Those “Guaranteed Income” Rental Home Investments

Rental condos in Kissimmee, Florida

A recent inquiry from a Canadian journalist has me revisiting this topic, as there is now a burgeoning industry of selling “rental home investments” to foreign investors, particularly the Canadians and the Chinese. For instance, some unsuccessful builders of failed subdivisions in places like Arizona and Nevada are advertising their unsold homes as “rental home investments” for which they or their agents promise to rent and manage for foreign investors. Their ads often tout “guaranteed ROI of xx%” or “guaranteed rental income for two years”. Are such investments a good deal?

“Guaranteed rental income for the first two years” is a seller promise that should be interpreted as a sign of weakness, not security, because a rental property in a stable market need not be sold with any such guarantees. What often happens, too, is that the property’s previous asking price has been inflated to more than cover the amount of these guaranteed rents.

Enforceability of guarantees

Guarantees are not quite guarantees if the builder or manager goes out of business, even if just to emerge again as another legal entity (for example, if the principals of Get Rich Quick LLC dissolved their LLC and reorganized as Get Rich Guaranteed LLC). If the guaranteed rents stop coming in, there is also the logistical problem of filing a lawsuit far away from home to collect what is due, and foreign investors are at a disadvantage in negotiating the complex U.S. justice system. Accept this common piece of advice from Craigslist:

“Only a scammer will ‘guarantee’ your transaction.”

Recommended Due Diligence for U.S. rental homes

1. Try to get vacancy rate data for the community the home is in at the most granular level, whether it is the subdivision, the zip code, or the census tract. One helpful tool at the moment is the U.S. Census, which recently completed a decennial census with data as of April 1, 2010. The U.S. Census Bureau counted vacant housing units as of that date and will soon publish data down to the census tract level. For instance, realtors crow about Green Valley, Arizona, being the second fastest growing town in Arizona, itself one of the fastest growing states, all according to the U.S. Census, but may neglect to mention that in Green Valley, a suburb of Tucson, the Census counted 4581 vacant housing units out of a total of 17,322, equivalent to a vacancy rate of 26.5%. What will happen to a rental home there after the guaranteed rental income runs out after one or two years? Tucson isn’t much better, having a 15.9% rental vacancy rate.

2. Google the name of the seller and the management company and look for consumer and investor complaints. It helps to add the words “scam”, “fraud” or “complaint” to your search terms to get beyond the pretty web sites of the scammers. Try “MRI Overseas Property scam”, for instance. The really active fraudsters, though, will publish articles designed to show up in such search results, such as “Get Rich Quick LLC – No Scam!” or “Guaranteed Riches, LLC – No Complaints Here!”, and may even write their own highly favorable Wikipedia article, so keep on searching all the results. If the company is so new that nothing can be found in a background search, Google the name of the principal of the company, and that’s often where you will find a history of a swindler moving from state to state or even nation to nation to perpetrate scams.

After applying the aforementioned screening criteria, you should have a much smaller list of prospective investments.

The Weakest Link in Appraisal/Valuation Reports is the Information Supplied by the Property Owner

Do not hire this kind of appraiser.


Some of my previous blog posts have touched upon this subject, whether it was the Jakko Poyry forest valuation report that SinoForest investors relied upon to their detriment (including John Paulson, who lost more than half a billion dollars), or the valuation report relying on false financial statements in the case of the Beijing Gateway Plaza fraud, or the Costa Rican appraisal report based on false representations of the property having full development entitlements.

The commonality in these instances was that an appraiser or valuer unwittingly relied upon false statements made by a property owner, resulting in a flawed valuation.

One thing missing from real estate appraisal and valuation textbooks is a statement of one fundamental human truth: People lie.

Because an appraisal or valuation report is often used to gain financing or to lessen taxes, appraisers should expect to be lied to. Most appraisers don’t seem to care about this, though, instead filling their reports with multiple disclaimers and limiting conditions. We are even taught that this is good appraising. In most English language valuation reports, for instance, one finds a standard exculpatory statement such as the following:

“No responsibility is assumed for accuracy of information furnished by the property owner.”

This is the Achilles heel of the appraisal profession throughout the world –-acceptance of inaccurate information from biased parties without verification. Some appraisers in high places even contend that it is not an appraiser or valuer's responsibility to verify such information. "Who am I, the fact police?" asked one. Yes, you should be.

Last week I was appraising an isolated “cave lodge” in hillbilly country. A New York area hotel valuation firm came in before and appraised it for $5 million based on the owner’s representations of renting it out at nightly rates of $1000 to $1800 for more than 85% of the year, with annual revenues of $368,200. No efforts were made to verify these revenues despite their implausibility and lack of customary expense categories, such as Payroll expense.

I asked for tax returns, both Federal income tax and state sales tax returns, and got a runaround with plenty of excuses and contradictions. The owner finally admitted that he has paid no sales taxes on his lodging revenues, and the only Federal tax return produced indicated revenues of about $36,000, or about 10% of what was previously represented.

