If the above sounds like an ocean full of hot water, it is, and five executives at American Realty Capital are swimming in it. Their life preserver appears to be an IPO for "American Realty Capital Properties", which may allow them to escape this little disaster, assuming the IPO is successful. The prospectus claims that this money pit will allow investors to capitalize on a "significant market opportunity", but in truth, this overpriced IPO looks to be nothing more than an attempt to slip from the grips of their personal guarantees and turn their upside down equity into cash, courtesy of a highly questionable appraisal. But don't worry, all of this is fully disclosed in the prospectus, and that's what makes it OK to dump this underwater dirt on a bunch of unsophisticated retail investors and their advisors.
The American Realty Capital Properties IPO is a best efforts offering which expires on September 6th, just 61 days from the effective date. This is obviously a very short fuse, and it indicates some level of desperation to get the deal done. Should the IPO fail, $82.6 million in debt will go into maturity default, allowing lenders to foreclose on the portfolio. If this happens, the upside down equity in the deal -- currently owned by the five execs at American Realty Capital -- will permanently go "poof!".
Perhaps this is why the appraisal was not a self-contained, market-based appraisal, and also why American Realty Capital dictated certain critical assumptions in order to arrive at the $131 million valuation. Indeed, the prospectus truthfully and obediently declares that the properties were "not subject to an appraisal of their fair market values" and that "the price to be paid by us for the acquisition of the assets in the formation transactions may exceed the fair market value of those assets."
Not only did the appraisers completely ignore fair market value (let's just skip that little detail, shall we?), they also assumed a 6.25% capitalization rate, which is the rate American Realty Capital told them to use, even though 6.25% appears to bear little relation to reality. Capitalization rates are critical valuation tools, and they are always derived independently by an appraiser using a market-based approach, not some dictat by the seller.
Based on that assumption and several others, ARCP claims the portfolio is worth $131 million. However, the independent third party experts that I checked suggest the market capitalization rate for these properties is much higher, which would make the ARCP portfolio value much lower. In fact, CBRE's retail valuation group reports that average national retail capitalization rates as of Q1 2011 was 7.97%:
Still, I could not be so sloppy as to smear ARC's incipient public company portfolio with the average national retail cap rate. This would be just as disingenuous as their imaginary 6.25%, since it would assume that ARCP's bank branches in Ohio and Michigan are no more desirable than some video store deal down the street, or the donut shop next door (or the $30 million Home Depot that was also thrown into the ARCP deal). So I checked on this too, and once again, John Calkain, the specialist, reports that triple net lease deals for bank properties are currently trading as much as 125 basis points below the national average, or at about 6.50%.
I then became curious about cap rates within the triple net lease retail bank branch niche, and it turns out that NNN deals for JP Morgan Chase, which Calkain calls "one of the higher rated retail tenants commonly seen in the net lease world", [url=http://www.netleaseadvisor.com/chasebank/]currently trade at about 6.40%[/url]. This is no surprise; JP Morgan Chase did not just survive the credit crisis, it thrived. It is now the largest financial institution in the United States with over $2 trillion in assets and over 5,000 retail branches from coast to coast. JP Morgan is rated A+ and Aa1 by Standard &Poor's and Moody's.
In contrast, ARCP's bank branches are leased to the American subsidiary of accident-prone RBS, which recently reported the largest loss in UK corporate history ($34.2 billion, and that's Billion with a "B"). RBS was subsequently taken over by the British government, and unlike AIG, there is no exit in sight. RBS is clearly no JP Morgan. With respect to the specific properties in the ARCP portfolio, they are located in Delaware, Connecticut, Illinois, Michigan, New Hampshire, New York, Ohio, Pennsylvania and Vermont, and RBS/Citizens reports that "further uncertainties cloud the near future because economic conditions remain difficult in our core regions in New England, the Mid-Atlantic and Midwest."
In complete candor, I can't say what the exact cap rate is without access to even more market data, but I can say it ain't 6.25%, and it's probably not even 6.50%. In all likelihood, the cap rate for these properties is much closer to 7% than it is to 6.25%. But one thing is certain: if American Realty Capital was truly interested in getting a real appraisal, not some piece of completely unreliable flim-flam, investors would not be stuck playing this insulting guessing game.
In addition to this obvious "red flag" on valuation,
The amount of this existing, non-refinanceable mortgage indebtedness is $82.6 million, and it matures in less than 45 days. The plan is to refinance this debt with $55 million in new debt, and $27.6 million in new equity raised in the IPO -- but that's happening only IF this hail mary IPO is successful. This indicates that the current owners of the portfolio, Nicholas Schorsch, William Kahane, Peter Budko, Brian Block, and Edward Weil, can't refinance the existing debt because they either don't have the $27.6 million in new equity that's required, which would be completely understandable, or they are unwilling to invest any further in the portfolio. Whatever the case, the fact that they're all pulling the rip cord on this deal is not exactly a confidence builder.
Yet another "red flag" is an additional $19.4 million in mezzanine debt, which was apparently not intended to remain outstanding beyond the initial maturity date on July 11th. This debt carries a blended coupon of 9.94%, more than 350 basis points above the senior debt. The mezzanine lenders have full recourse to an ARC subsidiary in the event of a default, and the loan carries a joint and several personal guarantee granted by two of the five ARC executives. Furthermore, the terms also provide for two one-year extension options that, if exercised, will cause the coupon to jump even higher -- to 10.125% in the first year and 10.625% in the second year. In that event, the debt also becomes subject to a lockout, meaning it cannot be prepaid. Terms like these are very generally referred to as "sunset" clauses, and the associated loans as "exploding debt", and their purpose is to make certain that the debt is repaid on time. However, this debt has already matured, which indicates that this debt is underwater too, and in the absence of new cash or some other miracle, those guarantees will soon be called.
In a nutshell, it appears that Messrs. Schorsch, Kahane, Budko, Block, and Weil are using this IPO to recapitalize a personal portfolio investment that is completely pear shaped, and probably not worth anything close to $131 million. On top of the bogus appraisal, the concentration of credit risk to a barely profitable European bank that remains in government conservatorship, and a narrow geographic concentration of assets, the cash flow from the portfolio has declined due to an August 2010 lease restructuring with the bank ("please help us, we can't pay the rent anymore!"). As a result, the vast majority of the portfolio's AFFO now comes from non-cash depreciation and amortization. Even so, the 7% dividend represents a payout ratio of between 95% and 130% on pro forma AFFO, depending on whether the IPO raises the minimum or the maximum.
This is slim coverage, and if the deal closes, ARCP's new lender plans to lock down ARCP management with a restrictive covenant that limits dividend payments to (i) 95.0% of AFFO or (ii) the amount required to maintain REIT status (this means a distribution equal to 90% of taxable income). Apparently, they are already keen to the usual non-traded REIT dividend trickery, and given the pro-forma payout ratios and this covenant, my guess is that the 7% dividend gets cut very soon after closing - assuming this grimy IPO even makes it out of the gate.
Interestingly, the offering is being co-lead by Ladenburg Thalman, which is said to be a front-runner to buy Securities America. Securities America is about to be cast off by Ameriprise, after it spent two years and hundreds of millions fighting fraud claims related to the sale of Medical Capital Holdings and Provident Royalties. So, it looks like birds of a feather do indeed flock together, except the American Realty Capital prospectus assures us that everything in this stinky little deal actually smells just fine ("to date, our track record has been excellent.") That may hold true true today, but in 45 days, if this IPO is successful, ARCP investors will be stuck holding their left over bags of manure.