Description

I recommend the purchase of common shares of NexPoint Residential Trust, Inc., by which one can acquire at a 7% cap rate a portfolio of multifamily buildings located in the sunbelt states of the Southeast and Southwest United States, among the highest population and job growth markets in the country.

Over the past few years, there has been a flood of new construction in the U.S. sunbelt, and NXRT’s markets have not been immune.  Abundant construction has pressured rents and occupancies, and will continue to do so for the two years.  Meanwhile, higher interest rates have resulted in significant cap rate expansion, lowering property values.  Consequently, NXRT’s stock price dropped from a high of $95 per share in April 2022 to a low of $26.21 in October 2023.

The construction boom is over.  NXRT, citing RealPage data, projects that deliveries of completed multifamily projects in its markets will peak in 3Q 2024, will begin tapering in earnest in 1Q 2025 (with 2025 deliveries projected to decline over 40% from 2024), and will decline to nearly zero in 2026.  NXRT's markets are among the highest population and job growth markets in the country.  Assuming current population trends continue, rent and occupancy pressures should begin abating in 2025 and supply and demand factors should result in rents rising again beginning in 2026.

The future of interest rates is anyone's guess.  Lower interest rates should result in cap rate compression, which, when combined with net operating income (NOI) growth beginning in 2026, should result in meaningful price appreciation five to seven years out.  If, on the other hand, interest rates do not decline, cap rate expansion is unlikely.  However, I view that scenario as bullish for property and financial performance.  At current rental rates, interest rates, and exit cap rates, new construction of Class A product does not pencil in NXRT’s markets.  (NXRT's portfolio consists primarily of Class B product; it goes without saying that new construction of Class B product makes even less sense in the current climate).  If cap rates do not decline, significantly higher rental rates will be required to incentivize new construction.  This bodes well for owners of existing properties in high demand areas.

Company.  NXRT is an externally managed multifamily REIT primarily focused on acquiring, owning, and operating middle-income (i.e., Class B) multifamily properties with "value add" potential in the larger cities and adjacent suburbs of the sunbelt states of the Southeastern and Southwestern U.S.  NXRT targets markets with the following characteristics:

• Attractive job growth and household formation fundamentals
• High costs of homeownership or of renting Class A multifamily apartments
• Elevated or increasing construction or replacement costs for multifamily real property

NXRT has a unique corporate history.  NXRT's starter portfolio was acquired by NexPoint Credit Strategies Fund ("NHF"), a publicly traded closed-end fund and 1940 Investment Company.  NHF spun-off NXRT as a publicly traded REIT in 2015 and distributed all of the NXRT's shares held by NHF to NHF's shareholders.  NXRT is one of several NexPoint-affiliated REITs.  In 2020, the NexPoint consortium brought public a residential mortgage trust, NexPoint Real Estate Finance ("NXRT").  And in 2022, NHF (which had spun-off NXRT in 2015) converted into a diversified REIT, NexPoint Diversified Real Estate Trust ("NXDT").  Various companies in the NexPoint complex have been written up on VIC:

• NXRT in 2015 and 2021
• NHF in 2015 and 2021 
• NREF in 2021 
• NXDT in 2022 and 2023

Management.  NXRT is externally managed by NexPoint Real Estate Advisors, L.P., which is an affiliate of NexPoint Advisors, L.P., an SEC-registered investment adviser.  NexPoint Advisors is controlled by James Dondero, NXRT's president and chairman of the Board (and who also owns approximately 11% of NXRT's common shares).

Dondero has a checkered past.  In 1993, he co-founded Highland Capital Management, L.P., an alternative assets manager which at one point managed nearly $40 billion.  Several of Highland's funds blew up during the financial crisis, and (often colorful and sometimes ugly) litigation ensued.  An arbitration award issued in connection with one piece of this litigation led to Highland filing for Chapter 11 bankruptcy protection in 2019.  The bankruptcy proceedings (which were themselves colorful) ultimately resulted in Dondero's ouster from Highland.

That a REIT is externally managed is typically a negative factor, compounded in this instance by the record of Dondero's behavior in previous ventures.  Ameliorating this are the following:

• Dondero owns approximately 11% of NXRT's common shares, meaning incentives are at least somewhat aligned.
• Although Dondero is NXRT's president and chairman, day to day management is handled by Brian Mitts (NXRT's CFO), Matt McGraner (NXRT's CIO), and Bonner McDermett (NXRT's VP of Asset and Investment Management).  Mitts, McGraner, and McDermett are the face of NXRT on earnings calls and at investment conferences.
• Most importantly, NXRT's (and, thus, management's) performance since 2015 has been stellar, ranking near the top of the multifamily universe in share price performance, NOI growth, and AFFO/share growth.