My favorite tall tale was when the owner told me that Cher had rented the place for a Halloween party last year. He should have picked a more mysterious celebrity, as Cher is a known concert performer, and it has been well established that she performed in Las Vegas (more than 1500 miles away) on Halloween night last year, and there are unauthorized YouTube videos to prove it.

A few weeks ago I was also asked to look at a vacant, 85-year-old multi-story warehouse. Two appraisers had relied on the owner’s representations and had made “extraordinary assumptions” that the elevators were operational (they were not) and relied on owner representations of “clear height” (the height to which goods can be stacked) and building area, apparently not measuring the building. Although the warehouse had been purchased for $430,000 in 2005, at the top of the market, and has remained vacant and unsold since then (having been listed for sale and lease in the mean time), both appraisers now estimated value to be about $2 million.

Conclusion

An appraisal or a valuation is only as good as the data and assumptions that it relies upon. Garbage in, garbage out. It is time for users of valuation services to ask questions about the reports they rely upon, questions such as “How did you verify this?”

Three Appraisals in Britain

London bed-and-breakfast inn

After Cozumel I flew to London, England, to appraise a portfolio of hospitality properties – a bed and breakfast inn and two restaurant/pub buildings in London, Windsor and Buckinghamshire.

My client, a private U.S. lender, had already received valuation reports prepared by British chartered surveyors which proved that the United States and the United Kingdom are two great nations separated by...a common language. Terms like “chartered surveyor”, “lettings”, “trading potential”, “realisable”, “consents” and “solicitors” are confusing to Americans in the context that they are presented in British reports. The reports reminded me of a classic “I Love Lucy” episode in which Lucy attempts to get walking directions in London. One reason I think that U.S. clients send me to appraise in so many British Commonwealth nations is that I write appraisal reports in American English and try to follow North American (US and Canadian) reporting standards.

I worked the first three years of my commercial appraisal career at a British company, Jones Lang Wootton. (JLW was eventually acquired by LaSalle Partners and the new entity was named Jones Lang LaSalle under different ownership and management.) Thus I have worked under both real estate valuation regimes and have some knowledge of British valuation methods and jargon.

The English properties

Restaurants and bed-and-breakfasts are not usually very profitable enterprises. While I don’t have current figures, a traditional rule-of-thumb has been that 80% of restaurants and bars do not last five years. Bed-and-breakfasts have had a similar failure rate, as they are often founded by amateurs.

As luck would have it, though, all 3 properties were owner-occupied and consisted of valuable real estate. The London metropolitan area, much like New York City, has a general shortage of available land for new construction, and a well-constructed building often has an intrinsic value independent of the relatively unprofitable businesses which may occupy it.

The London bed-and-breakfast, for instance, had previously been used only as a 12-bedroom residence. Similar residential sales in the area suggested a value of about one million pounds, a value not otherwise justified for a bed-and-breakfast business with a net income of less than 40,000 pounds per year.

The restaurant/pub building in Buckinghamshire had apartments on the second floor and was also situated on a block with one-million-pound residences, but the value had to be adjusted downward for the cost of conversion back to a residence. Pub sales in the area were at considerably lower prices in the range of 350,000 to 450,000 pounds, so my highest and best use analysis, considering the restaurant’s financial statements, established that the property was not being used in a manner which maximized value.

One nice thing about working in the UK is the availability of residential sales data. It is all contained in a national registry, unlike the United States. Similar to the U.S. is the prevalence of automated valuation technology, including free AVM technology, such as the Zoopla and Mouseprice web sites, which are similar to Zillow and Trulia in the U.S.

The restaurant in Windsor was more difficult to appraise, partly because it consisted of 3 adjacent buildings, one of which was owned only as leasehold. The leasehold building’s annual rent of 60,000 pounds per year (equivalent to $93,600 at today’s exchange rate), when compared to restaurant revenues, strongly suggested a negative leasehold value for these premises, which were not being fully utilized, and the leasehold building would therefore not be suitable for loan collateral. In addition, the entire restaurant property was not configured or located in a manner befitting a residential highest and best use.

Most of the restaurant operations seemed to be actually conducted in the freehold (fee simple owned) buildings, thus suggesting continued viability of a restaurant business if the lender had to foreclose on two of the three buildings.

In the end I relied most upon a gross rent multiplier method for the Windsor property, but estimating market rent as a function of the revenues earned by the restaurant operations. Finding comparable restaurant rentals is a difficult task, as restaurants are retail properties that can have significantly different rental values based on location and visibility. Very few leased restaurants, though, can afford rent beyond 8% of gross revenues, which limited affordable rent to about 61,000 pounds per year for this particular operation if it was a rental operation. While it could be argued that a more profitable restaurant operator could justify a higher rental rate, the occupying restaurateur was already a highly experienced restaurateur and celebrity caterer.

Differences between British and North American commercial appraisals

The British “valuer” is much more likely to have collegiate instruction in real estate and building subjects; North American (Canadian and American) appraisers typically receive their appraisal education from professional associations or trade schools after college. Present-day certification and designation requirements for U.S. commercial appraisers require them to hold baccalaureate degrees (unless “grandfathered in”), but the degree can be in any subject and often is. Americans do not typically train early in their lives to become appraisers; they accidentally become appraisers.

