Stuck Beside a Cap Rate with the Second Quarter Blues Again

...Or is it Deja Vu all over again? Whether it is Dylan or Yogi there are striking parallels between first quarter activity in 2010 and 2011. Both years began with a flurry of activity, cap rate compression and a more open lending environment. Deals were transacted and the outlook was positive. Then we hit the brakes. In early 2010, the collapse of the Greek economy set off a fear of European default with repercussions that were felt across the globe – an enlightening testament to the power and perils of a truly global economy. The good news of course is that by early summer, the net lease world was right again and deal making and cap rates responded to an improving economy and a lack of quality net lease product.

Following a solid close to the fourth quarter, 2011 got off to a roaring start with further cap rate compression and transactions closed at rates that rivaled those of the peak years of net lease investing. As the second quarter of 2011 approaches, we potentially find ourselves in a place that looks an awful lot like the second quarter of last year. Will news from across the globe cast a shadow on domestic trade? Will revolution, heightened U.S. involvement in the Middle East and a historic disaster in Japan stall the US economy and net lease investing in particular? Alternatively, just as in 2010, will the volatility in the bond and securities market drive investors to net lease assets that provide bond like, secure, stable returns with solid real estate fundamentals as a backstop to their investment?

Whitey Ford was pitching for the Yankees at Yankee stadium. Luis Aparicio led off for the White Sox with a first pitch base hit. Nellie Fox batted second fouled off a couple pitches and then got a base hit. The next batter hit a home run and Yankee manager Casey Stengel went out to the mound and asked Yogi "Has Whitey got anything?" to which Yogi replied, "What the hell do I know? I haven't caught one yet!"

Like Yogi we don’t have enough information yet but let us know what you think and how global events influence your investment strategy.

Shelby Pruett on $625M Net Lease Deal

Shelby Pruett is Managing Partner at Equity Capital Management - a self administered real estate company focused on investing in institutional quality, single-tenant office, industrial, and retail properties that are net leased to investment grade and other high credit quality tenants on a long-term basis.

HIPP: What is driving your sale of up to $625 million in net lease assets?

PRUETT: ECM’s primary objective has always been to provide its investors with attractive risk adjusted returns through multiple time periods and economic conditions. We are a private equity real estate firm and in 2010 filed to take part of our platform public through ECM Realty Trust.

During the IPO process we were approached by a number of private and public companies, including public REITS, interested in entering into joint ventures, merging, and or acquiring our assets. Through conversations with these companies, we came to a global solution that met all of the constituents needs. As a fiduciary to our investor we made the decision to enter into contracts to sell our assets to some of these parties, one of which was a public REIT.

HIPP: What are your thoughts on the IPO market as it relates to your business?

PRUETT: We still believe public platforms and markets hold merit. We had positive feedback from the public markets as one of the only large scale investors aggregating institutional quality net lease and sale leaseback assets. These net leases were backed by investment grade credit tenants, at significant discounts to the assets underlying values. The platform, team, strategy, board, and structure were well received in the market.

We carefully studied the reception other firms received in the IPO market and believe that while public markets in general are attractive, a company’s timing of entry is critical. At the time we made the decision to sell, we had not launched our road show. The global solution that materialized through the sale provided certainty and was beneficial to all parties. With that said, we believe the sale supported the viability of the platform ECM was bringing to the public market and we are continuing to review an execution in this area with alternative assets.

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UPREIT Follow Up...

Well, it appears that last week’s blog post on UPREITs struck a nerve because it generated a huge response. Not just in terms of viewership and comments but also in terms of questions. Below are a few of the more common questions that got raised:

What is tax treatment of my gain when I do convert my units?

Obviously you would want to consult your tax advisor to confirm what the treatment for your specific situation might be. That said, the treatment of your gain for tax purposes should be nearly identical to that of the gain you would have recognized had you simply just sold your property in a normal sale transaction. That means that un-recaptured section 1250 gain taxed at a 25% tax rate, as well as capital gains tax at the 15% rate will be considerations. Also, any appreciation in the stock will constitute additional 15% gain, and any depreciation expense you get allocated during your holding period will generally increase your un-recaptured section 1250 gain.

Are there any other quirks associated with a property contribution?

One other consideration is that during your holding period the rental income you will be allocated from the OP will have less depreciation expense from your contributed property than you would have otherwise expected. The rules are highly complex but essentially the built in gain you had on the day you contributed your property to the REIT (the difference between your tax basis and it’s FMV) is burned off by allocating you less depreciation expense, and consequently more income. As a practical matter, this means if you held your units for 39 years (or whatever the remaining depreciable life of the property is) you would have fully recognized your built in gain, albeit as ordinary income as opposed to capital gain. At that point, upon conversion you’d only have to recognize a gain from stock appreciation. Again, you’ll want to consult your tax advisor to make sure you understand the tax ramifications of such a transaction, as it can get tricky.