Portfolio.  NXRT owns 36 multifamily properties consisting of 13,174 units (including one 190 unit building held as available for sale) across the U.S. in Texas, Arizona, Georgia, Tennessee, Florida, Nevada, and North Carolina.  The geographic composition of the portfolio as a percentage of same store units is as follows:

Florida – 28.5% (consisting of 15% in South Florida, 9% in Orland, and 4.5% in Tampa)

Arizona – 15.5% (all in the Phoenix metro)

Texas – 15% (all in the Dallas/Fort Worth metro)

Georgia – 13% (all in the Atlanta metro)

Tennessee – 10% (all in the Nashville metro)

Nevada – 9% (all in the Las Vegas metro)

North Carolina – 9% (consisting of 5% in Raleigh and 4% in Charlotte)

Eight of NXRT's ten same-store markets rank in the top fourteen U.S. markets in total population growth from 2020 to 2023, while the job growth rate in eight of NXRT's ten same store markets outpaced the national job growth rate average of 1.28%.  NXRT owns properties in five of the top ten job growth markets.

Debt.  NXRT is highly leveraged, with a debt/EBITDA ratio of approximately 10.  However, NXRT carries no corporate level debt, having utilized property refinance proceeds and property sales proceeds to fully pay off its corporate credit facility over the past two years from a balance of $355 million in 2022.

All of NXRT's debt is property-level debt, with separate non-recourse mortgages secured by each of NXRT's properties.  Further, each property is owned by a separate SPE.  All but one of the property level mortgages are floating rate loans indexed to a spread over SOFR, and almost all loans are interest-only payment loans.  NXRT's rationale for utilizing floating rate loans was to maintain prepayment flexibility without incurring the substantial prepayment penalties or defeasance costs typically associated with fixed rate financing.

NXRT had the foresight to enter into swaps covering most of its property mortgages.  Thus, while the weighted average interest rate on NXRT’s mortgage debt is nearly 7%, the company’s effective interest rate was under 4% in 2023 due to the swaps.  The swaps begin rolling off this year, with $100 million rolling off in June, another $250 million rolling off in March 2025, and the balance rolling off by September 2026.  Thus, if market interest rates do not decline from current levels, NXRT’s effective interest rate will climb from under 4% to around 7% by 2027.

NXRT has limited near term maturities.  One loan with a principal balance of $15 million matures on July 1, 2024, but that is secured by NXRT’s sole property held for sale.  One loan with a principal balance of $42 million matures in September 2025 and four loans with an aggregate principal balance of $91 billion mature in October 2025.

Valuation.  NXRT trades at an implied cap rate of approximately 7% and at an AFFO multiple of 12, well below the multifamily sector's average AFFO multiple of over 15.  NXRT's enterprise value is as follows:

Projected Return.  Real estate projections are often just fun with numbers, but nonetheless a range of IRR projections, based on holding to 2030, follow, using the following range of assumptions:

In addition, no credit is given for share repurchases, and the dividend is held flat, even if cash flow would allow a higher dividend.  (In the bear case, the dividend is reduced beginning in 2027 to account for the lack of dividend coverage.)  Based on these assumptions, I project a bear case IRR of 4% exiting in 2030, a base case IRR of 11.6%, and a bull case IRR of 18.7%.

Risks

Interest rates.  If interest rates stay at current levels, or go higher, NXRT may be unable to cover its dividend in 2027.  In my bear case above, dividend coverage drops below 100% beginning in 2027.  Management is aware of the issue, but believes that if it meets its objective of increasing NOI at a 4% CAGR to 2027 (which significantly exceeds my bull case above), increased rates will not be an issue.  The opposite side of the coin is that, if current interest rates continue, little to no new construction will occur in NXRT's markets without substantially higher rents, ultimately benefiting rental rates and NOI.

Recession.  There is already a near term supply problem in NXRT’s markets.  A recession could result in reduced demand and falling rents.  Combining the reduced demand brought on by a recession with the current excess supply issues in NXRT's markets could make things ugly.  While cash flow issues may be helped in that instance by lower interest rates brought on by the recession, that is not a given.

Management (Dondero Baggage).  As noted above (1) NXRT management has performed extremely well, but (2) James Dondero, who controls the external manager, has a track record of less than ideal behavior in previous ventures.  Adversity reveals character, and when faced with adversity in previous ventures, the result has been (allegedly) poor stewardship and (actually) bankruptcies and ugly litigation.  NXRT has not faced any real adversity in its relatively brief existence.  If the combination of high interest rates, excess supply, and a demand-reducing recession result in challenging operating and financial conditions, the risk of Dondero engaging in self serving and shareholder unfriendly behavior is, based on past experience, almost certainly higher than zero.

Catalyst

Abatement of new construction deliveries

Continued population and job growth in NXRT markets

Time