Description

Newcastle Investment Corp (NCT) – 06/13/14 $4.89

The investment thesis for Newcastle Investment Corp (NCT) is very simple: a valuation arbitrage between mortgage REITs and senior housing REITs.  The thesis has an ongoing catalyst that should play out over the next 12-18 months to allow shareholders to capture that valuation arbitrage.  We expect returns in excess of 50% in the next 18 months with a moderate level of beta risk.  This investment is essentially a REIT investment and should be evaluated as such in assessing its attractiveness in the portfolio.  We believe NCT is particularly attractive for the portion of an investor’s portfolio geared towards generating income and also serves as a way to reduce overall equity beta in the portfolio while not sacrificing equity-like returns.

NCT is currently a hybrid mortgage REIT that is in the middle innings of transforming its operations into a senior housing REIT.  As of 3/31/14, about 43% of the equity is invested in senior housing assets, and the remainder invested 47% in CDO and legacy assets, 7% in golf course assets, and 3% in cash.  Over the course of the next 12-18 months, we expect NCT to generate cash from winding down or monetizing the CDO and legacy assets and redeploy that cash to senior housing assets.  Over the next 12-18 months as the senior housing portion of the assets becomes a vast majority of the total assets, NCT will become an attractive senior housing REIT asset, to which we believe the market will assign at least an average senior housing REIT market valuation.  This transformation of the business creates an opportunity for investors today to buy a REIT asset trading at a mortgage REIT multiple and over the next 12-18 months own a REIT asset trading at a senior housing REIT multiple, which is much higher than the average mortgage REIT multiple.

NCT has undergone a major transformation in the last 18 months.  NCT is an affiliate of Fortress Investment Group (FIG) and was split off from New Residential Investment (NRZ) in the spring of 2013.  You can read ele2996’s write-up on NCT from April 2013 for a background on NCT and the split off from NRZ as well as gary9’s write-up of NRZ from December 2013.   NCT is a very different investment since the VIC write-up in 2013 and has made significant progress in its business plan towards transforming into a senior housing REIT.  Since April 2013, NCT has split off from NRZ, acquired over $1bil in senior housing properties and spun off New Media Investment Group (an ancillary old media business) in Feb 2014 in a transaction that created shareholder value.  In many ways, the story has become more straight-forward as management has executed on its plan to become a senior housing REIT.

Fortress is the external manager of NCT.  Fortress is a well-established institutional real estate investor with strong expertise in the senior housing sector.  Fortress owns a senior housing operator, Holiday Retirement, which currently manages 51 of the independent living senior housing properties that NCT purchased from an affiliate of Holiday Retirement in December of 2013.  Some of the top Fortress managers are heavily invested in the NCT equity, with Wes Edens, the Chairman of NCT, personally holding over 2.7mil shares.  The management team has been together since the company’s founding 20 years ago and was able to generate strong performance since emerging from the financial crisis.  While NCT is externally managed by Fortress with a management fee of 1.5% and a performance fee of 25% above a 10% hurdle rate, shareholders won’t need to pay a performance fee for a while because of the steep decline during the financial crisis when NCT was operating as a mortgage REIT.

NCT has made tremendous progress in building up the senior housing portfolio.  They have increased the portfolio from 8 senior living properties with 836 beds at a cost of $153mil in December 2012 to over 86 properties with 10,500 beds at a cost of $1.6bil as of 3/31/14, making NCT one of the largest publicly traded owners of senior housing.  Senior housing is an attractive target market for acquisition with favorable demographic tailwinds and industry dynamics.  The overall supply demand characteristics remain favorable as new supply of independent living properties and senior housing remains muted.  The age 70+ population, the primary end demand for senior housing, in the US is expected to grow faster than any other demographic segment: 28 mil in 2010 to 53 mil in 2030.  As the aging US population increases, the number of senior housing beds continues to decrease.  There is an estimated $300 bil in senior housing properties in the US, approximately 70% of which are owned by mom and pop owners.  The fragmented nature of the industry makes it ripe for a professional operator like NCT to make acquisitions at attractive prices and generate upside by improving operating efficiencies.

As of 1Q14, NCT has $503mil of equity invested in senior housing assets, $182mil that are self-managed and $321mil that are leased triple net, which include the assets acquired from, and managed by, Fortress’ affiliate Holiday Retirement.  This acquisition features strong reserve/guaranty and a 2% rent escalation clause starting in 2015.  According to the 1Q14 guidance, NCT expects to have $700mil of equity invested by the end of 2Q14.  Currently, NCT has under contract $319mil in properties ($230mil equity; 15 properties) with a near term pipeline of $300-$500mil ($100-200mil equity; 25-30 properties) and medium term pipeline of $800-$1200mil ($250-$400mil equity; 50-75 properties).  Rather than competing for large portfolios that can attract 10-12 bids, the management team is targeting smaller portfolios that are less competitive and have better return characteristics.  So far, 95% of the portfolio was sourced off-market in non-brokered transactions.  Despite the rapid pace of acquisitions, the company’s acquisitions have so far performed well.  Part of the company’s acquisition strategy is to acquire under-managed assets from mom and pop owners and improve the assets’ performance by instituting professional management practices and increasing operational efficiencies.  The part of the portfolio that the company acquired in 2012, which is showing up now in same store sales metrics, has improved its levered yield to 23% in 1Q14 from 13% pre-acquisition. 

