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NorthStar Realty Finance Corporation (NYSE:NRF)

Q3 2012 Earnings Call

November 02, 2012, 02:00 pm ET

Executives

Al Tylis - Co-President, COO & Secretary

David Hamamoto - Chairman & CEO

Debra Hess - CFO

Analysts

Stephen Laws - Deutsche Bank

Joshua Barber - Stifel Nicolaus

Gabe Poggi - FBR Capital Markets

Chris York - JMP Securities

Operator

Good day ladies and gentlemen, thank you for standing-by. Welcome to the NorthStar Realty Finance Third Quarter 2012 Conference Call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be opened for questions. (Operator Instructions) This conference is being recorded today, Friday, November 2, 2012.

I would now like to turn the conference over to Al Tylis, Co-President and Chief Operating Officer for NorthStar Realty Finance. Please go ahead sir.

Al Tylis

Thank you very much. Welcome to NorthStar’s third quarter 2012 conference call. Before the call begins, I would like to remind everyone that certain statements made in the course of this call are not based on historical information and may constitute forward-looking statements. These statements are based on management’s current expectations and beliefs, and are subject to a number of trends and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements.

I refer you to the company’s filings made with the SEC for more detailed discussion of the risks and factors that could cause actual results to differ materially from those expressed or implied in any forward-looking statements made today. The company undertakes no duty to update any forward-looking statements that may be made in the course of this call.

Additionally, certain non-GAAP financial measures will be discussed on this conference call. Our presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. Reconciliations of these non-GAAP financial measures to the most comparable measures prepared in accordance with Generally Accepted Accounting Principles can be accessed through our filings with the SEC at www.sec.gov.

With that, I am now going to turn the call over to our Chairman and Chief Executive Officer, David Hamamoto. David?

David Hamamoto

Thanks Al and thanks everyone for joining us. In addition to Al, I am joined today by Dan Gilbert, our Co-President and CIO; Debra Hess, our CFO and Ron Lieberman, our General Counsel. During the third quarter of 2012, the US economy remained on its slow path to recovery dampened by the continued European sovereign debt crisis and looming uncertainty about US fiscal policy and the pending elections. However, commercial real estate fundamentals further improved during the quarter and investor interest in this sector remained strong.

Following the QE3 announcement, we saw a rally in the capital market and an increase in demand for CMBS which drove spreads considerably tighter during the quarter. During the third quarter of 2012, there was a total of $11 billion of non-agency CMBS issuance bringing total year-to-date issuance to $31 billion and full year expected target issuances have increased from $30 billion to a range of $40 billion to $45 billion.

Leveraging the improving conditions in the CMBS markets, we were extremely pleased to recently announce the pricing of our first securitization since 2007 of our originated loans. As we stated in the past, one of our primary objectives this year was to access the securitization market. This transaction is the first fully tranche transaction post the recession backed by newly originated non-conduit collateral and is a testament to the sophistication and strength of our commercial real estate debt origination platform and our solid operating and credit track record.

This transaction further allows us to effectively generate attractive returns for our shareholders well in excess of our cost to capital while decreasing our already minimal reliance on recourse debt. We are confident that this is just the beginning stages of the return to CMBS securitizations by commercial real estate finance REIT with strong and sophisticated commercial real estate debt origination platform and we look forward to further accessing this market as it continues to expand and improve.

In addition, during the third quarter, we continued to focus on expanding our franchise, making accretive investments and building long-term shareholder value. We announced the fifth consecutive increase to our common dividend, representing a 70% increase in cash distribution to our shareholder during this period. Looking ahead, our cash flows continue to be strong and we will continue to evaluate our dividend on a quarterly basis.

Turning to our asset management business, we continue to make significant progress in building out our non-traded REIT business. Our capital raising pace for a sponsored non-traded commercial real estate REIT, NorthStar Income remained strong and we continue to be a top 10 sponsor for capital raising in this sector.

Additionally, we're excited that the registration statement for our healthcare focused vehicle, NorthStar Healthcare Income was declared effective during the third quarter of 2012. As we mentioned on prior conference calls, this non-traded public REIT will be focused on debt and equity investments in the mid-acuity senior housing space, consistent with NorthStar’s $562 million of owned healthcare assets. Over the coming months, we look forward to executing selling agreements with broker dealers especially those financial advisors that have participated strongly in NorthStar Income and beginning to raise capital for this vehicle.

Overall, we have made significant progress towards reaching our long-term business objective and with the first step of returning to low cost non-recourse match funded asset level financing accomplished and coupled with our strong balance sheet and broad commercial real estate platform, we believe NorthStar is very well positioned to increase long-term shareholder value.

