Description

Long NXDT: Former closed end fund trading at ~60% of NAV with heavy insider buying and now converting to a REIT, having received SEC approval ~2 weeks ago.

NexPoint Diversified REIT (NXDT), previously known as NexPoint Strategic Opportunities Fund (NHF), is a closed-end real estate credit-focused fund in the process of converting to a REIT. It was previously written up by creditguy (Jan 2021) and bowd57 (2015) as NHF, and both authors have closed their recommendations since.

As a CEF, the fund focused on providing debt financing for real estate developers, but it also held common stock investments and credit securities, such as CLOs. The fund has since repositioned its portfolio to a more traditional REIT structure, holding mostly real estate, in anticipation of the conversion.

Management expects conversion will help “reduce the fund’s historic (40%) discount to net asset value, as REITs have, on average, traded more favorably relative to NAV than closed-end funds” (see below for historical P/NAV evolution). The only step remaining for conversion was SEC approval, which was requested on March 31st, 2021 and finally granted two weeks ago.

~50% of NAV is allocated to (mostly single-family) residential rentals and self-storage rentals, two markets that have shown strong growth backed by macro tailwinds (increased need to rent due to affordability coupled with desire for more space, and increased need for space due to frequent relocations / crowded flats, respectively). The rest of the NAV is in a mix of office, hotel, multifamily, timber, and life sciences real estate (in addition to some legacy financial instruments, most  of which are publicly traded). Our asset-level analysis of the real estate portfolio, based on public filings and discussions with the NXDT team, indicates that the majority of these properties are marked at relatively conservative valuations, making the current discount to NAV unwarranted - see below for the details for each asset:

• VineBrook Homes (18% of NAV) - Single-Family Rental property acquisition and management platform, owning >15k homes across 16 states (<5% vacancy). Operates in a market with low institutional ownership (<2% of total properties), and hence consolidation opportunities. Vinebrook has generated ~20% annualized returns on NAV since inception and has been acquiring single family portfolios at an attractive ~10% yield on rent (as shown below) which we believe showcases good management of the company. Vinebrook is valued on NXDT’s B/S at the REIT’s reported NAV, in turn implying a ~3.8% dividend yield, per March ’21 SEC filings. Comparable Invitation Homes (NYSE:INVH) trades at a 2.4% dividend yield.

• NexPoint Real Estate Financing (16% of NAV) - Mortgage REIT (NYSE:NREF) focusing on real estate lending to stabilized properties, managed by the same GP as NXDT (9.5% insider ownership); average remaining term of c.6.5 years, with 68% LTV, ~2x DSCR, and weighted-average coupon of 6.3%. Valued at its market price in NXDT’s NAV (implying ~9% dividend yield, in line with public comps from other GPs).

• NexPoint Storage Partners (14% of NAV) - Platform with 52 storage facilities (41 wholly owned in partnership with an operator) in major US metro areas (with dense population and above-average household income), 50% owned by NXDT. We estimate a potential 14% FCF yield on NAV once stabilized as per the following table (note that NXDT’s team expects to increase rent / unit once they reach full occupancy - current rent is discounted to attract more users):

• Cityplace Tower (10% of NAV) - 42-story trophy office building in Dallas, Texas, wholly owned by NXDT. The tower has 1.35m sqm, within which a 5 star hotel is being developed (set to be operated by InterContinental)- in addition to office space that is being leased. Asset is levered at 70% LTV. A comparable building across the street was sold in jan/22 and we know that it had a tax book value of $240/sqft, above the NAV-implied Cityplace valuation of ~$190/sqft. The NAV valuation implies, we believe, a 14% unlevered yield on rent if we assume market rents in the Dallas office market:

• Terrestar (9% of NAV) - Distressed debt investment made by Dondero using NXDT; valuation here is unclear due to the lack of disclosure and disagreements with auditor PwC on the NAV assessment, although NXDT’s IR has shown confidence in their ability to dispose of non-core assets such as this. We are giving a 50% haircut to this property in our valuation.

• SAFStor (7% of NAV) - SAFStor owns and develops single- and multistory self-storage properties in undersupplied markets. The current yield on cost is 8.6% across 23 completed projects according to the company, of which NXDT is exposed to 8. Full portfolio stabilization is expected for early-2025. We believe the current NAV implies a 6% FCF yield on NAV for the equity once the properties that NXDT has exposure to get stabilized, as shown below:

• Creek Pine (<3% of NAV) - >330k hectares of timberlands in East Texas producing >2,8 millions tonnes each harvest, with room to increase. Joint venture includes long-term supply agreements in place, being located near some of the top homebuilding markets in the US. GP valued Creek Pine Equity @$783M. Former auditors PwC also had disagreements with regards to the valuation of this asset. We cannot be sure that it is still on NXDT’s B/S, as it does not show up on the “top 10 exposures” reported by NXDT anymore (hence why we believe it must currently be <3% of NAV). We are placing a 50% haircut on this property in our valuation.

Based on all of the above, NXDT’s property portfolio could generate annual dividends worth 7% of NAV once all properties are stabilized, the remaining non-real estate holdings are rotated into real estate, and the company increases its leverage to a typical REIT level of 50% LTV (in line with NXDT’s guidance): 

As mentioned, the fund’s GP is NexPoint, a Dallas-based investment firm founded and run by James Dondero, who previously founded hedge fund Highland Partners. Dondero has a checkered past due to litigation against LPs of his hedge fund (see here). He is, however, heavily invested into NXDT (~100m USD) and has been adding at every chance that he has, so we believe that he is aligned. The actual NXDT real estate investment team is led by Matt McGraner, who leads the general partner's overall real estate investment platform. Matt has a great track record in other NexPoint REITs, namely NXRT - a single family residential REIT spun off from NHF/NXDT in 2015 that has gone on to compound at +20% per year since then. When we spoke with him, he seemed knowledgeable of NXDT's assets, in addition to articulating a coherent investment thesis for each asset in the portfolio and for the team's investment platform in general.

We believe that a big driver of the discount to NAV has been that the security was up to now "orphan" - having cut the dividend during Covid and after, NXDT went from yielding 10% to 4%, likely driving away yield-focused CEF investors. At the same time, until now, the company was not eligible for REIT index inclusion. As a consequence, we believe that the next months will serve to close the current NAV discount, as a new investor base (likely skewed towards passive funds, as NXDT gets added to indices) “adopts” the security. If this is not the case, our asset-level analysis also indicates potential for NXDT to pay a ~7% yield on current NAV by 2024-25, based on the stabilization of current properties and redeployment of non-core holdings - and we believe this should serve as a catalyst in itself.

When this happens, depending on the haircut one applies to the holdings whose NAV valuation has more uncertainty / had auditor disagreements (i.e. Terrestar and Creek Pine), we see ~30% upside to the current share price over a short time frame, with low downside even if we write these assets down to zero and additional upside from the effect of passive flows on a low-liquidity stock:

We believe the key risks here are a downturn in the real estate market and corporate governance / inflated NAV (given the GP’s past). The 40% discount to NAV and near term catalyst mitigate the first, in our opinion, while the heavy insider buying and our asset-level analysis makes us comfortable with the latter. An additional risk could have been the rise in interest rates, since the properties are levered at the asset-level. However, our analysis indicates most of these properties have interest rate caps in place at 2-3% (showing good risk management by the NXDT team).

Catalyst

Index inclusion

Stabilization of current properties increases cash flow

Increased investor outreach after REIT conversion