NexPoint Residential: Excessive Fees And High Leverage Muddy The Story
Summary
- NXRT has grown cash flows at a double-digit clip yet trades at a discount to peers based on FFO.
- NXRT is externally managed and pays sizable fees to its managers.
- NXRT maintains a leverage profile with twice as much debt as peers.
- I am neutral on NXRT as the valuation is not materially cheaper than peers when adjusted for debt.
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NexPoint Residential (NYSE:NXRT) is an apartment REIT that appears to trade at a discount to peers. While NXRT has shown strong FFO and dividend growth in recent years, investors may be overlooking the large debt load and the bloated expenses as compared to peers. Adjusted for debt, NXRT doesn’t trade at such an exaggerated discount, and thus shares do not seem to be pricing in the potential conflict of interest from external management. I hesitate to turn bearish on shares due to the resilience of apartment real estate, but readers are best advised to avoid shares.
Relative Discount In Attractive Space?
NXRT owns 39 apartment properties spread across 7 states:
NXRT has been able to steadily increase its average rent per unit to a modest $1,100 per month:
NXRT’s investment strategy is to focus on more affordable housing. We can see below that NXRT’s average rent per unit ranks among the lowest among peers, while its properties also rank among the highest in discounts to cost to own:
(2020 March Presentation)
NXRT believes that this gives it the best of both worlds: affordable housing as well as compelling motivation to rent versus own.
NXRT has no near-term debt maturities:
(2020 March Presentation)
In 2019, NXRT grew FFO by 19% to $1.93 per share and raised its dividend 11% to $1.138 per share, as SS NOI grew 6.7%. Most peers struggle to manage even 5-7% FFO growth, thus NXRT’s aggressive growth rate is well noted. Strangely enough, NXRT seems to trade at a discount to peers using traditional metrics. This isn’t so obvious when looking at dividend yield, but even here we can see below that NXRT’s dividend yield is slightly higher than peers:
(Chart by Best of Breed)
The apparent discount appears more obvious when looking at its FFO multiple:
(Chart by Best of Breed)
What are we missing? Why does NXRT trade cheaper than peers in spite of astronomically larger growth?
Fees, Fees, And More Fees
The first reason may be the high fee structure. NXRT is externally managed which means that it pays additional fees on top of the typical fees that you’d expect. This also creates the potential for conflict of interest.
NXRT’s FFO margin as a percentage of total revenues was a low 26.3% in 2019, which pales to the 48.5% seen at top tier peer Equity Residential (EQR). I break down some of the key expense items below:
(Chart by Best of Breed, data from 2019 10-K for NXRT 2019 10-K and EQR 2019 10-K)
As we can see above, Property & Maintenance as a percentage of revenues is 700 basis points higher than EQR. Corporate and Property G&A is 350 basis points higher than EQR. But that’s only the common expenses that you’d expect from an apartment REIT, and perhaps you could write off the operational efficiency difference to EQR’s best-of-breed management team.
The additional fees that NXRT pays to its external managers total an additional 7.1% of revenues. I now explain how those fees work.
The Advisory & Administrative fee is equal to $5.4 million, plus 1% of average assets. The property management fee is equal to 3% of monthly gross income. Both these fees imply that the external manager is heavily incentivized to grow at any cost, since fees incurred grows as assets grow. I note that the external manager could get more fees even if NXRT acquires assets in a manner which isn’t accretive to the bottom line. This helps to explain their high debt load, which I look at next.
There are other fees, also. In addition to the 3% of monthly gross income, NXRT also pays construction supervision fees, design fees, and acquisition fees - these aren’t included in the above calculation because they are capitalized on the balance sheet. These would add an additional 1.65% in expenses:
(2019 10-K)
NXRT is paying a lot of fees to its advisors, and that’s on top of it not being nearly as efficient as EQR.
Don’t Forget About The Debt
The issue with valuing NXRT using FFO is that it is ignoring leverage. Clearly, 15 times FFO for a company with low leverage is much more attractive than 15 times FFO for a company with high leverage.
With net debt standing at $1.36 billion in 2019, debt to NOI stood at 11.1 times, more than double the leverage profile of EQR. As explained above, I’m not surprised by the high leverage profile as NXRT’s external managers are incentivized to grow assets in order to grow their fees. The vast majority of the debt is secured to mortgages, with $216 million coming from their unsecured credit facility. That’s a positive as NXRT wouldn’t be at immediate danger of violating debt covenants. In a perfect environment, the high debt load may not matter and it might even improve shareholder returns. However, the high debt load means that if NXRT experiences financial difficulties, then it may be difficult to gain liquidity through issuing unsecured debt, as the credit markets are unlikely to lend to such a highly leveraged firm at a low-interest rate. I don’t think that apartment REITs will see significant volatility to revenues in 2020, though.
When adjusted for debt, we can see that NXRT doesn’t seem so cheap. NXRT trades at around a 5.9% cap rate, which isn’t too far from the 5.5% cap rate seen at EQR. Funny how much a difference debt can make?
Share Repurchase Program
Surprisingly, NXRT has been buying back stock. Since March 11, 2020, NXRT has repurchased 468,767 shares for $33.87 each. NXRT discloses that this is at a 27% discount to NAV of $46.31. Typically, share repurchase programs are bullish signals. In the case of NXRT, I’m not so sure.
For starters, I am skeptical about whether buying back shares is the most attractive use of capital. While NXRT states that it bought back shares at a 27% discount to NAV, their computation of NAV seems to be based on generous assumptions. Based on NXRT’s guide for $124.9 million in 2020 NOI, their NAV uses a cap rate of 4.9%. Given that they were buying shares in mid-March, I have no doubt that there were countless other investment opportunities offering a higher return - the broader market had already started collapsing due to the coronavirus.
There may be an explanation for the share repurchases. NXRT’s external manager is affiliated with Highland Capital Management, which due to bankruptcy proceedings needed to sell its stake in NXRT to raise cash. We can see below that NXRT has been matching Highland Capital Management sales with its own purchases:
(2020 March Presentation)
My hunch is that the reason for the share repurchases was to ensure that Highland Capital Management could sell its shares without moving the market.
Conclusion
On the surface, NXRT appears to sell at a sizable discount to apartment REIT peers on the basis of FFO and its accelerated growth. However, such analysis does not factor in their elevated debt load, nor does it take into account NXRT’s sizable fees to its external manager. While I am not outright bearish due to the plausible resilience of apartment rents, I am hesitant to buy shares, at least not at these levels. If NXRT is able to continue increasing its dividend at double-digit yields, then perhaps it can outperform peers, but investors should be mindful of the risks.
(Tipranks: no rating NXRT)
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This article was written by
Julian Lin is a financial analyst. He finds undervalued companies with secular growth that appreciate over time. His approach is to look for companies with strong balance sheets and management teams in sectors with long growth runways.
Julian is the leader of the investing group Best Of Breed Growth Stocks where he only shares positions in stocks which have a large probability of delivering large alpha relative to the S&P 500. He also combines growth-oriented principles with strict valuation hurdles to add an additional layer to the conventional margin of safety. Features include: exclusive access to Julian's highest conviction picks, full stock research reports, real-time trade alerts, macro market analysis, individual industry reports, a filtered watchlist, and community chat with access to Julian 24/7. Learn more.Analyst’s Disclosure: I am/we are long EQR. 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.
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