I will turn the call back over to Al who will discuss our business strategy and objectives. Al?

Al Tylis

Thanks David. Since the beginning of 2012 NorthStar has invested approximately $342 million of equity and $646 million of gross investments including $196 million of investments in the second quarter. Consistent with our investment strategy, these transactions include loan originations, repurchases of our CDO bonds as well as opportunistic real estate related investments.

Our investments year-to-date are projected to generate a weighted average return on equity of greater than 18%. On the loan origination front, we have been actively originating close on $535 million of loan investments year-to-date, including $308 million for NorthStar Income and we continue to have a very attractive and strong origination pipeline.

As David mentioned, our recently priced CMBS securitization was a significant accomplishment. Our strategy of utilizing match funded non-recourse financing for our CRE debt and CMBS investment has served us and shareholders well during the last several years and we will continue to focus on this attractive financing source.

The securitization will be collateralized with $351 million of aggregate principal amount of loans that originated at NorthStar and on behalf of NorthStar Income. A total of $228 million of investment grade bonds will be issued representing an advance rate of approximately 65% and the bonds will have a weighted average coupon of LIBOR plus 1.63%. NorthStar expects to generate a yield of approximately 20% on its investment equity in the securitization inclusive of all fees and estimated transaction expenses.

The addition of locking in an attractive yield on our invested equity this securitization allow us to recycle our current credit facilities for new line of originations. Our owned CDO bonds continue to be a compelling investment opportunity. As the CMBS market continues to rally, we have seen a significant product depreciation in our CDO bonds. Recently we sold the CDO bond that we had purchased at a significant discount upon the secondary market which we had anticipated holding maturity with an underwriting yield in excess of 20%.

We sold that bond and an IRR of 32% and that a yield to the buyer that we believe is in the mid-single digits. Overall our strategy for these bonds has not changed. We still expect to hold the majority of our repurchase CDO bonds and realized the potential $460 million embedded discount overtime.

However, we will continue to be opportunistic and consider selling certain bond as an alternative source of capital and we believe the time is appropriate to monetize our discount and redeploy the capital into the new and more accretive investments. We continue to see other commercial real estate related opportunities, and we can use our broad and de-commercial real estate investment experience to generate attractive risk adjusted returns.

Year-to-date we have invested equity of $89 million in these types of opportunistic investments, with an expected weighted average return on equity of 16% exclusive of potential upside in (inaudible). We will continue with our strategy of allocating capital to the investments we fell will result in the best long term risk adjustments returns for our shareholders.

In addition, to investing on our balance sheet, we continue to diversify our sources of cash flows by expanding our asset management business. Our non-traded REIT business continues to make significant progress and we have seen a significant increase in capital raising. During the third quarter of 2012 we raised a $127 million from NorthStar income compared to $92 million during the second quarter representing an increase of 38%.

NorthStar income raised $51 million in October bringing us to $504 million of capital raised in total. Although capital raising may have some monthly volatility, we are confident that overall capital raising should continue to increase as we continue to become a more prominent sponsor in this space. NorthStar income currently has 17 CRE loans and three CMBS investments with an aggregate principle balance to $405 million. We are confident that this business will result in a significant long term fee scheme for NorthStar that will be highly valued by the public market.

I would like to now turn the call over to Debra, who will review our financial results for the third quarter. Debra?

Debra Hess

Thanks Al. Good afternoon everyone. I would like to take a few minutes to discuss our GAAP and AFFO results for the quarter and our investment portfolio. As you saw in today's press release we reported a GAAP loss of $150 million or $1.11 per diluted shares for the third quarter of 2012. The largest contributor of our GAAP loss is the non-cash fair value adjustment. We mark our real estate securities portfolio or NorthStar in our cap source CDO bonds and our trust preferred debt to fair value for the income statement.

This represented a $184 million or $1.31 per diluted shares of the GAAP loss, which was primarily related to an increase in the value of our CDO bonds. As we have stated in the past, many of these GAAP losses simply represent an economic validation that our CDO bonds that we have purchased at significant discount to par are approaching par. The third quarter 2012 AFFO totaled $40 million or $0.28 per diluted shares.

To summarize our investment portfolio as of September 30, we had $2.8 billion of commercial real estate debt investments that are primarily financed in 5 soon to be 6 securitization that are not collateralized with each other. As of September 30, we had three non-performing loans representing $25 million in aggregate principal amount and $4 million of carrying value. A majority of our debt investments are first mortgage loans that we directly originated and we've seen the credit trends in our underlying portfolio continue to improve steadily. Loan loss reserves totaled $159 million as of September 30 or approximately 7% of total loans relating to 15 loans with carrying value of $231 million.

