10-K Season - Inland

10-Ks have all been filed and the scrutiny just begun.  I have run a basic financial statement analysis on the most recent Inland offerings - Inland Western Retail, Inland American, and Inland Diversified - and present a summary below.

In  Millions	Inland Western Retail	Inland American	Inland Diversified
Total Assets	$6,387	$11,392	$450
Total Liabilities	$4,090	$5,864	$224
Equity Raised	$4,595	$8,325	$260
Net Real Estate	$5,686	$9,563	$313
Direct Debt	$3,603	$5,532	$193
Leverage Ratio	63.3%	57.8%	61.5%
Revenue	$647	$1,232	$19
Net Income	($85)	($176)	($2)
FFO	$135	$253	$3.9
Mod Cash Flow[1]	$153	$442	$5.8
Dividends	$95	$418	$8.4
Yield ($10 share)	2.0%	5.0%	6.0%

Inland Diversified opened its offering in August 2009 and is raising funds at a reasonable pace.  At December 31, 2010, the REIT had $450 million of assets including $313 million of real estate owned directly.  The company generated $19 million total revenue and a $2 million net loss.  The shareholder 6% dividend is 46% covered by Funds from Operations and 69% by Modified Cash Flow.  While subsidizing dividends is common during the capital raising phase, especially this early, continuing the practice of distributing funds in excess of those generated will result in the dilution of shareholder equity.

Inland American closed its offering in April 2009.  At December 31, 2010, the REIT had $11.4 billion of assets including $9.6 billion of real estate owned directly.  Inland American realized $1.2 billion total revenue and a $176 million net loss.  The shareholder 5% dividend is 60% covered by Funds from Operations and 106% by Modified Cash Flow.  The company reported approximately $168 million of asset impairments during 2010, partially offset by about $22 million of realized gains.  The REIT appears to be managing its cash flow prudently, having already reduced its dividend to 5%.  However, it has recorded significant impairments and losses over the past three years.  Therefore, it would not be a surprise if share values are significantly lower than the original $10 share price, or even the current $8.03 DRIP price.

Inland Western Retail completed an internalization of its management in November 2007 and therefore has no formal affiliation with The Inland Group.  At December 31, 2010, the REIT had $6.4 billion of assets including $5.7 billion of real estate owned directly.  Inland Western realized $647 million total revenue and a $85 million net loss.  The shareholder 1.96% dividend is 142% covered by Funds from Operations and 162% by Modified Cash Flow. The REIT's operations have been severely adversely affected over the past three years by economic and market conditions.  Over this period, Inland Western has recorded impairments and realized net losses on the order of $659 million, partially offset by realized gains of $50 million from the sale of properties associated with discontinued operations.  The company also worked through significant debt refinancings over 2009 and 2010, and continues to negotiate with lenders on the remainder of the debt portfolio.  Close maturities include a $154 million line of credit due in 2011, $646 million of fixed rate and $26 million of variable rate debt in 2011, $411 million fixed and $88 million variable due in 2012,  and $320 million of fixed rate mortgages due in 2013.  While the REIT's management has worked diligently to preserve the value of the company's assets, it would not be unreasonable to estimate share value approximately equal to book value of $4.81 per share.

Inland Western has filed a Form S-11 with the SEC indicating its intention to list the shares on a stock exchange.

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[1] Modified Cash Flow is an Clarity Finance measure which equals (1) net income plus (2) depreciation and amortization, plus (3) acquisition fees and expenses, less (plus) (4) any realized or provisions for capital gains (losses) on the income statement, less (plus) (5) income (losses) from unconsolidated entities, plus (6) distributions from unconsolidated entities.

Supercharged ETFs

As I was catching up on my Forbes reading, I came across this article about leveraged ETFs.  Now I have shied away from any of the leveraged funds because their performance has confounded naive expectations.  For example, when a particular index would be up 20% one year, one would expect the 2x fund based on that index to be up 40%.  Experience showed us, though, that the fund might be up any where from 0% to 50%.  when the index registered a single digit gain, the fund may actually have lost money.  The key to the disconnect is in the mechanics of managing that leveraged exposure.  The fund rebalances to its leverage target every day.  That is the leverage on the initial NAV changes each day based on the cumulative gains realized since the inception of the investment.  Thus if the index experiences a 50% increase, the fund will take on 50% additional leverage, but the performance will still be calculated on the original investment.

