The Accounting Fraud At American Realty Capital Properties

In June, I wrote this article titled “Just Not Worth It: Stay Away From American Realty” that expressed my concern about American Realty’s Chairman Nicholas Schorsch, who is the architect of the mega-growth American Realty Empire and once sought mega-compensation to the tune of $92 million for meeting what I consider to be low hurdles to receive significant chunks of the “incentive bonus” amount (things like deliver 7% annual returns while the dividend yield is above that amount).

He is one of those investment characters that I put into the category of the more I find out, the less I like. His nickname is “Slick Nick.” You don’t earn that nickname by volunteering extra shifts at the soup kitchen and giving until it hurts when the Sunday collection basket comes around. You find genteel REIT analysts saying things like, “Mr. Schorch is a charming man that plays loose with the facts”; that’s a Southern way of saying “That guy is a liar.”  Schorsch has made a lot of money by setting up broker-dealers to advertise both his traded and non-traded REITs to clients, and he collects a 1-3% fee (sometimes he has tried to double that). His philosophy seems to be “as long as I find a way to keep those dividends coming, I can do whatever I want behind the curtain.” His fee structures for non-traded REITs are so opaque that FINRA is debating new disclosure rules in response to his practices. He angered his investor base by promising that he wouldn’t issue new shares at $12 a piece (because he said that the company was worth much more than that), and he went out and issued new shares shortly thereafter.

These are the contextual things I have in mind when I heard about Brian Block and Lisa McAlister were at the forefront of an error that overstated a measure of profitability by $0.02 (according to the company, Block and McAlister made an honest error in the first quarter, and then massaged a few numbers in the second quarter to cover up their incompetence). It’s not the amount involved is substantial—after all, we’re talking about $23 million in the scope of an $8 billion operation.

Rather, it’s a culture of sloppy numbers—not that long ago, they claimed that a $1.5 billion deal would have $100 million in fees, and not until after critical hedge fund managers cried foul about the lasciviousness of it, did the American Realty executives say, “Whoops, we meant $10 million.”

Here’s the thing: If they are telling the truth, this would be a wonderful buying opportunity. Reinvesting a 11-12% dividend yield into shares of a stock that is trading at only 80% of reported book value is a formula for creating wealth. It is value investing. American Realty is a substantial landlord to gas stations, banks, drug stores. If that $0.0833 remains intact for the next few years, American Realty could be one of the best investments you’ll ever make in your life. The assets are real (Walgreen and Red Lobster do pay them rent!), but there is also a substantial debt burden as well (that’s why American Realty is able to do all these deals—they pay top dollar to make acquisitions, and finance it with debt that has low monthly payments).

If someone buys the stock in the name of value investing, I get it. The shares are extremely beaten down. If there are no new developments, this could likely be the stock price low. Collecting $1 per year in dividend income on a stock trading for $9 can turn into something substantial quickly if you reinvest along the way. Heck, I did something similar once before when I bought Bank of America at $7-$8 per share. So I get it.

But there are two Benjamin Graham rules that I take seriously when investing, and get treated like more than mere aphorisms—they are thoughts meant to be mulled over, again and again.

One of them is that you shouldn’t in anything that you don’t understand. That’s why my articles are generally limited to some of the largest and most visible companies in the world. I understand how Nestle makes a profit selling Toll house cookies. I understand how Fanta syrup converts to profits in Atlanta at Coca-Cola’s headquarters. I understand how refining and packaging petroleum makes Irving, Texas the home to what is normally the most profitable firm in the United States, ExxonMobil. I understand how selling Gillette razors for $10 each (which cost $0.50 to produce and ship), over and over again, makes Procter & Gamble shareholders rich.

When I study American Realty, I can’t figure out the company’s normalized cash flow. There’s been too many acquisitions in too short of a time for me to get a handle on anything resembling normalized profits. I see the $0.08333 dividend that gets paid out each month, and I can’t clearly identify the relationship between the debt deployed and the source of the cash flow. It’s regularly said that the triple net lease sector of the real estate market is the easiest stuff to understand, and even dummies can figure it out; well, for this particular company, I can’t.

The other thing is trust. Benjamin Graham once said that if you can’t trust the numbers, you automatically should remove that investment from consideration. After all, it is a study of the numbers that lead you to find an investment attractive in the first place—if you can’t have confidence in the numbers, you stay away. Some people have total faith now that Kay is CEO, and see the company’s self-disclosure about the accounting error as proof that internal controls are working. They see the extent of independent auditors checking the books, and confirming the revisions, and have total faith in the company. If that is you, then I understand why you would choose to invest in ARCP.

But that is not me. If I was an ARCP owner, I would not find it surprising to learn about excessive management compensation, tripped-up secondary share offerings, or other ambiguous fees coming to light. I don’t like Schorsch’s capital raising approach where he hires stockbrockers to recommend his products, and then, after the mom-and-pop customers pay a fee for buying the shares, the commissions get split between Schorsch and the broker. Real estate growth is funded through debt because you have to return 90% of your net income to keep your tax classification status as a real estate investment trust, and since you don’t have much retained earnings to grow—you access the capital markets. Schorsch has chosen to do it through kickback arrangements that seduce mom-and-pop investors via the veneer of a high dividend yield. When I hear the CEO Kay say, “Shares are so cheap we might sell assets to repurchase shares,” I can’t help but speculate, “No, you’re going to sell assets to raise cash to keep paying out the dividend because your cash flows are weak compared to the debt load, and you need to keep that dividend payment intact otherwise the price of the stock will crater.”

When you invest, I want you to have fun. I want you to collect $2,000 each year in Conoco, Exxon, and Chevron dividends that will grow to $4,000 in 2021 and $8,000 in 2028. I don’t want you opening the Wall Street Journal with one eye in the morning, waiting to see what American Realty investment is up to next. I recognize this is a complicated situation. Someone looking at the hard assets here, and the liquidated value of them, might hold his nose and buy here (on the other hand, there is so much debt, and so many secured creditors ahead of common stockholders, who knows?). I’m definitely not disclaiming the possibility shares of the stock will rise in coming years, and buying the stock today could be one of the best times to make a highly lucrative investment. I definitely recognize that possibility. For me, it’s a matter of not being able to predict what the regular cash flows are, and not being able to relate that to the debt and the dividend on a comparative basis. For me, it’s also about trust. When we buy stock, we are passive, absentee owners. We are trusting our hard-earned savings to the stewardship of someone else. I get why people have 99% of their wealth in Berkshire Hathaway—Warren Buffett and Charlie Munger are the kind of people that invite reliance. I don’t feel the same way about things run by Nicholas Schorsch. Do your homework and read the candid takes of what happened when he was forced out of running a REIT in Pennsylvania, and maybe you’ll agree.