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ATexasSizedScheme

ExposingtheDarkestCorneroftheREITBusiness

UnitedDevelopmentFunding(UDF)

1

"Onlywhenthetidegoesoutdoyoudiscoverwhosbeenswimmingnaked."Sixyearsago,theFederalReserveset

inmotiononeofthegreatestfinancialexperimentsonrecord: settinginterestratesatzeroandseeingwhat

happens.Tothispoint,theresulthasbeenmassiveassetreflation.Whilewhathappensnextisstillthegreat

unknown,low

interest

rates

and

rising

asset

values

have

provided

great

cover

for

many

mistakes

made

over

the

pastsixyearsacrossallassetclasses.TheFedhastrulybeentherisingtidethathasliftedalmostallboats.Amid

thisrisingtide,anassetclassbestknownaspublicnontradedREITsemergedasaprominentretirementproduct

soldalmostexclusivelytoretailinvestors.Whenthetidegoesout,publicnontradedREITswillbeexposedforthe

terriblyflawedeconomicsonwhichthe$100billiondollarbusinesswasbuilt.

ApublicnontradedREITispublicbecauseithastheminimumnumberofshareholdersrequiredtobepublic;itis

nontradedbecauseitisnotlistedortradedonamajorstockexchange.Thisproductissoldtoretireesasalow

risk,longtermincomeproducingassetthatisnotsubjecttostockmarketvolatilitypedaledasafixedincome

productwithoutexposuretointerestrates. Inreality,aninvestmentinapublicnontradedREITistypicallyan

investmentinanilliquidstartuprealestatecompanythatmustaccumulateassetsquicklyandissubjecttothe

samemarketrisks(orgreatermarketrisks)asitspubliclytraded,moreliquidpeerswhichbenefitfromlowercosts

ofcapital.

Whenboileddowntotheleastcommondenominator,publicnontradedREITsexistbecauseofhighupfront

commissionsthatprovidetheincentiveforfinancialadviserstosacrificetheirclientsbestinterestfortheirown

personalgreed. PriortoanontradedREITeverpurchasinganassetwhichmayormaynotgeneratefuture

positivereturns,tentofifteenpercentofaninvestorscapitalisconsumedbyupfrontofferingfees,broker

commissionsandassetoriginationfees.Whilethehighupfrontfeeloadincentsinvestmentadviserstopushthe

productandisaprimaryreasonwhypublicnontradedREITsexist,itisalsowhysomanyaresettofailfromthe

beginning.

ThelowinterestrateenvironmenthasalsocontributedtothegrowthofthenontradedREITassetclass.Yield

starvedretailinvestorsarepromisedabovemarketreturnsandthenontradedREITsdeliver,atleastinitially.How

cananontradedREITwithnoassetstostart,subjecttoexorbitantfeesandcommissions,deliverabovemarket

returnsalmostimmediately?First,brokersmarktheinvestmentontheinvestorsstatementsattheofferingprice

andnotthenetpriceafterfeesthatfrequentlyexceed10%. Second,byraisingnewcapitalsubjectto

astronomicallyhigh(somemightevensaycriminal)feesandcommissionsandpartiallyusingthenewcapitalto

funddistributionstoshareholders.Thepracticeofpayingdistributionstocommonshareholdersbyraisingmore

highfrictioncapitalfromnewshareholders(ratherthanincomegeneratedfromassets)isirrational,but

unfortunately,hasbeenastapleofthenontradedREITuniverseoverthepastseveralyears.

TheSecurities

and

Exchange

Commission

(SEC)

describes

aPonzi

scheme

as

an

investment

fraud

that

involves

the

paymentofpurportedreturnstoexistinginvestorsfromfundscontributedbynewinvestors.Notallnontraded

REITsarePonzischemes,butalmostallnontradedREITsshareoneofthehallmarksofaPonzischemefunding

distributionstoshareholderswithfundscontributedbynewinvestors. ThedifferenceisthatnontradedREITs

plainlydisclosethispractice. Theissueissystemic,andtheSECisfullyawareoftheproblem,highlightingnon

tradedREITsasoneofthefivemostseriousproblemsaffectingretailinvestorsgoinginto2015.

