$18.00

OTC:DCAQP

Summary

A long position in DCAQP at the current price will allow an investor to clip coupons at 12% per year and enjoy ~40% upside to face value of $25, resulting in what I believe will be north of 20% annualized returns with very low risk.

This situation has been under the radar because the company has not published financials for the past seven years and did so only two weeks ago in connection with a pending tender offer at $18 for 70% of the shares (more about this below).

This security has a par value of $25 and the most recent balance sheet (3/31/2012) shows equity per preferred share of $94, providing ample margin of safety.

There are currently 1,646,583 shares outstanding, making this investment suitable for smaller funds and personal accounts. Originally, 2,990,000 shares were issued but DCAQP has been actively buying back shares over the past few years at prices averaging $14 in 2010 and $15.50 in 2011. This security has nearly $2 of accumulated dividends and therefore the real tender offer price is closer to $16.

Specifically I am advocating a long position, and not a participation in the tender offer. Between investments I control and other shareholders I am in contact with, I believe there are currently at least 10.3% of the shares that will not be participating in this tender.

History

DRA Advisors is a registered investment advisor with over $9 billion in AUM, focused in real estate investments. In 2005, DRA raised its DRA Growth and Income Fund V LLC. The fund made a bid for publicly traded CRT Properties (formerly known as Koger Equity), a REIT that owned over 11 million square feet of office buildings, and developable land, across various US cities. The total transaction value was around $1.7 billion.

The deal closed in late 2005. The entity DRA CRT Acquisition Corp (I’ll just refer to it and DCAQP interchangeably) was created as the “merger co.” Obviously in hindsight this was probably the worst time in history to be closing on 11 million square feet of office buildings.

During the following 6 years, DCAQP bought out the minority interests that partner Colonial Properties had in some of their buildings. They sold a number of buildings in the portfolio, handed the keys back to the bank on a few others, and restructured the debt underlying the balance of the office investments. Today the portfolio consists of 4.5 million square feet across 58 buildings in several southern U.S. cities.

DCAQP had been paying its coupons regularly since the transaction but dropped the coupon in November 2011, ostensibly to “improve liquidity and preserve capital.” Given the nature of its business it is likely DCAQP needed to preserve cash to help with tenant improvement and leasing commission expenses to position some of its office buildings for a sale.

Summary of office building holdings

DCAQP refers to its holdings as “office investments” because an investment can be 1 building or it could be a group of several buildings in a “campus,” and in both cases they are owned by the same ownership entity under DCAQP.

The summary is contained in the following PDF, which contains a lot of data that would be cumbersome to replicate here, including the ownership structures for the buildings. Most of the office investments are not cross collateralized, providing adequate protection for the investor:

https://dl.dropbox.com/u/424127/DRA%20CRT%20ACQUISITION%20-%20SUMMARY.pdf

The financials with notes can be found in the recent tender offer document (more about this below). Here is a link to the document for convenience:

https://dl.dropbox.com/u/424127/12-715%20DRA%20Advisors%20-%20Offer%20to%20Purchase%20v02.pdf

A note about the contents of the summary PDF. For each building, I estimate what the net rent is, and try to come up with a “Draconian” occupancy level (usually at a discount to the current occupancy level). To the resulting NOI, I apply the cap rate I believe is appropriate. From that, I deduct the current mortgage balance. The result is an investment by investment estimate of equity, which I divide by the current number of DCAQP shares outstanding (1.6mm). Therefore you can see where the pockets of value are.

Keep in mind that my estimate is supposed to be Draconian.

As a result, at the bottom I arrive at equity of $88mm or about $53.5 per preferred against a 3/31/2012 balance sheet equity of $155mm. The truth is probably somewhere in the middle, since the buildings produce enough cash flow to help the company pay for tenant improvements and leasing commissions (more about this in the financial section below). My point is to demonstrate that you are way over collateralized.

My cap rates are just my own personal estimates. I think older, more functionally obsolete buildings should sell at higher cap rates, whereas newer class A buildings will command lower cap rates.

For buildings where I know the price paid originally (from searching through press releases), I’ll indicate that in the PDF, but it’s important not to anchor on this since buildings trade primarily on multiples of NOI.

In any case, all of these buildings were bought on or before circa 2005/6.

Keep in mind that all buildings are managed externally by independent management companies, which gives me comfort that there is no “backdoor” funneling of cash flow to affiliated entities.

FINANCIALS

Maturities

You will note in the financials that there are two large mortgages which mature in October 2012. I believe DRA will not have a problem extending these loans, however, as mentioned above, in the off chance these buildings go into foreclosure, there is ample equity in the remaining borrowing entities to protect the value of this security.

