AI Quarterly Winter 2015

Q U A R T E R LY

Alternative Investments QUARTERLY

WINTER 2015 volUME 9 issue 1

REISA is now ADISA

The year 2014 was not just a good year for REISA. It was a fantastic and truly transformational year!

I Interval Fund Investing I Social Media Advertising I Factors Affecting Oil and Gas Plays I Q&A 1031

Q U A R T E R LY

WINTER 2015 volUME 9 issue 1

Alternative Investments QUARTERLY

ADISA Editorial Board Chair I Brandon Balkman I Orchard Securities

1 President’s Letter Whipped Into Shape

Eric Perkins I Perkins Law PLLC

ADISA News & Event

ADISA I 10401 N Meridian St., Suite 202 I Indianapolis, IN 46290

John Harrison I Executive Director I 317.663.4172 Adam Abubakr I Director of Accounting & Data Systems I 317.663.4177 Tanisha Bibbs I Education & Meetings Coordinator I 317.663.4174 Jennifer Fitzgerald I Director of Marketing I 317.663.4175 Tony Grego I Director of Business Development I 317.663.4173

10 Social Media Advertising for Your Financial Firm: A Necessary Tool

13 Part 1: 1031 Q&A

14 Interval Fund Investing— Mutual Fund Access to Alternative Investments

Copyright © 2015

not the “whip” business when automobiles hit the scene in the early 1900s. In fact, of the 100 largest industrial companies in the world between 1912 and 1995, almost half of them have disappeared, and more than a quarter experienced bankruptcy or a similar close shave with it. It was with this logic that our Association Board chose not to just create a new name, but embark on a new spirit of inclusion. Most everyone knows the early days of this association focused on one product, the 1031 exchange or TIC product. The association grew and was very successful in creating a strong base of members, providing education and networking opportunities, and spending significant resources on advocacy. As the market grew and changed, so did the association. At that time, staying true to its real estate roots, we renamed and broadened our scope to include all “real estate” type products in the securities industry. Today, many of our members are involved in multiple areas of the direct investment and alternative investment world. They have transitioned from making just Buggy Whips to embracing the many opportunities that are constantly presenting themselves in our markets.

This is how you stay relevant.

This is how you remain strong.

Sure, in the short term there is always a tinge of pain. But a worse pain would be doing nothing and suffering the fate of carriage makers, buggy whip manufacturers, and gas lantern proprietors everywhere.

Design I DesignMark I Susie Cooper

adisa.org

As a guy from the Motor City, I am well aware of the “Buggy Whip” analogy of companies that fail to adapt with the market they are in. Buggy Whip manufacturers, the story goes, went out of business because they failed to realize they were in the transportation business and

Direct: 317.663.4180 I Toll Free: 866.353.8422 Fax: 317.815.0871 I E-mail: adisa@adisa.org

By Mark Kosanke, 2014 ADISA President Concorde Financial Services

Executive Director’s Letter Was 2014 a Good Year?

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CONTACT INFORMATION

Whipped Into Shape

2

Linda Dewlaney I Preferred Partnership Services

Brandon Raatikka I FactRight, LLC

President’s Letter

20 Factors Affecting Oil and Gas Plays

It has been with great pleasure that I have been blessed with the opportunity to be President of the Association during this transition. For after all, it is a transition, and not simply a name change. The Board and the membership made it clear that ADISA will be the preeminent association representing the Alternative and Direct Investment space. We have an exciting future with new and exciting products on the horizon to join the

By ADISA (Alternative & Direct Investment Securities Association),

tried and true ones of our past. Buggy whips may be a thing of the past, but ADISA will transport you ahead

formerly REISA, formerly the Tenant-In-Common Association.

with the latest and greatest this industry has to offer. We can all look forward to a bigger, broader, stronger

All rights reserved. Readers may copy sections of this publication for personal use. However, it is a violation of U.S. copyright laws to

and more representative association than ever.

My best to all for a great year! ▲

copy substantial portions of the publication for any reason without permission. The Copyright Act of 1976 provides for damages for illegal copying. If you wish to copy and distribute sections of this publication, contact Jennifer Fitzgerald at jfitzgerald@adisa.org.

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Executive Director’s Letter

Was 2014 a Good Year?

By John Harrison, Executive Director, ADISA

Now for the numbers: About two-thirds of our constituent firms are broker-dealers, RIAs, registered reps, IARs and financial advisors.

Our programs continue to grow phenomenally, and we are approaching our new membership heights—a feat which shows a near doubling of our membership in the past few years.

The year 2014 was not just a good year for REISA. It was a fantastic and truly transformational year! Indeed the adoption of our new

By individuals, our growth looks like this:

name—ADISA—brought to life the realization that we have expanded to so much more than real estate. Our programs continue to grow phenomenally, and we are approaching our new membership heights—a feat which shows a near doubling of our membership in the past few years.

We have arrived as a trade association for the alternative investment space, but we’re also just getting started. There is so much more to bring to the table in terms of education at the events and year round, in speaking out for our industry, and in continuing to grow our impressive base of core members.

In 2014, Mark Kosanke led the Board in its thorough exploration of changing our name. Seeing our growth, coupled with our sound finances, it was the perfect storm to make manifest our expansion and live up to the diversification we love to preach.

