Description

Link

https://www.scribd.com/doc/277138770/NRF-Memo-August-2015?secret_password=8BV63aUgY9y2yrlCAJ4Q

Recommendation: Long NorthStar Realty (NRF)

At a 11.6% dividend yield (covered 1.13x), investors get paid to wait for the market to understand that NRF has transitioned its business model to an equity commercial real-estate (CRE) REIT from a mortgage REIT and that further lower cap-rate REITs will be spun-out similar to NorthStar Asset Management and NorthStar Europe (NRE). Additionally, NRF has asset sales (manufactured housing or net lease) that will be tapped in order to grow CAD via higher cap rate investments and close the valuation disconnect. Short-term worries surrounding “over-earning” risk from legacy CDOs is overblown given duration of these particular assets (3.5 years), small exposure and off-setting reinvestment CAD/NOI growth.

Next Catalyst

·         NRE Spin ~ NRE (European REIT spin) is teed up for a Sept/October ’15 effective spinout date. Assuming a 6.5% div yield for NRE, pro-forma NRF’s dividend yield would have to widen to 13% in order for this  transaction not be accretive. If NRF pro-forma trades at the current 11.5% dividend yield and NRE trades 120bps wide of Continental European REITS (6% vs. 4.8%), it’s 12% accretive to valuation  ($15.40/share) over the next 2 months.

·        Sale of Manufactured Housing (6-9 months) ~ Given sub 5% cap rates in the manufactured housing sector and inability to scale the business, management has made comments around selling or merging the  manufactured housing business with an existing player in the space. With NRF’s cap rate north of 10%, this type of transaction would result in meaningful cap-rate accretion to repurchase stock or redeploy the  capital without needing to issue equity.

·        Healthcare Spin ~ Assuming the NRE spin goes well and NRF is able to see its cap rate normalize back to an accretive level for future equity raises, we might see the healthcare spin sooner rather than later.  The reason why we saw the European spin first and not the healthcare was because it was holding up admittance into the MSCI Index and NAREIT Equity REIT classification. If the healthcare was to be spun, it  would be the crown jewel given its optimal scale ($427mm NOI) and low cap rates 5-6%. This would result in further cap-rate compression on a SoTP basis.

Valuation Scenarios (ignoring dividend return)

·         Downside Case (10% dividend cut, 12% dividend yield  ~ 13% downside ($12/share)

·         Base Case (8% dividend yield, no dividend growth/coverage ratio improves) ~ 45% upside ($20/share)

·         Upside Case (Euro & Healthcare Spin ~ weighted avg. 6.67%) ~ 76% upside ($24/share)

Risks:

·         Dividend Cut (at best 2-3 years out given CDO bond duration coupled with inability to recycle into mid-teens ROEs results in a 6.5% dividend cut)

·         Credit deterioration (tenant loss)

·         Dilutive CAD via equity raises to buy assets (NSAM CAD growth at NRF’s expense)

·         Rising interesting rates (Fed expected to raise in Sept or Dec ’15). Every 100bps rise in rates equates to a 12 cent negative impact to CAD)

·         Economic slowdown weighing on hotel portfolio and RevPar growth

·         External asset manager discount (NSAM)

Investment Thesis

NRF is a $19bn CRE REIT founded in 2004 by former head of Goldman Sach’s Whitehall Real Estate Funds, David Hamamoto. NRF is highly opportunistic employing a multi-strategy approach to commercial real estate. Since the IPO, NRF has returned 20%+ compounded returns to investors. Management is committed to realizing value through building platforms and spinning them off to shareholders (NorthStar Asset Management and NorthStar Europe) to capture cap rate compression.

