Northstar Realty Finance Corp. (NYSE:NRF) is a fairly complicated REIT. Because of the substantial complexity of the investment, it easier for shares to deviate substantially from the intrinsic value of the underlying portfolio. The result is greater price volatility and confusing when shares suddenly move by a substantial amount. It didn't have to be this way. It could have been so much simpler.
When I first received suggestions to look into NRF, I pulled up their investor presentation and scrolled through it. The first thing that struck me was the amount of needless complexity in the investment. The very first rebuttal to the market undervaluing a company should be complete transparency. If the assets are undervalued, the case should be made as simply as possible. The presentation is anything but simple. The presentation may leave investors thinking they found a great opportunity, but unsure how that business works. This is a fundamental problem. The cheap valuations suggest that this would be an ideal opportunity for value investors, but a disciplined value investor won't buy a company they can't understand.
What I Want to Share
My goal in this piece is not to establish a target price. My goal is to start breaking down the layers of needless complexity so shareholders and potential shareholders can understand precisely what they are holding or contemplating holding. The best way to do that is with a simple story.
The Three Investments
There are three investments shareholders must be familiar with to understand NRF. Obviously the first is NRF. The second is their recent spinoff known as Northstar Realty Europe (NYSE:NRE). The separation of NRE was supposed to unlock value for shareholders. That was a great storyline, but it didn't work out. The third company is their external manager, Northstar Asset Management Group (NYSE:NSAM). Usually external managers are held privately, but in this case the external manager is publicly traded. In my opinion, most of the problems afflicting NRF are a direct result of the poorly designed separation of NSAM from NRF.
For anyone that is new to NRF, I want to briefly touch on the portfolio:
Primarily this is commercial real estate, but it also contains some loans. If NRF wants to have both types of assets, they need to have complete segment level operating data provided on each segment. If they don't do that, then shareholders will have a more complicated time evaluating the combined business than they would have had evaluating the individual parts.
When it All Started Going Wrong
The date where things started going wrong is not necessarily the same as the date when the share prices started moving. Confusing the two would result in analyzing strictly price movements without understanding the fundamental businesses.
In Northstar Realty Finance's 10-Q for Q1 of 2014, they included the following statement under "Subsequent Events":
"In April 2014, NSAM filed Amendment No. 1 to the Registration Statement on Form 10 with the SEC under the Securities Exchange Act of 1934, as amended, to register shares of NSAM common stock. The information statement, which forms a part of the Registration Statement on Form 10, discloses that upon the consummation of the spin-off, holders of record of the our common stock as of the close of business on the relevant record date will receive one share of NSAM common stock for every one share of our common stock held. The information statement also discloses that in connection with and immediately prior to the consummation of the spin-off, we expect to effect a 1-for-2 reverse stock split of our common stock."
This was when the problem was born. I believe this problem is the reason share prices have been tanking. To combat the falling share price management created another spin off, but that was an ineffective strategy because the combination of NRE and NRF was not the problem.
When NSAM was separated from NRF it exposed the REIT to trading at a very well deserved discount to peers. Even if there is nothing wrong with the physical assets in the portfolio, the cost of compensating management is heavily problematic. When other analysts are suggesting that the present value of the management contract, after accounting for a "reasonable" cost of management is around $2.6 billion. This is greater than the value of NSAM, which also controls other lines of business.
It doesn't matter whether the contract is actually worth $2.6 billion. If it is worth anything remotely in that ball park, then management is failing to act in the best interests of shareholders. By splitting off management from NRF and assigning a hefty cost onto the REIT, they put it in a position where it was unlikely to trade at valuations where they could issue new equity. That puts the REIT in a difficult situation since it is no longer possible to grow through equity issuance. While many REITs can grow and create superior economies of scale, NRF faces a fee on equity issued. This makes buying back equity less effective than it would be for other REITs trading at a discount. NSAM specifically identifies for shareholders that their fees cannot be reduced under the management agreement and it has a 20 year term that is only able to be cancelled "for cause". It makes you wonder how fiduciary duties play into that definition, but it would require an overhaul of the board to eliminate members appearing on both the board for NSAM and for NRF for that to even come up.
Ironically for NSAM
Shareholders might think initially that any cost to NRF is a gain to NSAM, but that isn't true. When NRF can no longer issue equity at accretive levels to grow the portfolio (we passed that mile marker quite a ways back), then their fee income can hardly grow unless they were to issue dilutive equity. It is astounding that management believed this strategy might work.
Watch Out for Activists
Activists are pushing for change, but they aren't always interested in the best outcome for all shareholders. For instance, if they only hold NSAM they have no reason to worry about what is best for shareholders of NRF. The only action management of NSAM can take that would fulfill their fiduciary duty to both NSAM and NRF (as well as NRE) would be to recombine the companies. Selling the management contract would make it inherently more difficult for NRF to have the function internalized. Since this is the reason they are trading at such a discount, NSAM would be actively working against the best interest of NRF. Since NSAM's management is also NRF's management, they have an obligation to protect NRF. If anything, the fiduciary duty of management to NRF should be stronger because NSAM also has a responsibility to NRF as the external manager.
Activists may nominate a competing board, and normally I would immediately support activists. However, I'm not convinced that NSAM activists will be worried about the duties their company is bound to. In a nutshell, that is precisely why NRF must continue to trade at a discount to peers. Watch for activists that are genuinely interested in seeing this company fixed, rather than creating a large sale and dividend for shareholders of NSAM at the long term expense of NRF and NRE.
Land and Buildings has called on management to extend the deadline for nominating new members to the board. While management might play along, I doubt board members are very interested in the negotiations and I wouldn't be surprised to see Jonathan Litt, Founder of Land and Buildings, nominate some alternatives for the board.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.