AREI- TIC sponsor, brokers charged and arrested

California Attorney General Jerry Brown announced that three individuals have been arrested and charged with orchestrating a massive Ponzi scheme called AREI that swindled $200 million from thousands of investors.   Many of the projects were structured as tenant in common (TIC) investments.  James Koenig, one of those arrested and charged, was the principal operator of AREI.  In 1986, Koenig had been convicted of two counts of mail fraud in federal court.  He was sentenced to two years, six months in prison and ordered to make complete restitution in an amount not to exceed $5,000,000.  That fact was not disclosed to investors, although Koenig has stated that everybody “knew” about it. The other two individuals charged were Gary Armitage and Jeff Guidi, registered principals of ePlanning Securities, Inc., the broker dealer that raised most of the funds.  Armitage and Guidi are also shareholders and directors of the parent company of ePlanning.  Koenig, was a shareholder of the parent company of ePlanning, as well.   The complaint also alleges that several of AREI’s earlier projects were failures, failures that were not properly disclosed to later investors.  Koenig has stated that it was the Board of Directors of ePlanning,  ePlanning attorneys, and AREI’s attorneys that made the decisions regarding what should be disclosed in the offering memorandums.  The indictment that has been filed carries multiple counts which could keep these individuals, if convicted, in prison for the rest of their lives.

Western America- Desert Inn Office Center

These are four, small (116,000 Sq. Ft. total) office buildings on two contiguous parcels along Desert Inn Blvd. in Las Vegas.   It was purchased by Western America in January 2006 for $22,200,000, with an appraised value of $22,500,000. Western America immediately offered and sold this property to TIC investors for $24,720,000. The PPM contains an ARGUS spreadsheet projection for the building covering 10 years of operations into the future.  The projection is for increasing cash flow, year after year.    There are no added disclosures “to inform investors about the inherent uncertainty of financial modeling” that Western America would later add to its PPMS.   But this is largely beside the point.  It’s not the software.  If you want to get reality out of the software program, you need to put reality into the program.  This projection results in increasing cash flow, because that is the result that you get, based upon the assumptions that you make.   No PPM puts out projections that say: hey, this building is likely to lose money, especially beginning in the 4^th year.    Let’s say that you were a due diligence officer from one of the brokerage firms considering offering this project to investors, and that you are standing on the street in front of this building in January 2006.  What do you know and what do you want to know?  The PPM says that Nevada had been the fastest growing state in the US for 18 years in a row up to that point.  The projections say: more growth for another 10 years.   Ask yourself, is it likely?  18 years of growth, and the projection is for 10 years more of the same.  Can it happen? Has it ever happened?  What happens if the projection is wrong?   How important is this?  The PPM says that the vacancy rate for office space in Las Vegas was over 10% at that time, and that when completed,  the offices then under construction would add more than 10% to the total office space available.  So, was continued growth important, absolutely?    But was it likely to happen?    Probably not.   So why would any broker offer this particular property to investors at this price, at this time?

Western America – Basics

Western America is a real estate company located in Bellevue, WA.  President Jim Clark currently manages over $230 million and 1.3 million square feet of properties in four western states.   Western America is one of the smaller TIC sponsors, but in some regards, not terribly different from the others.  In 2006, Jim Clark authored an article in one of the TIC industry newsletters, questioning the use of ARGUS, the standard software used for creating those “projections” that the TIC industry puts in its PPMS.    Saying that financial forecasts made with ARGUS software were  ” limited, because reality is more detailed and variable than the design of the software ” , Clark noted that Western America had recently added disclosures to its PPMs “to inform investors about the inherent uncertainty of financial modeling.”    Clark makes cogent arguments about the inadequacy of software programs which rely upon “averages”  to make their projections and those which apply only linear analysis “even though real life is non-linear.”   He even suggests reasons why ARGUS may be acceptable for institutional investors but not TIC investors.  All in all, it is a thoughtful, reasoned article.   I wonder if he sent a copy to the investors in the dozen or so projects Western America had sold to TIC investors prior to the time he wrote this article.  Did he tell them that the projections Western America had provided, and which their broker made such a big deal about, may not have any utility in the real world.    See:  Western America- Desert Inn Office Center.

