Description

NRF is an opportunistic REIT founded/run by the former head of Goldman Sachs’ real estate private equity group.  It is significantly mispriced with several near term catalysts.  It has recently undergone a complex transition including a spin-off and transformative acquisitions.  The dividend yield should tighten from 9.1% currently (10.1% is my estimate for 2015) resulting in close to 40% upside over the next year.   The yield should tighten because: 1) NRF has evolved from a complex mortgage REIT into a simpler property REIT which deserves a lower yield.  2) It should now attract traditional REIT investors -- it is likely to be added to the MSCI REIT index near term.  3) Management continues to grow the dividend with attractive investments.   4) NRF is considering spinning off its healthcare portfolio which should further unlock the sum of the parts.

Overview

NRF is an opportunistic REIT founded/run by the former head of Goldman Sachs’ real estate private equity group.  It was founded in 1997 and IPO’d in 2004.  It has been in a complex transition in the last year including: 1) shifting from a commercial mortgage REIT (i.e. a REIT that invests in real estate debt) into a diversified property REIT, and 2) spinning off its management company into a separate public company on July 1 and becoming externally managed.   

NRF’s business mix has changed considerably in recent years. Pre-crisis, NRF was primarily a CDO sponsor.  It originated direct real estate loans and it bought CMBS which it financed via nine CDOs.  NRF has deconsolidated seven CDOs since the start of 2013 and still consolidates two CDOs.  CDOs made the financials very messy b/c the assets/liabilities of the CDOs show up on NRF’s balance sheet, although the debt is non-recourse.  Post crisis, NRF has been de-levering and shifting its asset mix to a direct real estate portfolio and opportunistic investments, while continuing to originate direct loans.

NRF has a $12bn on-balance sheet estate portfolio at Q2, pro forma for acquisitions that have not closed.  The asset mix is:

$9.6bn of direct real estate investments with a ~7% cash NOI (i.e. after property level opex, unlevered). 58% healthcare (of which: 37% is senior housing, 30% skilled nursing, 29% medical office, 5% hospitals).  The healthcare portfolio grew significantly with the announced $4bn acquisition of Griffin-American REIT in August.  NRF’s healthcare effort is run Jay Flaherty who is very well regarded as the former CEO of HCP, Inc., the largest healthcare REIT, from 2003-2013. 16% manufactured housing; 14% hotels; 8% net lease; 4% multi family.

$2.2bn of commercial real estate debt and securities with a ~12% unlevered yield.  ~45% of the portfolio is pre-crisis loans.  None of the loans are on non performing status.

$0.6bn of private equity secondary interests which it bought opportunistically from pension funds that needed liquidity.  The cash yield is ~20%.

The mix of CAD (cash available for distribution) after non-recourse funding costs is: 47% owned real estate, 16% PE secondary interests, 15% post-crisis loan investments, 14% pre-crisis CDOs and 8% minority interests with two other real estate companies.

Leverage/ROE

Debt plus preferred to equity is 2.9x.  Recourse debt plus preferred to equity is 0.6x.  The vast majority of the non recourse debt relates to mortgages on real estate owned. NRF tends to fund property acquisitions with 70% debt.  ROE on GAAP equity is 14% ROE.

Spin-off:

On June 30th NRF complete the spin-off of its external asset manager, NSAM, which was initially announced in December.  NRF is now an externally managed REIT.

Post spin, NRF has increased its dividend payout from 75% to 98%.

The external management agreement with NRF has an initial 20 year term.  NRF pays an initial base fee of $100mm plus 1.5% of all additional equity and preferred raised by NRF.  (The base fee is now up to $150mm due to capital raises since the spin was announced.)  NRF also pays a 15% incentive on CAD above $1.56 and a 25% incentive fee above CAD of $1.80.  Run rate CAD is ~$1.64.  NRF is paying ~1c or $3mm of incentive fees. 

Long Thesis

Valuation:

The run rate dividend yield is 9.1% ($1.60 dividend) rising to 10.1% ($1.78 dividend) by the end of 2015.  The yield should tighten to ~8% given the asset mix as the story continues to get simpler (e.g. more property investments vs CDO investments), and as NRF attracts traditional REIT investors post-spin.  I would also give weight to management’s ability to growth the dividend with accretive deals.  $1bn of equity raised and put to work at a 13-14% ROE is 3-5% accretive.  NRF raised $1.4bn of common so far in 2014. I think it is reasonable that NRF could raise at least $2bn in the next year, and potentially far more.  My estimates assume NRF raises $2bn of equity next year and deploys it at a 13% ROE (11.5% net of the management fee).

