IRS extends guidance on taxable stock dividends.

Morrison & Foerster LLP has issued a note to clients on IRS's extension of Revenue Procedure 2008-68 on taxable stock dividends:

On December 23, 2009, under Revenue Procedure 2010-12, the Internal Revenue Service (“IRS”) extended the period of temporary guidance regarding certain stock distributions by publicly-traded real estate investment trusts (“REITs”) and regulated investment companies (“RICs”).
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Revenue Procedure 2010-12 also clarifies it is permissible for the calculation of the number of shares to be received by any shareholder to be determined, over a period of up to two weeks ending as close as practicable to the payment date, based upon a formula using market prices that is designed to equate in value the number of shares to be received with the amount of money that could be received instead.

Having a longer determination period for the pricing of the dividend is a good thing, as it will reduce volatility during this sensitive interval.

New S-11's for Excel Trust and Invesco Mortgage Capital

Taking a look at the hot sheets (aka SEC EDGAR online) reveals that S-11's for two REITs have been filed this week.

1. Excel Trust (EXL)
2. Invesco Mortgage Capital (IVR)

Excel Trust (EXL)

Excel Trust is a new REIT, started by former New Plan Excel (NXP) folks, who are looking to buy retail assets. This S-11 gets an immediate de-merit for burying "Management History and Experience" all the way on page 94. Compare to how Pebblebrook Hotel Trust (PEB) made it very clear who was running the show and why you should invest with that management team. This isn't to say that there are any flaws

Folks who are real REIT old timers will remember Gary Sabin, as being involved in the merger of Excel Realty and New Plan Realty Trust to create the massive New Plan Excel Realty Trust back in 1998. New Plan Excel was eventually sold in 2007 to Centro Properties Group of Australia at very close to the top of the market. See also (Some burnt by hot commercial property December 24, 2009).

Unlike some other REITs which are completely blind pools, Excel Trust 2.0 plans to start with an initial book of properties contributed by the founders in exchange for shares of the new venture. That should allow for a fairly quick initiation of dividends after the IPO.

Invesco Mortgage Capital (IVR)

Invesco Mortgage Capital (IVR) has filed for a secondary offering to double the size of the company.  Invesco put out a heroic struggle in June 2009, to get the first post-bubble REIT public offering sold and distributed. These days IVR has some street credibility (due to $1.66 in post IPO dividends) and the stock is trading above book value. That is always important for MREITs and BDC's, because their real growth story is doing lots of accretive capital raises. 

The courage to sit tight.

Natixis economic research has a very sharp man in Patrick Artus, who has put out a research piece which describes a problem that many sensible investors face today. What happens when investors no longer want to buy anything?s (10 December 2009 - No. 542). Patrick asks "Could investors reject all asset classes?", and concludes yes.

Today, one could imagine a situation where investors no longer want to buy anything despite the abundance of liquidity:

• Emerging country securities and commodities since their valuation is excessive after the recent rises;
  
• Equities or credit in OECD countries due to the prospect of an inevitable decline in consumption;
  
• government securities due to the deterioration in public finances;
  
• Agencies or covered bonds, which have become too expensive relative to government bonds.

So if all other asset classes are rejected, there might be precautionary investment in liquidity and short-dated securities for a period of time.

These days I'm feeling pretty much the same, very little to strategically invest in, except cash. Within the REIT space it is pretty much a similar situation. Most equity reits are expensive for what you get, and overpriced if the economic situation gets worse. Only the blind pools have a compelling story, which is growth by deployment of capital without distraction from legacy debt/investments.

Why no BDCs?

One thing that is odd in the rush to file S-11's for new REITs, is the lack of filings of N-2's for new business development companies. So far just three have filed during this landrush to the SEC. The public markets have lost two BDC's (ALD and PCAP) to mergers, along with relatively little capital raising from secondary offerings. This doesn't make sense since the credit conditions in the middle market C&I lending are constrained and profitable.