North American appraisal reports, on the other hand, are more complete and try to be prima facie cases in support of estimates of value. British reports are briefer, do not demonstrate the analytical process used, do not present a “highest and best use analysis” (as in “would this building achieve the highest value as a residence or as a bed-and-breakfast?”) and do not typically present photographs or maps of comparable sales and rentals. They cannot therefore be reviewed critically by a foreigner. In other words, there is no basis for the reader to judge the competence or honesty of the valuer.

Working alongside British valuers, though, I sensed that they perceived more honor for their profession than North Americans appraisers do. There seemed to be more emphasis on honesty in their work, although there were certain practices that Americans would label as unethical, such as charging a professional fee as a proportion of the appraised value, which presents a conflict of interest. That being said, I trust the honesty of British valuation reports more than North American reports when I do not specifically know the appraiser or valuer.

Still, the considerably lesser British valuation reporting standards can be a cover for sloppy work. The most egregious case I saw at Jones Lang Wootton was in the appraisal of a portfolio of over 200 surplus bank branches as a result of the merger between Wells Fargo and Crocker Banks in 1986. The Director of Valuation saved the premier property for himself to appraise, the Wells Fargo Tower in downtown Los Angeles. When he arrived at an internal company meeting to go over final values, it was clear that he had not done his homework. He said, “So what’s a downtown L.A. office building worth, any way? $200 per square foot?” The chartered surveyor from San Francisco yelled out, “No! $300 per square foot”. “Well, then $300 per square foot it is,” said the Director of Valuation and the supporting two-page report quickly got written.

It is hard to judge professional ethics enforcement in either country. The Appraisal Institute, the most highly regarded of the several U.S. appraisal associations, has an ethics enforcement staff of just one, and she has been in situations of siding with appraisers who have already been disciplined by state appraiser licensing agencies; it is rare for a member of the Appraisal Institute to be expelled for ethical violations. RICS, the governing body over British Commonwealth valuers and many other types of real estate professionals, is said to have an ethics enforcement staff of about 3 dozen persons, a considerably more impressive number.

Yet, a few years ago when I pointed out to RICS that their international president was a U.S. appraiser who had actually lost his appraisal certification due to disciplinary action, RICS investigated and informed me that he did nothing wrong and voluntarily surrendered his certification in order to obtain an appraisal certification in another state, an action not required in the U.S., as I have held as many as 5 concurrent and different state certifications at one time. The Appraisal Subcommittee web site (www.asc.gov) publishes the names of all appraisers who are no longer licensed due to disciplinary action by a state agency, and his name is there, one of about 50 in his state.

Professional organizations cannot really be expected to police themselves well, though, due to professional friendships, potential "loss of face" and a prevailing sense of "There but for the grace of God go I," particularly when appraisers and valuers are constantly confronted with ethical challenges.

I am also skeptical of the massive RICS recruitment effort in the U.S., as RICS does not offer an educational program or testing here. A U.S. appraisal designation plus $500 per year gets one an MRICS designation, but what does that all really mean if RICS is not educating or testing here? It seems that their main goal is to collect $500 each from as many U.S. appraisers as possible without contributing to our profession here.

Some of my colleagues told me they pursued an MRICS or FRICS designation in order to solicit international work. As someone who worked at a British-owned international firm, however, I was never encouraged to pursue an RICS designation, but encouraged to pursue an MAI designation instead. Since then, I have worked many times in British Commonwealth nations
(Australia, Canada, Jamaica, Barbados, South Africa, Fiji, Singapore, Malaysia, Hong Kong and Great Britain) and not been asked if I have an RICS designation. Moreover, when I have called on RICS members in these countries, most have been cost estimators ("Quantity surveyors") rather than valuers.

Capturing the best of both systems

A British subject named John Lennon once wrote a memorable song called “Imagine” shortly before moving to the United States in 1971. Imagine if the English-speaking appraisers of the world could capture the best of both the British Commonwealth and North American systems, with British-style collegiate instruction and sense of professional honor coupled with the more descriptive and informative appraisal reporting standards found in the United States, while agreeing on a common professional vocabulary?

You may say that I'm a dreamer, but I'm not the only one.

Condo project appraisal in Cozumel

I am currently revisiting a condo project in Cozumel, Mexico, that I appraised three years ago. Cozumel is an island off of Mexico's Yucatan peninsula, a land full of lush tropical jungles and Mayan pyramids.

This particular condo project had a successful, sold-out first phase, but by late 2008 it was apparent that many vacation condo projects all over the world were in trouble. Many condo projects that I was visiting had stopped making sales altogether.

This project in Cozumel was faring slightly better; its rate of sales was down only 50% due to one of Cozumel’s unique attractions– it is a mecca for scuba divers from all over North America. Condo buyers at this particular project were typically both doctors and scuba divers, and the recession had hit this population subgroup less severely. Still, the forecast of a prolonged absorption of the unsold units resulted in a decision to not fund the construction of another phase. It was hoped that another lender would step in, but as can be seen in the photo, construction has been halted since 2008.