CRE Asset Class Breakdown 

Healthcare (35% of Assets) - $6.8bn portfolio consisting of 147 medical office buildings (MOBs) and 224 Senior Living Facilities (108 Skilled Nursing Homes & 14 Hospitals).

o    2015 NOI = $427mm

Lodging (17% of Assets) – $3.2bn hotel portfolio of $164 extended stay and premium branded select service hotels (21k keys). 91% of the properties are affiliated with Marriot or Hilton,

o    2015 EBITDA of $291mm

Europe CRE (12% of Assets) – $2.6bn real estate portfolio across 49 office properties and 9 countries. Approx. 5mm sq ft with a 91% occupancy rate and weighted average lease term of 5 years.

o    2015 NOI = $135mm

Manufactured Housing (8% of Assets) – $2.6 portfolio consisting of 123 communities (29k rentals). Occupancy stands at 86%.

o    2015 NOI of $114mm

Other CRE (net lease, multi-fam, multi-tenant, PE equity funds ~ 14% of Assets)

o    Net Lease 2015 NOI = $63mm

o    Multifamily 2015 NOI = $26mm

o    Multi-tenant 2015 NOI = $13mm

o    PE = $2.3bn in initial NAV

Legacy CRE Loans/Securities (14% of Assets)

·        Investment Thesis                     

  #1) Multiple REIT Spinouts in Progress                    

 NRF has a history of spinning out businesses to realize value. Last year, NSAM was spun out as a high-margin (80%+ EBITDA) asset manager to NRF and related spins assets.

In the 1Q15, NRF announced its 2^nd spin (NRF Europe) in an effort to simply the business and make it easier to be included in the RMZ REIT index. NRF currently trades at 7.7x 2015 CAD vs. 21x for European CRE and 25x for UK CRE REITS. The spin is expected to be completed in the Sept/Oct ’15, helping close the cap rate gap between NRF and comps.

  #2) Shareholder Base Makeover

 NRF has worked hard to transform the business from a mortgage REIT into an equity CRE REIT. Over the last 18 months, NRF has diversified the business and grown assets rapidly from a few billion to $19bn today. After 2 missed attempts, NAREIT reclassified NRF as an “Equity REIT” and RMZ announced the inclusion of NRF in the index as of May 31^st, 2015. The REIT industry moves slow, but overtime NRF’s

 #3) “Over-Earning” Risk from Legacy CDO Book & PE Secondaries Portfolio is Overblown

The largest criticism against NRF is the claim that even though the non-traditional portfolio is small on a capital basis, it is a large contributor to CAD. Given the CDO book and PE secondary funds aren’t levered at the asset level, the incremental margin contribution to CAD will be tough to replace into more traditional CRE assets. Based on my analysis of their these two high returning buckets, it appears that even under reasonable assumptions (12% reinvestment, 2yr weighted avg. life for the CDO book and 3% NOI growth over only 2 years), we cannot pierce the dividend coverage ratio.

CDO Portfolio – The CDO book is $376mm today (2/3rds bonds vs. 1/3^rd equity), with an average life of 3.16 years (3.5 years on equity & 3.0 years on bonds). The return on this portfolio is expected to be $100mm this year stepping down $90mm next year and rolling off in a few years. Ignoring the re-investment benefit of recycling the excess gains from higher yielding CDOs to CREs, a 12% ROE on reinvested proceeds and only assuming a 2 year life, the net shortfall is $55mm.

PE Secondaries Portfolio – NRF views this as a “real business” and not as a fleeting opportunity set once the market goes away. Institutional investors have consistently had a sizeable PE allocation over the last 20 years and given changing allocation policies at pensions and endowments, opportunities are created for NRF to create CRE at discounts to direct investments.

The team consistently compares the value differential between direct and indirect real estate as it relates to investing an incremental dollar of capital. Incremental capital has been flowing into the PE secondaries bucket given the high teens returns driven by late stage realizations, purchase discounts and diversified set of income streams (157 different funds ~ 94 GPs).

As of 2Q15 conversation with NRF, they confirmed that they are earning a 17% return on the PE secondaries book. The recent investments in 2^nd quarter were underwritten to a 15% return. The investors who are skeptical of these outsized returns claim that if one annualizes 1Q15 income from PE secondaries ($176mm p.a.), then this equates to a 19% return right now that is flowing through to CAD today. I don’t disagree with the strength of the returns here, but assume these higher yielding investments roll-off and are reinvested back at a 12% ROE. This results in a short-fall of $62mm.

