NexPoint's Hidden Value

| About: NexPoint Residential (NXRT)

Summary

Almost all new apartments being built are Class A, leaving the supply of Class B and Class C apartments almost static.

Within 24-36 months, NXRT typically updates the properties they purchase allowing them to earn higher rents going forward.

This is a spin-off from the NexPoint Credit Strategies Fund, which historically trades at a discount from NAV, whereas most REITs trade at or above NAV.

NXRT is an underfollowed and underappreciated REIT that offers a solid and safe dividend, has significant room for growth and has management aligned with shareholders.

NexPoint Residential Trust (NYSE:NXRT) is a REIT focused on the acquisition, asset management and disposition of multifamily apartments located primarily in the Southeast and Southwest of the United States. NXRT is externally advised by NexPoint Real Estate Advisors, LP an affiliate of High Capital Management, LP. NXRT was spun-off from the closed-end NexPoint Credit Strategies Fund (NYSE:NHF) on March 23, 2015 to better allow for the opportunity for growth in real-estate related assets. The fund also reasons that NXRT will have a different risk/return and asset profile than NHF and will allow for a more efficient vehicle to raise capital.

NXRT selectively develops Class A and Class B multifamily properties with value-add potential in large cities and suburban submarkets of large cities. RealtyMogul.com describes the difference between the two as:

Class A: These properties represent the highest quality buildings in their market and area. They are generally newer properties built within the last 15 years with top amenities, high-income earning tenants and low vacancy rates. Class A buildings are well located in the market and are typically professionally managed. Additionally, they typically demand the highest rent with little or no deferred maintenance issues.

Class B: One step down from Class A, these properties are generally older than Class A, tend to have lower income tenants and may or may not be professionally management. Rental income is typically lower than Class A along with some deferred maintenance issues. Mostly, these buildings are well maintained and many investors see this as a "value-add" investment opportunity because through renovation and common area improvements, the property can be upgraded to Class A or a Class B+.

In general, NXRT's focus is on locations that are major employment centers, have a stable workforce with positive net population growth, a favorable cost of living and a limited supply of new affordable housing.

The closed-end NHF fund historically trades at a 10%-12% discount to net asset value. Apartment REITs have historically traded close to their NAV and high-quality REITs often trade above NAV. As it stands, we view NXRT as having a significant margin of safety given their 4Q NAV [($976,273 total assets + $39,873 accumulated depreciation - $727,335 total liabilities) / 21,293 shares outstanding] of $13.56/share (compared to a NAV of $13.46 for 3Q). This is our lowest valuation, given that the value-add technique of NXRT will not be fully reflected in their book value. Using the market price of $13.00, this still represents upside of 4.31% to NAV. Page 9 of NXRT's 4Q supplemental information also gives a NAV range of $15.64-$20.71/share by using a mix of balance sheet numbers, estimates of NOI and third party cap rate ranges. We don't put much weight into these valuations but it does show management's expectations.

In their 4Q conference call, management detailed that they plan on selling three of their properties and having the deals closed by June of this year. They also specified which ones: the Meridian, the Park at Regency and the Mandarin Reserve. As of 12/31/2015, together these properties had a book value of $49.32 million and book value of debt of $35.64 million on them. The primary purpose of these sales is to pay off their $29 million bridge facility that comes due in August of this year. With a stated combined sales price of $64.25 million, this almost exactly pays off both the debt outstanding on the properties as well as the bridge facility (short by ~$390k). As management stated on their 4Q conference call, this translates to an average cap rate (net operating income/property value) of about 6%. This is at the low end of their expected range, which management believes proves their business model and strategy. Further, based on the $64.25 million sales price, this would translate to a return on investment on the properties of 23.2% (based on book value of debt on the properties and total book values).

We also believe this shows the impact of their value-add strategy. Up to December 31, 2015, 2,643 interior renovations have been done out of the total 13,155 units. The average monthly rental increase on these units is $93 and the average cost per renovated unit has been $4,728. Additionally, the rehabs that are done on the existing properties have an average change in rental rates of +11.4% and the ROI on the rehabs are an impressive 21.5%.