My price target is $22 based on an 8% yield for close to 40% return over a year including the dividend.  The price target assumes the run rate dividend at the end of 2015 is $1.78 which is a 95% payout on CAD of $1.87.  Here is how I justify the 8% target yield.

Roughly half of NRF’s CAD comes from legacy and opportunistic debt/equity investments which I would comp against the small universe of commercial mortgage REITs at a ~8.5% dividend yield and ~11x CAD (commercial mortgage REITs have 92% payout ratios similar to NRF).  All the commercial mortgage REITs are externally managed like NRF, and they tend to be more levered, like NRF, at 1.5-2.0x debt to equity.

The other half of CAD comes from owned real estate which I would comp against traditional property REITs at 4.8% dividend yields and 15x CAD.  There are several differences to consider: 1) I use a CAD multiple b/c NRF has a much higher payout than property REITs (97% vs 70%), so NRF’s yield should be higher, 2) NRF is externally managed vs most property REITs are internally managed, and 3) NRF is much more levered relative to property REITs at ~1x debt to equity.  To account for the external mgmt and leverage, I value the owned real estate at 12x CAD, or a 20% discount to comps.

Blended that is a ~11.5x target CAD multiple.  Using a 95% payout ratio, that implies an 8% yield.

Management

Mgmt is regarded as savvy investors.  They are very aggressive about putting money to work and highly incented.  NRF’s shareholder CAGR since IPO in 2004 is 19%.  NRF has invested $3.3bn YTD including $1.2bn of equity.  The pro forma weighted average ROE on new investments is ~14%.  In addition, NRF recently agreed to acquire a healthcare REIT, Griffin-American, for $4bn ($1.1bn of equity at a mid-11% ROE).

The top 3 executives own $48mm of stock and have unvested equity awards of $37mm.

Further Spin-off

Management has indicated that it will consider spinning-off a separate healthcare REIT near term if NRF’s valuation does not reflect the sum of the parts of value.  Management is very vocal about saying NRF’s valuation is too cheap relative to its SOTP. 

NRF’s health care real estate is the highest multiple segment.  Comps trade at 15x FFO and 5% yields, and it is large enough to be a separate company.  Management has indicated it could pursue a spin at any time.

Index Inclusion/Broader Interest

NRF is likely to be added to the MSCI US REIT index (RMZ) in the near term because it now meets the criteria of having >60% of revenues comprised of rental revenues from owned real estate.  Based on NRF’s market cap, it is likely to receive a top quartile weighting in the REIT index which should drive demand from index funds and interest from REIT dedicated investors. 

NRF is currently covered by a small handful of sell side analysts who cover commercial mortgages REITs.  I think it is likely that NRF will start to get covered by mainstream REIT analysts which should further raise its profile and valuation. 

Issues

NRF is may always have a discount to its theoretical SOTP b/c: 1) It has an opportunistic mandate and it does not have direct comps, although it should get simpler as the mix of owned property increases. 2) It is externally managed with the attendant conflicts of interest.  3) It is relatively highly levered at 2.9x debt plus preferred to equity vs comm’l mortgage REITs at 1.5-2.0x and trad’l REITS at 1x.

There are a few mitigants including: 1) significant insider ownership, 2) an incentive fee tied to accretion in CAD per share and 3) equity raises typically coincide with very attractive/accretive new investments, i.e. NRF raises equity at a 9% yield and puts the money to work at 14%.

The best years for putting new money to work have probably already passed in the US.  But, NRF is increasingly focused on Europe where there is still distress.  And, the US is just in the middle innings of the real estate cycle, so opportunistic investors like NRF should still be able to put money to work at low to mid teens ROEs.  NRF management is savvy and they should always find better than average opportunities (e.g. buying private equity LP interests, and being early to manufactured housing).

This posting is solely for the evaluation of club members and is not a recommendation to buy or sell this stock.  The views expressed are those of the author individually and should not be attributed to any affiliated investment firm, which may or may not hold positions consistent with the views expressed herein and may buy or sell shares at any time. 

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