NexPoint Residential Trust: Update, Substantial Discount to NAV

On February 22 at 5:30 pm, I'll be hosting the CFA Society Chicago's Special Situation Research Forum in the loop, the topic chosen was NexPoint Residential Trust (NXRT) which I've held since its spinoff from NexPoint Credit Strategies last April.  Some of this is a repeat from my previous post with some updated thoughts and numbers.  If you like/dislike this idea and want to join the discussion, or just enjoy talking stocks, please feel free to email me I'll add you to the attendee list.

NexPoint Residential Trust is a small orphaned Class B multi-family REIT that is externally managed by an affiliate of Highland Capital.  The REIT was started opportunistically in late 2013 inside of a Highland managed closed end fund, NexPoint Credit Strategies (NHF), as the management team saw an opportunity to buy neglected, under-invested suburban workforce apartment buildings, do some light renovations and re-lease rehabbed units at higher rates.  Highland spun-off the REIT last spring and it's since dropped ~20-30% which presumably takes raising equity off the table, and given its small market capitalization (~$235MM), once the initial rehabbing is completed management will likely look to sell the company as the private market is valuing multi-family units at a premium to the public markets.

Portfolio Overview

• NexPoint Residential owns 42 properties, consisting of 13,155 garden/suburban units spread primarily across the sunbelt (Dallas and Atlanta make up 50% of the market exposure).
• Average Monthly Rent: $796
• Occupancy: 93.1%
• 2015 NOI (run rate): $64.0-66.5 million - but ramping as they deploy excess cash to rehab
• All but one of the apartment complexes in a JV with their property manager, BH Management, where NexPoint owns 90% and BH owns 10%.  NexPoint maintains control and final say in any disposition scenario but also aligns the property manager as they're the boots on the ground in the turnaround process.
• The portfolio has significant debt (60-70% leverage ratio), more than other publicly traded peers, but still a reasonable amount and a structure most smaller/local real estate investors would employ.  Most of the debt is floating rate and on the property level, non-recourse to the parent, as management believes interest rates will stay lower for longer (appears the market agrees with them) and it allows for a simpler property-by-property sales as the mortgages can be assumed by the buyer.  The average interest rate as of 9/30 was 2.50%, most of these mortgages are pegged off of 1 month LIBOR which has gone up with the Fed Funds hike, so the current rate is likely somewhere between 2.50-2.75%.

Unlike Class A multi-family which has seen a building boom, especially in urban markets, Class B multi-family has seen little-to-no new construction in recent years.  It's just difficult to buy land and build apartments given current construction costs and make an acceptable return renting them out for $800 a month.  NexPoint Residential's properties are located in growing sunbelt markets that are seeing significant growth in population and jobs.  Lower energy and gas prices should act like a tax break for NexPoint's blue-collar commuter residents making them more attractive credits and able to endure rent increases.

A key part of NexPoint's strategy is to rehab communities by adding or improving lifestyle amenities (fitness centers, pools, clubhouses) and doing cosmetic upgrades to individual units (~$4k a piece) as they come off lease.  As of 9/30, they've rehabbed 13% of their units for $7.3 million resulting in an average rental increase of 11%, which has generated a 24.4% return on the rehab cost.  Since NexPoint is a small REIT, these incremental improvements can still move the needle fairly significantly and generate NOI growth versus new build development that exposes them to the market turning on them as they're leasing up (see HHC).

Funds From Operations

GAAP uses historical cost accounting convention for real estate assets and requires depreciation (except on land) which implies that real estate values diminish in a straight line over time.  We know that's typically the opposite, real estate values generally appreciate loosely following wage growth and inflation trends.  So the REIT industry created Funds From Operations (FFO) as a proxy for earnings that adds back depreciation expense and excludes gains from sales (since they'd be held at depreciated values) from net income.  Instead of P/E, P/FFO is commonly used in the REIT industry, but suffers from the same issues as different capital structures (like NXRT) can skew the ratio significantly one way or another.

NexPoint Residential looks really cheap on an FFO basis do their leveraged balance sheet.

* Acquired in 2015 (AEC was acquired at a 5.9% cap rate, HME at 5.6-6.2% cap rates)

If you normalize for the debt, NXRT is less of an outsider but still undervalued compared to other multi-family REITs and to where Home Properties and Associated Estates Realty Corp were bought out at in 2015.  But at under 7x forward FFO and a 7.40% dividend yield, I could see NexPoint generating some interest from retail investors looking for yield again now that rates don't appear to moving up soon.

NAV

To normalize for NexPoint Residential's capital structure, and to value the company based on a private market sale basis since any acquirer would have their own management team, capital structure, etc., an NAV calculation makes the most sense.

Below I'm assuming the company's new run rate net operating income including their November acquisition (333 unit - The Place at Vanderbilt) and historical rent increases will be just under $70 million.  Using a 6.5% cap rate, NexPoint's NAV would be approximately $18 per share, using the 6.1% cap rate that Milestone Apartments REIT recently paid for a similar Class B multi-family Landmark Apartment Trust portfolio would yield a $21 share price.  Given NexPoint's debt any small change either way in cap rates has a magnified impact on the resulting NAV.

To further that idea, I backed out what cap rate the market is currently valuing the company's assets at using the current share price and market capitalization.  Assuming my NOI projections are correct, the market is implying a 7.66% cap rate for NexPoint's assets, or a 20+% discount to what Milestone paid for Landmark in October.

Management

The market doesn't like external management structures, and for good reason, there's typically an agency problem as management's incentives are not aligned with their captive shareholders.  NexPoint's management contract is good, not great:

• Management Fee of 1.00% of Average Real Estate Assets, Administrative Fee of 0.20% of Average Real Estate Assets, and reimbursement of operating expenses but there's a total 1.50% cap on expenses paid to Highland.  The manager also has waived about $5.5 million in fees on the initial spinoff portfolio capping the fees at the same level they would have made if the spinoff didn't happen (not clear if this is a one time waiver or annual).
• Property Management Fee of 3% of monthly gross income to BH Management which works out to be another 0.50% on assets.

However, unlike many externally managed vehicles, Highland Capital and management itself purchased roughly 16% of the shares outstanding and their management contract doesn't have a termination fee.  Additionally, there are no dilutive incentive options or other forms of management compensation gravy trains that would dry up in the event of a sale.  On their conference calls management has been open about the idea of a sale if the valuation doesn't move up to peers to allow for a more sustainable, equity raise model of a typical REIT.  

Risks

• Highly leveraged (compared to peers) balance sheet with predominately floating rate debt - if short term interest rates were to rise quickly their interest expense would rise in kind.  Rising rates may at the same time lead to a fall in real estate prices which given the leverage would disproportionately impact the common stock.  Double whammy.
• External management structure - the market dislikes these to begin with and Highland Capital (via NexPoint, the adviser) recently made a play to manage the TICC Capital, a BDC that's seen activists swarming around for the management contract.  Is Highland interested in creating a platform of permanent capital vehicles?  Would they dilute shareholders and issue additional equity well below NAV to grow their management fee?
• Texas concentration - 35% of their units are located in Texas, primarily in the Dallas-Fort Worth area (2% in Houston).  Does the energy collapse hit the rest of the state and how hard?

NexPoint is too small to internalize management, the stock price is too low to issue equity, the balance sheet is too leverage for more debt, and management is incentived to sell.  I think a sale to a private equity firm or another apartment REIT is the likely end game.

Disclosure: I own shares of NXRT