Inn strongly trending markets this can actually work in the investor's favor, delivering performance that is greater than the advertised leverage.  In a directionless market with some volatility, the leveraged fund will tend to decline.  This result can be traced back to the mathematics of loss and gain that we all learned early on:  if an investment loses 50% of its value, it will take a 100% gain to break even.

The article acknowledges all of this and essentially says use them anyway.  I would recommend against using any of the leveraged funds, suggesting instead to use a brokerage account and buying your index tracking fund on margin.  The investor can maintain his leverage relative to his original investment, according to his own comfort.  Also, you can probably find a cheaper fund in which to invest.

Hazardous DRIPs

I am constantly amazed at the popularity of distribution reinvestment programs (DRIPs) on illiquid entities such as non-traded REITs.  That as much as half of distributions from a non-traded REIT are reinvested indicates that investors are not carefully considering this decision.

First, I understand the rationale for wanting to reinvest.  Compounding returns are a very powerful investment force for wealth accumulation, and we are taught that interest and dividend must be reinvested to achieve compounding.  Furthermore, the REIT discounts the share price at which the distributions are invested.

However, these benefits do not overcome the major disadvantage of these securities, their illiquidity.  These distributions offer a small amount of liquidity from an investment that is not currently marketable, and whose liquidity timing is distant if not uncertain.  The bird in the hand principle applies here.

What about compounding?  Yes, this aspect of wealth accumulation will be sacrificed.  On the positive side, it will avoid compounding negative returns.  More to the point, the sensitivity of real estate returns to acquisition and disposition endpoints, along with the relatively large minimum investment commitments required, suggest that time diversification could be more valuable than compounding in this asset class.

The discounted price is an even easier issue to address: it is an illusion.  The regular price of a share is typically $10.  That price includes say, 75 cents of commission and 25 cents of marketing assistance that is not spent on the the reinvested distributions.  So the net proceeds to the REIT (comparable to a mutual fund's NAV) are $9.  The dividend reinvestment program will sell shares at $9.50, so those reinvested shares are immediately diluted by 50 cents.  Not a good deal.

I have long recommended that investors decline the reinvestment opportunity and accumulate the cash dividends in their investment account.  If they are concerned about compounding, an option (albeit imperfect) is to invest in one of the REIT mutual funds or ETFs.  Vanguard REIT ETF (VNQ) is a low cost option for tracking the MSCI REIT Index.

Home Sweet Home

Smart Money examined the question of the value of home ownership as an investment.  The article challenges the conventional wisdom that home ownership is always and everywhere a good economically and socially.  There is little evidence presented, and I would daresay that there is little agreement among social scientists, about the societal value of a populace of home owners versus renters.  On the other hand, the article does not shy from drawing the conclusion that home ownership is weak mas an investment. The story arrives at this judgement based on flat home prices between 2000 and 2010.  In fact,  the return on home ownership is more complex than just whether or not the property has appreciated.

Home ownership has three elements to its return.  First is the appreciation of the asset.  While prices were flat over the first decade of the current century, the article notes that "the rate of appreciation in housing seems likely to return to its long-term historical average, which is only slightly higher than the rate of inflation."  While this growth of capital pales in comparison to the long term return to common stock, for instance, it is competitive with returns to Treasury securities.

The next element having an impact on returns are the costs of ownership.  These include taxes and insurance, as well as the regular maintenance and repairs to the property.  These expenses can easily approach or exceed the expected appreciation on the property.

The final element of return is rent.  Like food and clothing, housing is a human necessity.  By owning one's own housing, the homeowner avoids paying rent.  The rent avoided by owning the property varied by property size, type and location, but is often in the 8% - 10% range.  And rent is highly sensitive to inflation.

Now notice that there is no consideration given to mortgage interest and its tax deduction.  This is because borrowing money to purchase the home is a financing decision.  It will have no effect on the return to the asset.  It does have the effect of increasing the risk of owning the home, and thus amplifying the return, either positive or negative.

At the end of the day, the primary purpose of home ownership is avoiding the recurrent cost (rent) of housing.  From an economic standpoint, ownership tends to be a wash as an investment.  However, ownership provides non-economic benefits that renting does not: control over the timing, extent and details of repairs and improvements, sole access to the premises, a sense of accomplishment that accompanies ownership.  In short, I have resisted analyzing the purchase of a home as an investment favoring instead an analysis concentrating on the buy versus rent decision in the context of the individual's budget.

