On April 14th-16th, I attended this year's REISA conference in San Diego. It revealed prescient information regarding the activity and performance of non-traded REITs. I find it particularly relevant to open market REIT investors as it provides knowledge of the future of REITs. Many of these currently non-traded companies will either list, or merge with listed REITs and those who have a head start on the analysis will be positioned to take advantage. There were 2 examples of such activity in very recent REIT history that show the importance of knowing about these non-traded REITs: American Realty Capital Properties' (ARCP) purchase of ARCT3 and Spirit Realty's (NYSE:SRC) acquisition of CCPT2. In both cases, the mergers proved successful and the stocks have performed exceptionally well as a result. Cole Credit Properties 3 is poised to list in June of this year and I believe there are going be many similar opportunities in the near future. This article will provide the necessary analysis to make the right decision.
Non-traded REIT activity
Since the financial crisis which dampened activity, fund raising has been steadily increasing. It is estimated that this space will raise an all-time record $15B in 2013. The new focus of these is to have a liquidity event planned, even before they begin. With so many new REITs being formed and those from the previous cycle maturing, there will undoubtedly be an outpouring of non-listed REITs into the open exchanges. We will be given the opportunity to pick up shares both indirectly through the companies that acquire these and directly as they list. The important thing is to know which ones to buy and which to avoid.
While REISA has a clear bias in favor of all of them, sifting through the information with a truth-seeking filter sheds light on the matter. In my opinion, the 3 most important factors in determining the value of a non-listed REIT are the timing of fund-raising, the method of fund-raising and the allocation of resources. We will explore each of these in detail below.
Timing of fund-raising
Do not assume that a REIT listing now means that its capital was raised recently. Look closely at when the company began making acquisitions. Those that raised their money during or shortly after the Great Recession will have had the ability to acquire properties at bottom of the market prices, while those who raised money more recently are buying fully valued properties. This concept will become clearer through example.
American Realty Capital is the largest player in this space, but it is a very new company. Its various projects, even those that participate in the same sector, will have drastically different results. If we look back at ARCP and ARCT, these commenced shortly after the crisis. Consequently, they bought properties at highly accretive prices. ARCT was sold to Realty Income (NYSE:O) well above the initial $10 per share and ARCP now trades more than 50% above its initial price.
Nearly any non-traded REIT in the retail space that raised its money in 2008, 2009 or 2010 will be worth significantly more than the initial buy-in which is usually $10. Do your due diligence on REITs before they list and there will usually be an opportunity to pick them up below their intrinsic value.
The opposite can be said for those that are raising money now. Much of the approximate $15B being raised in 2013 is a direct result of the recent success of non-traded REIT liquidity events. The fact that those which were founded in 2008-2010 were quite successful has no bearing on the success of the current offerings. The environment has changed. Cap rates have compressed significantly, so most acquisitions are less profitable. With less profit, it becomes challenging to overcome the commissions and expenses of raising the funds and it may be very difficult for these to get out of the initial hole. Getting above water is made even more difficult by the oversized dividends these companies are pressured into. Among all non-traded REITs the average MFFO payout ratio is greater than 100%.
Method of fund-raising
There are numerous aspects of fund-raising methodology that must be analyzed. Commissions and fees must be known and disclosed. They can vary in both magnitude and alignment. Presently, the companies are putting effort into shifting compensation to later in the process. By avoiding the hit before money gets invested in properties, more acquisitions can be made. If this is done accretively, management can take a fee of similar absolute magnitude, but a smaller portion of the overall pool. Compensation packages in which fees are paid AFTER certain hurdles are achieved tend to be better for both management and shareholders.
Consider avoiding companies which take their fees upfront. When only $0.90 out of every dollar gets invested, it can be very difficult to get above water. I will illustrate this concept by example.
Two companies, A and B each charge 10% distributed between salaries, commissions and fees. Company A structures their compensation upfront, while company B defers the charges for 2 years. Imagine that each company has a very strong acquisition pipeline such that they can invest at a 10% cap rate.
Company A takes its fee and invests 90% of the initial capital which is worth around 109% after 2 years. Company B invests 100% of the initial capital which is worth 121% after 2 years at which point it takes its fee leaving 111% for the investors. Despite taking a fee of precisely equal magnitude and the companies making the same caliber of acquisitions, those who invested in the company with deferred fees made 22.2% more profit.
Deferred fees are great, but compensation packages can go 1 step further. Some structure their compensation such that they get paid if and only certain hurdles are met. This has 2 main effects.
- It increases management's alignment with shareholders as it becomes their vested interest to reach the performance hurdle.
- In the highly plausible event that the company loses money, it prevents the added loss of shareholders having to pay fees.
In addition to compensation, it is wise to pay attention to buy-in pricing. It can take multiple years to raise the desired amount of money. Over that time period, the value of the initial shares can change. If the initial acquisitions were profitable such that the shares are now worth $11, the issuance of further shares at the initial $10 would be dilutive. Some have static pricing, but others have adopted the new standard which is to have the buy-in price change with NAV.
There are both benefits and consequences to the new method. While it does prevent the dilution, it also increases costs as both properties and financials must be constantly appraised to update the NAV estimate.
Allocation of resources
With so many non-traded REITs, you can find one for nearly any business model. Each can be viable, but it is important to find one that matches its resource allocation with the available opportunities. We will once again use ARC as it has examples of each. ARCP made an excellent choice in resource allocation as retail properties were available in bulk and at very accretive cap rates at the time of its creation. The parent company, ARC, has a new offering out called ARCT 5. This, in my opinion, has terrible resource allocation. It is going back to the triple-net single tenant retail space, but not opportunistically. In addition to the smaller spreads, it creates an active competition for properties between it and ARCP which are run by the same management team. Competing against itself and getting diminished margins is not desirable resource allocation.
For a positive example, we can look at Inland American Real Estate Trust. It has paid close attention to market opportunities and realized that acquisition cap rates are low, but development cap rates remain high. It is developing student housing at a cost below market price. It can then hang on to the property to achieve solid leasing revenue, or flip it for a quick liquidity event. This, in my opinion, is intelligent allocation of resources that works in current market conditions.
There are going to be many non-traded REITs coming into the public domain in the near future. Using the tools listed above along with standard due diligence will allow investors to have a clear understanding of valuation from which to take advantage of mispricing as these roll in. The aspects I consider most pertinent are listed below.
- Timing: Look for those that raised their funds in 2008-2010.
- Compensation: Deferred and conditional compensation tends to yield superior results.
- Buy-in pricing: Be wary of dilution among those with a static buy-in price over many years.
- Resource allocation: Make certain that the business model is well suited for the present environment.
Disclosure: 2nd Market Capital and its affiliated accounts are long ARCP. This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer.
Disclosure: I am long ARCP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.