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November 06, 2009

Here's a Big Company Bailout by the Taxpayer That Even the Taxpayer's Missed!
by Reggie Middleton

Riddle me this. An industry gets into trouble due to chasing fads, loading up on debt and overpaying for property. Many participants in said industry flirt with insolvency due to difficulty meeting debt service and asset values that have dropped below liabilities. This industry has been gifted with a special tax provision that allows them to pay no corporate taxes as long as they pay out 90% of their income to their shareholders. By now I am sure you have guessed the industry, but let's move on.

After special meetings with the IRS, who were told that the world would end if these entities were forced to dump distressed real estate onto an already distressed market (in reality, commercial real estate prices will simply return to fundamentally supportable prices), these companies were given a special reprieve on top of their already gifted special reprieve that allows them to pay said dividends in stock rather than cash.

The need to conserve cash, as explained above, stems directly and primarily from imprudently participating in bubble binging, and from a tertiary perspective, the dwindling refinancing market - of which would not be such a big deal if companies didn't overpay for, and overleverage properties in the first place. The solution? Team up with the Wall Street banks that gave you the imprudent loans that most should have known couldn't be paid back in an effort to shift the losses to the retail investor. This is a win -win situation for the banks that made the loans as well as for the REITs that took the loans. Here is the playbook (for illustrative purposes only, of course):

Step #1: Pump the stock - Reference the upgrades, and notice they happen to occur right before a secondary offering - From ZeroHedge: Merrill Lynch In Full REIT Upgrade Mode - The Sequel. Notice that the upgrades are made despite the fact that the CRE market is in total shambles with no near to medium term improvement in sight.

Step #2: Dump the stock: Again from ZeroHedge: Bank Of America Merrill Lynch Gets Paid To Pay Itself Back In Developers Diversified.

Today, Developers Diversified Realty announced it was issuing $300 million in senior notes, with lead underwriter "BofA Merrill Lynch"...

... The final deal terms were $300 million of 9.625% notes due March 2016, priced at 99.42% to yield 9.75%. The syndicate, primarily BofA ML will pocket $5 million in underwriting fees (oddly, less than the customary 3% for a HY offering - are companies starting to demand more bang for their buck?).

And the ever crucial Use of Proceeds? Why paying back Bank of America's 2010 maturing credit facility, as if there was ever any surprise. More specifically:

We intend to use the net proceeds of this offering to repay debt, including, without limitation, one or more of:

• Borrowings under our $1.25 billion unsecured revolving credit facility maturing June 29, 2010 (with a one-year extension at our option subject to the satisfaction or waiver of customary closing conditions); as of June 30, 2009, total borrowings under our $1.25 billion unsecured revolving credit facility aggregated $1,169.5 million with a weighted average interest rate of 1.5%;

• Borrowings under our $75 million unsecured revolving credit facility maturing June 29, 2010 (with a one-year extension at our option subject to the satisfaction or waiver of customary closing conditions); as of June 30, 2009, there were no amounts outstanding under our $75 million unsecured revolving credit facility;

• A portion of our 4.625% Senior Notes due August 1, 2010; as of June 30, 2009, there was approximately $260.8 million aggregate principal amount of our 4.625% Senior Notes due August 1, 2010 outstanding; and

• A portion of our 5.000% Senior Notes due May 3, 2010; as of June 30, 2009, there was approximately $193.6 million aggregate principal amount of our 5.000% Senior Notes due May 3, 2010 outstanding.

Not a bad deal: the company refinances BofA's 2010 bank facility, which has a 1.5% interest rate with a 2016 term piece of paper, paying 9.625%. Any way you look at it, it goes to show the "solid fundamentals" behind the sector, where the cost of extending a maturity is 6 times the current interest rate!

This excerpt was taken from the ZeroHedge posted linked above. What I think they missed was that the yield on the secondary was much less relevant than it appeared, since DDR was probably going to pay it in stock (that's right, that funny stock split cum dividend thing).

Step #3: Shift the tax liabilities upon those who you dumped the stock on... The last step in this new REIT game, after dumping the unpayable debt converted into follow-on offering stock is to push the fake dividends and shift the tax liabilities of said fake dividends from the entity that generated the liability on to the investor. Normally, if the cash is not paid out, the REIT would have to pay the taxes on it. Now the REIT can keep the cash, dilute the stock by offering the pump and dump secondary, then pass the tax liability off to the guys that were suckered into buying the stuff, most likely by sell side brokers and analysts - as was exemplified by the BofA Merrill Lynch excerpts above.If you feel as if I (actually, Zerohedge since they broke the story) am being a little hard on the Merrill guys, check out what their ex-REIT analyst head had to say as soon as he left the company - More from Zerohedge: Some Totally Unexpected REIT Lack Of Love From Merrill Lynch -

"From a financing standpoint things are far worse; from a fundamental standpoint things are certainly getting worse."

