ERISA Valuation of Non-Traded Investments
As mandated by FINRA Regulatory Notice 09-09, and required under ERISA, non-traded companies (e.g. Equipment Leasing trusts, REITs, etc.) are required to provide, beginning no more than 18 months after the close of fundraising, and subsequently no less than annually, an updated share price based on an "orderly liquidation value".
The primary reason for this requirement is that shares of these companies held in IRA or other qualified accounts require an annual valuation for IRS reporting purposes. It is very important to note that the "orderly liquidation value" is based on the hypothetical liquidation of assets in a much shorter time frame than these types of programs require in order for their business model - and maximum value - to be realized. In short, the "Business Enterprise" or long term expectation of value may be significantly discounted using the OLV methodology. In fact, the objective for some (but not all) of these type of investment programs is to purchase assets at distressed valuations, manage them, and attempt to remarket them when their market values have potentially increased. When assets are valued at points in time before their values have potentially increased, they will most likely appear undervalued.
These valuations are performed solely for ERISA and FINRA purposes, and are typically based upon the manager's perception of market conditions respective of the assets in their portfolio. Combined with the fact that an independent valuation is not required for ERISA and FINRA purposes, the valuation - again, an estimate of orderly liquidity value by the manager - may not necessarily be viewed as an accurate reflection of the value of the holding, if held over time to program maturity. For a better understanding of the valuation mechanism, there is an excellent visual from KBS Capital Markets Group that should be reviewed by clicking on the title below (KBS Capital Markets is not necessarily reflective of all types of programs or funds in the non-traded REIT asset class, however it provides a hypothetical illustration for the valuation timeline which is applicable to all investments which fall under the FINRA mandate):
KBS CAPITAL MARKETS GROUP - UNDERSTANDING REIT VALUATIONS
Valuation of Equipment Leasing Programs
Due to the fact the Equipment Leasing Programs realize a substantial amount of depreciation over the years of operation, in a non-IRA environment, booking appreciation against portfolio value results in an adjusted basis that is reduced each year. This tax adjusted basis, while not a true reflection of 'Business Enterprise" value, is required to be utilized as part of the "Orderly Liquidation Value" calculation mandated by FINRA. As such, by the time the first valuation date arrives (18 months after the close of the fundraising period) between three to four years of depreciation has been realized against the portfolio, resulting in initial valuations in the 70% to 80% of par value range.
For example, when ICON Fund Twelve reported ERISA valuations for Fund Twelve as of December 31, 2009, it appeared that an investor who invested $10,000 at its inception had an investment worth $7,681.10. This valuation does not, however, include distributions that have been paid by the Fund. When you factor in distributions received for that time period, the investor may have an investment worth closer to $10,120.50 as of 12/31/2009.
Recently, ICON Fund Fourteen reached the point where the ERISA valuation was required, which reflects a valuation of approximately 75% of par value. Again, this is the "Orderly Liquidation Value" based on adjusted book value after depreciation and other factors. It DOES NOT reflect the "Business Enterprise Value" and the anticipated returns for investors over the full course of the program life cycle. The actual performance over the program life will be dependent on many factors OTHER THAN the ERISA valuation.
Valuation of Non-Traded REITSs and the Impact of Credit Crisis and Commercial Real Estate Property Values
Without a doubt, the credit crisis and its impact on certain market sectors will play into these valuations. For example, commercial real estate in all sectors is potentially impacted, due to the lack of buyers resulting from a reduction in available financing. This industry wide valuation impact is expected to be somewhat reflected in the REIT valuations, even though none of the REITs our clients are invested in are structured to actually liquidate their holdings prior to 2015. Non-traded REITs, where portfolio assets were acquired prior to the debt crisis of 2008, generally referred to as "Legacy" assets, are the ones most impacted by the FINRA mandated valuation, over and above the expected valuation adjustment for commercial real estate due to the credit crisis. The valuations vary due to differences in asset focus, occupancy, and valuation methodology from one program to another. The impact of a decline in commercial property values AND the FINRA mandated valuation has resulted in per share values in the 70-80% of par value (in programs where portfolio debt is lower), to share values in the 40 to 50% range (where portfolio debt is higher).
Legacy vs. Post Legacy
Bear in mind that the "post Legacy" REITs - those that have little to no asset acqusitiions prior to 2009 - have and are, in fact, taking advantage of this "buyer's market" right now - and as a result, upcoming valuations are actually expected to rise above the typical $10.00 per share "Par" value paid at purchase. The first of these, KBS REIT II is a good example of a "post Legacy" REIT, with the majority of assets in the portfolio being acquired after 2008. KBS REIT II recently released their valuation, which came in at $10.11 per share. When the net amount invested in the portfolio of this program (90% of funds raised) is taken into account, this indicates that the underlying value of assets within this REIT have increased by over 11%. Per KBS, 20 of the 24 real estate assets in the portfolio have increased in value subsequent to the acquisition dates, while the seven debt assets in the portfolio have increased by a total of 27%. You may view a copy of the KBS REIT II valuation by clicking on the title below:
Unsolicited Purchase Offers
Absent an understanding of the reasons for the ERISA valuation, a first blush impression of these valuations - those we have seen, and will continue to see from various sponsors of these programs - may cause concern among investors, due to an apparent and significant drop or reduction in share value from purchase price of any specific program.
That said, caution is needed, as there are companies that will aggressively solicit existing shareholders of non-traded companies in an effort to coerce them into a "panic-sell" of their shares - we have seen offers as low as ten to thirty cents on the dollar. If you receive such a solicitation, we encourage you to contact our office for review, as many times these can appear to be "official" giving the impression that the offer is from and encouraged by the program sponsor.
From an investor perspective, each program should be considered individually and in its original context, respective of the overall asset class diversification that may have been developed, as well as the anticipated timeframe or holding period to maturity of the program in question. Our initial planning takes into account existing liquidity needs at the onset, but your plan and needs may change over time. This is one of many reasons why we are quirte insistent on conducting periodic reviews with our clients no less than once per year.
As sponsors release their FINRA/ERISA valuations, investors will be notified directly, concurrent with share value adjustments which may appear on the statements from the investment sponsors and the IRA custodians. Of course, if you ever have any question about these investments and their values, you are encouraged to call or schedule a time to visit in person.
