Colony Financial (CLNY, $22.15) – a ‘sum of the parts’ story with a catalyst, levered to the housing recovery

Executive Summary

Colony Financial is $1.4bn mkt cap real estate finance company with a materially undervalued asset in the single family rental space (SFR), Colony American Homes.  That stake will be given a market reference price this week as the entity comes public (ticker CAHS).  Over time, we expect Colony to divest this stake and return its focus to the commercial real estate space in which it excels. Colony Financial is the public market vehicle and source of permanent capital for Colony Capital, one of the best real estate PE firms in the world.

CLNY may seem fairly valued at first look (6.4% dividend yield; 1.1x BV) but its equity stake in CAHS is worth $11.20 per CLNY share at the mid-point of the IPO range.  And CAHS does not currently distribute cash to CLNY.  Net of CLNY's stake in CAHS, you can buy the CLNY stub at an effective 12.5% yield.  If you hold for the ultimate monetization of CAHS and a re-rating of CLNY to a target 8% yield, you could make a 40% total return, or 25% annualized on a 1.5 year horizon, before assuming growth from leverage to a housing recovery.  

Colony American Homes (CAHS)

Much has been written about the opportunities in the single family rental (SFR) space.  In essence, pools of institutional capital have been raised opportunistically to take advantage of depressed prices and attractive financing.  Colony Capital has raised $2.2bn of capital to date to invest in this space, of which $550mm came from the CLNY vehicle. They have been buying homes in AZ, CA, NV and increasingly in FL, with targets of 11% gross rental yields and 6% net of property taxes, insurance and other property management costs. Note that 6% yield is unlevered and doesn’t bake in any home price appreciation (HPA) or rising rental rates, it is simply their cash on cash return once the homes are renovated and leased up.  Management expects to be able to get at least 50% leverage (i.e. Debt/Assets) with financing costs in the 3% range. This leads to a 9% levered yield before HPA and expectations of 3% rental rate increases – and will be the basis of an attractive dividend for this REIT. 

CAHS is going public this week, pricing is expected to be $11.50-$13/share. CLNY’s stake in the entity represents $11/share of value at the midpoint of the price range.  CLNY should own about 23% of CAHS following the IPO.

While a more detailed analysis is beyond the scope of this pitch, Colony expects CAHS to be one of the dominant SFR players in what is a scale business.  The other large player is Blackstone, which has been plowing money into the space. There are also a few 2^nd tier publicly traded players – SBY (spun out of Two Harbors),  RESI (spun out of Altisource Portfolio Solutions) and ARPI (recent IPO).  You would think this is a primarily a ‘local’ game, but there are clear economies of scale –e.g. cost of capital, purchasing building supplies for renovations etc.  I think CAHS is coming out at close to fair value, so further upside in that entity would be based on management doing a great job executing on their strategy.

Colony Financial ex the Colony American Homes

If you look at CLNY stock using a simple screen on Bloomberg, without knowing about CAHS, you’d think it is probably fairly valued. It has a 6.4% dividend yield and trades at 1.1x book, which seems “reasonable” for what is primarily a commercial real estate lender. The reality, of course, is that the CAHS take is currently not helping support the dividend, so you are really creating the residual of CLNY at a 12.5% yield, which is very attractive.

The business model is pretty simple – Colony makes opportunistic real-estate debt and equity investments, either in high yielding originations and secondary loan acquisitions.  They have their own 90+ person asset management team with significant NPL workout experience dating all the way back to the Resolution Trust Corp timeframe. As an example of the sorts of stuff they do, they were one the few players that were bidding for FDIC portfolios – where they typically received a 40% interest (FDIC kept 60%) but with 0% financing from the FDIC.

See their latest presentation

http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9NTA0OTczfENoaWxkSUQ9NTQ2Mjk1fFR5cGU9MQ==&t=1

They look for high single digit to low double digit returns on assets and employ modest leverage to get to double digit ROEs.  The reason they only use modest leverage is that they themselves often take more junior positions in the cap structure, such as sub debt or mezz loans at 60-80% LTV.  CLNY’s primary liability is a $200mm 5% convert that matures in 2023. Note that as of 3/31 CLNY had $1.67bn of assets, so we are talking about a low Debt/Asset ratio (~20%) which is by design.

Background on Colony Capital

In the twenty-two years since its inception, Colony has invested in diverse and complex property, corporate, and portfolio transactions across five continents through varied economic cycles. Since inception Colony has invested $50 billion in over 22,000 assets/loans and has ~$25 billion of assets under management (gross) with more than 300 investor relationships. CEO, Thomas Barrack, got his start with the Bass family.

Valuation / Returns Profile

I look at this in two scenarios

(A)   Holding period is thru year end ’13 – where the CAHS stake embedded in CLNY trades at a 35% discount to its public market value.  The IPO lockup ends ins 6 months, which can lead to the beginning of secondaries or a tax free split to crystalize the value.  

(B)   Holding period through year end ’14 – should be enough time for CLNY to sell down its stake in CAHS. I apply a 10% discount to account for taxes and some liquidity discount. I do not include any capital appreciation or dividends from the CAHS stake

CLNY’s closest comps are NRF and STWD – they are trading at 8% dividend yield (have sold off a bit recently given the move in the 10yr benchmark rate).  If you value the non SFR part of CLNY at an 8% yield, Scenario A yields a 30% IRR and Scenario B yields a 26% IRR. Note that this includes dividends along the way, but that those dividends aren’t themselves reinvested. On an absolute basis, I think a 550 bps spread to the 10 yr is reasonable for this sort of this business, and that would be a 7.6% yield at recent rates. At a 7.5% target yield, we are looking at a 30%+ IRR profile.  On the downside case, at a punitive 10% dividend yield, Scenario B generates a 15% IRR to Dec ’14, and does marginally better than break-even in Scenario A.

For background on the comps

http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9MTg0MDQ4fENoaWxkSUQ9LTF8VHlwZT0z&t=1

http://ir.starwoodpropertytrust.com/Cache/1001170494.PDF?Y=&O=PDF&D=&FID=1001170494&T=&IID=4235133

• IPO of CAHS this week
• Rerating to a lower dividend yield to account for non-SFR business supporting the current dividend
• Upside potential from ongoing HPA and rental rate increases