2500

2000

1500

1000

500

0

2009

2010

2011

2012

2013

2014 Fall

• We saw close to 2,000 people at our events, and about half of those our core customer members (broker-dealers, RIAs, registered representatives, IARs and advisors) • Our programs touched every topic in the industry in various formats: creative conference sessions like Shark Tanks, Town Halls, drill downs and workshops, webinars, and easy-to-use articles in our new magazine, Alternative Investments Quarterly

ADISA’s own financial story of late is also one of growth: 2013, a surplus of $163k (audited); and for 2014, a predicted surplus of $235k. We plan to reinvest these funds back into our programs and reserves.

Furthermore, our cost structure as a percentage of our revenue is even better than many philanthropic agencies: only 28 percent of our operation was spent on management and general (overhead) as judged by our 2014 independent audit.

What has made and what continues to enable our growth? It’s the members and the leaders you have

• We put forth substantive advocacy work to regulators and legislators in

elected. And those elected leaders have stepped up their game to actively design not only an association

response letters and alerts plus became part of major alliances (contributing

which suits their business needs for the short term, but they readily plant seeds for a bright future which will

editorially and financially to the major Washington efforts surrounding the

yield shade trees under which they may never get to sit.

important 1031 like-exchange issue)

This idea of effecting an efficient association for the greater industry good is at the very root of the

• Our progressive association governance structure now reaches out even

American association governance structure and at the heart of ADISA’s success. We have lasting offices of

more to ensure the widest range of companies in our space have a fair voice

leadership, but they are only inhabited for a short time by very capable and dynamic individuals who lend

in our elections

their talents and then make room for the next crew. In other words, like George Washington, they lead, win, and get back to their day jobs. It really is a noble moment of which we should be thankful. It’s no one’s association but yours, and you continue to choose the best among you to keep us all moving forward. ▲

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ADISA News & Events The following pages will update you on ADISA Board Elections, and Legislative and Regulatory Efforts, as well as the upcoming 2015 Conferences. ➤

2014 Annual Conference & Trade Show a Success!

ADISA’s 2014 Annual Conference & Trade Show welcomed almost 1,000 attendees and 70 exhibiting companies to Caesars Palace Las Vegas in September. The threeday event featured more than 50 educational sessions covering trends and tools dedicated to the alternative investments industry, and examined legislative and regulatory issues, REITs, BDCs, 1031 exchanges, oil and gas, and other popular topics. Keynote speaker, NFL legend Terry Bradshaw, closed out the conference.

The biggest announcement of the conference was the organization’s name change—from REISA (Real Estate Investment Securities Association) to ADISA (Alternative and Direct Investment Securities Association)—on which the Board of Directors voted unanimously.

“The change to Alternative and Direct Investment Securities Association better reflects our organization’s mission and what we provide to the alternative investment industry,” said ADISA Executive Director/CEO John Harrison. “Our association represents thousands of individuals in alternative investments from all types and sectors, and we strive to provide the best education, networking and advocacy for these professionals.”

Hip Hip

ADISA’s 2015 Annual Conference & Trade Show will be held October 12-14 at the Cosmopolitan Las Vegas.

Hooray!

ADISA also handed out its annual awards—the ACE (A Champion of Excellence) Award, the Distinguished Service Award and the President’s Award—at the conference. The recipients were:

Distinguished Service Award John Grady RCS Capital Corporation

President’s Award Mike Bendix DFPG Investments

ACE Award Griffin Capital Corporation

Bryan Mick Mick & Associates

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2015 ADISA Conferences FEATURED CLOSING KEYNOTE SPEAKER

Featured keynote speaker, NFL legend Terry Bradshaw, closed out the 2014 conference.

The biggest announcement of the conference was the organization’s name change— from REISA (Real Estate Investment Securities Association) to ADISA (Alternative and Direct Investment Securities Association).

2015 Spring Symposium March 22-24 Hyatt Regency New Orleans

2015 Due Diligence Forum July 14-15 Eden Roc Hotel, Miami, FL

2015 Annual Conference & Trade Show October 12-14 The Cosmopolitan Las Vegas

2015 ADISA Board of Directors ADISA (Alternative and Direct Investment Securities Association, f/k/a REISA), the nation’s leading trade association serving the alternative investment and securities industry, has elected new directors and officers to its 2015 board.

The 2015 ADISA board officers are: President: Tom Voekler, Kaplan Voekler Cunningham & Frank President-Elect: Mike Bendix, DFPG Investments

The newly elected 2015 board members, chosen by a vote of ADISA’s membership, are: Catherine Bowman, The Bowman Law Firm Austin Dutton, BDA Bridge Valley Financial John Grady, RCS Capital Corporation

Vice President: John Grady, RCS Capital Corporation

Peter Magnuson, Securities America

Secretary: Keith Lampi, Inland Private Capital Corporation

Derek O’Leary, ICON Investments

Treasurer & Immediate Past President: Mark Kosanke, Concorde Investment Services

Cory Neumiller, Capital Financial Services

The new board members join the returning board members, who were elected in 2014 to two-year terms, and include: Fred Baerenz, AOG Wealth Management Barbara Halper, FactRight Derek Peterson, Walton International Brad Updike, Mick & Associates Todd Van Pelt, Cambridge Investment Research Darryl Steinhause, ADISA General Counsel, DLA Piper ADISA board elections occur in the fall; each director was elected to a two-year term through 2016.

