Elizabeth’s note: Ron Rhoades, RIABiz’s One-Man Think Tank Columnist, is writing a series of columns on risks to an RIA’s most valuable asset, his or her reputation. In this piece, he takes on the topic of due diligence, with a detailed exploration of how his firm, Joseph Capital Management, looked into the holdings of a potential client. Ron is writing about due diligence — but also about the world of privately held REITs, which is coming under greater scrutiny by regulators, asthis Bloomberg News story explains.
With respect to investment due diligence, a registered investment advisor’s duty of due care could be summarized this way: An investment adviser possesses a fiduciary duty to the client to exercise good judgment, knowledge, and due diligence as to: (1) the investment strategies employed; (2) the investment products selected; and (3) the matching of those strategies to meet the needs and objectives of the client. The investment adviser shall exercise that degree of care ordinarily possessed and exercised in similar situations by a competent professional properly practicing in his or her field.
Permit me to illustrate a recent exercise of due diligence by our firm, when we analyzed a private REIT that a potential client owned.
The Prospective Client’s Private REITs
The prospective client of our firm, a retiree, had over one-half of his funds in three private real estate investment trusts (REITs), all with the same issuer. These REITs were heavily marketed to consumers by one brokerage firm. Leaving aside for the moment whether real estate as an asset class should be such a large part of the client’s asset allocation, and leaving aside for the moment whether REITs in general (or a fund composed of many REITs) is the proper means to access the returns of that asset class, the issue before our firm was whether private REITs (generally) are a good investment for our retired clients, and whether these particular REITs were of high quality and low risk.
I note that our firm – before taking on any client – generally undertakes an analysis of the client’s current portfolio – at no charge to the prospective client. The resulting analysis frames a discussion with the client regarding the inherent relationship between risk and return in the capital markets, and whether some risks are avoidable (or can be minimized). That way, we get to know the client’s attitudes as to his or her investments better. We can also better discern the client’s tolerance for various forms of investment risk.
2. REITs, Generally
First, our research on REITs was updated. We made several observations – material facts – which we believed were our duty to disclose to the client about REITs. Following is a short version of these observations:
• Generally, a REIT is a company that owns, and usually, operates income-producing real estate such as hotels, apartments, shopping centers, offices and warehouses. Some REITs also engage in financing real estate. To qualify as a REIT, a company must annually distribute at least 90% of its taxable income in dividends to its shareholders. However, unlike partnerships, a REIT cannot pass any tax losses through to its investors. Moreover, any company designated as a REIT must invest at least 75% of its total assets in and derive its income primarily from real estate held for the long term and from other limited items.
• As with any investment, there is no assurance that investment in a REIT will be profitable or that it will realize growth in value. Additionally, the price of publicly traded REIT shares is affected by the rate of return secured by a REIT, the price appreciation or depreciation for the real estate owned by the REIT, and other factors. Demand for REIT shares can swell or diminish over time, thereby affecting pricing, as investors consider whether to invest in REITs and real estate versus other asset classes.
• We are not a huge fan of REITs, for two primary reasons. First, the management costs and fees of REITs are generally quite high. In essence, the cost of managing real estate portfolios can consume a great portion of the net return of REITs. For this reason, we favor direct investment in real estate, for those of our clients who possess the ability and know-how to undertake such ventures over the long term, including by having the ability to directly manage real estate properties. Second, held in taxable accounts, REITs cast off a great deal of dividends – taxed as ordinary income. Unfortunately, tax losses (which may be generated due to depreciation expense, and other expenses, when they exceed operating income) are not passed through to shareholders of REITs.
Private REITs – Valuation Concerns
We then asked ourselves – what is the value of this private REIT’s shares, currently? The share price listed on the client’s brokerage statement was $11 per share – the same value as the acquisition price several years ago. How could this be right?
We reviewed this particular private REIT’s Prospectus and most recent annual report. Most of the initial shares of this particular private REIT were issued at $11 per share. Through the “Share Redemption Program” operated by the REIT, which provides opportunity for shareholders to redeem shares after they are owned for one year (such to certain restrictions), the price per share held constant at $11 per share over the past several years.
How can this be, when about 10% of the gross proceeds were utilized to fund the brokerage commissions and marketing expenses paid in connection with the offering? This approximately 10% decline in the capital available for investment is typical of the underwriting fees and expenses associated with the placement of private REIT shares. (Even then, this percentage decline does not include organizational expenses nor commissions paid in connection with specific real estate acquisitions.) One would think that the value per share would instantly decline to $10 per share, if not lower, but this was not the case for this private REIT.
