Sunday, April 26, 2009

Is There A REIT Reverse Inquiry Conspiracy?

As documented previously on Zero Hedge, concern #1 by a large margin for the administration is the issue of commercial real estate, and more specifically the disconnect between price discovery of CRE securities (especially in equities) and their deteriorating cash flow fundamentals. Investors who have actually done their homework and have established directional bets on CRE valuations, have, over the past month, been left wondering how it is possible that equity prices of REITs and other leveraged plays on CRE could possible be skyrocketing by over 100%, despite massive rolling dilutions and increasing fundamental weakness. Additionally, for all practical purposes, recent equity raises have been used merely to pay down secured debt financing (for the benefit exclusively of underwriter banks). As REIT analysts at Merrill Lynch would be happy to attest, the "improved" balance sheets, at best afford these companies several quarters of time, absent wholesale deleveraging (in or out of court), as declining FFO coupled with massive interest expense simply means that these credit facilities will only end up getting drawn down again sooner rather than later.

In this sense the equity raises are merely a desperate attempt by a select few fund managers who are massively underwater on their REIT bets, to prop up stock prices (after all these funds have some very concerned LPs they need to answer to, and as there is a monthly P&L reporting obligation, their very viability depends on posting at least a marginal rebound for one or two months so they can "live" to fight another day). This also explains the reverse inquiry nature of most recent REIT equity raises: these are not voluntary institutional and retail investors channeling interest to the Merrill and Goldman syndicate desks: it is, in fact, the opposite. On the day before an equity raise, the head of equity syndication at Merrill will call fund XYZ and ask them, essentially, if they would be willing to throw some good money after bad. The potential side effect of a forced short squeeze or, even more sinister, the feedback loop of leveraged ETFs getting thrown into the equation as a price trajectory perpetuating mechanism, is hopefully not discussed, although after last week's cloak and dagger disclosure about Bernanke and Paulson illegally strongarming Ken Lewis, nothing should surprise readers anymore.

In my search for candidates of this possible reverse inquiry mechanism, I stumbled upon some interesting clues, which have lead me to reexamine some old Zero Hedge favorite names. I present some observations.

A few days ago, Cohen & Steers (CNS), possibly the largest publicly-traded, long-biased REIT-focused asset manager reported its First Quarter results. As expected, the numbers were horrendous, underperforming the S&P500 by a vast margin. Of course, Zero Hedge readers should not be surprised by this performance: virtually the entire CNS portfolio is comprised of long REIT positions, which in Q1 lost over 30% of their value (in addition to a massive drubbing in all of 2008). It is thus not surprising that CNS reported that it saw major declines in Assets Under Management, which dropped to $11.6 billion at March 31, 2009, a 23.2% decline from from $15.1 billion at December 31, 2008, and a 60% decline from the $28.6 billion in AUM at March 31, 2008! What is very interesting is that of the $3.5 billion reduction in AUM, a majority, or $3.4 billion, was due to asset depreciation, and only $76 million was due to net capital redemptions, a major moderation from the $2.9 billion in redemptions year over year.

What is even more interesting, is that Cohen and Steer's institutional separate accounts (or managed accounts) stood at $5.6 billion, or nearly half of CNS's total AUM. And following up on this, and most interestingly, somehow Cohen and Steers managed to convince institutions to invest $395 million in its managed accounts, despite the decline in AUM for institutional separate accounts from $6.3 billion to $5.2 billion, before new capital inflows, an 18% decline. That is some truly phenomenal marketing PR. Just who these institutions are that have a (vested) interest in providing fresh capital to a REIT manager which demonstrates a market underperforming loss in AUM across the managed account class is truly very interesting and likely source of further much more focused investigation.