Evergreen-University Heights-San Marcos

This is a 288 unit apartment complex in San Marcos, TX.   It is located adjacent to the campus of Texas State University and used solely for student housing.  Like many student housing projects, it rents to students “by the bed”, meaning that several students are sharing each apartment.  The project competes for students with the University which provides traditional dormitory housing and with other apartment complexes in the neighborhood.   Putting aside the fact that investors were paying significantly more than the appraised value, and that the offering was loaded with fees to the sponsor, it should be obvious that to evaluate whether or not this project will succeed you need to have a good idea of two things 1) the number of students seeking beds and 2) the number of available beds.   Two things happened.  First, the University had a policy requiring freshman and most sophomores to live in dormitories.  This meant that the number of students actually renting off campus was only a portion of the student body.  It also meant that even if University enrollment increased, it would take time before those new students were potential renters for the property.   Second, more new apartments, close to campus, were already in the planning and construction phase when this was offered to investors.   Too many new beds were already scheduled to come into the market for the projections in the PPM to have a reasonable chance of coming true.   But brokers sold this project to 30-35 investors as if the income projected for them in the PPM was likely to happen.   This project was sold in June 2005.  During that school year occupancy was at 98%. One year later, occupancy was at 74% and cash flow was in trouble. The reason:  3 new competing housing projects had been completed, and there were a lot more beds available.  And these new beds will be available for years into the future.   So ask yourself:  the new beds that came into the market in that first year weren’t they planned or under construction when this project was offered to investors?   Of course they were.     

TSG Capital Fund I

In 2006, TSG, which portrayed itself as a successful real estate sponsor, sought to raise $15 million dollars for this fund.  The money was intended to be used by TSG to finance the acquisition of buildings which they could then resell to TIC investors.  Investors in this fund were offered 3% per month for their money with the intention that each of the loans was short term, as it only took a few months for TSG to resell any building.   It is amazing to me that any broker offered this fund to any investor.  In the first place, the very offering of this fund was a huge red flag concerning TSG’s finances and  operations.  At the time of this offering, TSG claimed to have successfully bought and sold 16 properties to TIC investors.  If you look at those offerings, TSG earned $2 million-$4 million in profit on each.  So if I were a broker considering offering this fund to investors, the first question I would ask is: Why does TSG need $15 million?   Also, 3% per month would tempt many banks and quite a few institutional investors.   Why would TSG go to small investors unless the professional investors had already passed?  Of course 3% per month is a very speculative rate of interest.   Where are the risks?  What are TSG’s finances really like?   The brokers who sold this fund might have asked, but TSG had no audited financial statements to show them.  This is the fund for which the State of Illinois wants to sanction TSG for not disclosing Rob Hannah’s prior investor litigation.  The truth is, there is enough about this fund to have made any broker and most customers stay away.   If your broker recommended this fund to you, I would question whether he/she knew what they were doing.

NNN-Grubb & Ellis

Grubb & Ellis Company is headquartered in Santa Ana, California.  TIC investors know the predecessor company NNN which was founded and operated by Anthony W. Thompson until November 2007.  At mid-year in 2007, NNN had $4.4 billion in tenant-in-common assets under management as a TIC sponsor and an industry-leading roster of 30,000 TIC clients.  On December 7, 2007, NNN Realty Advisors merged with and into a wholly owned subsidiary of Grubb & Ellis Company, or Grubb & Ellis.  The combined company retained the Grubb & Ellis name.    Grub & Ellis is one of the only TIC sponsors that is publically traded.  For the first quarter of 2009, the company reported a net loss of $41.5 million, or $0.65 per share.   The stock has traded for less than a dollar for some time, and a continued real estate slump has raised investor concerns that this company may yet slip into bankruptcy.

Moody National-Basics

Moody National Companies of Houston, TX. was formed in 1966 by Brett Moody.   Currently,  Moody’s real estate business includes $823 million of real estate consisting of 3,706 apartment units, 390,723 square feet of office properties and 14 hospitality properties throughout the United States.    In 2005, Moody National Realty Company sponsored its first private real estate program.  Between January 1, 2005 and December 31, 2008, Moody National Realty Company has, directly or indirectly, sponsored 46 privately offered prior real estate programs which raised approximately $427.91 million from more than 1,274 investors.   42 of these programs were TICs.   Many were structured as master leases.   A substantial portion of this portfolio are hotel properties.   In April 2009, the company reported that all were “operating”.    Nonetheless, beginning in the 4^th quarter of 2008, however, the company began to suspend payments to investors, including payments on its master lease obligations.