P&I for some buildings

Atlantic Center Plaza, Houston Westchase, Jacksonville Baymeadows, and the three buildings in the JPM LDP5 securitization have mortgages that have been restructured from interest only to principal and interest. As a result, every month we are building some equity by paying down principal. (Other buildings may have a similar structure but I could not find this information.)

Cash flow

Adding back D&A, you can see that operating cash flow has been over $44mm for 2011 and 2010 (and is equivalent to Q1 2012 annualized). After debt service, cash flow was $21mm in 2011. Coupon payments on the preferreds are only $3.5mm per year. What gives?

A lot of cash is consumed by paying tenant improvements (tenant space buildouts and other expenses to induce a tenant to sign a lease) and leasing commissions to brokers.

In 2011, $11.1mm was taken up in expenditures for improvements (some, if not most of this, certainly was tenant improvements), and another $6.5mm was used for leasing commissions, leaving only $3.2mm to pay for dividends. This is probably why DCAQP cut the dividend in late 2011.

While the company has upstreamed dividends to the common shareholders in the past, since the preferred dividends were suspended they are no longer able to do so. In recent years, the company has received inflows (presumably from the parent fund) to help with liquidity: $14.5mm of paid-in capital was contributed in 2010, $6.3mm in 2011, and $0.5mm in the first three months of 2012. These inflows were likely needed for working capital purposes.

At the current price for DCAQP, the “market cap” of the preferreds is a mere $28mm, so with cash flow after debt service of around $20mm, you are buying this at a very distressed multiple of cash flow.

Restricted cash

There are nearly $35mm of restricted cash on the balance sheet in addition to nearly $6mm of unrestricted cash. I would imagine that as these buildings get sold, the restricted cash gets released.

Importantly, the restricted cash is additional collateral required by the lenders for some of these office investments. Therefore, the Draconian LTV in the summary PDF can be adjusted by this extra collateral to arrive at a more realistic estimate.

Low cost mortgages

Most of the mortgages on the various office investments are in the 4.0-5.5% range. With rates low and, according to Bernanke, to remain low until late 2014, there is little risk in rising interest rates for now.

TENDER OFFER & RISKS

On July 23^rd, a tender offer was launched for these securities. The purchaser intends to buy as much as 70% of all shares at $18.00. The offer expires Aug 17^th. The offer document (link above) contains all relevant financials.

Because DCAQP is restricted from buying back preferreds while the coupons are suspended, the parent fund set up a subsidiary called G&I V CRT LLC to make the purchase.

If they are able to buy 66 2/3% of the shares outstanding, in theory DRA could amend the company’s articles of incorporation. These articles stipulate that two thirds of the holders are required to change the terms of the preferreds.

However, towards the bottom of the articles of incorporation, it reads that “No amendment, modification or waiver will be binding or effective with respect to any provision of these Articles of Amendment without the prior written consent of holders of not less than a majority of the shares of Series A Preferred Stock outstanding at the time that the action is taken.”

Therefore in theory a simple majority could alter the provision in the articles of amendment to make it so that a simple majority of the shares outstanding are needed to make the changes needed.

Let’s assume DRA does indeed get 70% of the shares. In theory, they could then vote to strip the preferreds of dividends, and indeed they could vote to make the preferreds have $0 liquidation preference, essentially making the paper worthless.

The benefit of screwing the remaining 30% of preferred shareholders in this scenario would amount to a mere $12mm (30% times the $41.1mm face amount). If they do this, DRA will get sued. Given that DCAQP is a Delaware corporation, most likely they will lose. Is it worth tarnishing a brand and reputation for a mere $12mm gain?

Further, the Delaware court of Chancery is a court of equity, meaning that it attempts to balance fairness. I have been told by those more knowledgeable than me that Delaware courts do not look positively on “vote buying,” i.e., using the power of vote on one class of securities to benefit another class of securities (the common stock, in this case). This is the main risk I see in this investment, but I do not think it is a large risk.

Finally, there have only been a few tender offers for preferreds below par in the past and these have had participation levels between 2-20% so I believe DRA is unlikely to meet a control hurdle.

ENDGAME & UPSIDE

In order for DCAQP to reward the investors in the DRA Growth and Income Fund V, it must pay dividends through its common stock. But in order to pay dividends on its common stock, it must first pay dividends on the preferred stock (DCAQP). Therefore, we are in their way and they must pay us first.

Dividends paid to common stockholders were $5.6mm in 2010 and $5.3mm in 2011. Dividends on the preferreds total $3.5mm per year. So common stockholders are suffering by a larger amount than us and the company has an incentive and a need to reward its fund investors again soon.