The last is an open question I will return to shortly, but in the meantime, it makes sense to present Cohen & Steers March 31 investment commentary for the Q1 period. Most notable here is CNS's disclosure that without it, none of the new equity raises in March (and likely April) would have been completed.
Cohen & Steers was instrumental in these capital raisings, and was a cornerstone investor in the offerings. We believe these transactions have demonstrated to the market that high-quality REITs have access to capital and can reduce their leverage, as needed. In our view, these companies, along with others that have strong balance sheets, will weather this recession and credit cycle and remain industry leaders.
Without the inflow of $395 million in "institutional separate account"capital, CNS would likely have been unable not only to be a "cornerstone investor", but to participate at all in any of these financings, which due to their reverse inquiry nature, would thus likely never have occurred in the first place as a seed investor is always critical in order to generate additional reverse inquiry interest. The first question a syndication desk gets when solicitation reverse inquiry interest is: "Who else is participating?" Absent a clear cut answer, the offering dies right then and there. This makes the question of just where these managed account inflows came from, all the more interesting.

The innocent conclusion is that Mr Robert Steers must really believe in dollar cost averaging. Alternatively, the fact that Merrill Lynch was the lead underwriter of virtually every single Cohen and Steers closed-end fund may potentially raise a few question marks (for our readers' convenience we have compiled some of the relevant Cohen & Steers prospectuses here - please note the lead underwriter in every single instance: Global Income Builder, Dividend Majors Fund, Quality Income Realty Fund, REIT and Preferred Income Fund, Premium Income Realty Fund, Total Return Realty Fund, Closed End Opportunity Fund, and the list goes on). The not so innocent conclusion is that Merrill, as Zero Hedge discussed previously, which would be very happy offload its credit exposure (via Bank Of America's key role as lead and syndication manager on the bulk of REITs secured credit facilities), with the assistance of its equity analysts, who would upgrade the respective REITs from Sell to Neutral or Buy ratings as soon as the offering was priced, may have had an ulterior motive to work with CNS, and facilitate their new capital generation, in order for them to serve as lead investors on all of the equity offerings (dilutions) that Merrill was lead underwriter on. An even more unwholesome pattern thus emerges: Merrill sells, CNS buys (using closed end funds which Merrill underwrote or new capital from "who knows where"), Merrill upgrades, REIT pays off Merrill secured loan, CNS marks profit on position as short squeeze in REIT stock is generated, and new investors put money into CNS after seeing "phenomenal" monthly or quarterly returns.

Quite interesting for the conspiracy minded.

But that's not all. On its April 23, Q1 conference call, Cohen and Steers had some interesting observations about the state of the REIT "deleveraging". CNS President Joseph Harvey had this to say about the company's willingness to throw tons of new capital at the REITs in the recent equitization wave:
"Our approach to these recapitalizations are to provide equity to these companies, to provide solutions to their balance sheet issues. Of course, you can't create 100% uncertainty. However, we believe that the equity that we and others are providing will be sufficient to get these companies through the year 2012. So we think that's a very long time horizon. We're confident that – by that time, the equity markets, other capital markets, will have improved. So we're extremely excited about these opportunities and the position of these companies once we execute these transactions."
Looks like Mr. Harvey has not focused a lot on threat of REIT refinancings. But who cares about 3 years down the line, when in the meantime you can bump up profits on a short squeeze and generate some additional investor interest in your fund (thus maintaining your biweekly paycheck).

Some more insightful disclosure from Mr. Harvey, who responds to Merrill analyst Cynthia Mayer's question of how far down the REIT equitization process the market is.
"In rough numbers – and again, this is a moving target depending on how the capital markets open up, but to delever the US REIT sector to levels that we think are sustainable, let's say it takes 40 to $50 billion of equity capital. In one-months' time, there has been about $10 billion that's been raised. So that's a pretty significant bite out of the apple. Now, of course, that's just the US. We think there is other opportunity outside of the US.

Let me also point out that if we have seen the lows in these stocks and we're gaining confidence that that's the fact, as we think through the next return cycle for REITs, I'd break it down into three phases. Phase one is the re-equitisation of the sector. There is going to be a phase two that we believe will be very dynamic and exciting from an investment perspective, and that phase is for our universe of companies to acquire assets from the private market who has their own leverage issues. And we know because of what the debt maturity schedule looks like in the real estate industry and what the capital structure of those assets is that there will be fore-selling. And based on our experience through the early to mid-90s, we believe that the public market will provide the capital to our universe of companies to take advantage of those opportunities to acquire from distressed sellers.
Zero Hedge would beg to differ that there is anything even remotely comparable between the current situation in the CRE market and that in the early 1990's. But that is irrelevant: Mr. Harvey essentially is hoping that there will be a greater fool available, to whom CNS can offload its REIT securities, ahead of what CNS believes will be a flouring period for commercial real estate beginning in 2012, which of course is contrary to what Zero Hedge and more and more market participants believe will happen, namely the refi crunch in 2012, which will expose CRE for the massive sham it truly is.

