## Monday, November 30, 2015

### More Non-traded REIT Perfidy: The Roll-up Grift

By Craig McCann and Regina Meng

We have extensively researched non-traded REITs and concluded that these illiquid direct participation programs have cost investors $50 billion compared to more liquid investments in traded REITs. Our Fiduciary Duties and Non-traded REITs (available here) provides a good overview of the problems with non-traded REITs and a summary of our empirical results. An Empirical Analysis of Non-Traded REITs (available here) contains a more detailed explanation of our research. Our previous blog posts on individual non-traded REITs are available here. This$50 billion cost we identify is a transfer of retail investors’ hard earned and saved assets – including IRA assets – to the Sponsors and third-tier brokers who sell non-traded REITs. Half the $50 billion wealth transfer results from high offering costs charged to investors which are used to pay the high commissions that motivate brokers to recommend such patently bad investments. The rest of the shortfall we attribute to extraordinarily high non-traded REIT ongoing expenses resulting from conflicts of interest in their affiliated party transactions. In recent years there, have been a number of “roll-up” transactions involving non-traded REITs. In a roll-up, a non-traded REIT is acquired by, or merged into, another REIT referred to as the “roll-up entity” in exchange for shares in the surviving firm. Given everything else we have learned about non-traded REIT Sponsors, we shouldn’t have been surprised to learn that they have figured out how to take money from non-traded REIT investors during Roll-up transactions and other “liquidity events”. Roll-ups Non-traded REITs are required by state securities regulators to include language that closely tracks the 2007 North American Securities Administrators Association’s Statement of Policy Regarding Real Estate Investment Trusts (available here) in their bylaws. NASAA guidelines protect shareholders in REITs which have not been trading for at least 12 months before being rolled-up. Non-traded REIT shareholders need protection because, unlike traded REIT shareholders, they can’t observe thickly traded market transaction prices when assessing the value of their shares. Also, non-traded REIT shareholders can’t rely on the market for corporate control to bid up the merger consideration if risk arbitrageurs determine the value offered is too low. This need is especially pronounced when, as is often the case in suspect acquisitions skirting the roll-up protections, the acquiring traded REIT is affiliated with the acquired non-traded REIT through the Sponsor. The protections afforded by the NASAA guidelines include the requirement or a contemporaneous independent appraisal of the non-traded REIT and the option for the non-traded REIT investors who vote against a proposed roll-up to receive their pro rata share of the appraised value. We have preliminarily analyzed 12 transactions: 2 occurred in 2006, 1 in 2012, 3 in 2013, 3 in 2014 and 3 occurred in 2015. The two transactions in 2006 maintain language which closely tracks the NASAA guidelines at the time of the merger. The 10 or more recent roll-ups exhibit a disturbing pattern. While the REITs are selling shares and raising proceeds their bylaws include the protections discussed above. Then shortly before a merger is announced, the non-traded REITs amend their bylaws, changing the definition of a roll-up and removing the investor protections the Sponsors had agreed to provide investors. Griffin-American Healthcare REIT II Consider NorthStar Realty’s acquisition of Griffin-American Healthcare REIT II. The cash and stock merger was announced August 5, 2014 with a Form 8-K (available here) and merger agreement (available here). Griffin-American Healthcare REIT II’s bylaws when money was being raised and securities sold from 2009 to 2014 are available here. The Roll-up definition at page 10 tracks the NASAA guideline language and clearly encompasses the August 5, 2014 acquisition by NorthStar. Griffin-American Healthcare REIT II “corrected” its definition of roll-up on May 1, 2014 to remove the shareholder protections. The filing is available here. The only change in the 2009 bylaws made in 2014 was to replace the language exempting some transactions from the roll-up protections: (a) a transaction involving securities of the Corporation that have been Listed for at least twelve months; was replaced with (a) a transaction involving securities of the Roll-Up Entity that have been listed on a national securities exchange for at least twelve months (emphasis added) Griffin-American Healthcare REIT II defined the Corporation in the original bylaws to be the non-traded REIT and revised the passage replacing the non-traded REIT with the Roll-up Entity effectively defined to be the acquiring firm, NorthStar Realty. Changing the meaning of one word allowed Griffin-American Healthcare REIT II to void the shareholder protections it promised investors - as required by state regulators as a condition to be allowed to sell securities - precisely when investors needed the protection. As a result of Griffin-American Healthcare REIT II’s bylaw changes, there was not an independent expert appraisal and the REIT’s dissenting shareholders were not given the option to take their pro rata share of an appraised value in cash. Why would the Sponsor who controlled the REIT eviscerate the shareholder protections precisely when they would protect shareholders? Maybe it was the$43 million Merger Termination Amount paid to the Sponsor-controlled Advisor to the REIT.

We see similar perfidy in other merger / roll-up transactions.

Carter Validus Mission Critical REIT, Inc.

At page 172 of Carter Validus Mission Critical REIT’s registration statement available here, you can find this language:

A “roll-up entity” is a partnership, REIT, corporation, trust or other similar entity created or surviving a roll-up transaction. A roll-up transaction does not include: (1) a transaction involving our securities that have been listed on a national securities exchange for at least twelve months; or (2) …

Notice there can be no ambiguity over the meaning of the phrase I underlined. The deceptive “correction” to “the Company” in the example above is transparent but this situation couldn’t be clearer.

Recently the Carter Validus REIT sent out a proxy statement (available here) that included a vote to delete the NASAA guidelines’ language.

The substance of the vote is at page 26

The claimed reason for the proposal is at page 24.

This is obviously disingenuous. When Carter Validus’ Sponsor registered securities for sale to the public, state regulators required and Carter Validus consented to provide minority shareholders certain rights if a transaction later occurred while the REIT was still non-traded. The requirement imposed was not that these protections only apply during the capital raise period. In fact, liquidity events include roll-ups typically occur only after the capital raise.

Yet, Carter Validus and other non-traded REITs in 2015 are saying we no longer need to have the protections since we are not raising any more equity proceeds. These REITs are really saying that they don’t intend to register any more securities for sale, and so its shareholders and NASAA can go to Hades.

Moreover, the shareholder vote mechanism isn’t redeeming. The NASAA guidelines are to protect the minority from a deal the majority approves of. A two-step vote – first one to remove the guidelines’ protections and then a second vote to approve a merger that should invoke the roll-up protections – can’t be allowed to void the protections that a majority vote on the same transaction alone would invoke.

Sophisticated people might call this conduct a clear breach of fiduciary duties but simple folks would surely call this stealing.