U.S. Advisors LLC. – Basics

U. S. Advisors LLC of Napa, CA. and its sister company, U. S. Commercial of Ladera, CA.  LLC were managed by Kevin Fitzgerald, H. Michael Schwartz and Paula Mathews.  This company, an active TIC sponsor sold approximately 75 projects through the end of 2005.  By that time, 24 of the properties had incurred operating deficits at the master lease level not covered by any reserves or income guarantees. Notwithstanding, the company continued to pay investors on underperforming properties without sending any kind of performance reports, keeping investors in the dark about just how bad things were. Thereafter, in February 2006, the firm raised $32 million from new investors to purchase a bottling plant in Phoenix . The plant had one tenant, a bottling company, which went bankrupt within 6 months.  Two years later, investors were able to recoup about 60% of their principal in this project.  Ask yourself, why would any financial professional have advised any of the investors to buy into this building if the sponsor had a history of non-performance and of not providing its investors with timely performance reports?

TSG- Article in Chicago Business

Several  correspondents directed me to an article in Crain’s Chicago Business which details several investor lawsuits against Rob Hannah, and TSG including one  where  investors charge that Mr. Hannah operated an investment vehicle “like a slush fund,” partly “to finance personal obligations and to support Hannah’s lavish lifestyle.”  The investors allege that Mr. Hannah used their money to help pay for a $5.2-million, 10,000-square-foot vacation home near Park City, Utah, according to the lawsuit, filed in September.     

The article notes that currently, investors are trying to oust TSG as manager of about 15 properties around the country, and a receiver has taken over three TSG properties in Michigan. 

It also notes that Mr. Hannah denies that any of these claims have any merit.

Sunwest – SEC action

On March 2, 2009 the US Securities and Exchange Commission filed a complaint against SunWest and Jon Harder alleging that they had committed fraud in the offering of their TIC securities.    This is the first enforcement action by the SEC against a major TIC sponsor.  

The thrust of the SEC complaint is that Sunwest misled investors about its performance, even though Sunwest never missed a rent payment on a master lease with investors from 2001 to around July 2008.

The Sunwest TICs were, for the most part, structured as Master Leases.

The Sunwest PPMs included the following disclosures:

“Recent historical data for the Property shows lower occupancy and higher operating expenses than the Master Tenant has projected . . . If actual operating results are below projected results, operating cash flow may not be sufficient to fund payments under the Master Lease.”

“Each Master Tenant is a newly-formed entity with no substantial assets other than its leasehold interest in the Property under the Master Lease.”

The SEC complaint stated:

“These statements represented to investors that the source of the Master Tenant’s 10 percent rent payment was the cash generated by the facility. While the Master Tenant’s obligation to pay rent might continue regardless of the financial performance of the property, the PPMs represented that the Master Tenant’s ability to make the rent payment was inextricably tied to the financial performance of the individual property.”

“To emphasize this point, the PPMs included financial projections for how Sunwest expected the property to perform once under its management.  The PPMs did not include financial statements for Sunwest or other Sunwest-managed properties.”

From approximately 2001 through approximately July 2008, the Sunwest TICs did not miss a rent payment

So what is the SEC complaining about?   Even though there is a master lease, the disclosure is that each property stands alone, and that if the property isn’t profitable the Master Tenant will not be able to pay its lease.  

The fact was that many Sunwest TICs were losing money, and all investors were getting paid anyway.

From which the SEC concluded: 

“Consequently, the payment to investors of the rent further conveyed to investors the false impression that Sunwest was managing their property profitably and successfully.”

Sunwest did not keep the funds from its various properties separate.  The SEC alleges that funds were co-mingled.   As a consequence, funds from facilities that generated positive cash flow, and at times, funds from certain new investments, were used to pay the returns to investors of other retirement facilities. Because the homes varied in profitability, on an enterprise-wide basis, successful homes were supporting unsuccessful ones.  By failing to disclose the commingling of funds, Sunwest concealed the fact that a significant number of properties were unsuccessful and understated the risk of investing. 

And of course- investors in the profitable properties weren’t getting all of their profits.

The SEC has historically used enforcement actions to end a message to a particular industry that it regulates, and this case will certainly be closely followed by the TIC industry. 

If nothing else, this complaint should certainly alert both brokers and investors that a “past performance table” in a PPM, without an audit of the books, and good internal controls, is potentially a problem.