Valuation

NCT is currently trading at a 9% yield on estimated 2014 dividends of $0.40/share.  In 2015, we expect NCT to earn about $0.50/share.  As NCT (1) deploys the $543mil generated from liquidation of the CDO and legacy portfolio into senior housing assets yielding north of 17% and (2) improves operational efficiencies in their managed portfolio (which they have demonstrated that they can do), we believe earnings could reach $0.58/share in 2016.

The valuation gap between mortgage REITs and senior housing REITs is substantial. 

Commercial mortgage REITs are trading at a median yield of 7.9%.

Credit mortgage REITs are trading at a median yield of 12.7%.

Healthcare REITs are trading on average at 14.6x P/2014E FFO with a 5.3% yield.

As NCT continues to shift the balance of the portfolio towards senior housing, we expect the stock to trade closer to a senior housing REIT peer yield of 4-6%.  As REITs are primarily an income generating vehicle, we expect investors to consider various valuation metrics but use yield as one of the primary metrics.  As a base case, valuing NCT at a conservative 6% yield on $0.50/share in earnings in 2015 and an 86% dividend payout ratio implies a valuation of $7.17/share.  A downside case in which the company stops pursuing acquisitions and experiences an operational hiccup that reduces dividends by 10% to $0.36 would mean a stock price of $4.00 based on a 9% yield assumption.  In an upside case in which the company executes on the senior housing acquisition, achieves operational efficiencies in its acquired properties and expands into the golf course segment, the company could trade as high as $9.06 based on $0.58/share in earnings in 2015 and an 86% dividend payout ratio capitalized at a 5.5% yield.

Moreover, we believe NCT’s senior housing assets are more attractive than the typical senior housing assets.  NCT owns primarily private-pay independent and assisted living properties (approximately 95% private-pay with no direct Medicare exposure).  These properties are more akin to multifamily housing as there is less healthcare services, less regulatory oversight and little government payment risk associated with NCT’s properties versus other senior housing assets more skewed towards skilled nursing.  Because of these dynamics, we would argue that NCT should be rewarded with a higher multiple (lower yield) within the senior housing space. 

Finally, while not baked into the business of the company or the valuation, NCT has the potential to consolidate the golf course industry like they are doing with the senior housing sector.  Currently, NCT has 7% of its assets in golf courses ($79mil in equity) and is currently third largest operator and fourth largest owner of golf courses in the country with 92 courses.  This segment of the business could potentially become a large part of the portfolio just like the senior housing segment if they pursue a strategy to roll up the golf course industry.  The golf course industry is similarly fragmented with 97% owned by mom and pop owners.  They are targeting a 22% annual rate of return on this segment.  The pipeline of acquisitions is robust with 225-300 assets.  If management decides to pursue this category, there could be further upside to the numbers.

Catalyst

- More senior housing asset acquisitions announced.  Provides market confidence that management team is executing its business plan and increases shift towards senior housing assets.

- NCT has discussed that it may spin off the senior housing asset if not award an appropriate valuation by the market.

- Generating cash from winding down of the CDO/legacy assets.

- More REIT/income investors buy the stock as NCT becomes more of a pure-play senior housing REIT stock.

- Acquisition of more golf course assets.

Risks

- Interest rate risk.  Much of the assets in the portfolio are credit assets, which should outperform in a rising interest rate environment.  We are using interest rate sensitive assets such as NCT in our portfolio to hedge our long equity positions.  However, one should be cognizant of the fact that because interest rates have been suppressed by the Fed for a while, there is a possibility that equities and bonds-like instruments could both sell off at the same time.  We are of the opinion that interest rates will be range bound and remain low for a while, but that discussion is best left for another forum.

- Execution risk.  Management may not be able to execute on its acquisition strategy or overpay for assets.  Half of the portfolio is already in senior housing assets, and management has the option to spin off the existing assets into a separate REIT and create value as they have done in the past.

CONCLUSION:  As NCT transforms its business into a senior housing REIT, the stock provides an opportunity to earn a 50%+ return over 12-18 months comprised of attractive dividends and revaluation as a senior housing REIT that will trade at a much lower yield.

DISCLAIMER:  DO NOT RELY ON THE INFORMATION SET FORTH IN THIS WRITE-UP AS THE BASIS UPON WHICH YOU MAKE AN INVESTMENT DECISION - PLEASE DO YOUR OWN WORK.  THE AUTHOR AND HIS FAMILY, FRIENDS, EMPLOYER, AND/OR FUNDS IN WHICH HE IS INVESTED MAY HOLD POSITIONS IN AND/OR TRADE, FROM TIME TO TIME, ANY OF THE SECURITIES MENTIONED IN THIS WRITE-UP.  THIS WRITE-UP DOES NOT PURPORT TO BE COMPLETE ON THE TOPICS ADDRESSED, AND THE AUTHOR TAKES NO RESPONSIBILITY TO UPDATE THIS WRITE-UP IN THE FUTURE.

Catalyst

Catalyst

- More senior housing asset acquisitions announced.  Provides market confidence that management team is executing its business plan and increases shift towards senior housing assets.

- NCT has discussed that it may spin off the senior housing asset if not award an appropriate valuation by the market.

- Generating cash from winding down of the CDO/legacy assets.

- More REIT/income investors buy the stock as NCT becomes more of a pure-play senior housing REIT stock.

- Acquisition of more golf course assets.