As of September 30 we had a $2.7 billion portfolio of real estate securities that are primarily CMBS. Our securities portfolio is primarily finance with fixed securitization and on the credit facility that we entered into in the fourth quarter of 2011. Our $1 billion commercial real estate portfolio continues to perform well. The portfolio is comprised of $405 million core commercial real estate property portfolio of suburban office, retail and industrial properties and a $562 million portfolio of healthcare properties which are predominantly private pay.

At September 30, our coordinate lease portfolio was 96% leased with an approximate 5.9 year weighted average lease term. And our net lease healthcare portfolio was 100% leased to third party operators with a weighted average lease coverage of 1.3 times and an approximate 7.2 year weighted average lease term. To summarize, we continue to generate strong stable cash flows from our investments with potential for upside and as a result we are able to increase our dividend for the fifth consecutive quarter. This concludes our prepared remarks for today. Now let's open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from the line of Stephen Laws with Deutsche Bank. please go ahead.

Stephen Laws - Deutsche Bank

Congratulations on the transaction. Can you talk about how the market conditions are at? Maybe your outlook on any more deals in the next three, six, 12 months and then given that ability to finance [someone] the changed the origination pipeline and how those loans are evaluated, can you give us an update on how you are looking at the business line today?

David Hamamoto

Yes, Steven, we feel obviously great about getting the first transaction done and I think it's a real milestone in terms of working through at the rating agencies and selling the bonds and I think we feel that it’s the early stages of beginning to do a lot of match funded, non-recourse financing in our core business. So we feel very good about it. I think obviously it sort of validates the business model and we would expect to continue to do a lot of these going forward. Overtime, we think that while the execution was very good on this transaction, we would expect overtime that spreads should continue to come in.

Stephen Laws - Deutsche Bank

Can you talk about given the activity there, maybe your capacity to fund the growth there or maybe an expectation of faster growth and then if you said you do decide to raise additional capital, maybe what you think is available and how you look at your total capital base across common equity preferred converts and other options you may have.

David Hamamoto

Yeah I think just generally given the growth that we’ve had in terms of capital raising and now the confidence that we have a securitization market match fund our assets we believe that we can increase the size and scale of loans that we are participating and so I think directionally you will see us gravitate to slightly higher average loan balance.

Stephen Laws - Deutsche Bank

One last question with the healthcare focus on REIT launching; do you expect that to cannibalize the current fund at all or is it going to be more incremental growth as you are targeting different investor type. Can you may be give a little color on how the two funds they differ as regards to raising capital?

David Hamamoto

It’s clearly a different focus so I don’t think we expect it to cannibalize at all. And in fact in terms of the efficiency and the profitability of our broker dealers, the fact that they have two products to sell now should make us that much more efficient and I think the overall volume of capital that we will be raising on a monthly basis should increase now that we have a second fund.

Operator

Thank you. Our next question is from the line of Joshua Barber with Stifel Nicolaus. Please go ahead.

Joshua Barber - Stifel Nicolaus

Debra I am wondering if you could tell me, do you have the ability on the FAS 157 and 59 to now not mark the assets and liabilities in your new securitization?

Debra Hess

Yes, it’s an instrument by interim basis so we will not mark the new securitization under phase 1, 59. Unfortunately, we can reverse what’s already been done on the other. Yes, on a go forward basis, we can allot.

Joshua Barber - Stifel Nicolaus

Okay, but you will be marking the asset on that because they are CMBS [help] to market?

Debra Hess

There are not CMBS. What we have is, we’ll continue other loans in our balance sheet, we are going to show financing, we are just going to replace our credit facility with some form of securitized note and the loans will not be marked and neither will be securitized note.

Joshua Barber - Stifel Nicolaus

Okay, that's makes sense, I am sorry. You guys mentioned that you sold one of the CMBS, excuse me. The repurchase CDO bonds in the quarter, I guess I am assuming that was one of the AAA bonds that you had just looking at the quarter-over-quarter movement. Can you tell us, I may have missed this, what the gain was and if that's included in the $0.28 of AFFO?

Debra Hess

No, it’s actually not included in the $0.28 of AFFO. Yeah, it’s just been reissued.

Joshua Barber - Stifel Nicolaus

How do you guys think about those gains from either the repayments on the AAAs or in terms of the ability to sell that, as it relates to your dividend paying ability? Do you think there you can, do you expect to be distributing some of those gains through income or would you prefer to and have the ability to retain that capital and then redeployed?

