There is a fair amount of market skepticism when it comes to mREITs. Many have paid dividends in excess of the sustainable magnitude, which temporarily props up the stock price and erodes book value, leading to the eventual crash. Northstar Realty Finance (NRF), however, offers a sustainable and growing 7.99% yield. In this article we will analyze Northstar's fundamentals and demonstrate its cash flows to be sufficient to sustain the dividend. We will then examine its recent and planned activity to show tremendous growth potential. The buy thesis will then be completed with valuation analysis and addressing the counterarguments.
In a previous article, in which we examined the dividend history of the legacy commercial mREITs, we revealed that NRF was the only one to pay a dividend through the entirety of the Great Recession.
While this history is a nice framework from which to make an argument, it is not self sufficient. Past performance has no bearing on the current viability of an investment. Instead, we must demonstrate sufficient CAD going forward to sustain and raise the dividend.
The income statement
NRF's first quarter revenue was $58.938mm from interest income and $60.888mm divided between rental revenues, commissions, and advisory fees. Taking out expenses this netted $23.739mm income from operations. One may note that this equates to only $0.126 per share, which is not enough to support the $0.19 distributions per quarter. However, income from operations does not tell the whole story.
Standard GAAP accounting shows net income attributable to NRF common shareholders of $36.622 or $0.20 per diluted share, which would be sufficient to cover this dividend. This also fails to represent their true income.
The GAAP accounting includes $13.585mm of unrealized gains, which does not influence cashflow and is arguably not a repeatable gain. For more accurate, repeatable earnings, we must exclude unrealized gains. Additionally, GAAP counted $15.074mm of depreciation as an expense. Many real estate properties, such as the healthcare and office properties making up a large portion of NRF's portfolio, do not lose value when properly maintained. Thus, this expense is accounting only and not reflective of repeatable earnings. Once we make these changes to more fully reflect repeatable earnings, NRF's quarterly earnings are $38.111mm or $0.2025 per share.
The repeatable earnings are sufficient to cover the dividend.
While sufficiently large repeatable earnings afford paying out dividends without a loss, there could still be issues when it comes to having the liquid resources for distribution. For this analysis, we must look at CAD. The graph below represents NRF's gross CAD projection and displays where it would come from.
After taking away scheduled cash expenses, it leaves $0.91-$0.99/share.
This would equate to a CAD payout ratio of 77%-83%. While NRF's internal management has been fairly honest with shareholders in the past, projections can be wrong. Let us dig deeper into certain aspects of its cash flows to verify the probability of this projection.
Real estate cash flows are quite easy to predict as it is mostly net profits from triple net leases. I find no fault with this number.
The cash flows from CDOs and other financial endeavors have set payout schedules and should also be accurate so long as nothing goes wrong. However, delinquency could substantially decrease the cash flow. While the economy is improving and delinquency risk has been reduced, it must be recognized as a potential source of missing on the estimate.
On the cash flow, there are numerous items pertaining to collection of management fees. Specifically, that from Northstar Income, Northstar Income II and Northstar Healthcare. These are non-traded REITs managed by the team internalized by NRF. Consequently, these fees contribute to cash flows available to NRF shareholders. Notice in the graph above how there is a deep blue and light blue portion on these bars. The deep blue represents the low end of the projection with the light blue showing the potential. I expect all 3 of these to fill the entirety of the maximum potential, and here is why.
The fees collected by NRF are directly related to the AUM of the non-traded REITs. 2013 has been a record setting year for fund raising and NRF's fundraising arm has been very successful. I believe the success of their fee collection revenues offsets some of the unaccounted for delinquency risk in the projection, making it overall an accurate figure. In addition to 2013 gains, NRF is continuing to open up new non-traded REITs so this revenue source may continue to grow.
Thus far, we have demonstrated NRF's dividend to be fully covered by both sustainable earnings and CAD. While a secure dividend is nice, NRF has increased it substantially each of the past 7 quarters and it would be of interest to shareholders to know if this pattern can continue. I believe that NRF is well positioned to continue raising its dividend and the substantiation of this claim will be shown in the next section.
NRF's Growth Prospects
Northstar has been busy this year with over $1.5B already invested at high rates of return.
Note that the expected current yield is not reflective of the cap rate, but rather the ROE. Thus, it includes the leveraged portion of the investment.
Such vast investment at such accretive rates is a rare find. The chart above referred to three types of transactions: Opportunistic, Real Estate Portfolio and CRE loans. Let us go over the specific transactions so as to verify the plausibility of actually achieving these returns and to measure the risk.
On February 15th, NRF along with one of its non-traded REITs, acquired partial LP interests in 45 real estate private equity funds for $400mm. $282mm of this price was contributed by NRF and the other $118mm by its non-traded REIT and the interest is split accordingly. The funds have an NAV of $789mm as reported on 6/30/12.
NRF earns 85% of the fund's distributions until it has received 1.5X its investment. Once NRF, together with its non-traded REIT receive $600mm the Class B partner from which NRF acquired its interest will begin getting 85% of the distributions until it recovers its initial cost. After that point, distributions are split between NRF and the Class B partner 51%/49% respectively.
This deal was opportunistic with a distressed seller, so NRF got the better end of the deal. It comes with a superb return as NRF is expected to glean over $50mm already in 2013. Further, the downside is minimized by NRF's preferred liquidation portion of $432mm of the fund's $789mm NAV.