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C o n g re

ss

SEC

FINRA

2014 Legislative & Regulatory Efforts ADISA’s (and up until September, REISA’s) Legislative & Regulatory Committee was diligent in making its voice heard among regulators and other legislative persons over the past year. Some highlights include:

REISA SUBMITS LETTER IN RESPONSE TO FINRA’S PROPOSED AMENDMENTS TO NASD RULE 2340 Mar 12, 2014

REISA SUBMITS RESPONSE TO FINRA’S PROPOSED AMENDMENTS TO RULE 2340 June 26, 2014

REISA’s Legislative & Regulatory Drafting Task Force submitted a letter to the SEC in response to FINRA’s proposed amendments to NASD Rule 2340—Customer Account Statements—to amend the provisions relating to the inclusion of per share estimated values for publicly registered DPP and REIT securities on customer account statements, as well as modify the requirements applicable to FINRA members’ participation in public offerings of DPP and REIT securities under FINRA Rule 2310 (the Proposed Amendments).

REISA’s Legislative & Regulatory Committee submitted a letter to the SEC in response to FINRA’s proposed amendments to Rule 2340.

REISA continues to believe in the importance of protecting the investing public while balancing the need for businesses and sponsors of quality real estate investment and other alternative investment products, along with the FINRA members who sell these products, to be able to efficiently raise capital without an overly burdensome regulatory scheme. REISA understands FINRA’s Corporate Financing Department’s push for action to ensure enhanced transparency and accountability. However, these investment programs have a unique place in the market for real estate securities and the investors attracted to these products are looking for real estate or other alternative products as an asset class in an illiquid, long-term investment. FINRA’s Proposed Amendments seek to fundamentally change the way that this product is understood and treated by member firms and their clients. REISA urges the Commission to disapprove the Proposed Amendments and asks FINRA to reconsider its suggested approach to Rule 2340.

REISA SUBMITS COMMENTS TO SEC REGARDING THE PROPOSED RULEMAKING IN CONNECTION WITH REVISIONS TO REGULATION A Mar 25, 2014 REISA’s Legislative & Regulatory Drafting Task Force submitted a letter in response to the SEC’s request for comments to the proposed rulemaking in connections with revisions to Regulation A, promulgated under Section 3(b) of the Securities Act of 1933, as amended (the Securities Act), as encapsulated in Title IV of the JOBS Act. REISA’s comments are focused on these issues: State Preemption, Limitation on Types of Issuers Able to Use Regulation A, 10% Cap on Investments in Tier 2 Offerings, and Application of Rule 15c2-11 of the Exchange Act and Rule 144 of the Securities Act.

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REISA APPLAUDS FINRA’S PROPOSAL TO EXTEND INTRODUCTION OF NEW RULES AFFECTING NON-TRADED REIT AND PRIVATE PLACEMENT INVESTOR STATEMENTS Jul 16, 2014 REISA applauds FINRA’s recent letter to the SEC regarding its final proposed changes to rule 2340, which affect non-traded real estate investment trust and private placement customer account statements.

FINRA’s letter proposes to extend the effective date of the amendments to no earlier than 18 months following approval from the SEC, providing additional time for non-traded REIT sponsors, brokers and dealer managers to adjust to the new rules.

REISA SUBMITS POTENTIAL TOPICS TO ADD/ REVISE TO NASAA REIT GUIDELINES Sep 12, 2014 On Sept. 12, REISA’s Legislative & Regulatory Committee submitted potential topics to add/revise to NASAA REIT Guidelines, in response to NASAA’s Direct Participation Programs Policy (the “Policy Group”) request for comments on the 33 items listed in the “NASAA REIT Guidelines: Potential Topics to Add/Revise” (the “Proposal”).

ADISA BOARD OF DIRECTORS VOTES TO ASSIST IN 1031 ADVOCACY EFFORTS Oct 23, 2014 ADISA’s board of directors has voted to support the IRS Section 1031 (like-kind exchange) advocacy efforts of two prominent industry groups – the Real Estate Roundtable and the Federation of Exchange Accommodators (FEA). A repeal of IRS Section 1031 was proposed by Congress in the Tax Reform Act of 2014 earlier this year, and has been under review since.

ADISA SUPPORTS RELIEF FROM FOREIGN INVESTMENT IN REAL PROPERTY TAX ACT Nov 19, 2014 ADISA has joined a coalition of 15 leading real estate trade associations in support of an ongoing legislative effort aimed at finding relief from the Foreign Investment in Real Property Tax Act (FIRPTA). The real estate trade association coalition submitted a letter to U.S. Senate Majority Leader Harry Reid and U.S. Senate Republican Leader Mitch McConnell urging the leaders to include a proposal made by U.S. Senators Robert Menendez and Mike Enzi in the legislative agenda for the remaining days of Congress.

REISA Delegation Meets with Regulators in Washington July 23, 2014 REISA sent a high-powered delegation of attorneys and industry leaders to Washington, D.C., in July, prior to the Due Diligence Forum, to share concerns and exchange views about ongoing regulatory issues affecting the alternative investment space. Board Members John Grady, Realty Capital Securities; Barbara Halper, FactRight; Darryl Steinhause, DLA Piper; President-Elect Tom Voekler, Kaplan Voekler Cunningham & Frank; and President Mark Kosanke, Concorde Investment Services, met with FINRA and SEC representatives to discuss issues facing the alternative and direct investments industry.

According to President Mark Kosanke, the day was highly successful, as REISA continues to work closely with both regulatory organizations to foster an open dialogue.

