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Will missteps menace Schorsch's empire?

Will missteps menace Schorsch's empire?

On top of accounting debacle, sales are down and IBD jumps ship

Oct 31, 2014 @ 10:43 am

By Bruce Kelly

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(Kam Tai)

With at least one major independent broker-dealer forecasting a potential slowdown in the sale of nontraded real estate investment trusts, the revelation this week of accounting errors that went intentionally uncorrected at Nicholas Schorsch's flagship REIT, the publicly traded American Realty Capital Properties Inc. (ARCP), could not have come at a worse time for the REIT czar.

In a conference call with analysts last week, Mark Casady, the chief executive of LPL Financial, one of the largest sellers of nontraded REITS, said the company sees the market for the investments potentially softening.

Meanwhile, a slackening pace in listings and mergers of nontraded REITs — so-called “liquidity events” — forced investment bank Robert A. Stanger & Co. Inc. to cut its forecast of nontraded REIT sales from $20 billion this year to $17.9 billion.

And on top of the broad industry slowdown in sales, at least one group of broker-dealers, National Planning Holdings, last week said it was temporarily suspending nontraded REITs sponsored or distributed by American Realty Capital (ARC), the privately held real estate sponsor and manager that is the backbone of Mr. Schorsch's empire. The independent-broker-dealer industry was buzzing with questions last week about whether other firms had also halted the sale of ARC products, but none could be confirmed.

Opening for business at the start of the real estate crash in 2007, ARC — and Mr. Schorsch — have come to dominate the nontraded REIT industry. After his broker-dealer, RCS Capital Corp. (RCAP), of which he is executive chairman, completes its pending acquisition of REIT sponsor Cole Capital from ARCP, Mr. Schorsch's companies will control more than half the annual sales volume in the nontraded REIT business.

Mr. Schorsch also has been a vocal critic of the nontraded REIT industry, drawing the ire of many of his competitors. But he is a force in the industry. He is chief executive of ARC, which creates nontraded REITs. He is chairman of ARCP, which has a market capitalization of $9 billion and so far has bought two of the ARC-sponsored net lease REITs, as well as a host of other properties not controlled by ARC.

The $23 million accounting error at ARCP, which involved a subsequent coverup and resignation of two senior executives, will hurt sales of ARC nontraded REITs, said Kevin Gannon, president and managing director at Stanger. “I think it has, to, at least in the short term, because of the wait-and-see approach the due-diligence people will have regarding this matter. Like the stock market, the reaction could be overblown at first.”

“We've seen this before and seen REIT sponsors sales hurt at first,” Mr. Gannon said. “They need to make sure any problems don't run deeper.” The accounting errors that reduced ARCP's adjusted funds from operation over the first half of the year was less of an issue than ARCP saying that error was identified but intentionally not corrected, he noted.

Mr. Gannon said he hopes that the episode is just a one-time event. “I sincerely hope [ARC and ARCP] can recover from it. But in the short run it's going to be painful.”

Nontraded REIT sales in general are potentially running out of steam, Mr. Casady noted.

“Alternative investments, particularly nontraded REITs, are cyclical in nature,” he said last Thursday during a conference call with investors and analysts. “We've just finished one of the greatest up cycles in real estate that we'll probably see in a period of time. I don't want to predict. But certainly it's been very strong.”

Capitalization rates, a measurement of profitability in real estate, “are at very low levels,” Mr. Casady said. “And therefore those products will be less popular and less appropriate [for clients] going forward.”

Meanwhile, Mr. Schorsch last week tried to quell any concerns of executives at the hundreds of independent broker-dealers that sell ARC nontraded REITs and other products during a conference call last Wednesday with 300 broker-dealer executives, hours after ARCP revealed its accounting problems.

He apologized for the accounting errors at ARCP, but he also attempted to downplay the impact it will have on his REIT empire. During the call, he said that the problems with accounting at ARCP in no way would affect the number of nontraded REITs that are created by ARC and sold by RCAP.

“How does it impact any [ARC] programs? It doesn't,” Mr. Schorsch said. “It doesn't impact any programs by Cole [Capital, another of his the nontraded REIT brands], he added.

“The headline is, mistakes were made, identified and the people involved were identified,” Mr. Schorsch said. “It will be fully corrected. It's not something I'm proud of or happy about. It's a very difficult situation to sever relationship with [ARCP's chief financial officer] Brian Block after all these years.”

It remains to be seen how deeply the accounting debacle will impact Mr. Schorsch and his REIT empire. Both the Wall Street Journal and Bloomberg reported last week that the Securities and Exchange Commission intended to launch an inquiry into the company's accounting irregularities. Plaintiff's lawyers started searching for ARCP stockholders and began to file lawsuits against ARCP, seeking millions in compensation.

But if ARC and Mr. Schorsch can weather the storm, they could see a turnaround in their current fortune. Mr. Gannon's forecast for nontraded REIT sales going forward was not as dour as Mr. Casady's. The slackening pace in nontraded REIT sales could very well pick up in 2015, Mr. Gannon said. Indeed, Mr. Stanger's forecast for nontraded REIT sales next year is an astounding $26.9 billion in sales, which would be the most ever.

“Less fund raising [across the nontraded REIT industry] at the moment doesn't surprise us,” Mr. Gannon said. “There is, however, in excess of $10 billion in pending liquidity events.”

“We thought some of those were going to happen in the fourth quarter but they might not happen till late in the quarter and therefore have more of an impact next year,” he said.

Tony Defazio, a spokesman for Mr. Schorsch and his businesses, said ARC had no comment about potential REIT sales. It also had no comment regarding potential questions from the SEC.

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