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ATexasSizedScheme

ExposingtheDarkestCorneroftheREITBusiness

UnitedDevelopmentFunding(UDF)

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TheFederalReserve,bykeepinginterestratesnearzero,hasmaskedthetrueextentoftheproblemasrisingasset

valueshavepartiallyoffsetthecarnagecreatedbymassivefeesandirrationaldistributionpractices.Intherare,

mostfavorablescenarios,nontradedREITmanagersmanagetoreturnprincipalatpar.Retailinvestorsconsider

thisawin

and

are

none

the

wiser;

not

appreciating

that

their

illiquid

investment

significantly

underperformed

publiclylistedpeers.TheMSCIREITindexhasalmostdoubledinthepastsixyearswhilenontradedREITsstruggle

toreturnpar;usuallyapremiumispaidforliquidity,nottheotherwayaround.

Inthelessfavorable,moretypicalscenarios,netassetvaluesactuallydeclineasthesecompaniesmortgagedthe

futuretopayoutsizedcurrentreturns,despitesignificantappreciationinrealestatevalues.Inthemostegregious

circumstances,abusinessmodelthatwasflawedtostart(andmadeworsebybadstewardship)evolvesinto

somethingthatlooksmorelikeaPonzischemethanarealestatebusinessaspoorinvestmentsaremaskedby

additionalcapitalraises.Badbusinessdecisionsbegetmorebadbusinessdecisionsandultimatelydevolvetothe

pointwheremaintainingtheschemeovercomeseffortstogeneratelegitimatereturns.

Thefollowing

will

detail

one

of

the

most

egregious

cases.

RCS

Capital

(RCAP)

has

been

the

funding

mechanism

by

whichretailcapitalhasunassuminglyandconsistentlymadeitswaytoUnitedDevelopmentFunding(UDF).

Thelargestvintagetodate,UnitedDevelopmentFundingIV(UDFIV,Nasdaqticker:UDF),marketsitselftoretail

investorsasanopportunitytodiversifyportfolioswithuniqueandfundamentallysoundinvestmentsinaffordable

residentialrealestate. Inreality,UDFIVisamortgageREITwithahighconcentrationofrisktoasingleborrower

andispartofalargerfamilyofREITsundertheUnitedDevelopmentFundingumbrella,whichoperatespublicly

listedandpublicnontradedREITs.

TheUDFumbrellaexhibitscharacteristicsemblematicofaPonzischeme:(1)newcapital,bothequityanddebt,is

usedtofunddistributionstoexistinginvestors;(2)subsequentUDFcompaniesprovidesignificantliquidityto

earliervintage

UDF

companies,

allowing

them

to

pay

earlier

investors;

and

(3)

ifthe

funding

mechanism

funneling

retailcapitaltothelatestUDFcompanyishalted,theearlierUDFcompaniesdonotappeartobecapableof

standingaloneandtheentirestructurewilllikelyunravel,withinvestorsleftholdingthebag.

UDFI,thefirstiteration,appearstohavebegunasaprivateentityownedbylimitedpartners,prefinancialcrisis,

investingasarealestatedeveloperandasalendertorealestatedevelopersandhomebuilders.UDFIwaslong

realestate,inaleveredway,attheworsttimetobeleveredandlongrealestate.AsUDFIbegantofalterduring

thefinancialcrisis,itappearsthatcapitalfromapublicnontradedentity,UnitedMortgageTrust(UMT),wasused

tohelpbailoutUDFI.UDFIandUMTareaffiliates,sharingcommonmanagement,andmanagementdecidedto

issueloansfromUMTtoUDFI,allowingUDFIanditssubsidiariestorepayvarious3rdpartydebt.

Unfortunately,UMT

was

in

the

core

business

of

issuing

sub

prime

residential

mortgages,

and

this

core

business

deterioratedrapidly. EnterUnitedDevelopmentFundingIII(UDFIII),aseparatepublicnontradedaffiliate,also

undercommonmanagementcontrol,whichwasusedtopurchaseasignificanteconomicparticipationinterestin

UMTsloantoUDFI,whichhappenedtogrowexponentiallythroughoutthefinancialcrisis,evenasUDFI

defaultedon3rdpartyloans. Throughthismechanism,UDFIIIretailcapitalappearstohavebeenusedtorepay

UMTretailcapitalwhichwasusedtobailoutUDFI. AndthePonzilikerealestateschemewassetinmotion.