1. Trian Capital Corp
2. THL Credit
3. Golub Capital BDC

The Trian and THL offerings are boring 2/20-catch up jobs. The Golub offering is interesting, because Golub Capital had previously filed to create Golub Capital Partners LLC. This would have a been an LLC type vehicle similar to Compass Diversified Trust (CODI) in that it was structured as an LLC instead of as an investment company. Golub capital gets credit in my book for having funny advertising. Not often do we get to see the world through the gold colored glasses of a mezzanine lender.

The N-2 for Golub Capital BDC gets an award for the most byzantine management fee arrangement I've ever seen. I'm honestly not sure I even understand it, but it appears to be a traditional 20%+catch incentive fee over an 8% hurdle combined with a moving cumulative total return high water mark based on the relative differences of two different calculations of net investment income and total return. It's honestly not worth figuring out. Hopefully they simplify this fee structure in an N-2/A. Make it a straight 1.25% assets + 20% excess of an 8% hurdle on a four quarter rolling average, and they should be all set.

Financial LLC's (like the original Golub Capital Partners) have been an unpopular form of investment because they are flow through entities which issue K-1 forms instead of 1099-DIVs. An investor in such a entity gets to report his/her allocable share of taxable income which may not be matched by actual cash distributions.

The investor base is limited because tax exempt investors (including mutual funds) cannot jeopardize their status with the Unrealted Business Taxable Income (UBTI) that publicly traded LLC's/LP give off. Unlike traditional natural resource/hard asset MLP's, financial MLPs tend to generate almost no deductions which have the effect of shielding cash dividends from taxation.

This attained ultimate silliness in the S-11's for Michael Vranos's Ellington financial, which was planning to invest in subprime mortgages and related assets. The offering memorandum disclosed that Ellington intended to distribute only 50% of its taxable income each year; resulting in an absurdly high effective tax rate since the IRS would asking shareholders to pay 35% on 100% of the companies taxable income. The effective tax rate on cash distributions would be 70%. So you had a proposed IPO in which institutional investors were both unable to, and too smart to invest in.

S-11's Three fresh today.

Today had four S-11's (Registration of securities issued by real estate companies) uploaded to the SEC's edgar system. If we ignore the private reit, we find...

1. Terreno Realty Corporation. (TNRO) -- Internally managed (ex AMB folks) reit targeting industrial properties. Industrial is an odd sector because the key issue is scoring good locations. The properties themselves tend to be cheap to build, since they generally big empty boxes with little finishing (except for high end R&D lab space which is its own niche targeted by folks like Biomed Realty (BMR) and Alexandria (ARE). Tight well aligned compensation structure, but most of the existing players are trading below replacement cost, because there is no shortage of industrial property what so ever.
   


2. Americold Realty Trust -- Cold-storage warehouses. These are a niche property type, though in general the demand for cold storage grows slowly. Americold used to be a Vornado project, before getting sold to its current owners.
   


3. Callahan Capital Properties (CCP) -- Class A Office REIT lead by ex-Trizec folks targeting properties in major coastal markets. I wish there was more to say to about this.
   

Why new is better than old, when it comes to REIT ipo's.

Way back when, (September 23 2009) Tom Petruno of the LA times wrote about the troubles of starting up a new REIT as a blind pool offering (Real estate vulture Colony Capital set to launch REIT IPO and Why investors are balking at IPOs of new vulture mortgage funds).

Buying into such an offering is making a macro bet that there are good investments out there, and a micro bet the management team will be able to identify these investments, generally run the company in a way that keeps it going for the long term and attracts investor interest.

With the exception of Lodging REIT Pebblebrook trust (PEB) these blind pool IPO's have been externally managed. There have been a number of S-11's for internally managed Hotel REITs (and as of Dec 11 an Class A Office REIT), which involve industry veterans with star (not iStar) power. Investing in any of these equity REITs means taking a macro view on the recovery of their target property sector. Financial reits require less operating expertise, since their assets are passive by nature, and if they need active management you are doing it wrong. The key skill is to carve a good investment out of a (pre-existing) messy situation, or be able to avoid messy situations

External management has a benefit in that you know what the companies cost structure is going to be. Incentive fees are tricky, since if not properly structured they can lead to "moral hazard" due to an emphasis on short term income. In theory an internally managed company should be prone to less empire building, but they can have more subtle issues of excessive compensation and awards of stock options.