CAD Shortfall Analysis vs. NOI Growth – If we add up the shortfall across the two buckets, we have a net shortfall of $117mm. However, we need to offset this further by NOI growth. Given that this scenario assumes a 2 year window, we need to grow NOI over the next two years. Management has guided to 4-5% NOI growth, but assuming 3.5% growth, we get $76mm. After NOI growth, our new net shortfall is $41mm to CAD (versus a current CAD cushion of $74mm). However, if we adjust 2yr NOI growth to 5% and recycled CRE investment ROE to 15%, our CAD cushion actually GROWS by $30mm reducing the dividend payout ratio to 84% vs. 89% today. Also, please keep in mind that this analysis also assumes no asset sales, further spins or secondary capital raises in the future.

Valuation & Risk/Reward

Fundamental Valuation ($20/share ~ 42% upside) – Assuming NRF doesn’t spin-out different REITS and is able to achieve an 8% dividend yield (approx ~ 420bps discount relative to NAREIT Equity REIT Index).

SoTP Valuation ($23/share) – If NRF continues to spin-out assets, the conglomerate discount will narrow. Baking in a 50bps discount b/c of the external structure and 50bps discount for multi-sector diversification, we have a $23/share or 50%+ upside.

NRE Spin Value 

NRE Spinout Valuation – NRF refiled the Form-10 this week (late August) and expected to get comments during September from the SEC. Management expects very few comments from the SEC based on their early feedback. Depending on the comment period length, NRF thinks the spin can happen as early as late Sept/early October.

 Pro-forma NRE CAD/Dividend Walk – Management’s first presentation earlier this year stated 20 cents in CAD. However, it included the last $600mm of assets purchased. Pro-forma for Trias (German Class A office tower). Assuming a 90% dividend payout ratio and an additional $400mm of dry-powder put to work ($3bn pro-forma portfolio at cost) at returns similar to the current set of European investments, we arrive at 22 cents of pro-forma CAD or 20 cent dividend per share (we are hearing that CAD is actually closer to 25 cents now based on loose comments from management to the street).

NRE Valuation Scenarios - Assuming a 6.0% div yield for NRE, pro-forma NRF’s dividend yield would have to widen to 13% in order for this transaction not to be accretive. If NRF pro-forma trades at its current 11.5% dividend yield and NRE trades 120bps wide of Continental European REITS (6% vs. 4.8%), it’s 12% accretive to valuation ($15.40/share) over the next month or so. However, additional upside exists.Given depressed real estate values in Europe, European REITs tend to be a total return asset class (dividend + capital appreciation). NRF management believes that they bought NRE's portfolio 20% cheap relative to its collective fair value. The cost basis for NRE is $2.6bn, so we close the 20% valuation discount, this translates into $3.25bn in asset value. Subtract out mortgage debt of 50% and then apply the 1.2x P/BV avg. across contiental Europe and UK REITs. We get to a valuation of $5.34/share vs. our 6% dividend rate valuation of $3.33. Using the higher valuation, we are created NRF-core at 16% pro-forma dividend yield on $1.40 dividend p.a.

Catalyst

   NRE Spin ~ NRE (European REIT spin) is teed up for a Sept/October ’15 effective spinout date. Assuming a 6.5% div yield for NRE, pro-forma NRF’s dividend yield would have to widen to 13% in order for this transaction not be accretive. If NRF pro-forma trades at the current 11.5% dividend yield and NRE trades 120bps wide of Continental European REITS (6% vs. 4.8%), it’s 12% accretive to valuation ($15.40/share) over the next 2 months.

·         Sale of Manufactured Housing (6-9 months) ~ Given sub 5% cap rates in the manufactured housing sector and inability to scale the business, management has made comments around selling or merging the manufactured housing business with an existing player in the space. With NRF’s cap rate north of 10%, this type of transaction would result in meaningful cap-rate accretion to repurchase stock or redeploy the capital without needing to issue equity.

·         Healthcare Spin ~ Assuming the NRE spin goes well and NRF is able to see its cap rate normalize back to an accretive level for future equity raises, we might see the healthcare spin sooner rather than later. The reason why we saw the European spin first and not the healthcare was because it was holding up admittance into the MSCI Index and NAREIT Equity REIT classification. If the healthcare was to be spun, it would be the crown jewel given its optimal scale ($427mm NOI) and low cap rates 5-6%. This would result in further cap-rate compression on a SoTP basis.