Like other private REITs, which generally do not trade publicly, this private REIT maintains a share redemption program through which it, in essence, sets the price per share of its own “stock.” As stated in the annual report: “The per-share estimated market value is deemed to be the offering price of the shares which is currently $11 per share. This is supported by the fact that the Company is currently selling shares to the public at price of $11 per share through its Dividend Reinvestment Plan and the [REIT] is repurchasing shares at $11 from shareholders under its Unit Redemption Program.”
But does this $11 per share constant valuation, over the past six or more years, make sense?
First, we analyzed book value of the underlying real estate investments. From the most recent Annual Report’s financial statements, we discerned that investments made (land, building, improvements, furniture, fixtures and equipment) divided by the number of shares outstanding resulted in an estimated “unadjusted book value” (based on real estate acquisition cost alone) of close to $10.00 per share. However, this estimate of book value per share does not include adjustment for depreciation for tax purposes (approx. $125m), nor any depreciation or appreciation of properties since their original acquisition, nor the effect of real estate commissions paid upon the acquisition of the properties themselves. Nor does this projection of book value include debt on the books of the REIT – which was equivalent to about 60 cents per share. We also observed that the hotels owned by this REIT were not re-valued by the REIT using either a market valuation approach nor by means of a valuation model taking into account current revenue and expenses (and applying a discount rate).
Surveying the broader commercial real estate market, we noted that the Moodys/REAL Commercial Property Price Index (CPPI) ranged in value from about $1.30 to about $1.70 for the period during which the majority of the capital for this REIT was raised (mid-2004 to mid-2006). As of the end of 2009 the index stood well below $1.20. While this broad index of commercial real estate may not be indicative of hotel values, we suspect that due to declines in revenues, due to the general economic decline, hotel valuations in recent years have also substantially declined from levels seen from 2004 through 2008.
We noted that some of the properties were acquired by the particular REIT held by our client in 2007 and early 2008 – near the high point of real estate values, generally.
In essence, and without the benefit of testing the current values of particular properties, our analysis concluded that it was highly unlikely that the underlying value of the real estate owned by the REIT justified a share price of $11 per share. In our view, the actual fair market value of the underlying assets was likely to be significantly lower – perhaps equivalent to $9.00 per share for the entire REIT’s holdings, or perhaps even less.
FINRA’s Rules On This Potential Misrepresentation of Current Values
This begs the question … Is the $11 per share price utilized by the REIT misleading? Would the price, if utilized on brokerage firm statements, also be misleading? As to the latter question, we turned to FINRA Regulatory Notices. While FINRA requires certain disclosures be made to individual investors on the account statements, there does not appear to be any rule that requires affirmative specific disclosure that the price per share may be (and likely is) established at an artificially high level by means of a share redemption program. Nor does there appear to be any requirement that a broker-dealer monitor the valuations of the private REITs on its statements, other than by referring to values per share set forth in the REIT’s annual report.
Of course, RIAs possess no such luxury – full disclosure of all material facts is required, and proper valuation of illiquid investments is a fundamental aspect of an RIA’s duties to the client.
It appeared to our firm that the underlying real estate values fluctuated down (as a result of commissions paid during the offering process), then up (as real estate value rose), and then down (in more recent years, due to declines in real estate values). Why don’t regulators require periodic valuation of a private REIT’s assets, when purchases and sales are made through share redemption programs?
At least one commentator has observed that this appears “like” a Ponzi scheme. By artificially keeping values of a private REIT at the initial offering price, despite declines in values due to offering expenses, borrowings, and/or price declines in the underlying holdings, those purchasing in that private REIT’s share redemption program may often overpay relative to the value of the underlying investments owned by the private REIT. At the same time, sellers often receive their original purchase price, and current shareholders of private REITs may hold onto their shares – not knowing for years and years that the real value of the REIT shares may be significantly less – as their brokerage statements continue to reflect the value shown in the Annual Report – which in turn is often the value artificially set by the share repurchase program.
Is This Private REIT a “Ponzi Scheme”?
Webster’s Dictionary defines a “Ponzi scheme” as “an investment swindle in which some early investors are paid off with money put up by later ones in order to encourage more and bigger risks.”
