Description

Investment Idea:

NorthStar Realty Europe (NRE) is a newly-formed European commercial real estate company with approximately $2.6 billion (at cost) of investments located throughout Europe, comprising 52 primarily class A office properties.  The properties encompass about 520 thousand square meters with a weighted average occupancy of 93% and a weighted average remaining lease term of 5.5 years.  Top tenants include BNP Paribas, Cushman & Wakefield, Ernst & Young and Deloitte.  As the parent company, NorthStar Realty Financial Corp (NRF), from which NRE was spun out, has been written up previously on VIC, this write-up will focus entirely on the spinco (NRE).  The stock began trading on the NYSE on a “when-issued” basis on October 20^th, and began trading regular way on November 2^nd.  With an expected distribution rate of $0.60 per share, the stock at $11.97 is trading at a dividend yield of 5.0%.  This vehicle was designed by management of NRF as a “plug and play” way for U.S. investors to gain exposure to European real estate.  We think the stock is worth $19 conservatively - for detailed valuation assumptions, see below. 

Here’s what we like about NRE:

1. Scarce asset in a space with tailwinds: With spreads of price office yields over 10 year sovereign bonds yields at wide levels vs the 10 year average and the ECB very early in the process of QE, we think the direction of cap rates is likely to go in the right direction, and there are few good vehicles (particularly those targeted to US investors) to take advantage of this tailwind

2. Strong management team: Anyone with a long history of investing in REITs will appreciate the importance of a solid management team.  Mahbod Nia, the CEO of NorthStar Realty Europe and Al Tylis, the CEO of NorthStar Asset Management Group, have strong reputations with well documented track records.  This should go a long way.

3. Strong pipeline of future acquisitions: Management has openly discussed a figure in the EUR 20-30B range in terms of interesting potential transactions, many multiples of the current portfolio value at cost.  Part of the reason for the large pipeline is that regulators in Europe are forcing liquidations of open-end funds.  NRE had been using the parent (NRF)’s high cost of equity capital to complete transactions, and based on early trading, it appears that NRE will enjoy a much lower cost of capital.  Those who have braved the turbulent waters of MLPs and more recently, “yieldcos”, should have a good appreciation for the virtuous cycles that can be created by low cost of capital deal machines. 

    

   Below is a bit more detail on the current portfolio of properties.

    

Valuation:

Below are some sensitivity tables as well as a comparables table.  There are multiple moving parts, but we think one important data point that seems to have been overlooked by the Street is that the $0.20 per share annualized CAD guidance does not take into account both the $340 million stock-settlable note transaction completed in late June 2015, nor does it account for incremental acquisitions that may be completed with the proceeds from the notes, nor from the $250 million of cash with which NRE was initially spun out.  We don’t have consensus numbers for P / CAD for the comp group butwith average yields of about 3.5% it’s easy to get comfortable with NRE’s 5% yield, especially with such a low initial payout ratio of 50% ($0.10 / $0.20). 

We think $19 is a pretty reasonable estimate for fair value, and that gives zero benefit for any new investments with disposable cash.    

Risks:

Interest rate risk: As with all REITs, rising interest rates will weigh against the whole group.

External management: NRE is externally managed by NorthStar Asset Management Group.  We have a lot of confidence in this management team, but it is worth noting that this company is dependent on an external manager. 

Reinvestment risk: A corollary to the external management question is that this company will be investing disposable cash and may do some portfolio restructuring as they see fit – we are taking some risk that they will make poor investment decisions.

Catalyst

Portfolio Actions: This management team will not sit idly for long - expect to see some use of the $250 million in cash towards CAD-accretive deals. 

Coverage Initiation: We think there will be at least 5 initiations in 2016, and based on the comp group and the strong reputation of the management team, price targets will likely approach $20 per share.

QE by the ECB: Let's face it, the ECB is behind the Fed, and we know the playbook.  Get long European real estate and hold on for the ride!