Incentive fee's and a business model based on financial leverage leads to trouble. The temptation to crank leverage as financing spreads (or gross yields on assets) decline is irresistible. And yet, a fixed management fee is an annuity to the manager. Which can create an incentive to grow the equity base of the company.

The upside to starting a company from scratch is that there are no "legacy" issues. Old debt maturities to refinance, formerly performing assets now non-performing, etc. Unless a REIT is into development, the very nature of the REIT model is that of accretive growth (via acquisitions) instead of internally generated growth (from re-investment and asset management). This is especially true for REITs owning passive financial assets, where there isn't much asset management to be done because you can't raise rents on a mortgage.

A brand new company with just cash is poised for a large amount of growth and corporate transformation relative to its initial state, compared to most public REITs which are just trying to stay alive and have no capital for growth. It is that combination of legacy issues and strangled capital that makes most existing REITs uninteresting. They trade an high multiple to their ability to generate FAD at the corporate REIT level.

This makes blind pool IPO's kind of fun, since they often trade at only a slight premium (or more often discount) to book value till the company shows signs of ramping up and gains some analyst coverage. As the company becomes fully invested, the dividend stream grow at the same time that the to Price/book multiple will increase to that of a stable proven company.

The new generation of mortgage REITs

So when I last posted, the mortgage crisis was just beginning. And I thinking it was a good time to get into the banks. Because they were looking pretty cheap, relative to their performance over the past 8 years or so at the time. Pretty much all the old line players in commercial mortgage REIT space were wiped out, or never fully recovered. (CT, AHR, CRZ, JRT, GKK, CBF, NCT).

Which is not to say that commercial mortgage lending is a bad idea, especially now that the main competitors in this space are on the ropes (banks, and to a lesser extent insurco's).

That has inspired a new generation of MREITs to sort out through the carnage, and enjoy the tax arbitrage of being a REIT rather than a C-Corp. So far around $1.7 Billion has been raised for these new MREITs, and that has been hard going except for Starwood Property (STWD) which raised $800M despite having a high fee structure and being associated with Barry Sternlicht. Most everyone else (except Colony/Pennymac) had to make some concessions on management fees.

• Residential Credit oriented
  
  
  
  1. Pennymac (PMT) -- Started up by ex-countrywide people (who created a good chunk of this mess to begin with). They have incentive fee's.
     
  2. Two Harbors (TWO) -- SPAC that became an MREIT targeting credit/interest rate sensitive residential assets, externally managed by ex-Cargill folk.
     
  
  
• Commercial Credit oriented.
  
  
  
  1. Starwood Property (STWD) -- Barry Sternlicht's venture. The last one he sponsored (with BFF Jay Sugarman) iStar (SFI) didn't do so well.
     
  2. Crexus (CXS) -- Commercial focused MREIT started by friends of NLY. Run by ex-TIAA-CREF (insurance company) folks, but with a highly outsourced business model. So far the market seems to think that a externally managed REIT that outsources its core operations is questionable. Also the history of dilutive capital raises at Chimera (CIM) isn't helpful.
     
  3. Apollo Commercial Real Estate Finance (ARI) -- A low cost venture set up by Apollo to managed commercial assets for 1.5% with no incentive fee's. Unfortunately the management agreement lacks real exclusivity in favor of ARI and it is very likely that the more interesting opportunities will steered towards private Apollo funds with the more traditional 2/20 fee scheme. Depending on your outlook, that could be a good thing.
     
  4. Colony Capital (CLNY) -- Thom Barrack's new venture. High fee's 1.5% + (20% incentive fee on a 8% hurdle). Most importantly they have a co-investment right with other Colony capital funds.
     
  
  
• Generalist Investors
  
  
  
  1. Invesco Mortgage Capital (IVR) -- Invesco made huge concessions to get this to be the first 2009 externally managed MREIT IPO. Low fee's (without the overhang of recouping underwriters discounts etc). So far mostly invested in agency RMBS, while very slowly gathering more credit sensitive assets.
     

What I'm really waiting for is new BDC's, but till then I'm holding onto a few shares of CLNY and IVR for old times sake.