I believe I have demonstrated the downside protection in this investment. As far as upside, I doubt that these preferreds will remain outstanding for much longer. It is likely that after the pay down of the Atlanta Chamblee / Orlando Lake Mary loan for $7.5mm in October, that the company will turn the coupons back on and use any excess cash flow to resume buying back preferreds in the open market.

Current cash (3/31/2012): $6mm
Cash flow for the remainder of the year, after debt service: $13.5mm
Paydown of loan in October: -$7.5mm
Cash remaining: $12.0mm – ample to pay TIs, leasing commissions, and potentially restart coupons

The coupons are currently three quarters in arrears and if they do not turn them back on by the 6^th quarter (Q1 2013), the holders of 10% of the shares can call a special meeting to appoint 2 members to DCAQP’s board of directors.

It’s unlikely that this fund will remain in existence for many more years; I have been told that similar real estate funds typically have a 3-year investment period, an 8 year holding period, and 2 optional 1-year extensions. Given its 2005 vintage this would put the first expiration date of the fund at 2016 and 2018 at the latest.

I am using an assumption of three more years for the preferreds. As such, this investment has a very attractive return profile from the current price regardless of whether the coupons are turned on next year or not.

Given that this is not a very liquid security at the current price, I am working with the assumption that an investor can bid $18.01 and buy an unlimited amount of shares, since the tender offer deadline is August 17^th and there is risk of pro-ration. In essence, an investor can create his own tender offer by just bidding above the current tender offer:

Scenario 1: coupons turned on next year

Scenario 2: coupons paid in a lump sum upon redemption

Links & resources for further research

The merger proxy for the CRT Properties acquisition by DRA CRT Acquisition Corp:

http://www.sec.gov/Archives/edgar/data/835664/000104746905021004/a2161819zdefm14a.htm

Articles of incorporation of Koger Equity (with the 2/3 provision and majority language):

http://www.sec.gov/Archives/edgar/data/835664/000095014403010754/g84898exv3wxcy.htm

The original prospectus for the Koger Equity preferreds, which eventually were converted into the current DCAQP with all terms intact:

http://www.sec.gov/Archives/edgar/data/835664/000095014403010593/g84572b2e424b2.htm

If you’d like to wade through old CRT Properties SEC filings to see what they paid for which buildings, they’re here:

http://www.sec.gov/cgi-bin/browse-edgar?action=getcompany&CIK=0000835664&type=&dateb=&owner=include&count=40

DRA Advisors is celebrating 25 years in existence. You can learn more about them on their website:

http://draadvisors.com/about.aspx

They keep a Spartan with information on DCAQP:

http://www.draadvisors.com/crt.aspx

APPENDIX – OFFICE INVESTMENT DETAILS

LIFE INSURANCE COMPANY MORTGAGES

Atlanta Center Plaza (1 building) – Class A

This property is known in the market as “mini me” because there is an identical tower next to it that is much taller. Regions just signed a lease on the ground floor. Alston & Bird, a law firm, left recently to consolidate their office at the taller tower. There are a lot of upcoming vacancies in this tower so hopefully they are able to re-tenant it quickly. Currently it is 83% occupied, but about 46% of the building is up for renewal in November 2013.

My valuation for this building is almost certainly way too low. I am using about $96.6mm; Met Life is the lender and they would not have extended a second mortgage on this building if it took them to 93% LTV, which is what I currently have. Using a more reasonable 80% LTV would imply a building value of $112.5mm.

That would imply value per preferred share of $13.7.

But I’ll stick to my Draconian $96.6mm valuation to show you how much cushion there is in this portfolio. That leaves us at $193 per square feet of construction which is probably below replacement cost for this building.

http://maps.google.com/maps?f=q&geocode=&q=1180+W.+Peachtree+Street,+Atlanta+GA+30309

Estimated equity per preferred share: $4.0

Dallas Signature Place (2 buildings) – Class A

EMC appears to be the largest tenant; other than that, I don’t have much more color on this building. As of late May it was 73% leased. It was bought for $38mm and my estimate of value, which is likely conservative, is almost $51mm ($116 psf, likely below replacement cost).

http://maps.google.com/maps?f=q&geocode=&q=14755+%26+14785+Preston+Road,+Dallas+TX+75254

Estimated equity per preferred share: $15.0

TOTAL FOR LIFE INSURANCE MORTGAGED PROPERTIES: $19.00 per share

Several of these properties have debt that was put into securitizations. Some of these have recently left the securitizations and are in the hands of private investors. I’ve left them in this group in case you’d like to dig up past securitization reports.