ADISA’s 2014 Legislative & Regulatory Committee was co-chaired by Deborah Froling, Arent Fox, and John Grady, RCS Capital Corporation. Drafting Task Force members included Deborah Froling; John Grady; 2014 President-Elect Tom Voekler; and ADISA General Counsel, Darryl Steinhause.

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Social Media Advertising for Your Financial Firm: A Necessary Tool

By Amy McIlwain Financial Social Media

Last fall, Twitter finally went public and solidified that all the major social networks are now publicly traded entities. With all the hype around the release of their IPOs, some forgot to consider how this would affect their users and the interface that they had grown to know and love. Because of increasing pressure from investors, it is no surprise (from a business prospective) that Facebook, Twitter, LinkedIn, YouTube, etc. would need to figure out how to make more money. The avenue that has proved successful: social media advertising.

Then & Now: What has changed? It’s crazy how much can change in one year!

Last summer, social media advertising was gaining some popularity, but it was still possible to establish and grow your social media presence organically (without paying). Because of the increased pressure from investors, the major players (most notably Facebook) have altered their newsfeed algorithms resulting in largely decreased organic reach.

Facebook: If you have been using a Facebook Page, I’m sure you have noticed the steady decline in your impressions on any single post. As of August 2014, the average business page post on Facebook was receiving only 3-6% reach of your total following.

This means that if you have 1,000 people that like your page, only around 50 people will see your average post in their newsfeed. This can vary depending on when you post, the type of content you share and how many fans typically like or share your content. This reach is down from about 16-20% of your fans in October 2013.

Because of the increased pressure from investors, the major players (most notably Facebook) have altered their newsfeed algorithms resulting in largely decreased organic reach.

Twitter: Facebook is not the only culprit. Twitter, as well as LinkedIn, is heavily favoring paid posts and advertisements as a way to grow your network quickly. Although you currently see all your following’s tweets in your timeline, tweets on average only reach around 10% of followers as they are quickly drowned out by other posts.

In addition, Twitter has always said that it would one day release an algorithm that alters this. Twitter has also started to add paid tweets, and tweets Twitter deems relevant, to your timeline, even if you don’t follow that particular brand.

Now that it is apparent that this is the way things are shifting in the social space, our only option, as marketers, is to learn the best ways to play their game. It may help to this about social advertising like this:

While paid promotions will cost you time and money, they cost far less than traditional advertising avenues and allow you to cast a wider (and more targeted) net beyond your current network.

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12%

Average Organic Reach of Content Published on Brand Facebook Pages social@Ogilvy Analysis of 100+ Facebook Brand Pages around the world with more than 48 total fans conducted by Social@Ogilvy in February 2014.

Please see our report, “Facebook Zero” at http://social@Ogilvy.com for details.

12.05% 11.58%

Part I: 1031 Q&A

10%

8.70% 8%

7.70%

4%

6.15%

All Pages

6%

4.04% 3.51% 2.97%

2.71%

Pages w/ >500K Likes

2.11%

2% Oct ‘13

Nov ‘13

Dec ‘13

Jan ‘14

Feb ‘14

Who uses social advertising? So you have decided that you are willing to give in and advertise on social media?

Well you are going to have some competition. Businesses are flocking to promote their content on social media. Check out some astonishing stats below about paid social activity: 1 Million: The number of small or medium sized businesses advertising on Facebook 500,000: Total number of Facebook pages promoting posts 2.5 Million: Total number of Facebook promoted posts 45%: Percentage of ads in the 2013 Super Bowl that included Twitter hashtags $200,000: Cost of a 24-Hour Promoted Trend on Twitter $100 Million: Estimated amount that Samsung spends on Facebook advertising per year (making the creator of the Galaxy phone the largest advertiser on Facebook)

What are some tips & tricks to get the most out of advertising? To get the most bang for your buck from your social media advertising, it is important to always focus on the same basics as you would with content creation.

Below are a few steps to help get the most return within your industry: 1. Always create and share content that is timely, relevant and authoritative. If it is entertaining or funny, that is an added bonus!

2. Define your goals for social advertising. When defining these goals, think about the type of people you need to be communicating with to achieve them.

3. We know that most businesses have a limited marketing budget, especially smaller firms. To make the most of this ad spend, focus your time and money only on the social platforms where your target audience lives. Just because you have decided to be a social company, doesn’t mean that you need to have a huge presence on all networks if your target demographic doesn’t use them.

4. To follow-up our last tip, start advertising slowly with one network. Your company has a Facebook, LinkedIn, Twitter

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and Google+ presence, but maybe your target audience is extremely active on Facebook, pretty active on LinkedIn and not super engaged on Twitter and Google+. Start your social media advertising with just Facebook. Once you start to master your ad copy and creative, and start to understand what really works, then begin to inch your way into LinkedIn advertising.

5. Create multiple variations of your ads to see what catches the attention of your audience. Try different pictures and post copy to see what resonates best and receives the most interaction. Each social network’s internal advertising platform makes it very easy to do this.

6. Analyze your efforts and make adjustments based on the results. Each network has an internal advertising analytics section that is relatively user-friendly, so take advantage. ▲

Question 1: Back in 2006, the TIC industry was a $3.5 billion equity business (over $7 billion of real estate acquisitions). Then, TICs became virtually extinct. What happened?