Al Tylis

I think, part of the long-term value proposition is the fund realized discount that we have in our CDO bonds. So I think certainly a portion of that whether it comes through just natural repayments or something like this CDO bond where it rallied so much where you sell it at a 5% or 6% yield then you can reinvest it accretively. We would expect to monetize that investment but certainly a portion of the proceeds we receive in either of those consensus we would consider distributing as part of our dividend.

Joshua Barber - Stifel Nicolaus

Okay. When you guys are warehousing loans today, both at the non-traded REIT level and at your balance sheet level for additional securitizations, is that just being held on your longer-term credit lines or would you anticipate putting some sort of repurchase agreement into place, there is something that has a more mark-to-market just shorter-term facilities for warehousing those assets?

Al Tylis

Now, I mean as you know Josh, we are sort of the shorter-term mark-to-market recourse facility is not something we've ever done and the intent is not to do it. So our facilities are good in that they are not mark-to-market and they are, they have a good (inaudible) and we would anticipate to the extent where retaining loans to ultimately securitize would be on facilities of that nature and quite honestly I think the facilities we have today, a good job of that I think with the securitization we would expect that other lenders would be more interested in providing capital with the thought of securitization exit.

Joshua Barber - Stifel Nicolaus

Okay. Last question just slightly different tack, looking at your core net lease portfolio here only about a six year weighted average lease term, can you talk about what your lease maturity schedule looks like for 2013 and I guess how would you expect the rents on a lot of those portfolios to trend?

David Hamamoto

Sorry Josh, we are just pulling the information. In our core net lease portfolio, we actually don't have any leases that mature till ’16 and I think its asset-by-asset in terms of where rents are compared to market but we feel like if we try average it out its probably right around market across the portfolio. I'm sure there are some that are higher and some at a lower. We feel like in place rents are pretty close to where market is today.

Operator

Our next question is from the line of Gabe Poggi with FBR Capital Markets. Please go ahead.

Gabe Poggi - FBR Capital Markets

A few quick questions, Al you may have said this earlier, if you did I apologize, was there any reason to split the equity of the junior piece of the CMBS deal between NorthStar and the private REIT, could NorthStar have taken down the whole chunk if they wanted?

Al Tylis

The reason is due to the joint securitization was just for efficiency purposes. You are paying, whether you do, we could have done two separate securitizations then you would be paying the rating agencies twice and you would have a lot of duplicative costs. So the idea was to do a joint securitization and you had some meaningful economic efficiencies for both vehicles.

Gabe Poggi - FBR Capital Markets

Do you guys have put, invested $646 million of assets kind of year-to-date that you guys have invested in, how much of that if any from the beginning of the year just to help me remind me would, is still in any of the CDOs, was put to work in the CDOs before the window is closed?

Al Tylis

That's all assets that were invested outside of the CDOs and directly on the balance sheet.

Gabe Poggi - FBR Capital Markets

Got you so that 342 of invested equity is outside of any “CDO” equity?

Al Tylis

Right.

Gabe Poggi - FBR Capital Markets

Okay. And then lastly this is kind of a different change of topic but just looking through the old transactions, NorthStar nine continues to perform quite well, it’s a big one, just any comments you have around that in that it is a securities CDO as compared to one of the loan CDOs, any comments there regarding the securities, how that's obviously held up really well but kind of how you guys are reviewing that vehicle going forward would be helpful?

Al Tylis

I think it has certainly held up well. The cash flow has been steady. In fact, I think over the course of this year, increased given our expectation, it's hard to talk on a long-term basis but certainly our expectation is with the markets improving that we would continue to hold up and ultimately there is increased value in that securitization over time.

Operator

Thank you. (Operator Instructions) Our next question is from the line of Chris York with JMP Securities. Please go ahead.

Chris York - JMP Securities

Most of my questions have been asked but I did want to follow-up on the healthcare REIT, the non-traded healthcare REIT, and how are you thinking about incremental cash flows in Q4. I know that you got it toward $30 million in cash flow yearly on that but when should we think about ramp on that instruments?

Al Tylis

As you know, these non-listed REIT vehicles, it takes a little bit of time in terms of still getting selling agreements signed and then ultimately, riding the tickets. So I think in terms of any potential additional income for Q4, I think if any as modest, I think it's really more of a vehicle we would expect to have some meaningful growth in 2013.

Chris York - JMP Securities

And then the net fees, should that roughly equal to about 3 percentage points as well?

Al Tylis

Similar, yeah, similar to the existing number.

Operator

Thank you. And ladies and gentlemen that does conclude the question-and-answer session as well as our conference call for today. If you would like to listen to our replay of today’s conference please dial 1-303-590-3030 or 1-800-406-7325 with the access code of 4570570. ACT would like to thank you for your participation. You may now disconnect.

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