Examining the dividend history of this REIT, we saw that the dividend rate was increased in a good year to 8.2 percent, based on the original offering price of $11 per share. Yet, earlier this year, the dividend rate decreased to 7.2 percent for the 2010 year, again based on the original offering price of $11 per share. Given the adverse market conditions (declining revenues for hotels, and declining values for real estate, in the past two years), maintaining the dividends at such high levels was impressive. Or was it?
The 2009 Annual Report states: “When dividends exceed earnings, we may use available credit to maintain the distribution rate [to shareholders] ... Distributions in 2009 … included a return of capital … The shortfall [between operating earnings and dividends paid out] was funded by borrowing on the line of credit and cash on hand.”
In other words, this private REIT is borrowing money to pay shareholders their expected distribution. This in turn reduces the book value of the shares of the REIT. Yet, by maintaining the per share price of $11 for purposes of the share redemption program, new shareholders are potentially buying shares at reduced values, permitting current shareholders to depart with their original values intact.
The Liquidity Concern
Our potential client has over 50% of his non-personal assets tied up in this private REIT and two other private REITs issued by the same affiliated parties. Should our client need funds, liquidity of these investments is obviously a concern. Will the share repurchase program, which generally permits shareholders to withdraw funds on a quarterly basis, continue?
As stated by Laurence Cohen, at his web site, The REIT Advisor, “Nine of the ten largest non-traded REITs have suspended their repurchase programs by the fourth quarter of 2009.”
We suspect that the private REIT we evaluated may one day suffer a “run” by shareholders who, seeing distribution rates decline, or if they “wise up” to the fall in the underlying value (perhaps aided by due diligence from RIAs), will seek the exits in droves. But too many shareholders looking to depart at any one time could easily result in the share repurchase program being suspended, or at the minimum being ineffective to provide liquidity to all the shareholders who desire to depart.
Further Concerns: Related Party Transactions and Conflicts of Interest
The Annual Report for this private REIT noted that the REIT had a contract with a “related party” “to provide brokerage services for the acquisition and disposition of the Company’s real estate assets In accordance with the contract … [the related party] is paid fee of 2% of the gross purchase price of any acquisitions or gross sale price of any dispositions of real estate investments subject to certain conditions.” This high expense of property acquisition and disposition obviously creates a conflict of interest for the management of the REIT, as over time there would be an incentive to engage in the buying and selling of properties (although there is no indication that such “churning” occurred here). Individual property acquisition and disposition fees in the 1% to 3% range are common for privately held REITs.
The Annual Report also noted that, in addition to the REIT having its own employees, the REIT pays another related party an “annual fee ranging from .1% to .25% of total equity proceeds received by the Company in addition to certain reimbursable expenses are payable for these [management] services.” The Annual Report also notes that another “wholly-owned subsidiary” provides “support services” to the REIT – for fees which varied tremendously from year to year. Also, the Annual Report stated that the REIT owned part of another subsidiary, which in turn owned partial ownership of “two Lear jets.”
The Annual Report correctly noted that “The [REIT] has significant transactions with related parties. These transactions cannot be construed to be arms length and the results of the [REIT’s] operations may be different if these transactions were conducted with non-related parties.”
In essence, this is not a “classic” Ponzi scheme, as it does not fit the definition of one. But, in our view, the practice of maintaining a constant share price, when the underlying value of the assets held by the private REIT may be much less (or sometimes more) should be highly disturbing to most individual investors.
Moreover, the lack of liquidity of privately held REITs, the tremendous acquisition-related commissions and expenses, and the numerous conflicts of interest possessed by this private REIT’s management make these shares highly unattractive, in our view, for nearly every retiree.
There may come a time when certain private REITs can be acquired, through secondary markets or share purchase programs, at discounts to what may be “real value” of the assets. At these times, shares of certain private REITs may prove attractive to certain investors, despite their possible illiquidity.
We discussed all of these concerns with the potential client. The result? A decision by the prospective client to exit the private REITs – as quickly as possible.
If you’ve read this far, perhaps you’ve concluded that this amount of due diligence is “not easy.” In fact, due diligence can often take a great deal of time. The knowledge required to conduct appropriate due diligence includes, but is not limited to, the ability to understand financial statements, prospectuses, and other SEC filings, as well as general understanding of the economy. Often a good deal of further investigative work – as well as common sense – needs to be applied. Yet, failure to conduct adequate due diligence on investments recommended (or held by clients) can easily result in reputational risk to both you, and to your RIA firm. No one should ever say being an RIA is “easy.”
In future issues I’ll explore how we conduct due diligence on other types of investment products, and discuss other aspects of the overall due diligence process.