An unprecedented double dip recession. Starting in 2007 and again in 2009, the US economy experienced a severe, unexpected and long-lasting double dip recession. The recession disproportionately and adversely impacted old TIC real estate investments by reducing rents, shrinking the pool of quality tenants, and generally creating a negative atmosphere (malaise) in which to retain tenants or re-tenant buildings.

The TIC structure proved problematic: the requirement for unanimous TIC owner consent made it difficult to accomplish work outs with lenders and tenants. The structural TIC issues were exacerbated by the varying degree of investor sophistication and general investor inability (or unwillingness) to contribute fresh capital to old TIC properties. Many investors did not have funds to support sorely needed capital calls and others simply refused to “put good money after bad.” Many TIC owners ran out of funds to re-tenant, repair and maintain properties to their former high standards. This happened even though most TIC properties were “adequately” funded with reserves to cover foreseeable events, but not the length and depth of the recession.

In addition, there was a general malaise in the country that instantaneously had an impact on valuations and made it more difficult to “get a deal done” with tenants and lenders. Many TIC investments had adequate reserves to weather a blip in the economy; few had enough reserves to weather “the perfect storm” that lasted five years.

CMBS debt, which financed most TIC properties, proved to be problematic in the context of a TIC work out. CMBS servicers transferred loans to special servicers who were generally slow in responding and uncooperative (or worse) in resolving property issues caused by the recession. Some special servicers seemed influenced by an unexpected profit motive at the expense of the TIC owners. In addition, CMBS debt essentially dried up overnight in mid-to-late 2007, making it much more difficult for TIC investors to finance their way out of challenging properties.

Finally, during the recession, many properties were sold or simply transferred from a nurturing and caring TIC sponsor to mercenary replacement sponsors, some of whom appeared to be more interested in collecting fees than saving properties and protecting the life savings of TIC investors. When the original sponsors exited and outliers took over TIC properties, many investors lost an ally and were left to fend for themselves in a complex world dominated by lawyers, servicers and investment bankers, well beyond their level of knowledge and expertise.

Question 2: What happened to the 50 plus sponsors who were “the leaders of the TIC industry”?

Most of the newbie TIC sponsors simply went out of business;

with Louis Rogers Capital Square Realty Advisors

some were put out of business. A small core of respected TIC sponsors transitioned into DST programs. They presently serve a vital role in providing fractionalized 1031 replacement property for old TIC and new exchange investors using the DST structure.

Question 3: What is the direction of fees and loads?

DST sponsor fees have trended down materially over the past five years. Most DST sponsors are working harder for lower net fees.

Broker-dealer commissions and allowances have declined slightly and are poised to decline further over time. It is important to continue the moderation of fees and loads to help put more investor dollars in the ground for the ultimate benefit of investors first, and BDs, reps and sponsors who are seeking a stable business model built to last for the long haul.

Question 4: What was the biggest surprise?

Bankruptcy of LandAmerica Financial Group, once a Fortune 500 company listed on the New York Stock Exchange. Who could have imagined that LandAmerica Exchange’s investment in auction rate securities would bankrupt an NYSE-listed public title insurance company? That was an eye-opener and a gamechanger that demonstrated the fragility of even large, respected public institutions. If this could happen to LandAmerica, it could happen to any large company (Lehman Brothers?).

Question 5: Greatest opportunity?

Old TIC rollovers will create a nice opportunity for sponsors and service providers. The TIC industry peaked in 2006. Most TIC properties were financed with 10 year debt. That means that the bulk of the remaining TIC properties will have to be sold no later than 2016, when their debt matures. Many of those investors will want to structure new exchanges to defer substantial taxable gains. Most will have severe tax issues if they do not exchange because of their low tax basis and high leverage. Without a new exchange to once again defer the gain, many investors will not have sufficient net proceeds to pay federal and state income taxes. In other words, without a qualifying exchange, a large number of old TIC investors will have to pay substantial deferred federal and state income taxes IN EXCESS OF THE NET PROCEEDS OF SALE. This will create a real sense of urgency and an opportunity for sponsors, BDs and reps to help satisfy the demand for investors who want a fractionalized replacement property. ▲

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Interval Fund Investing— Mutual Fund Access to Alternative Investments

By Scott Crowe Resource Real Estate

White Paper

Individual investors have long wished for the same access institutions have to alternative investments.

Interval funds have potential to unlock this access for the widest possible audience.

The global financial crisis has caused an important structural shift in investor preferences towards alternative investments and away from more volatile equity markets. In addition, bond yields have plummeted in the aftermath of the crisis, leaving investors without the ability to generate income. In essence, the crisis highlighted a flaw in the way many investors approach portfolio diversification—simply having a range of mutual funds with access to different “sectors” may not be enough to create appropriate diversification. For instance, while the underlying investment of a publicly traded real estate investment trust (REIT) may include real estate, an investor’s allocation can behave very much like the S&P 500. Institutions have implicitly acknowledged the limitations of equity market investments for decades, with most maintaining a large allocation to private investments, including real estate.1 The benefits of these allocations have shown a decrease in portfolio volatility, lower correlations with equity markets and the potential for increased returns. Historically, access to alternative private investments has been given exclusively to large institutional investors, but this is rapidly changing. The “mass affluent”2 are now demanding more sophisticated investment products.