CRE originated loan:
For $255mm, together with its non-traded REIT, NRF acquired a 35% ownership interest in Millford Plaza. This hotel has 1,331 rooms and is superbly located on Times Square. The other 65% of the hotel is owned by Rockpoint Group and Highgate Hotels, which operates the hotel.
NRF's portion of the $255mm is $166mm, with Northstar Income contributing the other $89mm. The investment has an initial return on equity of 12.5% annually but is subject to change with the hotel market. Both Smith Travel Research and PKF Hospitality suggest that RevPAR will continue to rise through 2014 and that minimal new supply will increase the profitability of hotels. I suspect that Millford Plaza will perform well as it has an irreplaceable location and sufficient size to host major conferences.
Real Estate Portfolio:
On April 8th, NRF closed on the acquisition of a manufactured housing portfolio consisting of 71 communities with 17,000 pad rental sites for $865mm, or an ROE around 14%. $640mm of this purchase price was funded with 10-year non-recourse mortgages at 4.02%.
Manufactured housing tends to be a reliable source of income and the fact that the mortgages are long term, fixed rate and non-recourse makes the overall transactions very low risk for such a high return.
Each of these transactions seems to have oversized reward relative to the risk and the chance of Northstar actually realizing its growth potential seems strong. Now that we have verified the sources of growth, let us take a look at its magnitude.
Scope of opportunity
A weighted average rate of return of 17% on $677mm of invested equity could generate around $115mm additional earnings annually. With today's share count of 198mm, that equates to over $0.58 per share. Given last year's CAD of $0.74, this represents potential year over year growth of over 78%. If NRF were to realize these extra earnings and keep the same payout ratio, it would cause a dividend raise of $0.46 annually to $1.22.
I believe that this illustrates the scope of opportunity. NRF could maintain its current trading multiple and appreciate 78% for total returns of around 88% over the next year (if the dividend increase happens linearly over the year).
Over the past 52 weeks, NRF has vastly outperformed the market.
However, it remains cheap relative to its Q1 annualized earnings with a price to earnings of 11.8. The value is even deeper when compared to projected 2013 CAD of $0.91-$0.99. Using the midpoint, this translates to a CAD multiple of only 10. If we take into consideration that its accretive acquisitions took place part way through the year, it is clear that pro-forma earnings are even stronger.
Why does NRF trade at a discount?
Well, I attribute the low trading multiple to the market's false association of NRF with other mREITs.
While NRF is classified as an mREIT, it is only about 1/3rd financial. The diversification provided by its asset management and real estate equity branches substantially reduces the risks typically associated with mREITs. The false association of NRF as an mREIT causes it to trade at mREIT multiples while it should trade somewhere between that of mREITs and equity REITs.
I believe that as it continues to grow its dividend, investors will become more trusting of its stability and its market price will rise accordingly. When this slight multiple appreciation is combined with the strong earnings growth potential, it could vastly outperform the market.
Counter-Arguments, Risks and Concerns
Many investors prefer to buy at or below book value. This principle tends to be more strongly enforced for mREITs than it is for equity REITs, so NRF's price to book of 1.8 can be quite a deterrent. I would like to address this concern by showing that NRF's stated book value is not reflective of its intrinsic value. Specifically, the carrying value of some of its securities is beneath the actual value.
In NRF's 10-Q it details their accounting procedures.
"The Company classifies its CRE securities investments as available for sale on the acquisition date, which are carried at fair value. The Company has generally elected to apply the fair value option of accounting for its CRE securities investments. For those CRE securities for which the fair value option of accounting was elected, any unrealized gains (losses) from any change in fair value is recorded in unrealized gains (losses) on investments."
NRF's CRE securities are carried at only $1.7B despite a principal value of $2.4B. The portion of this discount that is attributable to delinquencies SHOULD be accounted for when calculating intrinsic value, but the portion of the discount consequent to mark-to-market SHOULD NOT. We can therefore conclude that the actual value of NRF's securities portfolio is somewhere between $1.7B and $2.4B.
In addition to the CRE securities, NRF's CRE debt investments are carried below their true value.
Continued from the 10-Q
"CRE debt investments are generally intended to be held to maturity and, accordingly, are carried at cost, net of unamortized loan fees, discounts, premiums and unfunded commitments. CRE debt investments that are deemed to be impaired are carried at amortized cost less a loan loss reserve, if deemed appropriate, which approximates fair value."
While these only contribute $1.79B to the accounted book value, they will generate $2.3B principal return when held to maturity. Clearly, the true value of these investments is higher than that reflected in the book value.
While the price to book of NRF is 1.8, which is high, the price to intrinsic value is less severe.
An additional concern when investing in NRF is the fairly high leverage. While the reported debt to equity of 2.30 may not seem high, that is including a plethora of preferreds as equity. Given the senior position of preferreds over common in the capital stack, these should not be counted as equity from the shareholder's perspective. NRF's real debt to equity is quite a bit higher.
The bottom line
Northstar Realty Finance represents an excellent risk adjusted opportunity. The large yield is sustainable by both earnings and CAD. Expect continued dividend raises as the tremendous 2013 acquisition volume kicks in. Between multiple expansion as NRF's diversification is recognized and tremendous earnings growth, it could substantially outperform.
Disclosure: 2nd Market Capital and its affiliated accounts are long NRF. I am personally long NRF. This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer.
Disclosure: I am long NRF. 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.