Looking at some comparable REITs, we wanted to see the estimated funds from operations (FFO) for fiscal year 2016 (from Bloomberg) yield on the computed NAV [(Assets + Depreciation - Liabilities) / shares outstanding]. The comparable REITs listed below were taken from NXRT's March 2015 Presentation on Page 10 where it lists MAA, AEC, CPT and UDR as peers. We also included IRT because we view them as a similar type of REIT. Of these four comparable REITs, NXRT was the most favorable overall:

Market Cap

FFO/NAV

Price/NAV

Price/FFO

Dividend Coverage

NXRT

$277 mil

11.36%

0.96x

8.44x

1.86x

IRT

$320 mil

11.56%

0.91x

7.91x

1.19x

MAA

$7.65 bil

9.62%

1.65x

17.11x

1.80x

CPT

$7.27 bil

8.51%

1.47x

17.22x

1.57x

UDR

$10.22 bil

8.41%

1.81x

21.49x

1.52x

Click to enlarge

NAV as of 12/31/2015, Price and Market Cap as of 3/30/2016, expected 2016 dividends from Bloomberg

James Dondero is President of NXRT and Chairman of the Board of Directors. He is also the co-founder and President of Highland Capital Management and President of NexPoint Advisors. At the time of the spin-off, through various entities, Dondero had control over ~11.6% of NXRT based on current shares outstanding of 21.29 million (and a market cap of $277 million as of 3/30/2016). As of the most recent Form 4 filed on 2/11/2015, Mr. Dondero (including all related entities) owned 3,442,492, or about 16.16% of NXRT. While other officers and executives have also been near-unanimously buying shares since inception, they are not in heavy volumes (McGraner - 12,573; Goetz - 4,895; Costantino - 7,360; Mitts - 1,125; Laffer - 15,000). These are all of their direct ownership, so not included in the officer numbers are a few thousand shares that they indirectly own. We believe that management could be positioning themselves for a buyout based on this insider behavior. At the very least, it is our opinion that they continue to strongly believe the shares are undervalued.

Additionally, most of the debt on the properties have a floating rate and do not have any prepayment penalties -- setting them up perfectly for a would-be acquirer. It is also worth noting that on NXRTs Investor Presentation from March 2015 they list numerous comparable REITs on Page 10. Of the four NXRT Peers, Associated Estates Realty Corp. (NYSE:AEC) has already been bought out since the presentation and so has Home Properties, Inc. (NYSE:HME). In summary, of the 10 comparable REITs listed by NXRT, two have been bought out in less than a year.

From the company's 10-K dated 12/31/2015, we took each property and multiplied the number of units by the average effective monthly rent per unit (and multiply 12 to get rent/year), divided by the total property value to determine the unlevered yield. As a sample calculation, The Miramar Apartments have 314 units, an average rent of $586/month and a property value of $10.83 million. For this property, the result is an unlevered yield of 20.38%. Using this same methodology, NXRT's portfolio as a whole has an unlevered yield of 13.44%. We view this as very favorable even when considering the risks and drawbacks inherent in operating rental properties.

While page 74 of the 10-K shows the vast majority of properties increasing their average effective monthly rent from December 31, 2014 to December 31, 2015, we also predict that rental rates will increase further on the existing properties in the near future, given that most of them were acquired in early to mid-2014. Assuming NXRT's stated 24-36 month timeframe of improving properties from initial purchase, higher rates should start to be fully realized in the next 1-2 years.

Currently, dividends per share are expected to be $0.824 per year going forward. Based on the market price of $13.00, this would result in a yield of 6.34%. We view this dividend as reliable based on type of business, supply/demand of Class B housing and a FFO per share of $0.33 in 4Q along with managements FFO guidance of $1.49-$1.57/share for FY2016. Assuming a flat dividend for the year of $0.824, this would amount to a coverage ratio of 1.86x for the year from the midpoint.

Almost all new apartments being built are Class A, leaving the supply of Class B and Class C apartments almost static.

Conclusion

We believe that NXRT is a high-quality, underfollowed apartment REIT that with its value-add strategy serves a portion of the industry that is often taken for granted. We also believe that management is strongly aligned with shareholders based on their current ownership and behavior since the IPO. NXRT is extremely well positioned in a low interest rate environment because of the floating rate debt on their assets. Lastly (and most importantly for some), NXRT's 6.34% dividend is one of the larger in this space, and is covered handily, providing both safety and opportunity for growth.

Disclosure: Narwhal Capital Management is a registered investment advisor and our Form ADV Part 2 is available upon request. Although we are investment advisors, our publications are not to be construed as investment advice. We certify that the opinions and predictions set forth in this publication are, for better or worse, our professional beliefs at the time of publication. We are not under duress or pressure from the corporate entities mentioned in this report. Further, this is not a solicitation to take action; rather it is a summarization of our professional beliefs.

The security presented may be examples of securities held in Narwhal portfolios and may not be representative of the current or future investments of Narwhal portfolios. You should not assume that investments in the security mentioned was or will be profitable. We will furnish upon your request, a list of all securities purchased, sold or held in the portfolios referred to in this newsletter during the 12 months preceding the date of this newsletter.

Please note that Narwhal or related persons buy or sell for itself securities that it also recommends to clients. Past performance is no guarantee of future results.

Disclosure: I am/we are long NXRT.

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.