What are the transaction costs associated with such a transaction? Do I need to bring money to my own closing?

Transaction costs on the seller side are remarkably low, although it could result in needing to bring a nominal amount of money to the closing table. Often times such contributions are done by conveying the LLC, which owns the property, and in many cases can thus avoid transfer taxes that might otherwise apply. Also, most of the costs associated with the deal like legal fees, etc. are borne by the REIT. One thing to note however is any cash you receive from the REIT reimbursing your legal fees would be considered income to you.

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UPREITs: An Old Idea is New Again

Net Lease investments have long been a haven for those looking to invest in real estate without the headaches associated with management. Owners can rely on a predictable cash flow stream and a risk profile that’s essentially a function of their tenant’s credit.

Still though, there is an inherent lack of liquidity in real estate investments, triple-net or otherwise. Also, the notion of management and diversification takes on new meaning depending upon whether you own one property or twenty. Once you eclipse ten or twenty properties in a portfolio, even triple-net ones, management can become an issue. A tenant will always be rolling, and issues will present themselves regularly that need to be dealt with whether we want to or not.

At the other end of the spectrum, perhaps you own just one large property. An industrial warehouse, or a big box store, perhaps it was inherited. Now, all your eggs are in one basket from a diversification standpoint.

For the family, portfolio, or large single asset owner another ownership option is the REIT. Specifically, the UPREIT. These types of REITs are the perfect fit for the investor who doesn’t want any management responsibilities or the large single asset owner looking to diversify.

The way it works is the property owner contributes their property to the UPREIT in return for units in a partnership, which are transferable into shares in the REIT. The contribution of the property doesn’t trigger any tax gain. It’s not until the units are swapped for REIT shares that any tax is incurred. In this way it’s similar to a 1031 exchange. Additionally, like a 1031 exchange, it’s basically a cashless transaction from the perspective of the seller/contributor.

The difference is you are trading into something which is very liquid (assuming it’s a public REIT), as opposed to another piece of real estate. There is also potential upside in that the value of the stock can increase. Additionally, if you contribute one property into the REIT you’re now effectively diversified -- owning part of all the REIT’s properties. This is in contrast to exchanging one property for another. Furthermore, by not recognizing gain until you convert your units, you can choose the timing of your gain recognition.

Lastly, during your holding period you’re still receiving regular distributions. You still have a solid income producing investment.

None of this is new. This structure has existed for years. Recently, the startup of several new Net-Lease REITs (some public) has shined a new light on this opportunity. We’ve actually just put together a new whitepaper, which illustrates the process; its pros and cons.

Click Here to get it.

Many of the new funds and REITs that have started up recently have been having the same problem that every net lease investor has been having; the utter lack of quality inventory. It will be interesting to see if UPREIT contributions free up some of the quality product that has thus far been on the sidelines.

ICSC Observations

Andrew Fallon, Calkain Companies Associate, provides his obervations on the 2011 Mid-Atlantic ICSC.

• What differences did you see between this and last year’s conference?

This year’s ICSC Mid-Atlantic Conference had a very positive vibe. Attendance was up and there was a general buzz that was not there in 2010. I think that in February 2010, there was still a lot of uncertainly and concern about the economy and how the market would recover from the depressed conditions. In place of that uncertainty and concern was anticipation and optimism.

While there is always deal making at an ICSC conference, this year’s show seemed to have more velocity and urgency. There was a strong developer and third party presence, indicating that once stalled projects are back online and moving forward. Retailers and tenant reps were actively seeking new opportunities for expansion. On the heels of 2010, brokers, developers, lenders, and retailers are excited about continued growth and recovery in 2011.

• What was the outlook at this year’s conference?

The consensus is that the commercial real estate market bottomed out in 2008/2009 and significantly recovered in 2010. We are now accelerating from recovery to expansion. The capital markets discussion revealed not only that many lenders are active again, but also that they are willing to be flexible on terms. Of course, the flexibility is on core, class A assets, which are trading at pre-crash values -- meaning sub 7% and in some cases sub 6% cap rates. The obvious concern is when and how quickly interest rates will rise.

The bottom line: consumers are spending again, leasing activity is up, rental rates are increasing, and investment sales volume should exceed 2010. The outlook is positive, and next year, we might be discussing the successes of those who capitalized on spec development opportunities.

Andrew M. Fallon | Associate
CALKAIN COMPANIES, INC.

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