Originally From: https://blog.avisonyoung.com/2020/03/houston-interrupted.html
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REITWrecks: February 16, 2010
Formerly known as Wells REIT until it was spun out into a new, self-managed entity and renamed in 2007, Piedmont (PDM) sold 12 million shares at $14.50 and began trading on the New York Stock Exchange on the morning of February 10th. The Company had planned to offer 18 million shares at a price of $16-$18.
Piedmont, which owns and manages a 73 property, $4 billion portfolio of office buildings across the country, including trophy properties like the Aon Center in downtown Chicago and the Nestle headquarters in Los Angeles, has a colorful history.
The company was founded in 1997 by Leo Wells and quickly became adept at raising money through a network of independent brokers, paying them commissions of 7% along the way. Wells also earned lucrative acquisition fees for buying property, as well as advisory fees for managing the portfolio. Allegedly, Wells also encouraged investor participation in prayer chains for favorable acquisitions.
This unconventional model attracted the attention of many skeptics, including David Swensen, Yale Endowment’s chief investment officer. Swensen accused Wells of turning a blind eye toward investors’ best interests while he raced to raise money and buy more property. In his book “Unconventional Success” (pages 70-75), Swenson said the high fees simply encouraged two things: the sale of still more shares and the purchase of property – any property – at almost any price:
No rational buyer can compete with the Wells acquisition machine’s willingness to overpay for product. As a consequence, investors suffer the double indignity of high fees and poor investment prospects.
Unfortunately, the Piedmont IPO is confirming Swensen’s claims. Prior to the public listing, Wells orchestrated a 3 for 1 reverse stock split that created four separate classes of shares. Only one class, the Class A shares, now trade on the NYSE, while the rest will convert over time. This effectively delays a full “liquidity event” for another 12 months. The Class A shares traded up to $16 on Friday, but that still translates into a pre-split loss of almost 40%, according to The Rational Realist.
Even the Wall Street Journal pilloried the IPO. The Journal estimated that investors would have received a “paltry” 2.1% annual return including dividends, assuming the offering priced at the high end of the $18 range. According to an analysis by Green Street Advisors, had those investors simply bought shares in an index of publicly traded real-estate stocks, their total return over that time would have averaged about 8% a year.
Ironically, shareholders had the option of being cashed out in 2007 through a series of buyout offers from Lexington Realty Trust (LXP). Lexington offered to pay up to $9.25 per share (a post-split equivalent of more than $18 per share), but Wells never informed investors of the offers. Instead, he took the bulk of a $175 million payout as part of the spin off to Piedmont.
Sir Leo argued that the Lexington buyout offers were not material because they were merely tentative expressions of interest. Unfortunately, a federal district court disagreed, stating that “there can be no doubt that this information is material, as it would be considered important by a reasonable shareholder in deciding whether to vote for or against the [spin off].” The court also granted the plaintiff’s request for a class action, and discovery continues.
Certainly, public REITs are imperfect vehicles for a variety of reasons. They are highly correlated to equities, they can be much more volatile than the underlying real estate in which they invest, and they are not great as inflation hedges either. However, beginning at 9:30 every Monday through Friday, excluding holidays, investors in public REITs can vote with their feet and reclaim their money. Sadly, long-suffering Wells shareholders are stuck sucking swamp water for another 12 months before they finally get that freedom.
I love zerohedge. Last week, they posted a story whose headline blared “Kanjorski Admits There Is A Growing Bubble In Commercial Real Estate As S&P Observes CRE Losses Could Wipe Out Banking System.”
You’re forgiven if you didn’t know, but Kanjorski is a Congressman from the 11th District of Pennsylvania, and his website prominently features a picture of the beautiful Susquehanna River winding its way through an endless horizon of verdant green forests. Meanwhile, the S&P report never comes close to making such a cataclysmic, categorical observation about the U.S. banking system, and even if they had, who cares??
So what’s really going on in commercial real estate? Defaults are skyrocketing by almost every measure, but that’s hardly news. According to RealPoint’s monthly delinquency report, not only had delinquent, unpaid CMBS principal balances increased by 380%, but loss severity reached an all time high of 52%. For those of you following along at home, this means that many CMBS loans are worth no more than 48 cents on the dollar.
Excluding the Peter Cooper/Stuyvesant Town default from its estimated rate of delinquency growth, RealPoint predicts a CMBS default rate of roughly 8.5% by June 2010. Expressed in terms of delinquent, unpaid principal balance, this would be approximately 20 times higher than the low point set in March, 2007 – just as the market peaked. As CMBS delinquencies increase, specially serviced loans, as a percentage of overall CMBS outstanding, are skyrocketing:
This distress in the CMBS market serves as valuable, eyeball grabbing headlines for sites like zerohedge, but it’s more useful and instructive to compare the distress in CMBS distress to the relatively low default rates seen by other lenders. While Realpoint is dramatically predicting a CMBS default rate of 8.5% by June, Fannie Mae and Freddie Mac have consistently been clocking in with CRE default rates of just about one half of one percent, and insurance companies are reporting default rates of just about half that rate.
Clearly, the old CMBS model doesn’t work well, while the Fannie Mae/Freddie Mac model, which requires third party underwriters to take the first loss risk, is working much better. Having “skin in the game”, as it were, causes Fannie Mae DUS lenders and Feddie MAC correspondents to be much more cautious in underwriting their loans than a bank would be in making a loan that can instantly be turned into someone else’s problem via securitization. And often times, that “someone” isn’t all that smart. It’s all about pay for performance, and we should bring it back for real.