Recognizing this trend, investment sponsors have developed new ways for individual clients to access alternative investments, including real estate equity and debt through non-traded REITs3 as well as corporate credit through Business Development Companies (BDCs).4 Now, a new product type, the Interval Mutual Fund (iFund),5 is providing the next evolution in alternative investment products.

As mutual funds did for equities, iFunds have the potential to unlock alternative investments to the widest possible investor base while simultaneously providing greater price transparency and liquidity. In addition, iFunds may increase the efficiency and lower the expenses of investments in alternative assets by aggregating capital, thus decreasing costs as a percentage of assets—a significant benefit given the imminent rule changes for commission and fee transparency on client statements for non-traded REITs and BDCs.6

As mutual funds did for equities, iFunds have the potential to unlock alternative investments to the widest possible investor base while simultaneously providing greater price transparency and liquidity.

Interval Funds: the meeting point of alternative investments and mutual funds The iFund is simply a mutual fund that offers daily investment opportunities and limited redemptions at specific intervals (usually quarterly).7 This change to the mutual fund structure creates large advantages, however; it allows the fund to simultaneously invest both in private and public assets—with a structure that has both liquidity and a daily net asset value (NAV).

In turn, the sponsor may create a portfolio of investments with high yield and low correlation to equities, but without the usual limitations of private investments (illiquidity and lack of price transparency).

The liquidity feature and price transparency, in conjunction with sufficient portfolio diversification, can make iFunds suitable for a large pool of investors. This also allows interval funds to be held in both fee-based and commission-based accounts—an important benefit given the growth of fee-based assets and the advisors’ need to access alternative investments that complement existing mutual fund options.

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Graph 1: Interval Funds—intersection of alternatives and mutual funds An institutional real estate allocation may lower volatility and increase returns

Graph 1: Interval funds offer higher liquidity than private real estate, but reflect market fluctuations.

Private investments can offer higher yield and less correlation to the market, but they lack pricing transparency and liquidity. Interval Funds can capture the yield and correlation characteristics of private investments, but also provide liquidity and transparency.

Figure 2: Hypothetical Portfolio Allocation: 2000-2013 Figure 2: In the example scenario above, the three sample portfolios allocate various levels of investment to equities, bonds and diversified real estate income.

As more of the portfolio is allocated to diversified real estate, returns increase and volatility decreases.

Replicating an Institutional Approach to Real Estate Investments Individual investors’ access to real estate has traditionally been limited to publicly traded REITs and non-traded REITs. However, these products represent only a portion of the available access points to real estate investments. Simultaneously accessing different real estate investment types can optimize a real estate allocation by capturing the benefits of listed and non-listed investments, while mitigating their individual disadvantages. For example, investing directly in real estate through institutional private equity can produce moderate yields, growth and sector diversity, but not liquidity. Publicly traded REITs are liquid and give access to global investment opportunities, non-traditional asset types and growth—but come with a lower yield and higher equity market correlation. Debt can give yield and principal protection, but can fall short on interest rate hedging ability.

As shown above, an allocation of just equities and bonds (third pie chart in Figure 2) has potential to bring on more risk and lower returns than allocations that contain equities, bonds and diversified real estate income.11 When 10% of diversified real estate income is added to the allocation (second pie chart in Figure 2), risk decreases, while returns simultaneously increase.

When 20% of diversified real estate income is added to the portfolio (first pie chart in Figure 2), risk decreases even further, while returns simultaneously climb higher.

Chart 1: Characteristics of real estate investment types Chart 1: Breakdown of advantages and disadvantages of the three main types of real estate investments. The shaded circles indicate favorability towards the relevant characteristic.

Figure 1: An institutional real estate allocation10

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In the this example (Figure 1), replicating an institutional real estate allocation by including equal weights of direct real estate, credit investments (debt) and publicly traded REITs would have produced a yield of 5.7% and a total return of 8.1%, with a volatility of 8.0%8 over the last 13 years. The Sharpe Ratio would have been 1.02.9

A tool for new FINRA client statement rules The non-traded REIT industry faces a significant change with the expected implementation of new rules to client statement reporting.16 The changes for fee and commission transparency will have a considerable impact on the nontraded REIT market and, in particular, its fee and commission structures. Coupled with an increase in transparency on the net value of client positions, this change is likely to make interval funds, which have return profiles similar to non-traded REITs, more attractive for both advisors and clients. Interval Funds may be part of the solution for advisors impacted by the potential of lower commissions following the implementation of these new rules. iFunds already enjoy liquidity and transparency in pricing through a daily NAV. Advisors who have been reluctant to make use of more opaque alternative instruments17 may find iFunds suitable for more clients by virtue of their liquidity and transparency; and hence expanding the use of alternatives by their clients.

The ability to aggregate capital through iFunds provides a further advantage to the industry.

Economies of scale and mutual fund implementation can help decrease costs related to due diligence, research and distribution. Just as mutual funds led to the broadening of equity investment over the last two decades (with simultaneous fee compression and expansion of the industry), iFunds may prove a similar catalyst for expanded market penetration by alternatives.

Advisors who have been reluctant to make use of more opaque alternative instruments17 may find iFunds suitable for more clients by virtue of their liquidity and transparency; and hence expanding the use of alternatives by their clients.

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Analyzing Interval Funds iFunds’ attractiveness to investors depends on the content of

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their portfolios. Strategies will differ, and indeed, some will include a range of alternative assets in addition to real estate. However, there are a few essential aspects investors should consider when examining an iFund’s merits: • Investment strategy: Understand what asset classes the portfolio comprises as well as the largest positions in the fund.