SECURITIZED, BUT NOT CROSS-COLLATERALIZED PROPERTIES

Jacksonville Baymeadows Way (1 building) – Class B

For this building I have the exact NOI number since the securitization reports provide that information. At a 7% cap rate, I’m pegging value at $18.3mm ($82 psf). It’s so low because rents are low; net rent is only around $7.60. That’s probably because the FDIC is the largest tenant, taking up 79% of the building. Their lease expires on 11/30/2013.

http://maps.google.com/maps?f=q&geocode=&q=7777+Baymeadows+Way,+Jacksonville+FL+32256

Estimated equity per preferred share: $3.1

Westchase Corporate Center (1 building) – Class A

Largest tenants are SAP, Tricon Geographics and Santos USA Corp. 30% of GLA is expiring in 2012, and another 21% is expiring in 2013.

http://maps.google.com/maps?f=q&geocode=&q=10111+Richmond+Avenue,+Houston+TX+77042

Estimated equity per preferred share: $6.6

Broward Financial Center (1 building) – Class A

This building lost its marquee tenant last year when Templeton Global Investors, which leased 138,049 (approximately 42% of the building), left as its lease expired on 6/30/2011. The latest comments from the servicer indicate that an occupancy of 71% was expected in Q1 2012 as this space was backfilled with several tenants (Ryan Inc, Fox Sports, USA Government Social Security, and Sun-Sentinel).

The loan was extended a few times, sent to special servicing, and finally sold to Winthrop Realty Trust in May 2012. The borrower was seeking a two-year extension (from the latest maturity date of April 2012) to reposition the building and sell it. While I have no information on what type of extension Winthrop negotiated, the building was reported as 78% occupied by early August 2012.

http://maps.google.com/maps?f=q&geocode=&q=500+East+Broward+Boulevard,+Fort+Lauderdale+FL+33312

Estimated equity per preferred share: $10.4

TOTAL FOR SECURITIZED, BUT NOT CROSS-COLLATERALIZED PROPERTIES: $20.00 per share

SECURITIZED AND CROSS-COLLATERALIZED PROPERTIES

This part of the portfolio is the more “problematic” part since the loan-to-value of the cross-collateralized buildings appears so high. I say “appears” because rents have evidently not grown as much as initially envisioned and therefore property values are stagnant. There are some better and some worse properties in here, and unfortunately sometimes they are joined at the hip through the cross-collateralization of the mortgage.

On the positive side, with $39 / preferred share already accounted for above, the properties below could be foreclosed on without any effect on the rest of the portfolio. As such, they can be viewed as “gravy.”

That being said, I do not expect any foreclosures. The DSCR for the Chamblee/Lake Mary properties is estimated at over 2.4x, indicating that perhaps my fair value assumption is too Draconian.

For the second block below (Jacksonville JTB/Germantown/Orlando Central) my estimated DSCR is 1.57x, also indicating a good margin of safety.

Atlanta Chamblee (21 buildings) – Class B

From what I can tell this is a sprawling campus of 21 buildings (DRA refers to them as “University Office Park” in its tender offer document since every building is named after a different university). From Google street view images, some of these buildings appear quite old. The fair market value at origination of the mortgage in 2006 was $171mm and I am ascribing a value of approximately $114mm ($91 psf) by using a 9% cap rate on my stressed NOI estimate. Rents are quite low probably owing to a majority of the GLA being occupied by government agencies.

http://maps.google.com/maps?f=q&geocode=&q=2951+Flowers+Road+South,+Atlanta+GA+30341

This property is cross-collateralized with the next one.

Orlando Lake Mary (2 buildings) – Class A

Not much color on these buildings except that they are a bit over 70% leased as of mid July.

http://g.co/maps/cqzt2

Estimated equity per preferred share: $11.9

The following three investments are cross collateralized:

Jacksonville JTB (3 buildings) – Class A

Appears to have high quality tenants such as the insurer Zurich, as well as Johnson & Johnson.

http://maps.google.com/maps?f=q&geocode=&q=5011+Gate+Parkway,+Jacksonville+FL+32256

Memphis Germantown (6 buildings) – Class B

http://maps.google.com/maps?f=q&geocode=&q=51%2c+57%2c+60+%26+65+Germantown+Court+and+8000+%26+8001+Centerview+Parkway,+Memphis+TN+38018

Orlando Central (21 buildings) – Class B

http://maps.google.com/maps?f=q&geocode=&q=3555+Maguire+Boulevard,+Orlando+FL+32803

Estimated equity per preferred share: $2.5

TOTAL FOR SECURITIZED AND CROSS-COLLATERALIZED PROPERTIES: $14.4 per share

GRAND TOTAL EQUITY PER PREFERRED SHARE: $53.5

Approx $88mm, compared with $155mm balance sheet equity as of 3/31/2012

(balance sheet equity implies $94 per share)

Of course, par is $25, but the point of this exercise is to demonstrate that you are well over collateralized on this investment.