Amusingly, subsequent the call, Cynthia Mayer, who likely is not with the program, reiterates her Sell rating on Cohen & Steers.

Another last amusing point from the CRE conference call, is Harvey's response to UBS analyst Phil Wilhelm, who asks the logical question of what exactly is it that makes CNS comfortable that the REIT market has seen the bottom, and what themes is the company seeing that can support this claim. The answer leaves much to be desired:
We're really not comfortable discussing our short-term thinking on market movements and why. That's what we get paid to do for our clients. So, I'm not going to answer your question as to what gives us confidence as to why REITs have bottomed. We feel pretty confident in that, but we'll let you draw your own conclusions on that.

As I mentioned earlier, there is probably $30 billion US in equity that still needs to be raised over a couple of year period. So that's still a lot of capital relative beside the universe, and there is over a 100 REITs, so I'd say 15 of them have raised equity already. So there is going to be a lot of activity. We believe that the share prices have overshot on the downside to discount this financial risk. So as these balance sheet issues are solved, I know the stocks have performed and that's what has attracted investors to the area. So there is no assurance that this is going to continue if share prices rise to the point where the stocks reflect the opportunity to recap, it's going to get tougher for these deals to be done. But we think as long as they're done right and we've got a very specific formula for how they should be done, the market will – there is lot of capital out there that can absorb this equity.
May Zero Hedge ask just what this specific formula for how deals get done is? Could it involve managed accounts, a short squeeze, and Merrill Lynch in some capacity? Inquiring minds want to know. Because, despite CNS' stern promise that things are getting better, I for one would be happy to challenge anyone from CNS's management team or their portfolio managers one on one or one on many, that things, in fact, are not getting better, and once the refi cliff hits, thing will likely get a whole lot worse. I also have the numbers to back my assertions. One thing is for sure: Harvey is likely correct that there is another $30 billion or so in new equity raises down the pipeline. Zero Hedge would speculate that Merill, which is likely to be an underwriter on the bulk of these, will easily generate $1.5 billion in equity underwriting fees (the customary 5%), and CNS will likely be a happy "cornerstone investor" as more and more short squeezes are sprung. Technicals will dominate as fundamentals tell each and every investor will half a brain to run for the hills.

But then again, we live in a market where fundamental don't matter, and there is much more going on behind the scenes than is being let on. And for the most convincing example of the later, I bring your attention to the April 24 Q1 earnings call by Developers Diversified Realty Corp, one of the many beneficiaries of the REIT short squeeze. I bring your attention to the very end of the Q&A from the conference call, where EVP and CIO David Oakes chimes with the following cryptic disclosure:
"And I would like to add – to chime in here too, Jim, that I was at the real estate roundtable meeting the other day and we spent a few hours with Ben Bernanke, and he's pretty confident that we're going to see this help program for CMBS up and running within a few weeks; and very helpful that that's going to start to create a little bit of liquidity in the CMBS market, and we're in the queue with one of the major investment banks to do a significant self-financing when that becomes available."
Aside from this being a blatant attempt at Reg FD breach, would this bank potentially be Merrill Lynch one would wonder? But more relevantly, just what is it that Ben Bernanke is promising managers of very troubled REIT companies such as DDR? Perhaps, once done investigating Merrill-gate and Ken Lewis, and whether or not Mr. Bernanke was instrumental in putting that deal together, direct threats to Mr. Lewis' career notwithstanding, the new York State Attorney General can take a look at just how widespread taxpayer fund misappropriation is at the Federal Reserve level in order to buy a few quarters of breathing room for doomed REITs at the expense of fundamentally sound investment analysis. Sphere: Related Content
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