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• Internal investment management versus fund of funds approach: Does the iFund outsource investment management or keep this function “in house”? It is advantageous for the fund sponsor to perform this important function, as it allows better risk control and more accountability, in addition to potentially lower costs.

• Level of liquidity and transparency: The liquidity feature of the iFund structure is an important characteristic; a significant level of liquid assets will ensure the ability to meet redemptions.

Further, the allocation to liquid assets improves pricing transparency.

• Conflicts of interest: Conflicts can arise if the portfolio manager is allowed to invest in other funds of the sponsor.18 The most transparent way to ensure no conflicts is to preclude the iFund from investing in other funds of the sponsor.

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Conclusion

Scott Crowe Resource Real Estate

The demand for uncorrelated income is leading to new ways for advisors and their clients to access alternative investments. iFunds help meet this growing demand through a portfolio of alternative investment securities. Such an approach can replicate the benefits of an institutional approach to real estate investment for an expanded set of investors. In addition, the flexibility of the mutual fund structure can help advisors adapt to an evolving regulatory landscape. Important aspects to consider when assessing the merits of an interval fund include the investment strategy, internal management, liquidity and lack of conflicts. As the demand for uncorrelated yield continues to increase, iFunds can offer an important tool to gain the widest possible access by the widest possible audience to alternative investments. ▲

1—The Yale Endowment Fund is an example of a private investment platform with $20.8B AuM on June 30, 2013. The Endowment targets up to 90% in alternatives including private equity, absolute return, and real estate. http://investments.yale.edu/images/documents/Yale_Endowment_12.pdf http://investments.yale.edu/ 2—The mass affluent segment generally refers to U.S. individual investors or households with $100,000 to $1M in investable assets. http://www.wikinvest.com/wiki/Mass_Affluent 3—A direct, long-term real estate investment that uses the capital it raises from retail investors to purchase and manage income-producing properties. IPA.com, Investing in Non-Traded REITs. 4—A company that is created to help grow small companies in the initial stages of their development, similar to venture capital funds. Many BDCs are set up much like closed-end investment funds and are actually public companies that are listed on the NYSE, AMEX and NASDAQ. http://www.investopedia.com/terms/b/bdc.asp 5—While technically a continuously offered closed ended fund, the Interval Fund can also be described as a mutual fund which offers daily purchase for investment, but liquidity for redemptions at specific intervals (usually quarterly).

6—On February 3, 2014, the Financial Industry Regulatory Authority (FINRA) proposed changes to NASD Rule 2340 which would increase disclosure on the fees and commissions paid to brokers who sell non-traded REITs. 7—Redemptions are shares bought back from the shareholder/investor by the fund under a program referred to as the Share Redemption Program (SRP) to provide investors with a limited form of liquidity.

8—The underlying data for equity markets used in this analysis was based on the S&P500 Index that produced a yield of 2.0%, total return of 4.64% and a volatility of 17.99%; the data for publicly traded REIT markets used was the FTSE EPRA NAREIT Global Developed Index (RUGL) which produced a yield of 4.53%, total return of 9.43% and a volatility of 22.61%.

9—Sharpe Ratio determines an investment’s return per unit of risk and is calculated as total return divided by volatility.

10—To create a hypothetical institutional real estate allocation portfolio, we blended equal segments of direct real estate (NCREIF Property Index (NPNCRE); debt (Wells Fargo Preferred REIT Index (WHPSR); publicly traded REITs (FTSE EPRA NAREIT Global Developed Index (RUGL). Date time period: 12/31/13 to 12/29/00; source: Internal Resource Real Estate data.

11—Shown by an increased Sharpe Ratio.

12—The underlying data for equity markets used in this analysis was based on the S&P500 Index that produced a yield of 2.0%, total return of 4.64% and a volatility of 17.99%; the data for publicly traded REIT markets used was the FTSE EPRA NAREIT Global Developed Index (RUGL) which produced a yield of 4.53%, total return of 9.43% and a volatility of 22.61%.

13—The data for the bond markets used was based on the EFFAS Bond Index for U.S. 10-year government bonds (Bloomberg: USG5) which produced a yield of 5.37%, total return of 6.33%, and a volatility of 12.38%.

14—The hypothetical Diversified Real Estate Income portfolio is the same blend as shown in Figure 1. Please note that you cannot invest directly in an index.

15—Sharpe Ratio determines an investment’s return per unit of risk and is calculated as total return divided by volatility.

16—On February 3, 2014, the Financial Industry Regulatory Authority (FINRA) proposed changes to NASD Rule 2340 which would increase disclosure on the fees and commissions paid to brokers who sell non-traded REITs. Under the new rules, it is proposed that NTR client statements will display the per-share price net of the REIT’s expenses, with statements showing the share value after the deduction of fees and any expenses related to organization, offering and property acquisitions. Mutual Funds and Interval Funds tend to have lower fees and expenses and report a price plus commission cost basis on the client statement as opposed to the NTRs current net investment structure. We believe fuller disclosure will benefit both customers and the industry, and may lead to a more mutual fund-like fee structure, with different share classes.

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17—Only one in five of their clients are invested in non-traded REITs, at present. [Stanger Survey of Advisors 2013] 18—This is the case even if the fund board appoints a third-party sub advisor, if the board is composed of the sponsor’s representatives. In such an instance, the sponsor can effectively hire and fire the manager, which does not ensure impartiality when investing in the sponsor’s other products.