General worldwide conditions for vacation condos

The last three years or more have been difficult for second-home markets all over the world, as I have witnessed in such far-ranging locales as Barbados, Fiji, the Dominican Republic, Costa Rica and Canada.

Many of the failed overseas second home projects were high end luxury projects focused on a growing number of “multi-millionaires” in the world. Each project tried to achieve a certain prestige by promising top shelf amenities vital to the ultimate success of such luxury projects.

Unfortunately, the market for vacation real estate is discretionary, and the purchase of vacation real estate has moved further down the priority scale for a large number of potential buyers. For instance, one of the main motivations for the purchase of vacation real estate has been the potential for financial return from the investment. While there were forces in place for price appreciation in advance of the recent financial crisis, buyers now recognize that the potential for appreciation of luxury second homes has significantly deteriorated. As for the ability subsidize ownership costs or earn a return on investment by renting out one’s property, a worldwide oversupply of vacation homes is driving down returns on investment.

Another concern from likely buyers relates to the continued financial viability of substantially unsold projects, and the risk of promised amenities not being built or else operating at a substantial deficit which would require increases in homeowners association dues. For instance, many golf course sales nowadays are to homeowners associations trying to rescue an affiliated golf course from bankruptcy. That often requires a substantial increase in POA dues.

In addition, the allure of owning a home in high-end vacation communities comes from the prestige of belonging to a successful community. The financial distress and litigation associated with an unsuccessful project may instead have the opposite impact. Being associated with a troubled project affects the psychology of potential luxury real estate buyers. Instead of looking savvy, a purchaser could now look naive. This makes the proposition for purchase due to a project’s prestige more difficult than before.

The valuation of a failed project is exceedingly difficult, as it typically takes several years to get such a project restarted if at all. Patient capital is required, and it is difficult to construct a discounted cash flow model that can correctly forecast the timing of the project’s turnaround.

Other Yucatecan ruins

The following photos are of ruins left behind in Cozumel by a post-Mayan race of people known as "speculative real estate developers".

Next stop: London

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South African update: Will the ouster of Malema stop the decline in farm values?

In my last report on South Africa, I mentioned two possible factors in the price decline for South African game farms. One factor was the overall world surplus of vacation properties for the super-rich, and the second factor was political rhetoric calling for uncompensated government expropriation of white-owned land, rhetoric amplified by a rising star in South African politics, Julius Malema, the ANC’s Youth League President. Last Thursday, Malema was removed from his position and suspended from ANC for five years for bringing disrepute to the party, because of his divisive speeches within South Africa as well as his interference in the politics of neighboring countries. He has been constantly opposed by President Jacob Zuma.

The removal of Malema may help restore investor confidence, although the Johannesburg Stock Exchange All Shares Index was up by less than one percent after his sacking. The JSE AS index was hit hard earlier this week by a sovereign ratings downgrade from Moody’s.

Expropriation of white-owned properties

Confiscation of white-owned properties occurred during the 1990s in nearby Zimbabwe (formerly known as Rhodesia) and has resulted in a decline in agricultural productivity there and an overall implosion of the economy after a period of hyperinflation.

At end of the Apartheid Period of South Africa in the 1990s, 87% of commercial farmland was white-owned, and the new ANC-led government pledged a compensated program of land redistribution that would transfer 30% of white-owned land to blacks. Progress has been slow, and whites still own 84% of commercial farmland.

It is difficult to calculate the effect of the removal of Malema in restoring real estate market confidence. The ANC Youth League which he presided over still insists, after his ouster, on the nationalization of mines, a similar issue, and this matter is still being actively studied by the African National Congress despite the insistence of national leaders that it would never happen.

One problem also besetting the agricultural sector is the reportedly high murder rate of white farmers, most who are allegedly killed during ordinary robberies rather than politically motivated violence. More than 3000 farmers are alleged to have been murdered so far, a very alarming number, and Malema's removal will have little effect in stopping this trend.

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The Appraisal Institute has published my new book

Soft cover, 122 pages

ISBN: 978-1-935328-22-3

Stock Number:0751M
Fraud Prevention for Commercial Real Estate Valuation
Vernon Martin, CFE
Appraisal Institute
Price: $45.00
Member Price: $35.00
Plus shipping and handling

Direct link to Appraisal Institute book ordering web site: http://www.appraisalinstitute.org/store/p-283-fraud-prevention-for-commercial-real-estate-valuation.aspx

This is the Institute's description of the book:

"Mortgage and investment fraud are at an all-time high and there are serious consequences for appraisers who become involved in suspicious transactions. This book describes common methods of deception used in fraudulent schemes involving commercial properties and land. It presents various situations and conflicts of interest that have the potential to exploit the appraisal process for dishonest purposes.

Appraisers who can detect fraud can protect themselves from relying on inaccurate information that could compromise the valuation analysis. By thinking critically and challenging assumptions, commercial appraisers can keep out of trouble, whether it is trouble for themselves or for others who rely on their work.