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ATexasSizedScheme

ExposingtheDarkestCorneroftheREITBusiness

UnitedDevelopmentFunding(UDF)

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Astheproblemgrew,UDFpartneredwithRCAPtoraisealargerpooloffundsviaUDFIV.UDFIVhassince

providedliquiditytoUDFI,UMTandUDFIII,amongotheraffiliates,furtherexacerbatingtheproblemand

perpetuatingthescheme.AfterraisingcapitalasanontradedREIT,UDFIVcloseditsofferingandlistedonthe

Nasdaqin

June

2014.

As

prior

vintages

continually

needed

asource

of

liquidity,

RCAP

was

once

again

called

upon

toraisetheequity,thistimethroughthelatestvintage,UDFV,withamaximumofferingsizeof$1billion.

EachsubsequentUDFentityappearstooperatethesamebusiness,inthesamemarkets,lendingtothesame

borrowers,oftenontheexactsamedevelopments.Thesamethreeborrowerscollectivelyaccountfor90%ofboth

UDFIIIandUDFIV,withthelargestborroweraccountingforapproximately43%and67%,respectively.What

legitimatelenderwouldexposeitselftothislevelofconcentratedcreditrisk,andwhydomultipleentitiesexistto

dothesameexactthing?

ManagementatUDFwillarguethatithasbeenaprincipalbeneficiaryoflowinterestrates,thestrengthofthe

housingrecovery,thestrengthoftheTexaseconomyspecificallyand,ultimately,risingassetvaluesthathave

followed;it

will

also

maintain

that

its

loans

are

fully

covered

by

appreciating

collateral

values.

The

macroeconomic

argumentsmakeperfectsense. HowcouldarealestatelenderinDallas,Texas,beunderwatersixyearsintoa

steadyrecovery? Onthesurface,theexplanationinvolvesinheritingpastsinsofformerfundsthatpredatethe

financialcrisis,poorstewardship,unregulatedlending,andaflawedbusinessmodel. Belowthesurface,the

explanationislikelyalotmoresinister.

Visitstoactualdevelopmentsites,whichserveascollateraltoUDFdevelopmentloans,showthat,innumerous

instances,thereisnodevelopmentandthecollateralisstillnonincomeproducing,rawland2,3,5(asmuchas10)

yearsafterloanswereissued.Wheredidallthemoneygoifnottodevelopments?

ThereisalsoevidencethatUDFVhasindirectlyusednewretailcapitaltoprovideliquiditytoaffiliates,despite

specificallystating

in

its

prospectus

that

it

would

not

engage

in

these

practices.

It

also

appears

that

seventy

five

percentofUDFVsloanstodatehavebeenissuedtothesinglelargestborrowerofbothUDFIIIandUDFIV,and

thesenewloanshavebeenused,inthemajorityofcases,torepayoldloansissuedbyUDFIIIandUDFIV. Inshort,

UDFVappearstobethenewmechanismtoprovideliquiditytoUDFIIIandUDFIV. SimilartoaPonzischeme,it

appearsthatUDFVinvestorcapitalisbeingusedtoreturncapitaltoUDFIIIandUDFIVinvestors.Eachdaythatit

persists,newvictimsarecreatedwiththemostgulliblemoneyofall retailinvestorsandretirees ultimately

payingtheprice.

ThecracksinUDFsfacadearestartingtoappear. OnoraboutOctober30,2015,alawsuitwasfiledinTravis

County,TexasnamingUDFIVasacodefendantinacaseinvolvingallegationsoffraud,breachofcontract,tortious

interferenceandfraudulenttransfer. OnNovember24,2015,UMT,UDFIII,UDFIVandUDFVeachfiledForms8K

revealingthattheirindependentregisteredpublicaccountingfirm,WhitleyPennLLP,declinedonNovember19,

2015,tostandforreappointmentastheauditorforeachcompany. Onthesamedaythatitwasannouncedto

publicshareholdersthatWhitleyPennhaddeclinedtostandforreappointment,WilliamKahane(whoappearsto

beaffiliatedwithRCSCapital,ARCapitalandNicholasSchorsch)resignedfromUDFVsboard. OnNovember30,

2015,UDFIIIfiledaninvoluntarybankruptcypetitionintheUnitedStatesBankruptcyCourtfortheWestern

DistrictofTexasagainstUDFIIIandUDFIVssecondlargestnonaffiliatedborrower.OnDecember4,2015,the

letterattachedwassenttoWhitleyPennconcerningitsauditworkandtheForms8KfiledonNovember24,2015.