005 to 2007, says Fript. “It’s a big market, and a lot of people refinanced with CMBS. Along with that comes a high delinquency rate.”

I will never cease to be amazed at the lemming nature of sponsors and investors.   They must think that if everyone is doing it, it must be OK.   It is so much easier to follow the easy money flow than to seek out other investment alternatives.  This follow-the-herd mentality is a problem with sponsors and investors.  Sponsors want an easy sale and investors want to invest where it is popular.  Throughout history this type of thinking (or not thinking) has been the source of bubbles, ponzi and pyramid schemes, and now "seriously impaired loans" sitting in troubled CMBS.

CMBS Debt Values Soar
Bloomberg has an article on commercial real estate debt this morning.  CMBS prices are increasing as investors are betting the worst in commercial real estate is over. Here are a couple of points I noticed:

Investors are buying bonds tied to hotel, shopping center and skyscraper loans as more financing becomes available to borrowers, helping halt a slide in real-estate values. U.S. commercial property prices, which have declined 42 percent from their peak in 2007, rose for the third consecutive month in November, Moody’s Investors Service said in a statement yesterday.


So-called junior AAA commercial-mortgage backed securities, which are less insulated from losses than senior and mezzanine AAA classes, have increased almost 21 percent to 87 cents on the dollar during the past three months, according to data compiled by JPMorgan Chase & Co. The bonds, valued at about 51 cents six months ago, are at the highest levels since June 2008, JPMorgan data show.

Enthusiasm for real estate debt is generating new debt issuance:

Sales of commercial-mortgage backed securities are poised to climb to $45 billion this year, according to JPMorgan, after banks arranged $11.5 billion of the debt in 2010. Rising sales make it easier for property owners with maturing loans to refinance. Issuance plunged to $3.4 billion in 2009 compared with a record $234 billion in 2007, according to data compiled by Bloomberg.

Real estate has always been finance driven.  When money is available, deals got done.   It is hard to know exactly how much the lack of financing comprised of the 42% drop in real estate prices over the past three years.  In 2006 and 2007, there was $203 billion and $234 billion respectively, of CMBS debt issuance, which led to a frenzy of commercial real estate deals, like the huge Equity Office Properties buyout in early 2007.  When the debt crisis started, the flow of easy debt stopped.  In 2008 and 2009, CMBS issuance dropped to $12 billion and $3 billion, respectively, or just 5% and 1% of the amount issued in 2007.  I would argue that the lack of financing played a larger roll in the price drop of commercial real estate than the recession.  This finance influence can be seen in the market for Class A commercial office properties and multifamily properties, where reasonable debt is available and the demand is strong and cap rates are low.  Lower quality properites are not afforded the same type of debt, and therefore cap rates are higher and demand is not strong, which has lead to a bifurcated market.  

The estimate of $45 billion in CMBS issuance for 2011 is good news.  While it's only about 20% of the 2007 level, it's a big improvement from the paltry levels of 2008 and 2009.  More debt will help the overall commercial real estate market and the existing CMBS market.