Order now and arm yourself against real estate fraud!"

A note to my most faithful readers:

My previous book, "Lessons from Losses in Commercial Real Estate", is being retired due to my new venture with the Appraisal Institute. Although the overlap between the two books is small, the Appraisal Institute does not want me to compete with them with another book, and that is fair.

The Reasons Behind the Overbuilding of Luxury Retail Malls in China

Some readers may have mistakenly ascribed a political agenda to my postings about Chinese real estate. My views on commercial real estate are nonpartisan and non-ideological.

To those who think that I have been poking fun at “The Communists” or the Chinese government, I point out that the fiascos I've reported have been capitalistic decisions of private owners and investors which happen to have occurred on Chinese soil. (Only one, New South China Mall, had some government involvement, as it was financed by the Agricultural Bank of China, which was State-owned at the time of funding nine years ago.)

I even disagree with the notion that the People’s Republic of China is a communist society. During my trips to the PRC I’ve met many Chinese people, none who have ever expressed the sentiment that he or she wanted to create a classless, utopian society that benefited “The People” rather than themselves. Most just tell me “I want to be rich”. If I ask for an opinion of Chairman Mao, I generally get a strange look which implicitly asks “What century are you living in?”

As part of enforced “general education” requirements as an undergraduate at the University of Chicago, I was required to read The Communist Manifesto and The Russian Revolution (strictly in the context of critical inquiry), and neither Karl Marx nor Lenin ever stated that “The People shall have an Omega watch store every four blocks.” or "From each, according to his abilities; to each, a Gucci handbag." Overbuilding is not a Marxist concept, but Marx did explain in Das Kapital that overproduction is part of the natural outcome of a capitalistic society.

Karl Marx has probably caused more human suffering than any other philosopher who ever lived, but his criticism of capitalism was often insightful. He explained that technological advances increase labor productivity, which increases material wealth in the ruling classes while diminishing wages of workers, creating “poverty in the midst of plenty” manifested by overproduction and underconsumption. That may just be what is ailing China at the moment, as Chinese consumer spending as a proportion of GDP has been declining for the last half century in China.

Article in October issue of Shopping Centers Today

Next month’s issue of Shopping Centers Today (the house publication of the International Council of Shopping Centers) quotes me among other analysts in an article entitled “Many shiny new malls in Asia are devoid of tenants and shoppers”. Curt Hazlett reports many new but empty luxury malls in both China and India. There are various reasons cited, chiefly lack of experience and market analysis by the actual developers, who are private entrepreneurs.

This misallocation of resources is now being discouraged by the Chinese government. Recently, the Chinese Banking Regulatory Commission has been trying to proactively engineer a soft landing to a real estate bubble through stricter bank regulations. Reckless Chinese developers now find themselves unable to get Chinese bank loans for ill-conceived projects. The People’s Bank of China reports, for instance, that new lending to property developers declined to 42 billion yuan ($6.56 billion USD) in the second quarter of 2011, down 75% from 168 billion yuan in the first quarter. I have also seen similar policies put in place by the elected governments of Singapore and Hong Kong.

Real estate developers the world over are like heroin addicts, constantly seeking financing, and Chinese developers are no exception. If you give enough money to a developer, he will develop, because that is his raison d’etre. Chinese developers have found two alternate sources of funding after the shutting off of the Chinese banking spigot: private trust companies within China, which funnel investments from wealthy individuals and companies, and REITs created on foreign stock exchanges. The Chinese government is now cracking down on trust company lending, too.

So what is currently causing the continued overbuilding of luxury malls in China? In short, it is foreign investment. The “Chinese economic miracle” has been oversold to naïve foreign investors by self-serving capitalists. If the focus is on wealthy Chinese, most of their shopping is done outside the country, particularly in Hong Kong, in order to escape the VAT, the customs duty tax and the consumption tax, together adding up to as high as 60% on imported goods. That is why all the Hong Kong malls are full.

This last year has shown that it is easier to finance grandiose Chinese commercial real estate development schemes with equity offerings on foreign exchanges than with Chinese lenders. These equity investors (shareholders) have often been suckered because the "Chinese economic miracle" story has been so compelling and the IPO sponsors have been less than forthright. The logic that Chinese GDP growth is causing equivalent growth in consumer demand is contradicted by actual statistics: Per ISI Emerging Markets Inc., who maintains the CEIC China Premium Database, Chinese consumer spending as a proportion of GDP has now hit an all-time low of 34% and predicted to decline for two more years after being about 45% one decade ago and about 50% two decades ago, not quite the "consumption revolution" crowed about on empty New South China Mall's web site.

Walking through empty retail malls in Dongguan, Beijing and Shenyang, I was struck by the high prices on the merchandise offered. The median household income for Class-1 and Class-2 cities is estimated to be about $5700 per year, about 12% of the U.S. median, which is not conducive to a Gucci lifestyle. (The Chinese national average is about $3300 per year.) Wealthy Chinese, however, have the ability to travel and shop outside the country, where they find lower prices on luxury items, whether in Hong Kong, Singapore, Beverly Hills, or Vancouver. (Hong Kong attracts many Chinese shoppers due to the lack of a sales or value-added tax.) That narrows down the universe who have the resources and desire to buy their luxury goods domestically.