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Factors Affecting Oil and Gas Plays

By Kemp H. Hanley, CFA FactRight, LLC

It’s no secret that oil prices will drop when global growth slows or the market is oversupplied. But the recent slump has turned heads: at the end of 2014, the price of oil dipped to a level not seen since 2010. In a move that surprised many, Saudi Arabia cut its crude oil prices in October and again in November. While some analysts believe the price reductions are simply an effort to retain market share in an increasingly competitive environment, others contend the Saudis are specifically targeting the U.S. shale industry.

In either case, a further decline in price won’t necessarily spell doom for all oil and gas producers, but it could become an issue for some, particularly those with smaller, less-established operations, and, yes, those in the shale industry. In fact, according to Bloomberg, the shale-oil drilling boom in the U.S. is showing early signs of slowing: The nation’s oil rig count peaked at 1,609 on Oct. 10, 2014; rigs targeting oil sank to 1,568 as of Nov. 7 that same year.

Considering the current situation, broker dealers should give oil and gas plays that include these types of producers another look. In doing so, broker dealers should examine the following three factors to gauge a producer’s ability to weather a sustained drop in price.

Factor #1: Debt In recent years, low interest rates have enabled producers to get fresh debt capital to cover their operational cash shortages. Many smaller producers turned to the all-too-common strategy of piling on debt to boost growth. Unfortunately this strategy is far from sustainable under difficult market conditions: tightened margins can turn interest service payments into death sentences, halting exploration and production growth.

Not surprisingly, a Bloomberg analysis of 61 companies drilling for shale oil and gas found that debt among these companies had nearly doubled over the past four years, while revenues had inched up only 5.6 percent. Moreover, interest payments on that ballooning debt are taking up an even larger portion of revenues—even at today’s record-low interest rates—with 12 of the companies already paying more than 10 percent of their revenues in interest.

Broker dealers can use the following leverage ratios to determine how well a producer is managing debt: Debt/EBITDA, EBIT/Interest Expense and Debt/Equity. EBIT and EBITDA are two metrics that, in theory, can be used to pay interest on the debt and repay the principal.

Needless to say, producers that carry a large amount of debt on their balance sheet will undoubtedly find it more difficult to survive a prolonged drop in price. Which is why, for broker dealers, getting the entire story on a producer’s financial situation is key.

Factor #2: Location A producer’s cost is highly dependent on its drilling locations. Operators in more challenging geologic areas of production, such as those in the shale-rich Bakken and the Canadian oil sands, may feel a greater pinch compared to their counterparts in, say, Texas. That’s because it’s inherently more costly to drill for oil in these areas; it requires specialized drilling technology and crude oil must travel significant distances— across less-developed infrastructure—to reach the point of sale.

According to recent reports, break-even prices for U.S. oil fields range from $30 to more than $120/bbl. However, certain U.S. shale formations need upwards of $70/bbl to survive. In light of the volatile market, Continental Resources Inc., a major oil producer in North Dakota’s Bakken Shale, announced on Nov. 5 it would not be

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adding drilling rigs next year. Likewise, ConocoPhillips Co. declared that next year’s budget would fall below this year’s, causing the company to scrap plans for new wells in places such as Colorado’s Niobrara Shale.

Even so, it’s important to note: not all shale formations are equal. Economics even within the same formation can vary.

Some, by nature of their depth or elemental makeup, simply aren’t profitable at low prices. Others are profitable when prices are at the $65 mark.

With this in mind, broker dealers should consider a producer’s geographic diversification. Producers who have concentrated their rigs in challenging areas of production will, of course, find it harder to break even when margins become squeezed.

Factor #3: Operations A producer’s operations—particularly its management and technology—can drastically affect its ability to survive plummeting prices. Technology plays a significant role in the oil and gas industry, especially when it comes to shale; leading companies employ technologies that efficiently extract oil from shale and increase their margins. In fact, recent technological advances have sharply lowered the break-even point; fracking no longer ranks as one of the most expensive forms of oil production.

Producers who have invested in the latest technologies to unlock the oil from the shale will naturally be better positioned to survive— and even thrive—in a changing market.

Technology, of course, doesn’t do much on its own. For this reason, broker dealers should also look closely at a producer’s management: How experienced is the leadership team? What’s their track record through different market cycles? Are they qualified? Asking these types of questions can help broker dealers assess a producer’s resiliency in the face of downward oil-price trend.

What actions should broker dealers take? Broker dealers should continue to keep an eye on the situation, which is likely to change as global politics and economic conditions evolve. Broker dealers should also be watchful producers who disclose their reserves in terms of the “barrel of oil equivalent” (BOE). BOE is a reporting metric that allows companies to lump both oil and natural gas production into one calculation, resulting in a unit of energy.

While useful, the BOE metric can be misleading in terms of actual value, depending on whether the BOE is 100% natural gas with a market price of $3.50 per thousand cubic feet, or 100% oil worth $80 per barrel, or a combination thereof. Broker dealers should be watchful of producers who may attempt to use the BOE metric to pad the value of their gas reserves. The question to ask is “what percentage of production is oil, versus natural gas and natural gas liquids?”

Regardless, broker dealers should make sure they have all the facts—especially those that relate to a producer’s debt, location and operations—when ascertaining the risk associated with an oil or gas play. ▲

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