By Dan Hallett on December 6, 2012
The Globe and Mail shed a bit of light on the small universe of private real estate investment trusts (REITs) in Canada. The article touches on both the benefits and perils of this emerging product segment. I recently reviewed a Canadian private REIT, the highlights of which underline the critical importance of proper due diligence.
Brains, the body and conflicts of interest
I won’t name the REIT I reviewed because I haven’t completed full due diligence – just a preliminary review. But perhaps the most concerning was the REIT’s overall structure.
In the early days of income trusts – the late 1990s – portfolio manager Rick Howson used to talk about whether a trust’s ‘brains’ were inside or outside of the ‘body’. (He managed Saxon High Income, now known as Saxon Dividend Income, one of Canada’s first income trust mutual funds.) Howson preferred trusts where the management ‘brains’ resided inside of the trust ‘body’ – in large part for governance reasons.
It’s no wonder he preferred this structure. A group of companies provide services to the REIT that I reviewed ranging from property due diligence to day-to-day property management and sales (i.e. attracting investors into the fund). There are two problems with this structure.
First, each of the companies are completely outside of the REIT structure. Second, each is owned by the REIT’s co-founding general partners. While I didn’t not delve into this issue further, this structure has potential conflicts all over it.
I could not find a single word even mentioning that a conflict exists, let alone how the REIT deals with this conflict. On this note, I estimated that 11% of the REIT’s projected gross revenues will be paid to these external companies.
Perhaps all is fine with this REIT but at the very least, investors should have questioned the organization about these important issues.
Nowhere in the REIT’s offering document could I find any policies pertaining to how the REIT values its units on an ongoing basis. While investors can’t buy and sell the REIT all the time, there are periods when it is raising new capital and provisions under which investors can sell (with a big haircut). Accordingly, I would expect to see something – at least a few sentences – telling prospective investors how the REIT units are valued to make sure that pricing is as fair as possible for both buyers and sellers.
And this ties into my other major concern.
This REIT’s performance is nothing short of spectacular. Assessing a private REIT’s performance need not be complex. A good starting point is applying the bear market test. Any REIT that has been around long enough should have seen at least a little speed bump through 2008 and perhaps 2009 – putting a dent into performance during that period.
The REIT that was the subject of my review not only had no such speed bump – but it increased its distribution and wrote up its unit value in 2008. This may be fully justifiable but at the very least, this requires a heavy dose of scrutiny.
Recall that through the worst of the bear market – the darkest days lasted nearly six months – any asset that lacked liquidity saw its value sliced. The ultimate value of any asset depends on the proceeds that the seller can reasonably expect in an orderly sale. Even in an orderly sale, it seems reasonable that the price one could get for an asset – even income producing real estate – would have fallen at least modestly during the financial crisis’ most frightening weeks and months.
Yet this REIT saw fit to write up the value. Some might suggest that if rental income had risen a valuation bump was justified. Perhaps, but I was unable to obtain audited financials to confirm this. Recall that a REIT need not see increased revenue to hike its payout to investors. The REIT could have drawn down its cash balance or tap a line of credit.
Proper due diligence is a must
Whether you’re an investor looking to invest in a private REIT on your own or an advisor seeking alternatives to traditional stocks and bonds, the value of proper due diligence cannot be overstated. On the surface, the REIT that I reviewed looks really attractive. But as I dug into the details, many red flags emerged – of which I’ve shared only a few in this post.
There are some good quality and attractive private REITs. But take the time to do a proper and thorough due diligence review prior to handing over your (or your clients’) hard earned savings.
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