Recruiting foreign investors

Foreign investors may have misconceptions about Chinese shoppers based on the Chinese shoppers who travel to their own countries. These shoppers represent the affluent class of China, which is small in proportion to the total population. Mall investment sponsors have been capitalizing on this misconception.

Foreign investors are easier to take advantage of than Chinese investors due to their lack of legal recourse when they are cheated. Law enforcement can be heavy-handed within China. For instance, while I was staying in Shenzhen, the former mayor had just been convicted of corruption and sentenced to death. Executives of a company committing fraud on the Shenzhen or Shanghai stock exchanges are subject to severe criminal penalties, particularly if they cheat the government. Not so if the company is listed on a foreign exchange, such as Hong Kong, Singapore, New York or Toronto.

From GAAP to CRAAP

Just as U.S. securities laws are not extra-territorial, neither are Chinese securities laws. China does not have GAAP (Generally Accepted Accounting Principles), so the rules governing accounting are different; Chinese accounting policy has been nicknamed CRAAP (Chinese Regularly Accepted Accounting Policy) by hedge fund manager Jim Chanos.

The Chinese economic miracle has been a 30-year growth trajectory that has averaged annual GDP growth of 10% per year (according to the government) and created 115 billionaires as of the last Forbes count. Just remember, though, that the building of empty malls and office buildings is part of that GDP growth.

Chinese consumer spending has failed to keep pace, too, as Chinese household income, is less than 10% of U.S. household income. This is what Marx predicted would happen to capitalist societies, that workers would end up being financially unable to buy the very products they were producing. The empty luxury malls are evidence of that.

A Visit to Perennial China Retail Trust’s Assets in Shenyang, China 鹏瑞利中国零售信托

Recapping my June post on Perennial China Retail Trust (PCRT), PCRT was a recent Chinese real estate IPO on the Singapore exchange which advertised itself as the only “pure play on Chinese retail” available to Singaporean investors. It advertised “a total valuation of approximately S$1.1 billion as of December 31, 2010” based on an "independent valuation" of its five principal assets, which are two malls and an office complex situated together in Shenyang and malls in Foshan and Chengdu, but the valuation report was based on the false premise that all five properties had been completed and fully leased, when only one building, the Red Star Macalline Furniture Mall, had been completed and opened, and the malls in Foshan and Chengdu had not only not been started, but the land had not yet been acquired by PCRT at that time. In other words, the Foshan and Chengdu malls did not exist, yet they had been included in the current market valuation of this trust, as published on page 434 of the Prospectus.

In other words, the valuer had not been independent and had instead abetted the misrepresentations of the IPO sponsor. It should also be noted that the CEO/IPO sponsor receives substantial annual compensation (0.38% of appraised value) based on the independent valuation rather than the market capitalization of the outstanding shares, which is now less than half the amount of the "independent valuation" report. This is another built-in conflict of interest within PCRT.

I also questioned why the Singapore Exchange would allow PCRT to represent undeveloped properties as being fully developed and leased in their representations to the public of total asset valuation and why there were no controls on the misbehavior of supposedly “independent valuers” who are in reality the paid advocates of IPO sponsors.

PCRT initially attempted to go public in February by offering approximately 1.1 billion shares at S$1 per share but received an inadequate response. The offering was re-priced at S70 cents per share in June and was fully subscribed at that time. Since then, the market-traded share price has declined to S40 cents per share as of October 5, 2011. With 1,121,695,000 shares outstanding, this represents a loss to investors of more than S$336 million in market capitalization.

The visit to Shenyang

The location of the Shenyang properties is highly visible and accessible via the First Ring Road, and the Longemont Mall also has its own bus depot and subway rail station. This is a first-rate location.

I was disappointed to find the renamed Red Star Macalline Global Home Furniture Life Mall closed for the day at the time of my arrival at 7:15 pm. I naively assumed that it would be open late like most Chinese malls, but its official closing time is 6:30 pm; the error was mine. The closing time is the same at the other Red Star Macalline store in Shenyang.

The Longemont Shopping Mall had its opening on July 1st and is a beautiful sight to behold. The only things lacking are tenants and shoppers and western-style toilets. (Chinese "squat" toilets are simply porcelain holes in the floor. For a purposely western-style mall, this is an incongruity that I just cannot take sitting down.)

Ground floor of mall, 7:15 pm on a Friday evening

First floor of atrium

Third floor

To be fair, basement levels B1 and B2 have a hubbub of activity drawn by a major 20,000 square meter (215,000 square foot) supermarket with linkages to the city’s bus and rapid transit systems. Floors 1 through 7 were a different matter entirely, as seen in the other photos. My visit was timed between 7:15 and 8:30 pm on a Friday evening.