As a matter of fact, this alleged "bait and switch" behavior was called out by ZeroHedge in an open letter to the SEC: Open Letter To The SEC Regarding Wall Street's REIT Bait-And-Switch:

Zero Hedge is well aware that our regulatory friends at the SEC and FINRA enjoy going through our articles in search of the "next big scam." We are always happy to make their lives a little easier and not only connect the dots but give them everything they need on a silver platter so that even a green securities lawyer, 4 hours fresh out of law school, would be able to comprehend and litigate.

A few weeks ago I caught on a troubling trend whereby Merrill Lynch/Bank of America embarked on an epic quest to underwrite equity follow on offerings for a vast majority of the lowest quality REITs including Kimco, ProLogis, Duke Realty and others. I say lowest quality, because Merrill's own analysts had a Sell rating on these names as recently as March 31 (for Kimco) and January 6 (for ProLogis). How the global economy has really changed for the better of REITs since then is still a mystery to me. But I digress.

The following is the dividend payment history as gaken from DDR's website, to help drive the point home on the dividend thing:

Historical Dividends Issued

I guess they consulted some of their financial engineers, and decided a couple of pennies (literally) would do for now, though:

CLEVELAND, OH, Sep 10 (MARKET WIRE) --

Developers Diversified Realty (NYSE: DDR) today declared its third quarter 2009 common stock dividend of $0.02 per share. The common dividend is payable October 15, 2009 to shareholders of record at the close of business on September 23, 2009.

The Company has elected to maintain a cash dividend comparable to prior quarters but has elected to not pay the stock portion as the Company's most recent estimates indicate that the payment of the stock portion is not required to maintain REIT status. The Company will continue to review its dividend policy on a quarterly basis and make payments sufficient to maintain REIT status, receive favorable tax treatment and provide yield to shareholders while prudently assessing its current liquidity and the state of the capital markets.

This does tend to make one wonder what the hell income investors are thinking in buying a virtually income-less investment that has such potential for capital loss! To attempt to drive this point home, let's take an individual investor in the 34% tax bracket that has 10k shaes of Brand X REIT at $20 per share, and receives $1 dividend, 90% of which was paid in stock. This equates to $9,000 stock (re)distribution and $1,000 in cash. He will end up paying (.34 * $9,000) $3,332 in taxes on what amounts to a stock split, and will only have (.34 * $1,000) $660 in cash to cover it from the balance of the dividend distribution. In this scenario, the retail investor will be out of $2,672 in after tax cash for every $10,000 of 90% stock dividend distribution. Will he ever see that income again? Doubtful! Hey, what if Reggie Middleton is right (see "Boo!!! Will Halloween Scare the Market into Respecting the Fundamentals?" and "Re: Commerical Real Estate and REITs - It's About That Time, again...") and the CRE market tanks even more in the future? Well, Mr. Investor will have some capital losses with which he can try to convince his accountant to try to use in some creative and imaginative fashion to offset that phantom income (albeit attached to some quite corporeal taxes) that he never saw, touched, nor even had a chance to spend!

It appears as if we have been catching REITs in all types of mischevious things as of late. Remember GGP? In "If only more rich heiresses read my blog" I made note of the big lawsuit filed by the heiress to the ex-GGP's ex-fortune suing her law firm for misconduct. If she read BoomBustBlog she, her lawyers and the SEC would have seen that we practically laid out a roadmap of misconduct for all interested parties, complete with pretty charts and everything (excerpted from "blog readers chimed in with their expertise and opinions"):

I read your post on the redemption and share purchase with great interest. I reviewed the 13D filing and there seems to be an exhibit missing. The section summarizing the 500M loan facility, references the complete loan agreement as an exhibit. It is no where to be found. Where is it?

The prohibition of personal loans under section 402 of Sarbanes-Oxley amended section 13 of the 1934 SEC act, broadly prohibits public companies from making or arranging many types of personal loans, directly or indirectly, to their directors and executive officers.

As you aptly note, there are a boatload of questions. Not the least of which is the question concerning the terms of the Citi loan. I think what you're alluding to as the real purpose of these transactions follows: GGP issues shares 22.8 m shares at $36 dollars a share (821M). MBCP III takes 10% of the issue for $88M. MBCP III purchases division "B" interest from the Matthew Bucksbaum Trust and General Growth Corporation, paying for the "interest with GGP LP units the to Bucksbaum Trust.

Next up will be a list of REITs that didn't make my final shortlist, then next week I will debut the first of my 4th quarter 2009 REIT short candidates for subscribers.

Reggie Middleton
Reggie Middleton, LLC
Perpetual Interests, LLCTM
http://boombustblog.com/

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