Municipal Bonds Revisited

Bloomberg has a story a bout how "dumb" money is fleeing municipal bond mutual funds.  Later in the article, though, do it yourself investors are credited with aggressively buying individual bonds.  Advisors and brokers are also buying on behalf of their clients, but at about half the rate as DIY investors, according to BondDesk Group. 

Municipal bonds may be the best value in the fixed income marketplace today.  Muni bonds are trading at 40 to 90 basis points higher yields than treasuries, depending on the maturities.  They usually trade at parity on a taxable equivalent basis.  The pricing is suggesting that munis are expected to default at a rate of 1% per year, a rate six time higher than since July 2009 and 15 times the rate since the 1970s.

Right now, the muni market appears to be offering free money.  There are some opportunities overseas as well, with European gilts trading at 100 basis points over Treasuries, and Australian governments at 200 basis points. These yield advantages assume no turnaround in the value of the dollar, which can not be assured.  Certainly, the bonds on the taxable portion of client portfolios should be in tax exempts.

Simple Portfolio Strategy from Forbes Magazine

William Baldwin provides a simple portfolio strategy in the January 17 issue of Forbes.  It is the prototypical long-term horizon recommendation that the asset allocation calculators all over the web give you.  What's different is that his rationale is simple.  Consider that equities are likely to earn 5% per year after inflation, bonds about 2%.  Put the bonds in a tax deferred account and carefully manage the realized gains in the taxable equity account, and you can avoid paying taxes currently.  A 50-50 portfolio will return 3.5% plus inflation over the long term.  If you invest when P/E ratios are high (> 20) , it will be a little bit less; when P/Es are low, a little bit more.  The S&P 500 is trading at a P/E of 16.3 based on 2010 earnings as of today's close.

Now, this is not a retiree's portfolio.  The markets is too volatile to confidently predict this kind of return over the next ten years.  And portfolio that is producing current income is so sensitive to market movements that one early year of underpeformance can cripple the income potential for the remainder of retirement.  But for people still in their accumulation years,  this can be a valuable framework for portfolio construction.

FINRA is Looking into Wells ... Again

On April 10, Investment News had a note that FINRA had made a preliminary decision to recommend disciplinary action against Wells Investment Securities.  The information was contained in a SEC filing by Wells Timberland REIT.  The REIT reported that:

On August 25, 2010, the Enforcement Department of the Financial Industry Regulatory Authority, Inc. (“FINRA”) notified Wells Investment Securities, Inc. (“WIS”), the dealer manager for the initial public offering of common stock of the Registrant and for the Registrant's current follow-on offering, that FINRA had made a preliminary determination that disciplinary action be brought against WIS for (1) using various sales materials related to the Registrant's public offerings that allegedly failed to comply with the content standards of FINRA's advertising rules, (2) allegedly failing to implement its supervisory system in an effective manner in order to achieve compliance with FINRA's advertising rules, and (3) allegedly failing to maintain written supervisory systems and procedures that were reasonably designed to safeguard customer information. FINRA stayed its August notification and requested additional information from WIS regarding its investigation. On March 1, 2011, the FINRA Enforcement Department notified WIS that FINRA had made a preliminary determination to recommend that disciplinary action be brought against WIS for allegedly failing to inform FINRA that the board of directors of the Registrant approved the deferral of the Registrant's election of REIT status, which was done in connection with its acquisition of the Mahrt Timberland in 2007. FINRA also proposed a censure of WIS and a fine. Before FINRA seeks authorization to issue a formal complaint, WIS has the opportunity to provide a statement to FINRA indicating why no disciplinary action should be brought. WIS intends to make such a submission responsive to the issues raised in both the August 2010 and March 2011 notifications on or before April 11, 2011. WIS intends to vigorously defend these charges.

Wells Core Office REIT made a similar filing.

This is the third time that Wells' sales practices have been questioned by FINRA.  In March 2001, Wells entered a written undertakings that it would not violate compensation regulations in conducting sales and due diligence conferences.  In August 2003, Wells consented to sanctions relating to the improper conduct of sales and due diligence conferences.

Wells is a very aggressive sales organization.  That aggressiveness has brought success in raising capital.  Unfortunately, the returns on that capital have been spotty, as a review of Wells' record in liquidated properties and full cycle programs would attest.