Basement supermarket

Many multi-level Asian malls also have their top floor or floors devoted exclusively to restaurants, and this can be one of the busiest sections of a mall in the evening. Not so here. Longemont’s 7th floor is also devoted to restaurants, plus an ice skating rink, but it appears that only half of the restaurant space has been rented out.

Seventh floor restaurant level

While I was dining on shredded dog meat in chili sauce on the 7th floor, I asked an employee why the Red Star Furniture mall was closed so early, and he was surprised to hear that it was already closed for the day, claiming that it was supposed to be open until 9 pm just like the Longemont Mall. “Not many people go there,” he also said. Nevertheless, the signs at Red Star Mall clearly indicate a 6:30 pm closing time.

Miscount of tenants at Longemont Shopping Mall

Although the PCRT web site advertises Longemont Mall as having 800 tenants, the number of open stores appears to be less than 200.

Is Longemont Shopping Mall "skating on thin ice"?

Two 56-story office towers are still under construction and show progress compared to previous photos from June. Leasing activity is not known yet.

Options on other sites next to future High Speed Chinese Rail Stations are also mentioned in the Prospectus. The July 23rd high speed train crash in Zhejiang that killed 40 and injured almost 200 revealed shoddy standards and official corruption which warranted the the arrest of the former railway minister Liu Zhijun. As a consequence, railway construction is now being delayed, with only one-third of projects still ongoing construction, while many railway construction workers complain about not being paid (more than 2000 alone at the China Railway Engineering Corporation.) What is the consequence for PCRT assets located at future high speed rail locations?

Remember, too, that all 5 properties are situated on ground leases. The Shenyang lease expires in year 2059, while the Foshan and Chengdu leases expire ten years earlier. What will happen then? The Chinese ground lease system only started in 1980, so none have expired yet, and there is no case history to learn from about when valuable malls sit on expiring ground leases.

Investors in PCRT (N9LU on the Singapore exchange) are probably quite disappointed now; those who bought at the offering price of 70 cents have seen a 43% decrease in value since June. $336 million of investor value has been lost since the first day of public trading. For those who relied on the independent valuation report, I don't know what legal recourse they have in Singapore.

One bit of encouraging news is that CEO Pua Seck Guan has finally started buying shares at recent market prices. Why didn't he buy before now?

Disclosures: None. I have no short or long position in this stock.

Appraisal in Tepotzotlan, Mexico

The story sounded compelling: 26 hectares of flat, residentially zoned land at the northern periphery of the Mexico City metropolitan area, not far from the Autopista, the major north-south highway leading to Mexico City, 42 kilometers south. Next door was said to be a gated subdivision with a golf course. The owners claimed to have had a bank appraisal in 2006 establishing a value of 177 million pesos, equivalent to about $16 million USD at that time.

The idea of the site’s potential for residential subdivision seemed plausible at first. As modern life takes over Mexico City, it has increasingly grown like an American city, with residents fleeing to growing suburbs and the city population actually declining, similar to Chicago, Detroit or Baltimore. The subject property initially sounded like an ideal location for a new housing subdivision.

The paper chase

One of the documents I requested from the landowner was the most recent predial (property tax receipt). I use it to double-check items such as owner, location, tax ID number (clave catastral), and assessed value, which I hope might point me in the right direction of true market value.

I was provided instead with a predial from 1992, indicating an assessed value of 87,696,000 pesos. Why would they do something like that?

At today’s exchange rate of 12.18 pesos to one dollar, the land would have been worth $7,200,000 back then, but that would be in nuevos pesos, which were not established until 1993, after a period of hyperinflation, when Mexico issued the “new peso” to replace and be valued at 1000 old pesos. The exchange rate on the date of the predial would have been 3064 “old” pesos to one dollar, with the assessed value being equivalent to only $28,621 USD!

Thus, the purpose of providing a predial dated prior to 1993 was an attempt to confuse me. The alleged bank appraisal from 2006 never materialized, either.

The property inspection

After exiting from the Autopista, we traveled another half hour on roads that progressively got narrower and rougher, making numerous turns as we traveled through residential neighborhoods with speed bumps on every block. The paved roads then ended and we traveled on narrow, rutted dirt roads.

Arriving at the site, I found it to be a hillside. The elevation dropped by 150 feet from top to bottom.

Immediately west was a neighborhood of makeshift shacks and dirt roads.
Immediately south was a neighborhood of modest, concrete block structures on small lots, served by paved roads. Graffiti was prevalent.

Immediately north was the countryside. Immediately east was the gated subdivision I had heard about.

Neighboring gated community

After walking about the subject property, we drove to the gated community next door to perhaps give me some idea of the residential development potential of the subject site.

The guardhouse was closed. One of the four gates was open to traffic, however. Once inside, I saw mostly vacant lots, a few structures, some which appeared to be vacant, and no golf course. Census data indicated that only 18 households live in this subdivision. The developer is still advertising to build attractive new 3-bedroom homes of 2500 to 2600 square feet for 1.2 million pesos unfurnished or 1.5 million pesos furnished, equivalent to about $98,000 and $123,000.

Comparable properties

Sales of large parcels were not to be found, so I turned to listings. The most similar property in terms of size and proximity was in the next town west, but its H500A (municipality of Tepotzotlan) zoning allowed 5 times as much residential density as the subject site – 20 dwellings per hectare or 8 dwellings per acre. Its listing price translated to about $72,000 per hectare, for five times the allowable density. Other local parcels were priced as low as $20,000 per hectare (although that one was in a more remote location).

It soon became apparent that the appraised value was going to fall far short of the $16 million that the lender was led to believe. Moreover, this particular lender’s minimum loan size is $1 million with a maximum loan-to-value ratio of 50% for raw land, so there was no real possibility of getting a deal done here.

Costa Rican Teak Farms for Gringo Investors

I’ve been preparing for an upcoming tree farm appraisal assignment in Costa Rica, but learned late that what was thought to be a teak farm is actually a tree farm with lesser tree species. Nevertheless, something should be said about the teak farm market in Costa Rica.

In the late 1980s Costa Rican President Oscar Arias declared a state of emergency concerning the depletion of the nation’s forests, much of which had been felled for timber harvesting or cattle ranching. Generous tax exemptions were put in place to encourage commercial reforestation projects. Capitalism quickly and enthusiastically addressed the problem, and some of those who observed the flow of international capital into Costa Rican forestry investments figured out that perhaps there was more money to be made by selling forestry investments than in actually growing, harvesting and processing the trees.

As with any market for investment properties, distortions are created when properties are developed in response to investor demand rather than consumer demand. For instance, great surpluses of “rental homes” were developed in Arizona, Las Vegas and Kissimmee, Florida, not in response to a shortage of housing in those areas, but to sell to out-of-state investors. Costa Rican tree farms are now repeating the same concept all over again.

Teak became the preferred tree farm crop because of its high value. There were no restrictions on the creation of new supply in Costa Rica, so many entrepreneurs got into the teak plantation business and European “investment funds” (syndications) were organized to develop teak plantations for small investors, charging high mark-ups. Many teak plantations were subdivided into smaller parcels for purchase by small, absentee investors in North America and Europe.

Misleading data crowding out objective data

The Costa Rican timber market is fragmented and lacking in price information, which has led to the crowding out of objective information by hyperbole crafted by investment promoters, many of who claim historical investment returns in the timber industry of greater than 13% per year. This is not based on Costa Rican data, however.

The most recent price survey among the Costa Rican members of OLAT (the Latin American Teak Organization) indicates prices between $120 and $595 per cubic meter for standing teak trees, depending upon diameter, but prices appear to have decreased since February of this year. For instance, standing teak trees of 50 to 59 centimeters in diameter were priced at an average of $220 per cubic meter then but are now priced at $175 per cubic meter, a drop of 20% in the last six months. Mature trees above 30 years in age have much greater value per cubic meter than immature (“short rotation”) trees, as they can be more efficiently processed into large pieces of sawn wood.

Investment promoters, however, are misleading investors with pro forma cash flow projections based on price increases of 5 to 10% per year, despite the increasing supply of Costa Rican teak, and unrealistically shortened maturity times of 20 to 25 years. OLAT’s data is based on reported prices for mature 30-to-50-year-old trees (the older, the more valuable) and describes 20 to 25-year old plantations as “young plantations” for which there is insufficient market price data, and also commenting that “Latin America will supply an important part of the teak market, but is not properly geared to marketing short rotation material. This will change in the coming years, with the knowledge that producers are not getting the best price, the market being controlled by buyers.” In Asia, teak trees are often not harvested until 60 years.

As for the balance between teak supply and demand in Costa Rica, OLAT states “With all the money that was invested by forestry funds over the years in Latin America many plantations were enthusiastically created and the know-how has been improving steadily. Lacking, to some extent, are the sales aspects of plantation products.”

Investment Promoters and Scam Artists

Some investment promoters are not even selling land to investors, just the trees themselves. It is important to know that titled ownership in Costa Rica extends to real estate only; there are no tree titles, and the idea of tree titles in a nation with so many more trees than people would be an administrative nightmare, even if it was tried.  How does one prove ownership of trees that are situated on someone else’s land? Any contract in English is not valid or enforceable in Costa Rican courts, either.

Many investors claim to be victims of scams in which plantation owners sell tree ownership and then charge a fee to manage the tree investment; Tropical American Tree Farms seems to have attracted the most complaints. Most of the alleged fraudsters are gringos themselves, including Eric Heckler, who was a fugitive from mortgage fraud charges in Florida when found selling Costa Rican teak trees that weren't his before being extradited back to the U.S. in 2009.

In the numerous listings of teak plantations for sale in Costa Rica, a sizeable discount per tree is apparent for the larger plantations, indicating an insufficient demand for the quantities of teak they are producing, with prices as low as $167 per standing tree for 20-year-old trees, which translates to about $244 per cubic meter (based on an average of 0.8639 cubic meters per 20-year-old teak tree), or 58 cents per board-foot, quite a bit lower than even the OLAT-published prices.

Next stop: Tepotzotlan, Mexico

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